![]() ![]() Risk aversion also means we prefer smooth consumption. Your utility function measures the satisfaction you get from different bundles of goods, services, or investments. Now, some people are more risk averse than others, depending on their utility function: #2) Utility Function In this case, the gain or loss of a bet is measured in terms of the initial wealth of the investor, instead of an absolute value. They have the same relative risk aversion. It’s safe to say everyone, no matter how rich or poor, will likely avoid this bet. Now, what if the bet is in proportion to your wealth? Say 50%. They don’t care as much so they would take the bet, because losing 10k is not as bad to them. However, will a person with a million dollars in their bank account avoid this bet? Probably not. A rational being would take this bet, yet, most people will avoid it. What is a fair bet? One whose expected value is zero.įor example, would you take a bet where you have a 50% chance of winning $10,000 and a 50% chance to lose $10,000? This is a fair bet. Investors’ risk aversion will affect the demand for financial assets, which in turn has an impact on the price of these assets.Ī risk averse investor will avoid a fair bet. Why? Because this allows us to compare if one investor is more risk averse than another, and to understand how an investor’s risk aversion affects his investment behavior ( how does he choose the assets that compose his portfolio). We want to measure an investor’s aversion to risk. They prefer lower returns with known risks over higher returns with unknown risks. Risk aversion is the tendency investors have to prefer certainty over uncertainty. Constant Relative Risk Aversion Utility Function Example #1) Risk Aversion ![]()
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