CHAPTER 6 Risk Aversion and Capital Allocation to Ricky Ase HEGRIN Risk and Risk Aversion In Chupa 5 we intoducd the concepts of the holding pei eur (HPR) andthe excess rum over the rskee rte, We alto discstedeximation ofthe rik premlam (he ‘expected excess return and the standad devito ofthe rate of retar, which we tea ‘be measure of porto risk. We demonsted these concepts with a seanio anaiss of a tpeciic risky portfolio (Spreadsheet 5.1). To enpasiethat bearing risk ypc most be accompanied by award inthe form of risk premium, we fst distinguish baween ‘pecsltion and gambling, Risk, Speculation, and Gambling ‘One definition of speculation is “ine assumption of considerable investment isk to bin ‘commensurate gain” Although ths defisiton is Fie linguini i is weles witht fest specifying whats meant by "considerable risk” apd “commensurate gain” By “considerable isk” we mean tha he risk i sfiient to afet the dein. A ind idl might eet an laestment that has a posive isk premium because the potent ‘sin is insufficient o makeup forthe ree involved, By “commensurate ain” we me 4 Positive risk premium, thal xan expected profit gretr tan terse altematve “To gamble "to bet or wager on an uncertain outcome” If yeu compare thi efinion 10 at of speculation yoo wl see that the central ference isthe lnk of "commeasi- ‘ate gaia” Economically speaking. a gamble the assumption of sk for no purpose bat joyment ofthe risk sel whereas specasion i underttken inspite ofthe rk volved tease one perceives favorable ile radeoffT tn 4 gamble ino speculative prospec eres an adequate risk premium to compensate ris-averse investors fr the Fiske they bear Hence, risk aversion and speclation are not incotistent. Notice that 8 sky investment with ask premium of 2, sometimes called fale game, mounts 0 & {ramble A riskeaverse investor wil eet it Tn some cases a gamble may appear to the participants as speculation. Suppose two loves disagree sharply about the future exchange rte ofthe US. dollar against the Bish pound. They may choose to bet onthe outcome. Seppose tht Pal wil pay Mary $100 the value of £1 exceds $1.60 one yea rom aow, whereas Mary wll py Pals {he pod i worth les than $1.6. There ae ony two relevant oatcomes: (1) the pond wil exceed $1.60, or) it wl fal below $1.60. IFboth Paul and Mary agice 0 he prob ‘Shlies ofthe two porsble outcomes, nd if neither party antpses os, mt be at they asign p= Stocach outcome. In that cate th expected polit to oth is eo and each has entered one side of gambling prospect ‘Whats more likely, however, tat the bet ult fom differences in the probabilities ‘hat Pal and Mary assign tthe outcome. Mary asigns itp > 5, whereas Pals asses. iment sp <5, They perceive subjectively, two different ponpecteBennomts call hit ase of diferng beliefs "heteroencous expectations” In sch cases investor on eat side ‘of nancial poston see themstves as speculating rather than gambling Both Poland Macy shoul be aking. Why isthe oter wil wo investi the sie of ashy prospect hat belies offers a negative expected prof The ideal wat resolve heterogenents tli i or Pal std Mary o “merge thi informaton” thts, foreach uty to ven that or se posresees all eleva information and process the informs ‘on propery. OF course, the acquisition of lformatcn andthe extensive communication that is required to elimina all heterogeneity in expectations is cosy, and this upto & point heterogeneous expectations eannot be taken sation I, however, Pal and Mary ‘ner such conactefequendy. they woul recognize the information problem in one of 181PART Il Poole Theory and Practice ‘wo ways Ether they wil eatze dat they are creating gambles wheo each wis ba of Sine consistent loser wil ada hat be or she hasbeen beting ote ass of Inferioe recass. ‘Asume thet della denominated Til fn the United States and pound:denominated At egdom oer equal yields to matury Both ae short-term ass, and boty ion arcane c. Nestne ofers investors ark premium, However US. invest a ee subject to exchange rate risk because the pounds earned on the U.K Tro il bg eachanged fr datas atthe future exchange rte the US. Ivestor engaging in speculation or gambling? Risk Aversion and Utility Values The bidery of es of eta on various act classes potent In