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Wednesday, 13 May 2015

INVESTMENT ANALYSIS – RISK LOVERS AND RISK AVERTERS




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ILLUSTRATION:
There are undoubtedly individuals who love or prefer risk and there are others who are indifferent to it. Both logic and scientific observation suggest that most investors and investment manages are predominantly risk averters.  What do you think is the most logically satisfying reason for this?

 SOLUTION:
A risk lover is one who prefers risk, giving chance between more or less risky investment with identical expected return will prefer the most risky investment to the less risky one.  Faced with the same choice, the risk avert will select the less risky investment.


The person who is indifferent will not care which investment he receives.  The theory that has come to be accepted as capable of explaining risk aversion is generally known as the UTILITY THEORY.  Most people appear to have dealing with marginal utility for money.   This directly affects their attitude towards risk.  This is so because, one gets pain from loss than the amount of pleasure derived from N1 gain.   Technically, diminishing marginal utility implies that utility increases as wealth increases and at a declining rate. If we have the notion of diminishing marginal utility of wealth, it follows that a person’s utility will decrease more with a loss of N1 in wealth than it would increase with a gain of N1.


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