KIRAN KUMAR K V
Market Rationality Argument
There are certain suppositions upon which markets work. It assumes that human beings are rational, in fact, always rational. Their sole objective is to maximize the return for a given level of risk that they are taking. The concept of risk-adjusted return, that’s the foundation block of many asset pricing and valuation models, highlights the risk-aversion behaviour of investors. Risk-aversion relates to the behaviour of individuals under uncertainty. If an individual is offered two options: one, where he will get Rs. 50 for sure and two, a gamble with a 50% chance of getting Rs. 100 and another 50% chance of getting nothing. The investor may react in three ways: He may choose the latter and gamble; He may choose the former and be conservative; He may choose to be indifferent, as the expected value before the bet in both the cases is Rs. 50
When he chooses to gamble, he is referred to as risk-seeker. A risk-seeking or risk-loving investor chooses uncertainty over certainty, as he gets extra ‘utility’ from the uncertainty associated with the gamble. It can be observed in individual’s behaviors like buying a lottery, or gambling in a casino or even sitting on a giant wheel. Risk-seekers are also the ones who calculate the risk. Let’s consider in the above example, if the latter option gave a 40% chance of getting Rs. 50 and 60% of nothing, a risk-seeker may have avoided the gamble.
When he chooses to be indifferent, the investor is referred to as risk-neutral. He is an investor who cares only about the return. Uncertainty is not at all a parameter of analysis for a risk-neutral investor. A risk-neutral behaviour can be found when the investment at stake is insignificant part of their wealth.
If an investor chooses the guaranteed income over gamble, he can be referred to as a risk-averse investor. He will generally shy away from risky investments, even if the return is lower as long as it is guaranteed. That does not mean he will not at all take risk. It just means that he is not comfortable with the return he is getting for the amount of risk he is assuming. He looks for a risk-return tradeoff that results in that extra-utility for him. Because individuals are different in their preferences, all risk-averse individuals may not rank investment alternatives in the same manner. Take the example of Rs. 50 gamble; all risk-averse individuals will rank the guaranteed outcome of Rs. 50 higher the option of gambling the same. What would have happened if the guaranteed outcome was Rs. 40 and not Rs. 50? Some risk-averse investors might consider Rs. 40 inadequate, others might accept it, and still others might become indifferent. This suggests that individuals are risk-averse and they prefer more to less. They are also able to rank different investment alternatives in order of their preference and such ranking are internally consistent. Such utility function is represented by the economist’s function: &