Risk preference is the attitude of taking financial risks by an investor. An individual investor, while making an investment decision, would take risks according to his or her risk preferences.
What is Risk Preference?
Risk Preference is one’s tendency to choose either a risky or less risky option. Usually, economists and finance professionals, and investors apply the concept of risk preference in economics, but the concept can be applied to any decision one makes that involves risk.
Depending upon the risk preference, the investor will classify the risks associated with an investment and thereby find the investments that match his/her preferences.
There are two major factors that affect the decisions of decision-makers. These are the expected values and the measures of standard deviation.
It is however impossible to realize whether investors will go for high expected values and high standard deviations or they will stick to low expected values and low standard deviations. That is where the concept of risk preference arises.
Types of Risk preference Investor
Depending on the expected values of return and standard deviations, the risk preferences of investors can be categorized into the following three types
- Risk-Averse Investors
- Risk-Neutral Investors
- Risk-Seeking Investors
Risk-averse investors prefer to take lesser risks. They attach lower utility to increasing wealth. In other words, risk-averse investors try to skip investments that have a higher potential to lose rather than profit from the investments.
An example of risk-averse investors is the case of retiring individuals for whom higher returns from an investment are less meaningful than a loss arising from the investments.
They would prefer to skip the potential rise in wealth and stick to minimal returns with their funds and therefore would seek less risk and returns in the process.
Risk-neutral investors attach the same utility to increase in wealth and decrease in wealth. It is of no consideration whether a potential investment would gain wealth and return high amounts of profits, or it would be loss-making in the long run. They are neutral to the potential increase or decrease of wealth.
Risk-neutral investors are the ones who want to invest their money depending on their ideas of gain or loss rather than analyzing or checking the risks associated with an investment.
Risk-seeking investors attach more utility to increasing wealth even if it means they would have to take more risk in the process.
In the process of investing, risk-seeking investors look for the potential gain of wealth from the investments.
Risk-seeking investors are the ones who get higher returns on their investments, although they may lose more money from an investment as well.
As an example, we could consider individuals who invest in property as a class of risk-seeking investors because property prices fluctuate more often than other forms of investment.