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.
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.
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.
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.
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