If an investor’s utility function is expressed as U=E®−12Aσ2 and the measure for risk aversion has a value of −2, the risk-seeking investor is most likely to choose:
A.Investment 2.
B.Investment 3.
C.Investment 4.
C is correct. Investment 4 provides the highest utility value (0.2700) for a risk-seeking investor, who has a measure of risk aversion equal to −2.
Expected return does not mean that is the actual return, it is the weighted mean. Consider a guaranteed 10% investment (Er=10%) and an investment that has a 50% chance of returning 12% and a 50% chance of returning 6% (Er=9%). A risk seeking investor would take this option even though it is riskier and has a lower Er.
Some people just love to gamble, don’t you have a buddy like that who even though the odds may not make sense, they’ll take the bet because they just love to gamble and when they lose they say “Whatever it made the game more interesting to watch”. Thats how I look at risk seeking investors, they don’t care about the return, they just want the most excitement.
Risk-seeking investors are attracted by the promise of extraordinary returns, not just the fun or the gamble themselves.
If I give you two different opportunities:
100% safety of receiving US$ 250,000
20% safety of receiving US$ 1,000,000
Traditional Finance would say “get option 1” because its expected return is higher than the second option. Note that we are not even talking about risk yet.
In my personal opinion, I would get option 1 primarily because I’m risk averse. Getting 250K in the pocket for free is cool. I don’t care if “I’m losing” the other 750K.
However, in the mind of a risk-seeking investor, the promise of being able to get 4 times those 250K is an incredible opportunity. So this kind of investor takes the 2nd option. He does not care if he ends up losing the already safe 250K. He despises those 250K over the opportunity of being a millionareeee!!!
Real Life Risk-Seeking Investors’ Preferred Investments: