What is the Certainty Equivalent Method?

Certainty equivalent is the amount of cash an investor would accept today than going for a larger amount of cash tomorrow. Investors often use this to deny the risk. The Certainty equivalent helps investors earn a guaranteed income on their investment rather than going for increased risk on their investment portfolios. It is a method of reducing risk while also reducing the income from given investment instruments.

Certainty Equivalent is Popular among Risk-Averse Investors

Certainty equivalent is quite a popular method among risk-averse investors. These investors do not want to invest in high-return but risky investments. Instead, they forgo higher returns for the lesser amount of income during the same period of returns on investments.

For example, let’s suppose that a government bond offers a 3% return on investments. There is another bond that offers 7% returns, but it is not guaranteed as in the case of the government bond. In such circumstances, a risk-averse investor will go for the government bond rather than going for the high-return bond.

The concept of certainty equivalent is instrumental in evaluating risk. It depends on the risk tolerance of an individual and hence differs from person to person. For example, investors nearing their retirement would be high certainty equivalent, as they do not wish to take increased risks on their investments.

How is the Certainty Equivalent Method Useful?

Certainty equivalent offers an idea of how much return an investment must produce to attract an investment. For example, let’s take the abovementioned example of certainty equivalent where the government bond pays 3% and the other bond pays 7%. If the investor ignores the 7% return for the 3% bond, the business offering a 7% bond needs to realize that it will have to increase the return to attract the investor. So, this helps in having an idea of how much the investment should return for the investors to be interested in it.

Merits of Certainty Equivalent Method

Following are the merits of using the Certainty Equivalent Method −

• It shows the investment options that are safer and hence are more reliable.

• Investors can have an idea of the risk they must take for increased returns.

• It shows the minimum returns that are possible from an investment.

• The investors can be certain about the returns of similar other bonds referring to the certainty equivalent bond.

Demerits of Certainty Equivalent Method

Following are the demerits of using the Certainty Equivalent Method −

• It is based on market demands and not a foolproof method of investing.

• The time value of money is ignored in the certainty equivalent method.

• It does not apply to all kinds of investments.

• It applies more to risk-averse investors than other forms of investors.