Risk Aversion and Risk Premium 🧠💰
Why do some people prefer safe bank deposits while others invest in volatile cryptocurrencies? The answer lies in their Risk Preference. In finance, we usually assume that investors are "rational"—meaning they don't take risks unless they are paid for it. This payment is the Risk Premium.
1. Meaning of Risk Aversion
Risk Aversion is a psychological trait where an investor, when faced with two investments with the same expected return, will always choose the one with the lower risk.
Most individual investors and institutions are Risk Averse. They dislike uncertainty and require a "bribe" (in the form of higher return) to move away from safe assets.
2. Risk Preferences of Investors
Investors can be broadly classified into three categories based on their attitude toward risk:
Loading case study…
Summary of Attitudes:
3. The Concept of Risk Premium
The Risk Premium is the additional return an investor requires to hold a risky asset instead of a risk-free asset.
Risk Premium = Expected Return of Asset - Risk-Free Rate
The Risk-Return Spectrum:
- Government Bonds: 5% Return (Risk-Free).
- Corporate Stocks: 12% Expected Return.
- Equitry Risk Premium: 12% - 5% = 7%.
Fundamental Law of Finance: There is a direct relationship between risk and reward. As an investor accepts more risk, they demand a higher Risk Premium.
4. Why is Risk Premium Important?
- Asset Pricing: It determines the price of stocks and bonds in the market.
- Capital Allocation: It guides investors on where to put their money.
- Hurdle Rate: Companies use it to decide if a new project is worth the risk.
Summary
- Most investors are Risk Averse; they avoid risk if they can.
- Risk Premium is the "extra reward" for taking on uncertainty.
- The higher the risk, the higher the required risk premium.
- Understanding your own risk preference is the first step in building a personalized portfolio.
Quiz Time! 🎯
Loading quiz…