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ETF Specialist

Taking Risk into Account in the Active vs. Passive Debate

Why a risk-averse investor is even more likely to use a passive fund.

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How much would you pay for an investment that has a 50% probability to pay $1,000,000 and a 50% probability to pay nothing if you could enter the investment only one time?

While the expected value of this payoff is $500,000, most people would not pay anywhere near that amount to enter this investment. The probability of the zero payoff is just too high. The more risk averse you are, the less you would be willing to pay. Let's say that you would be willing to pay $200,000 to enter this investment. In economic utility theory, this amount is known as the certainty equivalent. We can apply this same concept to the active versus passive debate.

Michael Rawson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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