Chapter Sat wel a aa abn emprical stds leave no Jot that risky asets command as pe Tuer the mareplce This implies hat most investor ar isk avr aoe po te sk averse reject iavertment prtfoloth are fas games ct wore Pies [menos are wing to consider oly Fk-re o speculative Frospsts with haveik premiums, Loosely speaking, erisk-vere investor “penalizes” the expect aon ror any pono by a cerain ecelage(r penalizes the expt profit ra tsar mnt econ or he ik aoe Te eae the i he ae he Laos night wonder why we asue ik vena fundamental We els hat ranean ald accep. ths view from spl inrospetin, bt we discus the aes ‘Son me uly Append A of tis chat. ne nrte be ames we confront when choosing among portfolios with vaying egos of in, conser a pei xample. Suppose the ire rei SH and tat sre otic oe atereatvenakyporoios with Hk premiums, expected rts sar and deviations a given in Table 61. Te isk premiums and dears fk (an aa SD) of he porolios in the table ze chosen o represent the proper of ta ons (L,Hghsk bonds (A), ad large stocks (2. AcorSngy these poetos re a ety higher ask preiums fo compentt forget Hk How might ‘vests chose arong them? Tear ep tae wai unk each proto as more atractve when ts exerted turn ey er wens is igh But when sk increases along wih eu, te ‘slab eve portfolios wo vios, How can investor gan te rte at which they ne weling to ade off return against i? ee ae ha ach iment can assign & welfare, ce wy, Score to competing smesioutgonolionn the bas of te expected return and isk of those portolios. Higher ae Perc auigned to portobios with more tractive iak-retum pois, Pontos rae epg lity sores for biherexpetd returns and lower scores for higher vole Te ee sonar "searing ese ar leiumal. One resonable fenton at Bs ‘able 6.1 bie ey Pentas natsree [Tow ak 2 o beri) Miners) © Hoh & Rak remiom Expected Return Rsk)CHAPTER 6 Risk Aversion and Capa Allocation to Risky Aes ‘nen employe by both financial thors and the CFA Insite assigns a portfolio with pected return) and variance of turns othe following wy sore: U= Bw) ~ Maat on ere U is the wility vale and Ais am index ofthe investor’ rk aversion. The fcr of ‘ais usa sealing convention. To we Bgtion 6.1, rates of eur must be expressed as decimals rater than perceatages ‘Bgaton 6:1 i consistent wih the notion tht wily is enhanced by high expected ‘eur and diminished by high isk. Noe tat see portion receive awit sore qual to thee (oa) rat fret, becase they eceive no peal for risk. The extent {Bich the variance of sky portfolios lowers lity depends on A th iavest's Spee of ik aversion. More rskaverse invests (who have the larger valoes of A) penalize Fak iovesments more severly. Investors chosing emong competing imesineat porter las wl select he one providing the highest wit level. The nearby bor dscusses some techniques tat nancial adviser seo sang the ik version of heir cients. Example 6.1 Evaluating Investments by Using Utility Scores Consider tee investors with diferent degrees of risk averion: y= 2, Aa = 3.5, and ‘As 5, al of whom ae evaluating the thee pordlios a Table 61. Besa the is iee Ine is assumed tobe 5%, Equation pis that ll re ivesore would stign vty sere of 05 to the rst alert, Table 62 presents the wtlty score hat woud be signed by cach investor w each poo, The portfolio with the bigest uty sore for ‘ach avestr appears ino. Netie tat he igh ik porto, H, wouabe chose aly by tte imvestor withthe lowest degre of rk atesion, y ~ 2, wh he low ik pool, sald be passed over even by the mast averse of ur thc investors, All hee portfolios bat the ifs alternative forthe investors wi levels of rik aversion given inthe ble We can interpret the uty score of risky portfolios as certainty equivalent rate of rau. The cent equivalent mt ete rate tat rife favements would teed to ‘fer to provide the sre ult sore a the risky portfolio In other words it ste rae tha if eared with certainty, wold provide a uly score equivalent to tat of the pot {obo in question. The cea equivalent rate of retum is «naira way to compar he iy values of competing probs. [Now we can sy tata portfolio is desimble only if is cenaity equivalent rem cxceds that ofthe ris-rce aematv. A sliciently iske-avese investor ray asin any sky portfolio, ven one with postive ik premium, acerany