To take risks is to make decisions for which the favorability of outcomes is uncertain. Therefore, every individual and business entity is a risk taker at some level. However, the existence of risk takers who are prepared to put their capital and/or reputation at risk in the hope of a financial reward is a necessary precondition for a capitalist model of society. In the discipline of financial economics, risk takers are subcategorized into risk lover, risk neutral, and risk averse (Blake 2000). Traditional finance theory, applying assumptions of rational behavior, argues that the majority of people are risk averters, and hence “risk averse.” Given a choice of two investment opportunities with identical expected returns and uncertain but symmetrical probability distributions with different degrees of dispersion, i.e. risk, the less risky option is always selected by risk averters. Risk averters are said to have a declining marginal utility of wealth. A risk-neutral investor, in contrast, would be indifferent between the two options presented above, because the potential for a less favorable outcome than expected is exactly offset by the equal probability of a more favorable outcome. Finally, a risk lover would prefer the riskier choice because the utility conferred by a financial gain more than offsets the utility destroyed by a financial loss of equal magnitude. Under the above distribution assumption risk lovers, unlike risk averters, always have an increasing marginal utility of wealth (Tobin 1958).
According to traditional finance theory based on rational risk-averse behavior, a professional risk taker such as a firm manager or an entrepreneur differs from an individual investor or portfolio manager who is concerned with the preservation of wealth (capital) in real terms. Professional risk takers apply their knowledge and expertise to gain exposure to a specific category, or categories, of largely nonsystematic business risk in which they believe themselves to have a competitive advantage. Such risk averters resemble the “plungers” described by James Tobin (1958) who have indifference curves that, although always upward sloping, may be either linear or upwardly convex. In contrast, wealth-preserving investors seek to diversify away nonsystematic risk exposure to retain only systematic risk that can then be managed according to their risk preferences. They achieve this by allocating their capital between many specialist professional risk takers—that is, by investing the capital in many firms and risky assets—hence delegating their nonsystematic risk decisions to firm managers. Tobin (1958) describes the second category of risk averters as “diversifiers,” and explains how the existence of plungers and the shape of utility functions are dependent upon the restrictions applied to the assumed probability distribution.
Frank H. Knight (1921) refers to risk as the quantifiable component of uncertainty in economic decision-making. However, John Maynard Keynes (1936) refers to “animal spirits” when he questions the foundations of neoclassical economics on the grounds that the risk-return trade-off implied by rational models of decision-making are difficult to implement in practice because risk is largely unquantifiable beforehand; furthermore, he argues that it is not possible to distinguish quantifiable risk from unquantifiable risk when making long-term investment decisions. Milton Friedman and Leonard J. Savage (1948) examine the implications for investors’ utility functions of the apparently contradictory behavior of individuals who purchase insurance contracts, accepting a certain small loss in exchange for avoiding the low probability of a big loss (risk-avoiding behavior), while at the same time purchasing lottery tickets with a negative expected return in exchange for the very low probability of a big gain (risk-seeking behavior). Subsequent work in behavioral finance, such as that reviewed by David Hirshleifer (2001) and Meir Statman (1999), argues that rather than the cold calculating behavior implied by neoclassical economics and traditional finance theory, many risk takers exhibit an optimistic bias, referred to as “overconfidence,” that may lead to risk-seeking behavior when faced with certain losses. Eddie Dekel and Suzanne Scotchmer (1999) discuss evolutionary explanations for risk-seeking behavior, citing the arguments of psychologists and evolutionary biologists to the effect that optimistic risk-seeking behavior exhibited by some individuals has allowed humans, as a species, to survive environmental shocks in which the expected value, and outcome, for the risk-averse majority would have been negative, and fatal.
SEE ALSO Friedman, Milton; Risk; Risk Neutrality; Risk-Return Tradeoff; Tobin, James
Blake, David. 2000. Financial Market Analysis. Chichester, U.K.: Wiley.
Dekel, Eddie, and Suzanne Scotchmer. 1999. On the Evolution of Attitudes Towards Risk in Winner-Take-All Games. Journal of Economic Theory 87 (1): 125–143.
Friedman, Milton, and Leonard J. Savage. 1948. The Utility Analysis of Choices Involving Risk. Journal of Political Economy 56 (4): 279–304.
Hirshleifer, David. 2001. Investor Psychology and Asset Pricing. Journal of Finance 56 (4): 1533–1597.
Keynes, John Maynard. 1936. The General Theory of Employment, Interest, and Money. London: Macmillan.
Knight, Frank H.  1933. Risk, Uncertainty, and Profit. London: London School of Economics and Political Sciences.
Statman, Meir. 1999. Behavioural Finance: Past Battles and Future Engagements. Financial Analysts Journal 55 (6): 18–27.
Tobin, James. 1958. Liquidity Preference as Behaviour Towards Risk. Review of Economic Studies 25 (2): 65–86.
Isaac T. Tabner