Risk pervades economic life. Some people gamble for fun, some addicts gamble in spite of
themselves. Most people are risk-averse. They volunteer to take risks only if offered
favourable odds that on average yield a profit. Conversely, most people insure, despite less
than fair odds, to reduce the risks they otherwise face.
Risk-aversion reflects the diminishing marginal utility of wealth. A fair gamble in monetary
terms yields less extra utility when it succeeds than it sacrifices when it fails. Hence people
refuse fair gambles, except for very small stakes. The prevalence of risk aversion means that
people look for ways to reduce risk and must pay others to take over their risk-bearing.
Insurance pools risks that are substantially independent to reduce the aggregate risk, and
spreads any residual risk across many people so that each has a small stake in the risk that
cannot be pooled away.
Insurance markets are inhibited by adverse selection and moral hazard. The former means that high-risk clients are more likely to take out insurance; the latter means that the act of
insuring increases the likelihood that the undesired outcome will occur.
Company shares have a higher average return but a much more variable return than that on
Treasury bills or bank deposits.
Portfolio choices depend on the investor’s tastes – the trade-offs between risk and average
return that yield equal utility – and on the opportunities that the market provides – the risk
and return combinations on existing assets.
When risks on different asset returns are independent, the risk of the whole portfolio can be
reduced by diversification across assets.
The risk that an asset contributes to a portfolio is not measured by the variability of that
asset’s own return but on the correlation of its return with the return on other assets. An
asset that is negatively correlated with other assets will actually reduce the risk on the whole
portfolio even though its own return is risky. Conversely, assets with a strong positive
correlation with the rest of the portfolio increase the overall risk. The value of beta for an
asset measures its correlation with other assets.
In equilibrium risky assets earn higher rates of return on average to compensate portfolio
holders for bearing this extra risk. High beta assets have high returns. If an asset is offering
too high an expected return for its risk class, people will buy the asset, bidding up its price
until the expected return is forced back to its equilibrium level.
In an efficient market assets are priced to reflect the latest available information about their
risk and return. There are no easy systematic investment opportunities to beat the market
unless you systematically get or use new information faster than other people. Evidence
from share prices is compatible with stock market efficiency but speculative bubbles
sometimes occur.
Forward markets set a price today for future delivery of and payment for goods. They allow
people to hedge against risky spot prices in the future by making a contract today.
Speculators take over this risk and require a premium unless they can match buyers and
sellers.
