14.2 Managing Risk

14.2 a. Risk Aversion

Risk averse is a description of an investor who, when faced with two investments with a similar expected return (but different risks), will prefer the one with the lower risk. ^[5]

Example: Investors looking for “safer” investments will generally stick to certificates of deposit (CDs), Treasury bills, and government bonds, which generally have lower returns. ^[5]

^{Risk Aversion [6]}

14.2 b. The Markets for Insurance

Adverse selection refers to a situation where sellers have information that buyers do not, or vice versa, about some aspect of product quality. In the case of insurance, adverse selection is the tendency of those in dangerous jobs or high-risk lifestyles to get life insurance. To fight adverse selection, insurance companies try to reduce exposure to large claims by limiting coverage or raising premiums. ^[7]

Example: A health insurance company charges higher premiums for customers who smoke. ^[7]

^{Adverse Selection [8]}

14.2 c. Diversification of Firm-Specific Risk

A risk control technique that spreads loss exposures over a myriad of projects, products, areas, or markets ^[9] specific risk, or diversifiable risk, is the risk of losing an investment due to company or industry-specific hazard. An investor uses diversification to manage risk by investing in a variety of assets ^[10].

Example: Investing in a combination of stocks, bonds, and treasury bills to reduce overall financial risk ^[9].

^{Diversification Risk [11]}

14.2 d. The Trade-off between Risk and Return

The risk-return tradeoff is the principle that potential return rises with an increase in risk. Low levels of uncertainty or risk are associated with low potential returns, whereas high levels of uncertainty or risk are associated with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor is willing to accept the possibility of losses ^[12].

Example: A penny stock position may be extremely high risk on a singular basis, but if it is the only position of its kind and represents a small percentage of the portfolio, the overall risk may be minimal ^[12].

^{Risk-Return Tradeoff [13]}