I know that risk neutral is indifferent to risk, so the only thing that matters to him is return. He will maximize his return. being indiffeent to risk. His risk averse coefficient is zero. His indifference curve is straight. Risk lover on the oyher hand likes both high risk and high return. His risk averse coeff is negative. The indifference curve is downward sloping
These above two might be helpful theoritically. But what is the difference? Say, there are following investment opportunities:
Investment Expected return Std deviation
1 12 30
2 15 35
3 21 40
4 24 45
Both the types pick 4. Suppose of there is one more with E® = 24, and risk = 50, what will the risk lover pick? Obviously not this because nobody is mad enough to pick more risk?? So, risk neutral and risk lover choose 4. I think it always will be this only. Risk neutral and risk lover investors would always choose the same investment. Beg to differ? Explain.
Risk neutral only cares about return, regardless of risk. Risk lover only cares about risk, regardless of return. You are making the assumption that the risk lover is trying to take the most risk that provides the most return, which is what a rational investor does. A risk lover, as define in the curriculum, is one that irrationally chooses based on risk only, without concern for the amount of return.
The example in the CFAI material is a gambler. If you look at the odds, no one in their right mind would risk money for the expected return on any games in a casino. Risk takers don’t care.
The above example is not a good one in that it’s a coincidence that selection four is chosen by both. It’s chosen by risk neutral because of the higher return. It’s chosen by risk lover because if offers the higher risk. If option 1 had the highest risk, risk lovers would choose that one, even though it has lowest return.
I could not understand your point. You say that even if option 1 had the highest risk say 50% std deduction, risk lover would go for it be the return remain at the same initial lower level? So in a way you say that option 1 with return 12 and std dev 50, is better than option 4 with return 30 and std dev 45? because he loves risk??
Siidheart, while you said you could not understand lawnm0wer’s point, you actully understand his point correctly. That’s exactly correct interpretation that CFAI and finance theory dictate.
I think definition of the “risk lover” in finance theory if compares to the real life “risk lover” is a bit simplistic, but in essence it is correct.Think about a lottery player that play it everyday. The winning amount could be huge, in millions, while paying a small amount for the lottery ticket, thus the standard deviation is huge. But if you calculated expected return based on the probability of winning, the E® is less than the lottery ticket cost. But does any of the addicted gambler care? I don’t think so. The higher the winning prize, the more excited they are about it.
Your initial understanding of a risk lover was close to the definition of being risk averse. Risk aversion is not avoiding risk at all cost possible, but getting appropriate reward for bearing risk, therefore could be low return - low risk or high return - high risk. Determination is the slope (return/sd). On exam if they give you the table above, the one with highest expected return - risk neutral would choose, the one with highest risk - risk lover would choose, the one with highest slope (return divided by risk) - risk averse would choose.
Correct. I’m not saying it makes sense, because to a rational investor (like you or me), would not choose that investment because of poor risk-reward trade off. However, a risk taker, a gambler, wants to take the most risk, regardless of return.
Thanks to both of you for the clarification. I too love risk.