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Risk aversion has been described as the expression of individual inclination for ‘certainty over uncertainty’ hence the need to reduce possible worst results susceptible to (Kolakowski, 2010). This are individuals who have a preference for low risk but safer guaranteed…
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Download file to see previous pages... The investor who prefers to bank his funds to generate a fixed ‘certain’ interest at the end of a term is the classic case of risk-averse individual while a casino gambler who bets against high ‘uncertain’ odds is at the other end of the spectrum (Pietersz, 2009).
In scenario whereby an individual investment is assured of a £500 return, in the uncertain situation, a bet is considered that with a toss of a penny, the individual can get £1,000 or naught, while in the certain situation the individual will definitely receive the £500. Although both situations have a guaranteed return of £500, the uncertain situation has a 50 percent chance of garnering £1,000 or nothing. Therefore, three possible scenarios emerge:
Risk aversion is therefore a characteristic case of martingale effect whereby the most likely scenario is the investor risk-taker only gaining the original amount (Yates, 2009). In modern portfolio theory, risk aversion is calculated as the added subsidiary return an investor needs to admit supplementary risk, which is calculated through the standard deviation of the ROI or the square root of its variance (Baker, 2001).
Modern portfolio theory established mean-variance efficient portfolios in a fixed time horizon that ignored future market movements hence not applicable to multi-period investment horizon. Sharpe (1964), Lintner (1965) and Mossin (1966) separately have been ascribed to establishing the Capital Asset Pricing Model (CAPM) model that was developed from Markowitzs (1959) exposition of the Modern Portfolio Theory (MPT) particularly the mean-variance model. The fundamental theory of the CAPM indicates that there is a linear link involving systematic risk, as measured by beta, and projected share returns (Brewton, 2009). The CAPM model endeavours to illustrate the linkage by applying beta to describe the differences involving the likely proceeds from shares and share portfolios (Laubscher, 2002, p. ...Download file to see next pagesRead More
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