I Want To Raise The Stakes

Yesterday, I spent about an hour talking to my bestie before she went to her MBA finance class. Though our conversation centered way more on boys than it did finance, there are some takeaways that apply to both topics. For example, if you put yourself out there, it may be risky, but the return could be more than worth it.

So let’s talk about that risk. Where does one’s appetite for risk fit into the financial equations we use for building the optimal portfolio? The way I learned it from Professor Bill Reese at Tulane University, risk appetite can be quantified using a variable “A”, which is formally called “the coefficient of risk aversion.” This coefficient fits perfectly into the following “Utility Function”, which measures the desirability of a particular investment based on its expected return, risk and of course, an individual’s risk appetite:

  U = E(r) – ½ A σ2  

U, the utility score for an investment, quantifies the desirability of that investment to a given investor based on their A value, the investment’s E(r) or expected return, and the investment’s level of risk, represented by sigma. 

For investors who prefer less risky investments, their A quotient multiplied by the investment’s standard deviation will detract from any profit they expect to receive.  But some people actually prefer a risky investment just for the exhilaration that being adventurous can bring.  The breakdown is as follows: 

If an investor’s A > 0, they are risk-averse, meaning that any risk from an investment will detract from the investment’s utility score. 

If an investor’s A = 0, they are risk-neutral, meaning that they are impervious to any investment’s risk; the only factor affecting an investment’s utility score is that investment’s expected return. 

If an investors A < 0, they are risk-loving and any risk associated with an investment will in fact add to that investment’s expected return in determining its desirability. 

But how exactly do we determine the value of A for ourselves or for others? Doing so involves presenting investors with a series of questions that compiled, can average into a value.  I will save that topic for another blog, but if you’re interested in exploring in advance, you know where to find me.  In the meantime, I have a few last thoughts to impart: 

My professors in school would often say that being risk-loving is equivalent to being a sociopath, or getting exhilarated at the thought of one’s house burning down.  I very much disagree.  Risk, just like fear, is an inherent part of our psyches.  How else can we explain today’s obsession with True Crime, roller coasters, or my personal favorite from my bucket-list: bungee jumping? 

Sometimes the risk of an investment is in fact a draw without even thinking about what additional gain we could achieve.  Because taking risks teaches us, not only about our limits or lack there-of, but what is possible that we never had the courage to imagine.  I may be saying this as someone with an A way below zero, but I do believe that a love for risk, even if it’s not every day, is a universal trait we all share.