In the former scenario, the person receives $50. For example, a risk-averse investor might choose to put their money into a bank account with a low but guaranteed interest rate, rather than into a stock that may have high expected returns, but also involves a chance of losing value.ĬE – Certainty equivalent E(U(W)) – Expected value of the utility (expected utility) of the uncertain payment W E(W) – Expected value of the uncertain payment U(CE) – Utility of the certainty equivalent U(E(W)) – Utility of the expected value of the uncertain payment U(W 0) – Utility of the minimal payment U(W 1) – Utility of the maximal payment W 0 – Minimal payment W 1 – Maximal payment RP – Risk premiumĪ person is given the choice between two scenarios: one with a guaranteed payoff, and one with a risky payoff with same average value. Risk aversion explains the inclination to agree to a situation with a more predictable, but possibly lower payoff, rather than another situation with a highly unpredictable, but possibly higher payoff. In economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more certain outcome. Right graph: With fixed probabilities of two alternative states 1 and 2, risk averse indifference curves over pairs of state-contingent outcomes are convex. Middle graph: In standard deviation-expected value space, risk averse indifference curves are upward sloped. Left graph: A risk averse utility function is concave (from below), while a risk loving utility function is convex. Risk aversion (red) contrasted to risk neutrality (yellow) and risk loving (orange) in different settings.

For the related psychological concept, see Risk aversion (psychology).

Power utility function