1.2 Are investors risk-averse?
We will define ‘risk premium’ as an extra reward required by investors to compensate for perceived uncertainty in the amount or timing of an expected return.
But do investors in fact require an extra premium for uncertainty, or is this perhaps just a convenient assumption?
The following activity is designed to give you an opportunity to test your own reactions.
Consider two alternative and mutually exclusive investments. Investment A is guaranteed to produce a constant annual real rate of return of x%. Investment B is guaranteed to produce an average annual real rate of return of x% over a period of many years, but the actual annual returns will be scattered widely around this average value. Which investment would you choose, and why? You may wish to use the Comments section below to ask other students whether they reach the same conclusion as you do – and for the same reasons.
You probably found that most people preferred Investment A, but what sort of reasons did you and they give? One answer is something like this. The benefit conferred by the unexpected extra income of, say, £a in a good year is somehow less than the corresponding pain inflicted by the unexpected shortfall of £a in a bad year. This could be because, as our income increases, we spend each marginal pound on less essential goods and services. On average, for every good year when Investment B produces a return of (x + a)%, there will be a correspondingly bad year when it produces a return of only (x – a)%. In the terminology of economics, the extra a% earned in the good year gives the investor less utility than is lost by the shortfall of a% in the bad year. So the total utility of the fluctuating returns on B will be less than the total utility of the constant return on A. Most investors will therefore prefer Investment A.
So much for the theoretical argument. Is it supported by empirical observation? The answer is a clear ‘yes’. The detailed mathematics of this risk/return trade-off is dealt with by more advanced topics such as the benefits of diversification and portfolio theory. What is important at this early stage of the debate is that you accept that there is a risk/return trade-off, and understand how risk is quantified. We can express this trade-off by saying that investors are risk-averse. By this we do not mean that they avoid risk at all costs, or that they routinely seek to insure away all risks. We mean rather that for a given level of return, investors prefer less risk to more risk, and that for a given level of risk, they prefer more return to less return.