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Hi, guys. I am confused about these two question. In first question, the answer said when risk aversion goes up, the return will be lower. However, in question 2, C is incorrect because increase in risk aversion it will have a high expected return. I am really confusing. It seems like both question are conflicted.
Risk aversion is the opposite of being risk seeking. A more risk averse investor is more likely to choose a more conservative portfolio of assets. Investor B is more risk averse, therefore he will likely have a lower risk tolerance and subsequently a lower expected return (answer B).
In the second question they are referring to an investor (call him 2) who is more risk averse than investor 1. If you put investor 2 in a portfolio designed for investor 1, he is going to have a lower utility because it doesnt fit his needs.
Expected utility = E(r portfolio) - .5*risk aversion*variance(portfolio). It’s a level 3 calculation and I’m not sure that it’s required at level 1, but the idea stands. The amount of utility (satifaction) that he gets out of putting him in a product that doesn’t fit his needs will be lower than if you put him in a product that he liked better. In either case, the expected return on the portfolio (answer C) will be unchanged because he is getting put into a riskier portfolio. Nonetheless, the satisfaction that he gets from it will be lower.
Hope it helps, good luck next saturday.
A more risk averse investor will have steep IC(indifference curve). does it mean a higher risk averse will high expected return? since along the indifference curve the expected retrun is increasing.
can you explain why expected return is unchanged in second question? still cant get it
If the portfolio is 60% stocks and 40% bonds with an expected return of 8% and a standard deviation of 6%.
It’s optimal for the first investor; he loves it. This is the optimal amount of risk he is willing to take and in return expects 8% return.
You use the same portfolio and put investor 2 in it. He is more risk averse, so maybe an optimal portfolio is 60% bonds and 40% stocks. Nonetheless, you put him in the portfolio (60 eqt 40 bonds). Is he now going to expect that that portfolio is now going to have an expected return of 6% and 4% standard deviation? No, he still expects the return and standard deviation to be 8% and 6% respectively. However, it doesn’t fit his needs, it’s too risky, he’s going to be sweating bullets checking his portfolio statements every day to see if the portfolio has lost value. He doesn’t expect that the portfolio is now going to have different measurements, he just doesn’t like it.
I found one of CAPM assumption in Kaplan." Risk aversion is to accept a greater degree of risk, investor require a higher expected return." therefore, whats wrong with question 1, I think answer C is a correct answer because investor B has a higher risk averse so he has a higher return
C is wrong.
Person b is more risk averse. He likes safety. His optimal portfolio is going to be less risky with less return than person a. All my reasoning is above.
Thank you very much, very good explanation, hope you can score best this Saturday as well.