An investor is considered risk averse if their utility function is characterized by what?

• A. Concave shape
• B. Linear shape
• C. Convex shape
• D. Flat shape

Answer: (A)

An investor is considered risk averse if their utility function has a concave shape. This characteristic indicates that as the investor's wealth increases, the additional utility gained from each incremental unit of wealth decreases. In simpler terms, the investor derives less satisfaction from each additional dollar earned, reflecting a preference to avoid risk and favor safer investments. This behavior demonstrates that a risk-averse individual would require a higher expected return to accept a higher level of risk, as they value the certainty of known outcomes more than the uncertain potential for higher returns.

In the context of investment decisions, this concave utility curve leads risk-averse investors to prefer portfolios that minimize volatility, even if it means forgoing potentially higher but riskier returns. This fundamental concept helps explain why risk tolerance varies among individuals and informs how portfolios should be constructed to align with an investor’s risk profile.