How does risk-neutral approach affect investment decision making?

The risk-neutral approach is a concept in economics that assumes individuals make decisions based solely on the expected values of outcomes, without considering the level of risk associated with those outcomes. In other words, it assumes that individuals are indifferent to risk and only care about the expected return.

When it comes to investment decision making, the risk-neutral approach can have several implications. Firstly, it suggests that investors would be willing to invest in projects or assets with higher expected returns, even if they come with higher levels of risk. This is because, under the risk-neutral approach, investors do not consider the riskiness of the investment and only focus on the expected return.

Secondly, the risk-neutral approach implies that investors would not require any additional compensation for taking on higher levels of risk. This means that they would be willing to accept lower returns for less risky investments, as long as the expected return is the same. In other words, investors would be indifferent between a low-risk investment with a lower return and a high-risk investment with a higher return, as long as the expected return is equal.

Furthermore, the risk-neutral approach can also affect the valuation of assets or projects. It suggests that the value of an asset or project is solely determined by its expected cash flows, without considering the risk associated with those cash flows. This means that the risk-neutral approach can lead to different valuations compared to approaches that consider risk, such as the risk-averse or risk-seeking approaches.

Overall, the risk-neutral approach affects investment decision making by assuming that individuals are indifferent to risk and only consider the expected return. This can lead to different investment choices, valuations, and risk preferences compared to approaches that consider risk.