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The author of this chapter is Aswath Damodaran. This file was retrieved at http://people.stern.nyu.edu/adamodar/pdfiles/valrisk/ch2.pdf on 14 Feb 2013.

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CHAPTER 2

WHY DO WE CARE ABOUT RISK?

Do human beings seek out risk or avoid it? How does risk affect behavior and what are the consequences for business and investment decisions? The answers to these questions lie at the heart of any discussion about risk. Individuals may be averse to risk but they are also attracted to it and different people respond differently to the same risk stimuli. In this chapter, we will begin by looking at the attraction that risk holds to human beings and how it affects behavior. We will then consider what we mean by risk aversion and why it matters for risk management. We will follow up and consider how best to measure risk aversion, looking at a range of techniques that have been developed in economics. In the final section, we will consider the consequences of risk aversion for corporate finance, investments and valuation.

The Duality of Risk In a world where people sky dive and bungee jump for pleasure, and gambling is a multi-billion dollar business, it is clear that human beings collectively are sometimes attracted to risk and that some are more susceptible to its attraction than others. While psychoanalysts at the beginning of the twentieth century considered risk-taking behavior to be a disease, the fact that it is so widespread suggests that it is part of human nature to be attracted to risk, even when there is no rational payoff to being exposed to risk. The seeds, it coud be argued, may have been planted in our hunter-gatherer days when survival mandated taking risks and there were no “play it safe” options. At the same time, though, there is evidence that human beings try to avoid risk in both physical and financial pursuits. The same person who puts his life at risk climbing mountains may refuse to drive a car without his seat belt on or to invest in stocks,...