What is Risk Neutral
Risk neutral is a mindset where an investor is indifferent to risk when making an investment decision. The risk-neutral investor places himself in the middle of the risk spectrum, represented by risk-seeking investors at one end and risk-averse investors at the other. Risk-neutral measures have extensive application in the pricing of derivatives.
BREAKING DOWN Risk Neutral
Risk neutral is a term used to describe the mental framework of a person when deciding where to allocate money. Given two investment opportunities, for example, a risk-neutral investor only looks at the potential gains of each investment and ignores the potential downside risk.
A risk neutral investor, therefore, is only concerned about the expected return of his or her investment. A classic experiment to define a person's risk-taking appetites involves an investor faced with a choice between receiving either $100 with 100% certainty or $200 with 50% certainty. The risk-neutral investor has no preference either way, since the expected value of $100 is the same for both outcomes. In contrast, the risk-averse investor generally settles for the "sure thing" or 100% certain $100, while the risk-seeking investor opts for the 50% chance of getting $200.
Risk Neutral in Investing and Business
A risk-neutral is deciding between two investment, with one being a high-growth technology company that is not yet profitable but has seen large capital gains in the short term. The other company, similar to Disney, is a mature firm with stable earnings, profits, and dividends but does not provide the upside potential of the tech stock.
The investor conducts his own analysis and surmises the technology company has a 50% probability of doubling its share price and a 50% probability of declining sharply in value. The mature company has a 70% chance of remaining price-stable and distributing a quarterly dividend, and only a 30% chance of not paying a dividend in the upcoming year. Given the investor is risk neutral, the technology stock provides higher potential returns, and he chooses to invest in the growing company.
Additionally, a person can be risk neutral when starting a business. Since there are high amounts of business risk associated with launching a company, a risk-averse person chooses not to move forward with a business endeavor. A risk-neutral person looks pragmatically at the potential benefits of starting a company, and if the expected payoff is high enough, he chooses to start the business and ignores the multitude of risks.