Risk Aversion and Asset Allocation

Question 1

What is Risk Aversion?

Answer 1

An investor’s unwillingness to make a risky investment unless investment generates additional return

Question 2

What is Risk premium?

Answer 2

added reward/incentive for taking risk

Question 3

What is Risk tolerance?

Answer 3

opposite of risk aversion

Question 4

Why Are Investors Risk-Averse?

Answer 4

• Risk aversion a result of diminishing marginal utility

- Diminishing marginal utility: decreased gain in utility for each additional dollar

Question 5

What is a Utility score?

Answer 5

• mechanism for ranking risky investments
• Trade-off between expected returns and standard deviations (i.e., risk)
• Score based on investor’s level of risk aversion

Question 6

What are the parts of the Utility formula?

Answer 6

A = risk aversion parameter (degree of risk aversion).
•All else being equal, the higher the A, the lower the U (utility).
•The higher the U, the more desirable the investment.
•The higher the E(r) (expected return), the higher the U.
•The higher the σ (standard deviation), the lower the U.
•The higher the A, the greater the investor’s desire to avoid high σ.

Question 7

What does it mean to be indifferent?

Answer 7

• Investor has no preference between investments.

- Indifference arises when utility scores are equal

Question 8

What is preference?

Answer 8

When an investor chooses one investment over another, based on utility score and risk aversion.

Question 9

What is dominance?

Answer 9

When all investors, regardless of risk aversion, would opt for a given investment.

Question 10

What is asset allocation?

Answer 10

• Refers to allocation of investment capital among various asset classes ◦E.g., cash, stocks, bonds, commodities, real estate
• Simplified model: risk-free investments and risky securities
• Overall investment risk derived from proportion of risk-free vs. risky holdings

Question 11

How do you assemble the Optimal

Investment Portfolio?

Answer 11

• Asset allocation:

- Creation of optimal risky portfolio

Question 12

What are the two broad asset classes?

Answer 12

Risk-free securities (f): e.g., bank account, Treasury bill, money market account

Risky assets (P): e.g., stocks, bonds, commodities, real estate, stock portfolio, bond portfolio, mutual fund, and so on

Question 13

What is a portfolio weight?

Answer 13

Share of capital invested in a given asset class.

Question 14

How do you choose the best combination?

Answer 14

• Best for investor: combination with highest U.
• Portfolio weight of P based on risk aversion (A).
• Must know E(r) and σ to calculate U.

Question 15

What is leverage?

Answer 15

borrowing money to invest.

Question 16

What are some active investing tactics?

Answer 16

market timing: Shifting money between risk-free assets and risky portfolio depending on market trends

security selection: Giving more weight to certain securities in risky portfolio in expectation that their returns will rise

Question 17

What are some passive investing strategies?

Answer 17

• Allocating capital between risk-free assets and risky portfolios based on investor’s risk-aversion level
• No market timing or security selection

Question 18

What does slope measure?

Answer 18

measure of risk premium per unit of risk.