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Concept
Risk aversion
Summary
In economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more certain outcome. Risk aversion explains the inclination to agree to a situation with a more predictable, but possibly lower payoff, rather than another situation with a highly unpredictable, but possibly higher payoff. For example, a risk-averse investor might choose to put their money into a bank account with a low but guaranteed interest rate, rather than into a stock that may have high expected returns, but also involves a chance of losing value.
A person is given the choice between two scenarios: one with a guaranteed payoff, and one with a risky payoff with same average value. In the former scenario, the person receives 100 or nothing. The expected payoff for both scenarios is 50 (for example, 50 payment.
risk loving (or risk seeking) – if they would accept the bet even when the guaranteed payment is more than 60).
The average payoff of the gamble, known as its expected value, is $50. The smallest dollar amount that an individual would be indifferent to spending on a gamble or guarantee is called the certainty equivalent, which is also used as a measure of risk aversion. An individual that is risk averse has a certainty equivalent that is smaller than the prediction of uncertain gains.
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Related concepts (29)
Expected utility hypothesis
The expected utility hypothesis is a popular concept in economics that serves as a reference guide for decision making when the payoff is uncertain. The theory describes which options rational individuals should choose in a situation with uncertainty, based on their risk aversion. The expected utility hypothesis states an agent chooses between risky prospects by comparing expected utility values (i.e. the weighted sum of adding the respective utility values of payoffs multiplied by their probabilities).
Risk
In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environment), often focusing on negative, undesirable consequences. Many different definitions have been proposed. The international standard definition of risk for common understanding in different applications is "effect of uncertainty on objectives".
Risk aversion
In economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more certain outcome. Risk aversion explains the inclination to agree to a situation with a more predictable, but possibly lower payoff, rather than another situation with a highly unpredictable, but possibly higher payoff.
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