Risk Aversion: Definition, Example and Implications

Risk aversion is a behavioral economics concept that describes a person’s hesitancy to take a risk with an uncertain outcome. If you’re financially risk-averse, you’ll choose the low-risk preservation of your existing liquid capital over the volatility of a high-risk investment, even if there’s the possibility of a high rate of return.

Let’s say you have a choice between two scenarios. In one, you’re offered $50 with no strings attached, a guaranteed, risk-free return. In the second scenario, you flip a coin. If it lands on heads, you get $100. If it lands on tails, you get nothing. The expected value (the probability multiplied by the value of each outcome) of the payoff is $50 since the 50 percent chance you’ll receive $100 (higher returns) is worth the price of losing the guaranteed $50.

The degree of risk aversion you experience depends on your risk attitude. Your measure of risk aversion falls into one of three mindsets:

• Risk-averse: If you’re risk-averse, not only will you choose the guaranteed payout, but you’re also more likely to accept less than the payout (for example, $40) to avoid the riskier option.
• Risk-neutral: If you’re risk-neutral, you’ll only focus on the rate of the potential payout without worrying about the level of risk. The term might sound a bit confusing since a gamble is naturally more risky than a guaranteed reward, but the primary meaning is that you have no loss aversion. You’re only interest is the possible gain.
• Risk-seeking: If you’re risk-seeking, not only are you more likely to flip the coin, but the only way you’d accept the low-risk guaranteed option is if it had a higher expected return than the gamble.

Economists define the amount you’d accept instead of the gamble as the certainty equivalent. The risk premium is the difference between the certainty equivalent and the expected value.

Your level of risk aversion can impact your investment decisions. Risk-averse investors:

1. 1. Choose lower-risk financial investments: If you’re a risk-averse investor, you’ll choose low-risk investments such as savings accounts, certificates of deposit (CDs), municipal and corporate bonds, and dividend growth stocks. These investments are almost guaranteed to retain the amount initially invested.
2. 2. Prefer liquidity: If you don’t like risk-taking, you’ll always want to access your money freely without trapping it in a volatile stock market.
3. 3. Prioritize less risk to their existing assets: If you’re risk-averse, you’d rather hang on to the money you have and are less likely to invest in a risky asset. Older investors and retirees often fall into this category.

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