Q- Two investors have utility functions that differ only with regard to the coefficient of risk aversion. Relative to the investor with a higher coefficient of risk aversion, the optimal portfolio for the investor with a lower coefficient of risk aversion will most likely have:
a lower level of risk and return.
a higher level of risk and return.
the same level of risk and return.
Solution
B is correct. A less risk-averse investor’s highest utility curve, given the lower coefficient of risk aversion, is likely to touch the capital allocation line at a point that would represent a portfolio with higher risk and more expected return.
A is incorrect because for a high coefficient of risk aversion, the investor will seek a lot of return for a bit of extra risk and will have an optimal portfolio that is tangential to the capital allocation line at a lower level of risk and return relative to the investor with a lower coefficient of risk aversion.
C is incorrect because only investors with identical coefficients of risk aversion would select the same optimal portfolio. Why so? I thought more risk averse the investor is, higher the return he expects… Then why a less risk-averse investor represent a portfolio with higher risk and more expected return? Please help me out
The most risk averse investor will stick all of their money in a risk-free investment: under their mattress. What return will they expect in that case?