Josephine Norton
Risk-neutral investors are indifferent to risk when making investment decisions. They focus on the potential gain of the investment instead, overlooking the risk potential. For example, a risk-neutral investor would be indifferent between a 100% chance of receiving $1,000, versus a 50% chance of receiving $2,000 (and a 50% chance of receiving nothing). In portfolio choice, a risk-neutral investor would invest exclusively in the asset with the highest expected yield, ignoring its risk features relative to those of other assets.
| Characteristics | Values |
|---|---|
| Indifference to risk | A risk-neutral person would be indifferent to the risk of losing $1000 with the possibility of making a $50 gain or risking only $100 to make the same $50 gain |
| Focus on potential gain | A risk-neutral investor would focus on the potential gain of an investment, overlooking the risk potential |
| Indifference to probability | A risk-neutral person would be indifferent to the probability of a gain, for example, they would be indifferent between a 100% chance of receiving $1000, versus a 50% chance of receiving $2000 (and a 50% chance of receiving nothing)> |
What You'll Learn
Risk-neutral probabilities
In the context of the theory of the firm, a risk-neutral firm facing risk about the market price of its product and caring only about profit would maximise the expected value of its profit. A risk-averse firm in the same environment would typically take a more cautious approach. In portfolio choice, a risk-neutral investor who can choose any combination of an array of risky assets would invest exclusively in the asset with the highest expected yield, ignoring its risk features relative to those of other assets.
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Risk-neutral preferences
In the context of the theory of the firm, a risk-neutral firm facing risk about the market price of its product and caring only about profit would maximise the expected value of its profit. This would be done with respect to its choices of labour input usage, output produced, etc.
A risk-neutral investor who is able to choose any combination of an array of risky assets (various companies' stocks, various companies' bonds, etc.) would invest exclusively in the asset with the highest expected yield, ignoring its risk features relative to those of other assets. For instance, a risk-averse investor would not consider the choice to risk a $1000 loss with the possibility of making a $50 gain to be the same as risking only $100 to make the same $50 gain. However, someone who is risk-neutral would.
Shareholders may also want firms to make decisions in a risk-neutral manner, as individual investors can hedge risk exposure themselves by buying the shares of a number of other firms to diversify and offset these risk factors.
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Risk-neutral mindset
In the context of portfolio choice, a risk-neutral investor would invest exclusively in the asset with the highest expected yield, ignoring its risk features relative to those of other assets. This is in contrast to a risk-averse investor, who would take a more cautious approach and consider the inherent risks of each investment option.
Shareholders may also want firms to make decisions in a risk-neutral manner, as individual investors can hedge their risk exposure by buying the shares of a number of other firms to diversify and offset these risk factors.
Overall, a risk-neutral mindset involves prioritising potential gains over risk considerations when making investment decisions.
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Risk-neutral probabilities in asset value
A risk-neutral person is indifferent to risk when making an investment decision. They will focus on the potential gain of the investment instead. For example, a risk-neutral person would be indifferent between a 100% chance of receiving $1,000, versus a 50% chance of receiving $2,000 (and a 50% chance of receiving nothing).
In the context of the theory of the firm, a risk-neutral firm facing risk about the market price of its product, and caring only about profit, would maximise the expected value of its profit. A risk-neutral investor who can choose any combination of an array of risky assets (various companies' stocks, various companies' bonds, etc.) would invest exclusively in the asset with the highest expected yield, ignoring its risk features relative to those of other assets.
Shareholders may also want firms to make decisions in a risk-neutral manner, as individual investors can hedge risk exposure themselves by buying the shares of a number of other firms to diversify and offset these risk factors.
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Risk-neutral decision-making
For example, a risk-averse investor would not consider the choice to risk a $1000 loss with the possibility of making a $50 gain to be the same as risking only $100 to make the same $50 gain. However, someone who is risk-neutral would. Another example would be an individual who is indifferent between a 100% chance of receiving $1000, versus a 50% chance of receiving $2000 (and a 50% chance of receiving nothing).
In the context of the theory of the firm, a risk-neutral firm facing risk about the market price of its product, and caring only about profit, would maximise the expected value of its profit (with respect to its choices of labour input usage, output produced, etc.). But a risk-averse firm in the same environment would typically take a more cautious approach.
Shareholders may also want firms to make decisions in a risk-neutral manner, as individual investors can hedge risk exposure themselves by buying the shares of a number of other firms to diversify and offset these risk factors.
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Frequently asked questions
A risk-neutral investor is someone who is indifferent to risk when making an investment decision. They focus on the potential gain of the investment instead.
A risk-neutral investor would solely consider the gains of each investment, while choosing to overlook the risk potential (even though they may be aware of the inherent risk). For example, a risk-neutral investor would choose an investment with a 100% chance of receiving $1,000 over an investment with a 50% chance of receiving $2,000 (and a 50% chance of receiving nothing).
A risk-averse investor would not consider the choice to risk a $1000 loss with the possibility of making a $50 gain to be the same as risking only $100 to make the same $50 gain. However, a risk-neutral investor would.
