Risk Averse

Risk-averse signifies a reluctance to take on risks, and an investor is termed as being risk-averse when they prefer a low return investment with known risks as opposed to a higher return investment with unknown risks. All forms of investments carry a level of inherent risk, and a risk-averse investor is one who is averse to the risks associated with uncertainty.

Investors invest in the financial market depending on their preferences and risk appetite. Investors who do not prefer to take high risks will invest in instruments that give a low but steady return or put their money into stocks that are stable and are least affected by market volatility. However, they may lose the opportunity to earn high returns in the process.

• Risk aversion refers to a preference for minimizing or avoiding risk in investment or decision-making situations.
• Risk-averse individuals prioritize capital preservation and are willing to accept lower potential returns in exchange for lower levels of risk.
• Risk aversion is influenced by factors such as personal financial circumstances, investment goals, time horizons, and individual risk tolerance.
• Conservative investment strategies, like investing in low-risk assets such as government bonds or diversifying portfolios, are common among risk-averse individuals to mitigate specific risks.

Risk averse investments are for such investor opts to avoid risks altogether in his/her investment. Such an investor aims to protect the investment made and is likely to choose instruments that offer certainty in the payback whilst carrying the lowest level of risks. Although all investments carry a certain level of inherent risk, such a risk averse person chooses an investment that carries a minimal level of known risks – the degree of uncertainty is maintained at a minimal level.

Each investor's risk appetite and investment preferences vary. Although being risk-averse provides certain advantages, the opportunity costs are extremely high. The purpose of investment is to earn maximum profit at minimal risks. A certain level of risk needs to be undertaken to earn a decent level of return. Therefore, it is better to be risk diverse.

This refers to portfolio diversification wherein the investments are spread across industries and companies, and therefore the portfolio does not stand to be affected by any volatility in any particular industry. Another way to ensure that the optimum returns are earned for the portfolio is to seek the advice of financial experts. Although seasoned investors invest based on their knowledge and experience, it is always advisable to take into account the views of a financial expert as well prior to making any investments.

This type of investor is not attracted by lucrative returns from risky assets and prefers to earn lower returns with a secure investment. They strictly follow certain strategies that help them to decide which type of investment option to choose from and whether it aligns with their goals and expectations.

The kind of risk averse investments chosen by risk-averse investors usually contain the following features –

• There is a guaranteed return on the principal as well as the return (either interest or profits). Thus, the investor will receive a fixed amount as return on the investment as long as they stay invested in it
• Easy liquidity is another interest feature of such investments. They can be easily converted into cash as and when required.
• In such investments, the investor will get  a  lower level of return as compared to the market return; Since they are risk-averse, they are ready to accept this less return because high return will also come with high risk.
• Degree of uncertainty is minimal in a risk averse theory. Due to extremely low risk, the investor is certain about getting a fixed and steady income throughout the investment period.

Let us understand the graph given below to get a better idea of the risk averse psychology.. The x-axis shows the risk factor and the Y-axis shows the return factor.

It shows that with the rise in risk for any kind of investment, the return also rises. Thus if an investor wants a high return on their investment, they should expect to or have the ability to bear a higher return.

There are various types of investment opportunities that can be used in a risk averse psychology. The investment options chosen include the following:

• Savings Account
• Certificate of Deposit
• Municipal Bonds
• Treasury Bills, Notes, Bonds
• Treasury Inflation-Protected Securities (TIPS);
• Money Market Funds.

Let us assume that John wants to invest in financial instruments that have the minimum risk as well as a guaranteed return. John is comfortable with low return but it should provide a fixed cash flow at some fixed time intervals. In such a case Certificate of Deposits or fixed deposits are a very good option, that will give an annual fixed return with no risk of loss. Thus, John is a risk-averse investor.

Just as every financial concept or opportunity has its own advantages and disadvantages, they also exist in this case. Let us first look at the various advantages of such investments.

• Loss of Principal: The fundamental risk in any type of investment is the risk of loss of capital. Such a risk averse person is the one who ensures a guaranteed return in his/her investments, and therefore the risk of loss of capital is minimal.
• Lower Risk: They take a lower level of risk by choice of investments as opposed to other kinds of investors. Although this results in a lower income, it is much safer.
• Steady Income: Retired people are most likely to be risk-averse as their intent is to ensure a steady income with minimal risks. Low-risk investments offer steady periodic income to the investors.

It is necessary to understand the disadvantages of the risk averse theory too.

One of the main disadvantages is the high opportunity cost. This type of investor is more likely to choose steady and safe investments and, in the process, gives up opportunities to invest in other forms of lucrative instruments. The opportunity cost is fairly high.

Such investors are not able to explore different avenues of investments because of their risk averse attitude. Thus, they lose the opportunity to learn and earn from various sources.

Since such investors are very careful with their investments are give up different kind of opportunities, their funds remain underutilized in the financial market. If funds are not properly mobilized, they do not generate return not only for the investor but the total economy as a whole.

This has been a guide to Risk-Averse and it's meaning. We explain it with example, graph, strategy, types of investments, advantages & disadvantages. You can learn more about portfolio management from the following articles –

• Investment Risk
• Diversifiable Risk
• High Risk Investments Examples
• Reinvestment Risk Examples