Lesson 9 of 14 · All lessons in this module
  1. Portfolio expected return and varianceVideo lesson
  2. Portfolio returns over time: drift and rebalancing
  3. The covariance matrix and many-asset portfolios
  4. Correlation and diversification
  5. Scenario-based portfolio risk and the many-asset limit
  6. Integrated cases: three-asset risk from volatilities, correlations and scenarios
  7. Minimum-variance and efficient frontiersVideo lesson
  8. Finding the minimum-variance portfolio and optimising weights
  9. Risk aversion and utilityVideo lesson
  10. Indifference curves and the capital allocation lineVideo lesson
  11. Theory assumptions, risk-aversion measures and the Sharpe ratio of the CAL
  12. Optimal risky portfolio and the optimal investor portfolioVideo lesson
  13. The risk-free asset, the market portfolio and the CMLVideo lesson
  14. Beta, the security market line and the CAPM

This lesson is part of the 2027 curriculum. You are following the 2026 curriculum, where it is not taught in this form. Switch if you are sitting the exam under the 2027 curriculum.

Lesson 9 of 14 · 13 min

Risk aversion and utility

A utility function turns each investor's attitude to risk into one number per investment, so investments can be ranked: U=E(r)−12Aσ2U = E(r) - \tfrac{1}{2}A\sigma^2.

In short

  • Offered a sure amount or a gamble with the same expected value: the risk-averse investor takes the sure amount, the risk-neutral investor is indifferent, the risk seeker takes the gamble.
  • Markets price assets as if the typical investor is risk averse; we assume risk aversion from here on.
  • Risk tolerance is the opposite of risk aversion: more tolerance, more willingness to take risk.
  • Utility U=E(r)−12Aσ2U = E(r) - \tfrac{1}{2}A\sigma^2: A>0A > 0 risk averse, A=0A = 0 risk neutral, A<0A < 0 risk seeking.
  • Utility only ranks choices for one investor; it cannot be compared or added across people.
  • A risk-free asset (σ=0\sigma = 0) gives the same utility to everyone: its return.

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