risk+aversion

__**Risk Aversion**__

A person who is risk averse prefers a plan that will lead to a certain amount of money to an alternative plan that leads to an expected amount of money. The idea of deriving some excitement from taking a small risk doesn't appeal to someone who is risk averse. Someone who is risk averse prefers waiting for several seconds for a car to pass to hustling across an intersection to save time. Even when faced with a much smaller risk that colliding with a moving car, a person who has a truly risk averse nature will make the safe choice.

According to Samuel A. Baker at the University of South Carolina, a television game show is a great example that can help determine a person’s risk profile. For example, let’s say that a contestant on a game show wins $10,000 and is given the option of walking away with the money or playing again knowing there is a 50% chance of winning $10,000 more.

A person who chooses to walk away with the $10,000 is risk averse. This person is not willing to risk the money that has already been won in order to take a chance on winning more money.

__**References**__

Baye, Micheal R. __Managerial Economics and Business Strategy__. 2006, pp. 438 Samuel A. Baker, copyright 1999-2001 http://hspm.sph.sc.edu/COURSES/ECON/RiskA/RiskA.html

__**Sample Test Questions**__

Betty is risk averse and has $100 to invest. How will Betty invest her money?

a. Purchase one share of stock ABC for $100 b. Deposit the money in a money market account at a credit union c. Buy 100 lottery tickets d. Give the money to Fred, the head of a start up company that will manufacture running shoes.

Betty will deposit the $100 in the account with her credit union. She may possibly earn a lower rate of return with this option than with one of the other options, but she prefers the idea of knowing exactly what rate of return she will receive to the uncertain possibility of a higher return earned through one of the other investment options.

Two friends, Joe and Fred, walk into a casino, each with a $20 bill in their pocket. The $20 represents a small portion of their income and both Fred and Joe have accepted the fact that they might leave the casino with a complimentary soft drink but without the $20. If they go to the roulette table and Fred places all of his money on #19 and Joe places half of his money on Red, which description best describes Joe:

a. Risk lover b. Risk averse

Joe is risk averse. He isn’t willing to wager all of his money on a single turn. He prefers to start by wagering only half of his money and he chooses a bet that poses a lower risk than Fred’s bet. By putting his money on red, Joe has chosen an outcome that has a probability of nearly 50% given that there are 18 red numbers, 18 black numbers and only two green-colored zeroes on the board.

Tom is an employee at a firm that is located downtown where parking is scarce. He has been lucky enough to find street parking in a legal spot twice this week, but he is running late on Wednesday. Tom has heard from co-workers that the city is cracking down on illegal street parking lately. As he gets close to his office, what does Tom choose to do? a. Try to find legal street parking b. Park in the first spot on the street that he sees and take his chances with a parking ticket c. Drive an extra half block on find a spot in a parking garage

The correct answer is c. Tom is risk averse, so he will choose the safe option because he doesn't want to run the risk that he will get a parking ticket.