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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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