Question

Explain the relationship between risk-loving and risk-averse investors, and the strategy of diversification?

True, because the benefits to diversification are greater for a person who cares more about reducing risk?

Answer 1

Risk loving or risk seeking is a tendency of an investor where it chooses to invest in asset having high risk where as risk averse is the tendency with in the investor to avoid risk even if it comes by reducing the expected return by certain points and that is where the diversification comes into the picture. The diversification is basically the idea that when securities which have negative correlation with each other are put together in a portfolio then the overall risk of the portfolio is reduced then the individual stocks in the portfolio. Diversification is an appropriate strategy for a risk averse investor because he is able to reduce the risk significantly where as still not giving up too much on the expected return. Diversification is also related to the idea of CAPM model where only the market risk or systematic risk for the security is important so the non-systematic risk is eliminated away by diversifying your portfolio. However, in the case of risk seeking investor the diversification might not be that useful because in order to have high expected return the investor would like to have high risky and high return stocks.