Another important application of consumer choice theory is looking at investor choice. How investors park their money across different assets. And to motivate this if you look at a portfolio of common stocks, and when people have analyzed this going back to the early 1800s, the annual average rate of return on common stocks has averaged 6%, per year. By contrast, treasury bills have an average annual rate of return, over that same time period, of point 6%. So why would any investor in his or her right mind put money in treasury bills versus common stocks? Another perspective on this, had you put a dollar in common stocks, as of 1802, today that dollar in real terms would be worth $500,000. Had you put that same dollar in treasury bills that same dollar would be worth only $350 today, in real terms. So why would you sacrifice such a potential gain as an investor? The reason you might, is your tolerance for risk. While it's true common stocks have an average annual rate of return of 6%, they also have much more variation year-to-year in those returns. That 6% rate of return may be arrived at by an 18% increase one year coupled with a 6% decline the next year, and the average over the two year period being 6%. Whereas, the return on treasury bills are very predictable and much less risky. At least until later in 2013, there was no talk about a government potential default on its payment. So treasury bills were an incredibly secure asset. And let's look at how that translates into thinking about how investors should position their, should allocate their wealth. There's a return-risk tradeoff that'll determine an investor's appetite for how much do I want to put into stocks, how much do I want to put in treasury bills and other forms of assets. Risk is bad. Whereas returns on the vertical axis are good. These indifference curves in this type of setting have an upward slope to em. So to take on additional risk from point A to point B, for the investor to remain on the same indifference curve she has to be compensated with a higher return to stay on U2. So if we're going to add from risk 1 to risk 2 additional risk to their portfolio, we have to add additional return to compensate. The more averse you are to risk, the more steeply sloped your indifference curves will be relating return to risk. You have to be compensated with more return, if you're more risk-averse, to take on that same additional risk from risk 1 to risk 2. So when people are advising or making their own asset allocation decisions, fundamentally, underneath it they're thinking about these risk return trade offs, and how they're portrayed by indifference curves. And then one other example, when we look at entrepreneurs versus non-entrepreneurs, nowadays seven out of ten high school students indicate they eventually want to start their own business. It's been growing over time. One of the fundamental insights of entrepreneurs is that they're willing, they have more of an appetite for risk, they're more tolerant of risk for the same return. let's see an example of this. in figure 5.14, we show an entrepreneur's indifference curve map relating return to risk versus a non entrepreneur. For the same increase in return, from return 1 to return 2, an entrepreneur is willing to take on my risk, from risk 1 E to risk 2 E, a greater horizontal distance for that same increase in return than a non-entrepreneur's willing to take on. so folks that are more averse to risk and taking chances, the advice is an entrepreneurial career is less likely to be a good fit for your future.
