Risk aversion

Risk aversion is a concept in psychology, economics and finance theory explaining the behaviour of consumers and investors under uncertainty. Risk aversion occurs when a person is willing to accept a lower expected payoff if it means they can have a more predictable outcome. For a more general discussion see the main article risk.

Example

A person is given the choice between a bet of either receiving $100 or nothing, both with a probability of 50%, or instead, a certain (100% probability) payment. Now she is risk averse if she would rather accept a payoff of $40 with probability 100% than the bet, risk neutral if she was indifferent between the bet and a certain $50 payment, risk-loving (risk-proclive) if it required that the payment be $60 to induce her to take the certain option over the bet (i.e. if the certain payment was $50, the risk loving individual would prefer the bet over the $50).

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(The average payoff of the bet, the expected value would be $50. The amount accepted is called the certainty equivalent, the difference between it and expected value the risk premium).

Related Topics:
Expected value - Certainty equivalent - Risk premium

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