Investing in any market is all about risk. No investment is inherently 100 per cent safe or guaranteed. Therefore, the axiom "the greater the risk, the greater the reward" especially holds true in investments. However, not all people want to take great risks with their money. Thus, financial professionals break investors into categories based on the investor's appetite for risk: risk averse, risk neutral and risk seeking.
Classic Example to Determine Risk Preference
This example can clarify the terms of risk preference and demonstrate what type of person falls into each category.: A coin flipper propositions a man with two scenarios. These scenarios include Option 1, a guaranteed payout of some undisclosed, but negotiable amount; and Option 2, payout not guaranteed, but may result in £0 or £65. The man has the option to guess heads or tails, or to abstain from the toss and take the guaranteed payment. The expected payout in this scenario is £32 -- or £65-$0, divided by 2. Now we can determine the actions of each category of investor based on risk preference.
The Risk-Averse Investor
The risk-averse investor would generally choose the guaranteed payment. He believes that something is better than nothing and would rather "play it safe." If the payment was too small, even the risk-averse investor might decide to take his chances with the coin flip. The payout still needs to meet his demand for a return on investment -- in this case, only his time. Risk-averse investors tend to choose safer investments to place their assets. Some examples include certificates of deposits or CDs, savings accounts, U.S. Treasury bonds and whole-term life insurance.
The Risk-Neutral Investor
Because the expected payout is £32, the risk-neutral investor would choose the guaranteed payment if it's £32 or more. If the payment is less than £32, the risk-neutral investor would take his chances with the coin flip. He has no preference between taking his chances to win £65 or £0 and taking a guaranteed £32. To state this in another way, the risk-neutral investor selects the investment with the highest expected return. He does not take into account the risk of an investment in his decision making.
The Risk-Seeking Investor
The risk-seeking investor would take his chances with the coin flip unless he was offered a guaranteed payout of more than £32. The keener the investor is for risk, the higher the guaranteed payout would have to be for him to take it. Risk seekers invest in stocks with high beta -- a type of risk -- speculative investments, junk bonds and even gambling. They determine when the potential return is worth the risk of their capital investment.
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