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What is Risk Preference? (Financial Management)
Risk Preference is one’s tendency to choose either a risky or less risky option. Usually, economists and finance professionals, and investors apply the concept of risk preference in economics, but the concept can be applied to any decision one makes that involves risk. There are several types of risk preferences, and the risk involved generally depends on the decision-maker and the investor for whom the decision-maker takes the risk.
The risk-seeking preference applies to investors who are willing to take increased risks to achieve higher-than-usual returns. It is necessary to weigh all the factors associated with the risk and assess these risks against the probabilities of occurring in this type of risk preference. Such actions allow the decision-maker to check if the risk is worth the chance. Sometimes some people with risk-seeking preferences work together to evaluate the risks and form a consensus to invest in high-risk securities too.
Individuals who do not want to take any risk are called to have risk-averse preferences. Such people always tend to make safer investments instead of taking an opportunity to invest in high-risk securities with the probability of failure. For investors with a risk-averse preference, the guarantee of return holds more weight than any other possible result. Risk-averse assessments of decision-makers in an organization helps to delegate the right authority to the right people and avoid probable disastrous decisions of the organization.
Investors with risk-neutral preference do not care about the risks associated with the decision-making. They are only concerned about the final result. A risk-neutral individual chooses the assets that have the highest possible gains or returns without considering possible outcomes. These preferences equally apply to individuals and investment firms that create reputations depending on a risk preference strategy.
Investors should understand their risk tolerance depending on the needs and circumstances irrespective of whether they invest personally or hire a firm to do it. Risk tolerance has several variables. "Time" and "returns" usually influence what kind of risk one needs to take. For example, a retiree is often risk-averse because he will not have time to make it up in the eventuality of a large loss. On the other hand, someone in their late 20s should choose to take more chances with their assets, opting for "risk-seeking" preference.
Risk preference is dependable on the kind of risks one tends to seek but one thing that is clear is that no investor would like to go through a palpable loss even when they seek the highest risk. Therefore, forming a balanced portfolio containing a mix of both high-risk securities and low-risk ones is the most suitable option.
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