What is Risk Averse?
A risk-averse investor is one who avoids risk and typically opts for conservative investment options to minimize potential losses.
People who are risk-averse are generally not comfortable with risky investment options — Their tolerance for risk is low. Risk-averse investors usually prefer conservative investment opportunities, even if it means lower returns. These include savings accounts, certificates of deposit (CDs), and certain bonds. Risk-seeking investors are the opposite — They generally go for investments with higher risks and higher potential returns, such as stocks and mutual funds. While risk aversion can help an investor avoid losing money, it can also mean choosing investments with lower average returns.
Imagine Penny wants to start investing for the first time. She has always had a low tolerance for risk, so she sits down with a financial advisor to learn about conservative investment opportunities. Her advisor recommends she put her money in a high-yield savings account and fixed-rate government bonds, both of which offer steady income. With this strategy, Penny likely won’t see a significant return, but she’ll almost certainly get her money back with modest interest.
Risk-averse investing is like buying a minivan instead of a motorcycle…
You might not get to your destination as fast, and many people will think the minivan is less fun. However, if what you’re looking for is safety, the minivan is the way to go. Likewise, risk-averse investments might not get you a huge profit, and some people won’t think they’re that much fun. But in the end, you’ll almost certainly get your money back with interest.
The term risk-averse could apply to any scenario, but it appears regularly in the world of finance and investing. Risk-averse investors are those who seek out low-risk investment opportunities to reduce potential losses. In the interest of reducing risk, they’re also willing to accept smaller returns.
Certain investment opportunities are good candidates for risk-averse investors because they are less volatile and more likely to allow investors to recover their money. These include high-yield savings accounts, certificates of deposit (CDs), and government bonds.
People at specific points in their investment journeys are more likely to have a low tolerance for risk. For example, those who are retired or very close to retirement are likely to opt for investments with little to no risk when they can. They need the money to fund their retirement and can’t afford to wait for their assets to bounce back after a setback. Those saving for a short-term goal, such as a down payment on a house or a wedding in the next few years, may also be better off putting their money in low-risk investments. They don’t have time for the market to reset after a decline.
For those who want to stick with low-risk investments, a few options combine modest returns with minimum risk:
A savings account at a bank is one of the safest places to put your money. The Federal Deposit Insurance Corporation (FDIC) insures up to $250,000 you deposit in savings accounts at a given bank. You can access your money anytime, and your interest rate is guaranteed, although it can change over time. Many savings account interest rates don’t get close to 1 percent, but some high-yield savings accounts offer more competitive rates. For example, as of January 2020, a few banks offered savings accounts with annual percentage yields of around 2 percent.
Think of a money market account as a combination of a checking and savings account. It’s an interest-bearing account that you can find at your local bank or credit union. Your money earns interest, usually at a higher rate than a savings account, but you may also have a checkbook or debit card for your account. Money market accounts typically have limits on the number of withdrawals you can make per month and sometimes higher minimum balance requirements than savings accounts. Money market accounts are also FDIC-insured up to $250,000.
The US Treasury Department issues several types of securities to raise money, including Treasury bills (T-bills) and Treasury bonds (T-bonds). T-bills mature within a year and don’t pay interest regularly, while T-bonds mature in 10 years or more and pay interest twice a year. The life of these securities can range from as short as four weeks for some T-bills to as long as 30 years for T-bonds. Treasury securities are some of the safest investments you can make, because they have the full backing of the federal government. You have a guarantee that you’ll recover your principal and interest. However, there is the risk that rising market interest rates or inflation can make fixed-rate bonds and bills a relatively less attractive investment.
Corporations also issue bonds to raise money, often for capital projects or for funding business growth. They do not carry any guarantees like Treasury bonds, since they don’t have the backing of the federal government. But they’re still considered to be low risk, as long as they have a AAA rating from any of the major credit rating agencies. AAA is the highest rating the agencies issue, and it indicates that a company has minimal credit risk and has demonstrated creditworthiness.
While all stocks come with risk, dividend stocks can provide a reliable income. Dividend stocks are those that pay dividends (regular payments that companies make to stock owners) to shareholders every year. Dividend stocks are subject to market volatility like other stocks. But the dividend income they provide can help offset potential losses or enhance potential gains. Companies can always stop issuing dividends, but those dividend stocks tend to focus more on stable growth. After all, a company would be hesitant to promise dividends to investors unless it expected to continue to be able to fund them with earnings.
Certificates of deposit (CDs) are financial products that banks and credit unions offer. Customers deposit a lump-sum and let it sit for a set amount of time, and the financial institution pays them back with interest. CDs can last a few months or as much as 10 years. CDs don’t offer the potential returns that stocks might, but they are a safer investment option, since the return is guaranteed. CD interest rates are sometimes higher than that of the average savings or money market account because you aren’t allowed to touch your money. The FDIC insures these funds up to $250,000.
Keep in mind that, while some investments are less risky than others, there’s still a chance of losing money by investing in stocks or bonds. Even with a checking or savings account or a CD, you may be responsible for fees or penalties. You may want to consult with an advisor and do your research to thoroughly understand risks and rewards before investing.
The opposite of risk-averse is risk-seeking, which describes investors who look for more volatile and uncertain investments for the chance of higher returns. While many people focus on maintaining their wealth and growing it steadily over time, risk-seeking investors want to increase their wealth more aggressively. They might do this not only for the potential returns on their investment, but also for the excitement that risk brings.
These individuals are likely to seek out riskier stocks, as well as other high-risk investments like angel investing and venture capital. They may also seek a life of entrepreneurship, giving up a secure job with a salary and benefits for the excitement and potential returns of starting their own business. The potential for failure doesn’t scare them away as it might a risk-averse investor — The unknown outcome is often part of the fun.
Risk-neutral investors don’t take risk level into consideration at all when they’re considering investment opportunities — They only look at possible returns. While risk-seeking investors might enjoy risk, those that are neutral don’t take risk into account. In the real world, most investors are not risk-neutral.
Imagine you could invest $500 for a guaranteed return of $50. Or you could invest the same sum for a 50 percent chance of a $100 profit. The risk-averse investor would almost certainly choose the sure thing for a return of $50. The risk-seeking investor would probably choose the riskier option, partly for the potential return and partly because he or she enjoys the risk. The risk-neutral investor would choose the second option, ignoring risk and focusing on the highest potential returns.
Whether it makes sense to be a risk-averse investor depends on your situation and preferences. There are certain times when a financial advisor would probably recommend a conservative investment strategy. For example, investors nearing retirement might want to move funds into lower-risk options, since they’ll need to live off the money quite soon.
Choosing safer investments is a solid choice anytime you’re setting aside money that you’ll need back soon. Stock market volatility can be fine for financial goals that are five or even 30 years away, but you may want to take fewer risks if you’re investing money you’ll need in a year or two.
Aversion to risk does have an opportunity cost. The returns you’ll see on low-risk investments like savings accounts and bonds likely won’t compare in the long run with the 10% percent average annual returns the stock market has seen since 1928 (not adjusted for inflation).
With low-risk investments, returns might not only fail to keep up with the stock market, but also with inflation. In a year where your savings account pays you a 2 percent interest rate and inflation grows by 3 percent, you’ve essentially lost money.
Advisors often recommend choosing a more aggressive investment strategy for retirement when you’re younger and moving to less risky investments when you get closer to retirement.
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