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:
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.
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.
Portfolio Calculations
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 riskaverse investor will not be as risky as the optimal portfolio of an investor who is willing to accept more risk. 
Related Articles

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. 
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 ... 
Investing
The Workings of Equity Portfolio Management
Portfolio management is a necessity, not an afterthought, in achieving analytical efficiency. 
Personal Finance
What Does It Really Mean to Be Risk Averse?
We canâ€™t really get away from risk and there are many meanings for this thing we call risk. 
Investing
How To Manage Portfolio Risk
Follow these tips to successfully manage portfolio risk. 
Financial Advisor
Active Risk vs. Residual Risk: Differences and Examples
Active risk and residual risk are common risk measurements in portfolio management. Understand the differences between them and find example calculations. 
Investing
How to Construct a HighRisk Portfolio
A highrisk portfolio requires finesse and knowledge, but it can produce aboveaverage returns. 
Financial Advisor
Example of Applying Modern Portfolio Theory (MPS)
See how an investor can maximize expected return for a given level of risk by altering the proportions of the assets held. 
Retirement
How To Create a Retirement Portfolio Strategy
Properly planned retirement portfolio strategies are needed for maximum profit, in this article find out the rules of retirement income planning. 
Financial Advisor
Measure Your Portfolio's Performance
Measuring the success of your investment solely on the portfolio return may leave you blindsided to risk. Learn how to evaluate your investment return.