4. Risk Aversion and Portfolio Selection
d. explain risk aversion and its implications for portfolio selection;
What is the difference between risk-neutral and risk seekers?
- Risk-neutral = Investors who do not demand a premium for risk
- Risk seekers = Investors that enjoy risk are said to be risk seekers (lottery tickets)
What is Utility Theory and how does it relate to risk?
Because risk can be quantified as the sum of the variance of the returns over time, it is possible to assign a utility score (aka utility value, utility function) to any portfolio by subtracting its variance from its expected return to yield a number that would be commensurate with an investor's tolerance for risk, or a measure of their satisfaction with the investment.
- $$Utility\ Score = Expected\ Return - 0.5 * \sigma^2 A$$
A = Risk aversion coefficient
What is an indifference curve?
An investor's indifference curves specify his or her preferences when making risk-return trade-offs. He or she will accept any portfolio with a utility score on his or her risk-indifference curve as being equally acceptable.
What is a portfolio's Sharpe measure or reward-to-variability ratio?
The slope of a portfolio's expected return (y-axis) and standard deviation (x-axis).