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How to measure Investment Risk Aversion

Authors:
  • Algorithm Invest

Abstract

Measuring investors risk aversion is an important step in the RiskM methodology to include capital management into automated software systems. This model was published here for the first time at 14.10.2018.
My answers for the question “How can be measured the risk aversion?”
by Cristian Păuna
cristian.pauna@ie.ase.ro
14.10.2018
In my opinion asking what is your risk aversion?” is completely similar with “how much
money do you agree to risk?” The question came to me from the activity of investment when it is
about to implement an automated trading software for a new beneficiary. Before to set up the risk
level and the exposed capital, you have to know the investors risk appetite. The simple question
“How much money do you want to risk?” gets usually complicated answers and never a direct
response with a simple amount of money.
I have found some articles in the scientific literature regarding this subject but each of them
are related with a particular domain. A part of these models are related with the notion of “utility”,
meaning that the amount of money risked by a person is in direct correlation with the utility of the
product or service achieved. In my opinion a direct correlation function between the risk aversion
and the utility is not the case just because the utility is a relative notion when it is about people
from different financial or social status.
The real case is that the risk aversion is proportional with the income. To have this
conclusion I have asked 200 people from different social starts. An interesting part is that, even the
risk aversion is directly proportional with the income level more than 90% of the respondents
confirmed me that they have a maximum risk amount, at least for the first part of the investment,
until some profit will be recorder. Once a profit is achieved, a part of it can be also risked. 92% of
the respondents answered positively for this case.
For the investments activities, I have found that the risk aversion is also in direct correlation
with the profit expectation. Here the utility comes into action. An activity with a higher profit rate will
be preferred by the investors who will be more interested to risk higher amount of money, even a
higher profit involves a higher risk level. This fact is a reality and comes from the human nature
and become more obvious after first profits were achieved.
Therefore, in my opinion, the risk appetite of an investor (R) is given by the simple formula:
( )
PSIR +=
;min
and the risk aversion is of course
R
A1
=
where ρ is a percentage of the income I, S is the maximum amount which depends on the social
status or on the financial power of the investor and ξ is the reinvested percentage of the realized
profit.
In my opinion the function above is confirmed for any activity related with a financial risk.
The formula is also confirmed for any type of investor, individual or institutional, any kind of entity
that is subject or a risk. Using this structure for the risk aversion the discussion about the risk level
are more clear and any one can answer directly to define each term of the R function.
One more interesting think is that the risk aversion is fluctuating in time, in direct correlation
with the seasonality of the personal expenditure. Even for institutional investors a seasonality
factor is recorded, even some of the questioned persons are professionals. The fact is that lower
rates for the risk aversion is recorded near the winter holidays, higher values in summer. To avoid
this factor we have to think the risk appetite and the risk aversion for an entire period of time, an
year for example which is a realistic time measure for any investment activity.
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