We then assign this number the letter A, which is called the "risk aversion coefficient". 1: U = E (r) – 0,5 x A x σ 2. In this formula, U represents the utility or score to give this investment in a given portfolio by comparing it to a risk-free investment, such as treasury bills.
For a risk-averse investor, the standard deviation (or variance) of the return distribution is a relevant measure of risk if returns are normally distributed. Also, if the evaluation is on a standalone asset, then the relevant risk measure is standard deviation. Why is risk averse concave utility?
For example, at point C there is a high risk with a very low yield. From an objective and rational perspective, any investor would choose the AB line, which is the ideal portfolio with the minimum risk relative to the chosen level of returns. The question that arises is, what is the level of risk the investor is able to endure?
Several qualitative psychological methods suggest that one should determine what is the most appropriate risk for them, that is to say, decide how much to invest in stocks, bonds and the money market. Some tests help determine the psychological profile of an investor.