equivalent eof en 163 Investor Risk Utility core of PortfolloL__UMity Score of Portola M _Uility score of Portoio H Beesionta) (ee) = ahs = 03) (eo) om =) i) = te a 20 = HxRx Oa O55 GO = mw axa OOO 4B—Wxdx Po oo 35 OMe 35x05 ~ 0686 OH asK a OMS 13_—¥x 35K 2 O8 50 7-H xSxO5= OO wa SK P= OH 1s_mxSx Fe os ‘Table 62 my ily scores of aerate ports orien wth vying degree ik aversionPART Il Poot Theoy and Practice thats blow hk ie rte, which wll ese the investor to reject the risky portfolio. At the ame time, ess isk-veae investor may assign the same prio aceraaty eave Meats that eceots the nak fee ate and thus wil prefer the portfolio tothe isk fee ‘Mummatve. Ire nik premium is eo cr native to begin with, ay downward adjustment to uly only sakes the pontoio ook worse Ts craintyeqivalet rate wil be below That of he iste erative forall risk-averse investor. ‘portfolio hasan expected rate of return of 20% and standard deviation of 30%. Tis Are ie rate of return of 79, Would an investor with rik-aversion parameter A = 4 re: fer to investin Tso the sky portfolior What f= 2? a contrat 0 rskavers investor, risk-neutral ivestors (with A = 0) ge risky prope soley by thelr expected rates of return, The evel of rik silent othe k= veal veto, meaning hat ther #00 pealy fo sk Fr this avestora pc's Crainty equieent ee smply ts expected rat of ren "Rok lover (ioe whom AO) x bppy to engage in fi aes a gambles his mes toc adj cxpeted return spward vo ake int acount the fun” of confronting the vicars sk Ris over il vay ke afi ame beaut thei upward adjustment ery forse ges the fi game certainty equivalent that exceeds the alternative of the rise aves. ‘We cus dpc the individual's tradeoff between ss and ret by pong the char tert of posal investent portfolios ht he iniviual would view as equally ae Heer abn with ates measuring the expected value and standard deviation of pontoio eum, Fague61 plo the characteristics of one portfolio dented ntl f which has expected ret EU) td standard deviation opis prefered ty rakes nveners to any porn in quadrant TV because it as an expert eur a ls ewer han any portolio in that guaretand sandal devon elt ‘eels tan ay porfolo i that quadrant. Conversely, any portion quant I+ [Greterred econ! Figure 6.1. The vade-off between rak and return ofa potential investment porttio,CHAPTER 6 Rik Averon and Capital Alcan to Ricky Ase ecferbe to portlioP because its expected ru i equal or prester than P's and its for deviton i equal tor smaller han P's Ths is he mea standard deviation, o equivalent, mean-variance (M-Y) criterion. Incanbe sated follows: porfolo A dominates if Be) = Bin) tetat least one inequity i ict (rls out the quai) Tate expected retam-standard deviation plane in Figure 6.1, the prefered directions ortwes, because in tis diction we smitaneouly increase the expected run and eres te varince of the tof eur. This meas that ary portfolio tht ies northwest Ps superior What ante sd stout poo in quadrants I and I? Their desi, compared “i dopends on the exact eof the investor’ ik aersion. Suppose an ivestr en esl porto that are sully stracive a pata P String at a increase in a Sar devious be compensated fer by an nceae in expected eur, he pit Qin Figure 62 i eqaly deal to his investor a Plavestors wil be emul [ced o potolios with hia isk and high expected reams compared With eter por [i wt ower ik bt lower expe fein Thse equally preferedpatoics |g il inthe rean-sandard Seviion - - Foe on cave ale the Inference [are wtch const al porto points ihe sume tly abe Figure 6.2) “To deerme some of the point hat Fee ty valves of sever posibe [pets for bn ivesor with A= ited in Table 63. Not at cach Plo ofes sential! ui, beease Abe porlos with higher expected reun tBobavehigherisk standard deviation. mating Risk Aversion might we go about exinating the of rik aveson we might expect fp cere in race? A umber of stds may be wed. The question icine nay bo sof simplest Figure 62 The inatlerenc Grve tanned, can snus only s Retvera hgh geese) an} cdfom (moter) or Tow (conservative) ev eb of te octet of Fk aversion 4 Now lhe indiferenc curve of es ik Da complex questionars allowing {verse investor compare to the inditference bjs 1 pinpoint specie levels of ‘lve drown Figure 62? Fist seo ceticts, ask woul be Oram both nditference curves pesing Foes to choowe from var tof ‘hough point 2 patel ote.