What is risk neutral? Definition and meaning
Risk neutral is a term that is used to describe investors who are insensitive to risk. The investor effectively ignores the risk completely when making an investment decision. If you present a risk neutral investor with two possible investments that carry different levels of risk, he or she considers just the expected return from each investment – their risks are irrelevant to him or her.
Risk neutral is different from risk averse – which describes a person who chooses certainty and dislikes risk. The term is not the same as risk seeking either – which describes an investor who likes risk; if you like something you are not indifferent.
The risk neutral investor is simply not interest in risk at all, risk does not enter his or her cognitive radar – he or she is indifferent – regardless of whether it is high or low risk.
The curvature of the utility function of the three investors in this chart tells us whether they are risk averse, neutral or seeking (risk takers). The straight line corresponds to a risk neutral investor, the concave shape suggests a risk averse investor, while the convex shape corresponds to a risk taker. (Image: adapted from quora.com)
Risk neutral vs. risk averse
Imagine you have two people in front of you – an investor who is averse to risk and one who is neutral. You offer them two possible investment opportunities:
– Invest $500 with 100% certainty that it will increase to $550 in one year.
– Invest $100 with a 50% certainty that it will increase to $150 in one year, and a 50% chance that it might decline to $50.
The risk averse investor will choose the first option, because of the certainty.
The investor who is neutral to risk will not mind which one, because they both offer a return of $50. If you ignore the risk (losing $50), and only focus on the return – $50 in each case – both investments are equally appealing.
Individuals who are neutral to risk will take a long time to carefully weigh up investment options rather than making a rapid decision to either avoid risk or embrace it. Most of us focus almost entirely on the risk aspect.
Risk neutral investors are significantly less common than their risk averse and risk seeking counterparts. Most of us are risk averse, and find the notion of risk neutrality rather strange.
Video – Risk neutral, averse and seeking
In this video, William Spaniel explains what risk aversion, risk neutrality, and risk acceptance are. He then gives us a lottery scenario and asks his students to complete a questionnaire that will determine what each person’s attitude to risk is.
He suspects that most of the participants will be risk averse, and doubts there will be a single case of risk neutrality.