Lecture 5: Risk and Risk Aversion

Is the stock market overvalued?

Source: “U.S. Stocks Are Now Pricier Than They Were in the Dot-Com Era”, WSJ, Aug 31, 2025
 Is the stock market overvalued?

Source: How the west got hooked on economic support, Financial Times, Aug 17, 2025
 Topics for today

1. Basic measures of risk

2. Risk aversion and investment choice

3. Utility theory
 Expected return and standard deviation
𝑇 Expected return can be estimated as the
1 sample average return
𝐸 𝑟 = ෍ 𝑟𝑡
𝑇 =AVERAGE(Data range) in Excel
𝑡=1

𝑇
1 2 Variance is the average squared deviation
2
𝜎 = ෍ 𝑟𝑡 − 𝐸 𝑟 between each realized return and the
𝑇−1 expected return
𝑡=1
=VAR.S(Data range) in Excel

Standard deviation is the square root of

𝜎= 𝜎2 variance (easier to interpret since it is in
units of return, not squared return)
=STDEV.S(Data range) in Excel
 Merger ”arbitrage” (aka risk arb)

• On 15 August 2011, Google made a $40 per share offer for Motorola

• Pre-announcement stock price $25 jumped to $38

Stock price reaction to announcement

Source: Figure 6, Peter Van Tassel (2016), FRBNY Staff Report

 The Historical Record
(Annual Returns 1927 – 2018)
T-bills – Low risk and return (𝐸 𝑟 = 3.38%)
Figure 5.6
T-bonds – Medium risk and return (𝐸 𝑟 = 5.58%)
Figure 5.6
Stocks – High risk and return (𝐸 𝑟 = 11.72%)
Figure 5.6
Historical records in a table
Historical risk and return in a figure

Risk premium = 𝐸 𝑟 − 𝑟𝑓
 How do we measure risk?

𝑇
1 2
Standard deviation of returns 𝜎2 = ෍ 𝑟𝑡 − 𝐸 𝑟
𝑇−1
𝑡=1
 How do we measure risk?
𝑇
1 2
Standard deviation of returns 𝜎2 = ෍ 𝑟𝑡 − 𝐸 𝑟
𝑇−1
𝑡=1
• Standard deviation measures deviations on the upside and
downside as “equal”

→ Only a measure of risk if distribution of return is symmetric around

mean

• To be a complete measure of risk it requires returns to be

normally distributed
Normal distribution
Figure 5.3
Are stock returns normally distributed?
Figure 5.6
 Fraction of Months

10%
20%
25%

15%

0%
5%
-30%
-28%
-26%
-24%
-22%
-20%
-18%
-16%
-14%
-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
16%
Monthly Return (CRSP value-weighted)

18%
20%
22%
24%
26%
Monthly returns are closer to normal

28%
30%
 Takeaways

• Distribution of annual returns do not resemble normality

• An effect of compounding
• (For the mathematically inclined, the sum of two normally
distributed variables is normal, but the product is not)

• Monthly returns are closer to normality

• But still more extreme events than we would expect

 In most finance applications

• Extreme events are more common than implied by normality

• Called kurtosis, or “fat tails”

• Returns are not symmetrically distributed, leans more

towards one or the other side

• Measured with skewness

Skewness in a figure
Figure 5.4
Kurtosis in a figure
Figure 5.5
 Risk measures focused on the downside
• Value at Risk (VaR)
- Loss that will be incurred in an extreme adverse event, or a low
probability event
- 5% worst event typical VaR level

• Expected Shortfall (ES)

- The expected (average) loss if in we end up in an extreme adverse
event, or a low probability event (typically 5% worst cases)

• Lower partial standard deviation (LPSD)

• Standard deviation of only downside returns below some pre-set
level (for example the risk-free return)
 Utility Theory

Assumption throughout:

Investors prefer more to less and dislike risk

Happiness increases in wealth at a decreasing rate

1. We like money for the things we can consume with it:

- Cars, houses, clothes, nice dinners

2. The more we consume, the happier we are

3. As we consume more, the value of consuming for an additional dollar

shrinks

• These statements are consistent with risk aversion (why?)

Utility with Risk Aversion
Utility with Risk Aversion
 Certainty equivalent
The certainty equivalent of a risky asset is the sum of money
that guarantees the expected utility of the risky asset

- In some sense, it is your “valuation” of the bet

The expected utility of the risky asset equals the utility function
evaluated at the certainty equivalent:

෩
𝑈 𝑊𝐶𝐸 = 𝐸 𝑈 𝑊

For a risk averse investor: ෩

𝐸𝑈 𝑊 <𝑈 𝐸 𝑊
 More money = happier?

NA = North America

Source: Fig 1, Jebb, Tay, Diener and Oishi (2018), Nature

 More money = happier?

Source: Fig 1, Killingsworth (2021), PNAS

 Can money buy you happiness?
Some newspaper links (many more if you search)

• The Economist: Money buys happiness but euphoria comes dear (Feb
5, 2021)

• Wall Street Journal: Can money buy you happiness? (Nov 10, 2014)

• Financial Times: Link between earnings and happiness is a tenous one

(Feb 6, 2018)
 Which would you pick?

$400,000 for sure Your choice of suitcase: one is empty, the

other one contains $1,000,000
Cost of risk increases faster than expected returns
𝐸 𝑅 = $500,000 𝐸 𝑅 = $500,000

Your choice of suitcase: one is empty, the Your choice of suitcase: one forces you to
other one contains $1,000,000 pay my mortgage of $1,000,000
the other one contains $2,000,000
Start of tangent
 Additional important concepts
• Standard risk averse utility function

𝑈 = 𝐸 𝑟 − 0.5 ∗ 𝐴 ∗ 𝜎 2

• Indifference curves

• Combinations of 𝐸 𝑟 and 𝜎 that gives us the same utility

• Depends on A

• We demand increasingly large 𝐸 𝑟 for higher 𝜎

Why do we gamble?
 Why do we gamble?

Characteristics of gambles

• Low expected return

• Uncertain outcomes

• Is gambling a prudent investment strategy?

Andonov, Bauer and Cremers (2017), Fig 1
 Pension funds and discount rates

“U.S. public pension funds with a higher level of underfunding

per participant … take more risk and use higher discount rates.
The increased risk-taking by U.S. public funds is negatively
related to their performance.”
Andonov, Bauer and Cremers (2017), Review of Financial Studies
 Why do we gamble?

Characteristics of gambles

• Low expected return

• Uncertain outcomes

• In casinos, designed for house to win

Are gambles normally distributed?

Source: [Link]
 Why do people gamble?
• Theoretical argument: individuals may prefer skewness in
distributions
(Golec and Tamarkin, 1998, Journal of Political Economy)

• Experimental evidence that individuals prefer positive

skewness, and increase their risk-taking when participating
in skewed lotteries
(Grossman and Eckel, 2015, Journal of Risk and Uncertainty)

• Firms may “gamble for resurrection”

• Why?
 Gambling (and investing)
Some newspaper links

• The Economist
• Special report on gambling (Jul 10, 2010)

• Wall Street Journal

• How often do gamblers really win?(Oct 11, 2013)
• Gambling is the only game in town (Nov 22, 2020)

• Financial Times
• Investing versus gambling: a fine line to thread (Sep 15, 2020)
• The troubling legacy of Britan's gambling experiment (Jul 19, 2019)
End of tangent
 Summary

• Today we covered how to measure risk

• We discussed risk aversion and how it impacts our

preferences

• We introduced a utility theory framework that will be useful in

upcoming classes