Does anyone know how is the answer related to the question? I agree with the question, but I dont see how that is answering the question!
Thanks!
Are investors more risk averse when facing total risk or active risk? Explain why.
Investors are more risk averse when facing active risk. To obtain an active return—a return higher than a passive benchmark—the investor must accept active risk. To believe that an active return is possible, the investor must believe that there are active managers who can produce it and that the investor will be able to pick those successful managers. Second, an active equity style will also be judged against a passive benchmark. It is difficult to generate alpha and those who don’t face pressure from their superiors. Lastly, higher active returns mean that more is invested with the high return active manager, and this results in less diversification.
It’s correct. If you are responsible for a portfolio and you decide to use active management and it fails then you need to possibly take heat from your manager and explain why you didn’t choose passive. So naturally when picking an active manager you’re more hesitant and risk averse. Secondly, if you find and active manager who can generate alpha then they’re saying most would dump all their money into that one manager rather than diversifying across multiple.
A third reason could also be that if you believe that active management has value, then you have to be able to pick that person. So if you mess up, I imagine there is regret as wel, leading to more aversion.