Overview of Risk Aversion
We are all familiar with the website known as Craigslist. There, you simply type in what you are looking for and see if anyone has one for sale. This website also allows someone to sell items they may no longer want instead of throwing them away. In doing so, the seller has a chance to earn money for the items they no longer want.
So, let's imagine you have a couch you no longer need. Rather than throwing it into the dumpster, you decide to try and sell it on Craigslist. After a few weeks of no response, a gentleman offers you $20 less than your asking price. You then need to consider should you hold out for your asking price and risk not selling the couch at all, or should you take a loss and guarantee yourself some amount of money? What you have just been a part of is the concept of risk aversion.
Definition of Risk Aversion
So what exactly is risk aversion? Well, it's a concept where an individual is faced with uncertainty, and they must decide how they will react to that uncertainty. For example, when it comes to investments, an individual may prefer to go with the investment that has the lowest risks even though it may not bring in the most return. Those individuals that tend to turn away from the uncertainties and risks are known as risk averse individuals.
Risk Averse Behaviors
We now know what risk aversion is, but let's look a little deeper at an individual that falls under this category, otherwise known as an risk averse individual.
For starters, risk averse people, do not like risks. They do not like the uncertainties that surround the risk no matter how big the payoff could be.
Second, risk averse people are often investors looking to make the best investment. This often means a possible lower payoff with known risks in order to avoid higher or unknown risks.
Lastly, even though some investments result in higher payoffs, such as those in the stock market, a risk averse investor would rather get a definite return, such as investing in government bonds. The bottom line is: while the stock market could pay off in a big way, not knowing how things will turn out is too much of a risk for someone who is a risk averse investor.
Examples
Let's now use game shows as an example to explain the term risk aversion a little more.
Carol and her husband Bob won tickets to a game show that will be airing in their hometown. After watching numerous episodes of the popular show, both Carol and Bob understand that the concept of the show is to take risks in order to win more prizes.
At the beginning of the game, Carol is given $100. She must decide if she will walk away with the money or take a chance and see what is behind door number 1. Carol knows that $100 is more then she had when she went to the game and therefore a nice prize. However, she also knows that if she gives up her $100 for what is behind door number 1, she could win even more money, but she could also lose her $100 if the sign behind the door says 'you lose everything.'
Unlike her husband, Carol does not like risks. She is very frugal with her money, and $100 is a safe guarantee with low risks. However, Bob and the rest of the audience cheer her on, trying to convince her to take on the higher risk in order to get a higher return.
What will Carol do? If Carol is a risk averse person, she is likely to take the $100 even though there could be a lot more money behind the door. There is little risk involved in taking the $100. On the other hand, Bob, who is the exact opposite of Carol, may be more likely to take the higher risk and give up his $100 with the hopes that his risk-taking will pay off with a higher return. Bob is not a risk averse individual.
Lesson Summary
Risk aversion is a term used to describe a concept where an individual is faced with uncertainty and they must decide how they will react to that uncertainty. Those who do not like risks are known as a risk averse individual. Risk averse individuals will generally take the lower return because there is less risk involved, even though there is a chance to get a higher return, such as with investments in the stock market. Risk averse people do not want to gamble with the high risks and the uncertainty of the results and would rather go with more certain investments like government bonds.
