Risk Aversion
Risk aversion is an investor's general desire to avoid participation in "risky" behavior or, in this case, risky investments. Investors typically wish to maximize their return with the least amount of risk possible. When faced with two investment opportunities with similar returns, good investor will always choose the investment with the least risk as there is no benefit to choosing a higher level of risk unless there is also an increased level of return.

Insurance is a great example of investors' risk aversion. Given the potential for a car accident, an investor would rather pay for insurance and minimize the risk of a huge outlay in the event of an accident.

Markowitz Portfolio Theory
Harry Markowitz developed the portfolio model. This model includes not only expected return, but also includes the level of risk for a particular return. Markowitz assumed the following about an individual's investment behavior:

  • Given the same level of expected return, an investor will choose the investment with the lowest amount of risk.
  • Investors measure risk in terms of an investment's variance or standard deviation.
  • For each investment, the investor can quantify the investment's expected return and the probability of those returns over a specified time horizon.
  • Investors seek to maximize their utility.
  • Investors make decision based on an investment's risk and return, therefore, an investor's utility curve is based on risk and return.


The Efficient Frontier
Markowitz' work on an individual's investment behavior is important not only when looking at individual investment, but also in the context of a portfolio. The risk of a portfolio takes into account each investment's risk and return as well as the investment's correlation with the other investments in the portfolio.

Look Out!
Risk of a portfolio is affected by the risk of each investment in the portfolio relative to its return, as well as each investment\'s correlation with the other investments in the portfolio.



A portfolio is considered efficient if it gives the investor a higher expected return with the same or lower level of risk as compared to another investment. The efficient frontieris simply a plot of those efficient portfolios, as illustrated below.

Figure 17.2: Efficient Frontier




While an efficient frontier illustrates each of the efficient portfolios relative to risk and return levels, each of the efficient portfolios may not be appropriate for every investor. Recall that when creating an investment policy, return and risk were the key objectives. An investor's risk profile is illustrated with indifference curves. The optimal portfolio, then, is the point on the efficient frontier that is tangential to the investor's highest indifference curve. See our article: A Guide to Portfolio Construction, for some essential steps when taking a systematic approach to constructing a portfolio.

Look Out!

The optimal portfolio for a risk-averse investor will not be as risky as the optimal portfolio of an investor who is willing to accept more risk.




Portfolio Calculations

Related Articles
  1. Managing Wealth

    Modern Portfolio Theory: Why It's Still Hip

    See why investors today still follow this old set of principles that reduce risk and increase returns through diversification.
  2. Investing

    Find The Highest Returns With The Sharpe Ratio

    Learn how to follow the efficient frontier to increase your chances of successful investing.
  3. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in Modern portfolio theory to quantify investment risk.
  4. Investing

    Explaining The Efficient Frontier

    Most investment choices involve a tradeoff between risk and reward. The "Efficient Frontier" is a modern portfolio theory tool that shows investors the best possible return they can expect from ...
  5. Financial Advisor

    The Workings Of Equity Portfolio Management

    Achieve analytical efficiency by applying your evaluation to a key set of stocks.
  6. Financial Advisor

    Risk Tolerance Only Tells Half The Story

    Just because you're willing to accept a risk, doesn't mean you always should.
  7. Managing Wealth

    Achieving Optimal Asset Allocation

    Minimizing risk while maximizing return with the right mix of securities is the key to achieving your optimal asset allocation.
  8. Investing

    How To Manage Portfolio Risk

    Follow these tips to successfully manage portfolio risk.
  9. Investing

    Understanding Risk Averse Investing

    Risk averse describes a low level of risk an investor is willing to accept on his investments. An investor who is risk averse prefers little risk and is willing to accept a lower return because ...
  10. Investing

    The History Of The Modern Portfolio

    Learn how the writings of John Burr Williams and Harry Markowitz led to the creation of the investment portfolio.
Frequently Asked Questions
  1. How do you calculate r-squared in Excel?

    Calculate R-squared in Microsoft Excel by creating two data ranges to correlate. Use the Correlation formula to correlate ...
  2. What is the Difference Between International Monetary Fund and the World Bank?

    Learn about the International Monetary Fund and the World Bank and how they are differentiated by their respective functions ...
  3. Where Did the Bull and Bear Market Get Their Names?

    The terms bull and bear are used to describe general actions and attitudes, or sentiment, either of an individual (bear and ...
  4. What's the difference between Google's GOOG and GOOGL stock tickers?

    Learn the difference between Google's GOOG and GOOGL ticker symbols. Splitting shares into classes prevents management from ...
Trading Center