In the realm of finance and economics, Risk Aversion is a concept that addresses how people will react to a situation with uncertain outcomes.
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Risk aversion can be applied to many different situations including investments, lotteries, and any other situations with uncertain outcomes.
It attempts to measure the tolerance for risk and uncertainty. Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with a more certain, but possibly lower, expected payoff. For example, a risk-averse investor might choose to put his or her money into a bank account with a low but guaranteed interest rate instead of investing in a stock that may have high expected returns, but also involves a chance of losing value. Risk aversion can be applied to many different situations, including investments, lotteries, and other situations with uncertain outcomes. Because organizations are composed of individuals, risk aversion at the individual level plays a role in organizational decision making.
People fall under different categories of risk aversion. If we look at an example where a person could receive 50 dollars without risk, or take a gamble where they receive 100 dollars or 0 dollars depending on the outcome of a coin flip, we can explain the differences. We see when we use the expected payoffs of each scenario we see that each has an expected payoff of 50 dollars. Situation one has a 100% chance of getting 50 dollars so it's expected payoff is (1)(50)=50. For the second situation, the expected payoff deals with a 50-50 chance of getting 100 or 0 dollars so, (.5)(100)+(.5)(0)=50. This is important to know for this example. A risk-averse, or risk avoiding person would take the guaranteed payment of 50, or even less than that (40 or 30) depending on how risk averse they are. A risk neutral person would be indifferent between taking the gamble or the guaranteed money. Finally a risk loving person would take the non-guaranteed chance of possibly winning 100 dollars, rather than settling for the guaranteed option. If the guaranteed option was greater than 50 dollars, then the risk lover might consider the possibility of taking it.
This can be extended to capital budgeting. A firm's management can adopt different stances based on how risk averse they feel they should be, given different market qualities and firm conditions. They will make capital investments that they feel will have the best payoffs, given the risks involved, and if they take a more risk averse stance they will make capital investment decisions that have a more guaranteed payoff. On the other hand, if they be more risk loving, they will be attracted to the more risky investments for capital that they believe have a chance for higher payoff.