‘Time for Investing’s Four-Letter Word ten’ money pouty preventing You Yom meeting impute objectwes hee ening your kids to the clege Fe rig reer ees wen tne afeyoed se net drat hela oC eseay ete nou onoverexposthemiles {ones sobeforete mrke oe down ond sa coun, {sure that you understand your tolerance for and "Rsesing your ik tocar, however, can be ty ‘You mst crit not only how much ak you an aod ‘ecemilng how muh ik ou cen andyout ter eromeral tance foriaiemore dic Rt ey tequmriy “other, ary nancial adviser, bokerage fm and utc fand connie have crete kez Fatpoplecrerine tha thy secon, (Wake a ogresivenvertars Some fms tht fe ach once Mel eh Ronee Ae Ines Mew York aed Vanguard Group in Matern Pa "yan edema ay erat es jective restuee people can et get 2 as ough {Geno tar uk erences mposble for someone troy soy ent er yt take mere an te Sera pen” ‘able 63 — ne oe sould bee sop 9 ep to esi ik toe bic acount “resecon se, mary exper are 10 mks “inst people can and ose wha of otto avg op Ne Sahay 2 nan aon New Tork Zeta noon nk eck eae tiny cant este Sore ME Rape |WHAT'S YOUR RISK TOLERANCE? 1 ht ode ater you pt money to an iene ‘Seu to auming ore Renn Sr nd nt ble: oe [esimes fe 2%, bate put» porto bang Standard Deviation. Fi) aa? “Arcee ta investment accounts of active investors would provide cberaton of bo portoliocompsiion changes over tne. Coupling this infermation wih exists ofthe [Pefti mbinsook of ese postions would piacipe allow us to caleulle ine tor implied isk aversion coef. nul, rescrchers tack behavior of groups of indvidaals to obi average deeeee cof risk aversion, These sts range from observed purchase of insurance policies x ‘durables warranties wo lborsupply and agrepateconsemptica behavior.188 PART 11 Postel Tory an Pace SOLUTIONS TO CONCEPT CHECKS 1, Be men hing on exchange ne ik by vein in 2 pound enrinte e he ‘Se UK balaan i US Bl For exami fot te US, at UK. meas a 5% a ‘cure echasge ne $2 pe pod # 2 evesiea ty can ay 1 pound, lh abe ‘edn Eg ot ceria ao fru earod value of 03 pods be yerend ‘Achnge $210 jr pond he 1. pou canbe exchanged for 105 > $2.10» $205 fee rm ote ins of tb r= $20882 = 11025 oe r= 10299, move dh it ‘Pull om US, ble: Ter fhe ear exec ler exchange ae moves, ‘SEUK bila pecue vermont teria, RB For the A= veto ity oft ay poo s on @hx4%.3)= 02 le ew oie Ue - 06K 4x0)= 07 ‘The nestor il referable. Of suse, msne fils andthe porto ‘mate oven er hat noe hice bere) enor th A = Diet, ety of ek pri =20-(4x2% 9) 11 nie te ty iso pin £7. Th ee ick re neta rf iy nin Thee vee er as a sllwerniflrnce core. As ince oe Incense exper tno ear ay oe oil ee on Holding 0% of oui captain Ready Ass eat hat ores opr i the ly porta ded oe, 70% 0 50%. ‘out ay porbo i conse to vet 5% ia E nd 46% in BT te propria of Ein your ove rte 5% 54% = 27%, end tele vale of yous poston nF ‘tones 27 = $00,CHAPTER 6 Rsk vemion end Capa Allocation to Risky Ass andard dein plane proce tat ae cmmevce fom he By ca fs fd ih vaous progr) He om ae fms i ie me rec hy fed The bye of he CAL (apn! accan lie) same ever BE couaiy sans esa fr al of ese pordlio,Foealy, you met Oey a aoity fel wit ecg run Bl) sd ttt devton os Ne acter wast ise 7, ben the perl’ exe cum nd Tenia dviaton we re) = 14% 88-9) Dts rear voli no of porto is Bed _MBH = 0) _ Bed =n Sear »r o ics indpenent fie poprion» Te unig sn Domowng ns re cng 7 = 7% f = 9% The andar ein of Fes ct 2, a exposed a oft tif from 15% 0 17. ‘reso of te orp CAL B=", B= rte ding ne 24 exe vga ‘ein both case spe inten: 729 1022 fore edi age, rm 672210 fot booving Foon eye at 00 ip) = 1Ssop = 22 Aalovesor wi eae of ik erie ‘Pailcbrse «potion ine ky porto ot B= Win te sumed ames 08 wih A 3 wed at =x ous wiz he dee oi verion dees from te xg alu of 40 ew va of’, Pre oars Sin potas m4 0 55%, Accorigy, both text ‘Rua dd Gevinson ote opinal oro cea: By) = 91 + (55X08 = 114 efor: 1028) pon 58% 22 121 Geto: O12) ‘investors wow ere karen ich ha hy nol a he iy pron re Teo 1008 ot es = 1.0) ang er thn booming, 5 ar arty he borowing re The lent kav of ae ie al 100% i the st Cg) Weces we fore dere of a avers seo of” ear frome parton fe eestent oppor Be 08