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A certainty equivalent is a payoff which is risk free that someone will accept instead of gambling on a return which may be larger, but which comes with risk. The amount of the certainty equivalent varies from person to person. Someone who is risk averse may accept one which is smaller than the potential payoff involved with the gamble, while others may demand a higher certainty equivalent in order to consider it worth their while to abandon the riskier endeavor.
A common example of the certainty equivalent can be seen on game shows. Contestants on game shows are often offered a choice: they can take a sum of money and walk away, or they can proceed to the next phase of the show to compete for more money. The show calculates this sum carefully. Risk averse contestants may accept the payoff and leave, content to walk away with some money rather than none. Others may turn down the offer and proceed to the next phase and a chance to go home with more substantial winnings.
In the investment community, certainty equivalents can be important. A new company, for example, wants to attract investors who are willing to gamble on its shares for a chance at a big payoff. They have to consider risk-free alternatives which may be available when they are working to attract investors so that they can think about the certainty equivalent for individual investors. If the initial price for shares is set too high, investors will not be interested.
The higher payout may be an uncertain payoff, especially in the financial world. Likewise, some game shows are structured in a way which obscures the total potential of the payoff, with the sum varying. For example, contestants may spin a wheel to see how much money they win. This can affect the certainty equivalent for individuals because they may understandably be concerned about the unknown nature of the risk.
Certainty equivalents come up in the context of determining a risk premium for a given investment or other activity. The risk premium is determined by subtracting the risk-free payout from the expected return from the riskier investment. Creating a risk premium can make an investment or similar activity more appealing, because people are willing to take a chance on the higher payoff. This tactic is often used in environments like game shows to increase tension and create an incentive to continue.
@seag47 – If someone with an addictive personality goes on a game show, they will always opt for the larger prize. My cousin did this, and she lost twelve thousand dollars.
The grand prize was a new car worth $40,000. She needed the thrill of the chase, and she couldn't resist. She was devastated at losing the money that had been hers to keep just seconds prior to her decision.
Then again, sometimes the outcome is worth the risk. Many times, I have seen people on these shows actually win the grand prize. From Hawaiian vacations to luxury vehicles, real fantasy prizes are actually given away on these shows.
I dealt with certainty equivalents and risks when I first enrolled in my company's 401(k) plan. My financial adviser suggested that I invest in three different risk levels, as well as in a risk-free alternative.
I invested a little in a low risk category. I placed the most in medium risk shares, and the least in high risk shares. I also put some money in the risk-free option, so I would never lose it all.
I knew I had the opportunity to change these amounts at any time, but since I don't know much about accounting, I have left it the same. I figure that a medium risk is a good place to have most of my money
, because the potential payoff is better than a low risk, and the danger is not as great as in a high risk situation.
When the market crashed, I did worry about my losses a bit, but I knew that I still had my certainty equivalent. It felt good to know I hadn't lost everything.
Every time I watch a game show and a contestant has accrued several thousand dollars, I scream at them to take the cash and walk away. The chances of winning the larger prize are so slim that it seems dumb to take that chance when you have a guaranteed certainty equivalent in front of you!
Of course, their judgment may be swayed by the chants from the crowd to take the risk. Also, they could be experiencing a high from their winning streak. They may really believe that they will win if they take that chance.
To me, five thousand in the hand is worth ten thousand in the proverbial bush. I would much rather go home with enough money to pay off my car loan than risk going home with no more than I started with.
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