What Is Risk Averse?
The term risk-averse describes the investor who chooses the preservation of capital over the potential for a higher-than-average return. In investing, risk equals price volatility. A volatile investment can make you rich or devour your savings. A conservative investment will grow slowly and steadily over time.
Low-risk means stability. A low-risk investment guarantees a reasonable if unspectacular return, with a near-zero chance that any of the original investment will be lost. Generally, the return on a low-risk investment will match, or slightly exceed, the level of inflation over time. A high-risk investment may gain or lose a bundle of money.
- Risk-averse investors prioritize the safety of principal over the possibility of a higher return on their money.
- They prefer liquid investments. That is, their money can be accessed when needed, regardless of market conditions at the moment.
- Risk-averse investors generally favor municipal and corporate bonds, CDs, and savings accounts.
Understanding Risk Averse
The term risk-neutral describes the attitude of an individual who evaluates investment alternatives by focusing solely on potential gains regardless of the risk. That may seem counter-intuitive—to evaluate reward without considering risk seems inherently risky.
Nonetheless, offered two investment opportunities, the risk-neutral investor looks only at the potential gains of each investment and ignores the potential downside risk. The risk-averse investor will pass up the opportunity for a large gain in favor of safety.
Risk-Averse Investment Choices
Risk-averse investors typically invest their money in savings accounts, certificates of deposit (CDs), municipal and corporate bonds, and dividend growth stocks. All of the above, except for municipal and corporate bonds and dividend growth stocks, virtually guarantee that the amount invested will still be there whenever the investor chooses to cash it in.
Dividend growth stocks, like any stock shares, move up or down in value. However, they are known for two major attributes: They are shares of mature companies with proven track records and a steady flow of income, and they regularly pay their investors a dividend. This dividend can be paid to the investor as an income supplement or reinvested in the company's stock to add to the account's growth over time.
Risk-averse investors also are known as conservative investors. They are, by nature or by circumstances, unwilling to accept volatility in their investment portfolios. They want their investments to be highly liquid. That is, that money must be there in full when they're ready to make a withdrawal. No waiting for the markets to swing up again.
The greatest number of risk-averse investors can be found among older investors and retirees. They may have spent decades building a nest egg. Now that they are using it, or planning on using it soon, they are unwilling to risk losses.
Examples of Risk-Averse Investments
High-yield savings account from a bank or credit union provides a stable return with virtually no investment risk. The Federal Deposit Insurance Corp. (FDIC) and the National Credit Union Administration (NCUA), insure funds held in these savings accounts up to generous limits.
The term "high-yield" is relative, however. The return on the money should meet or slightly exceed the level of inflation.
Municipal and Corporate Bonds
State and local governments and corporations routinely raise money by issuing bonds. These debt instruments pay a steady interest income stream to their investors. Bonds also tend to offer lower risk than stocks. Note that bonds do come with risks—Russia defaulted on some of its debts during a financial crisis in 1998. The global financial crisis of 2008-2009 was partially caused by the collapse of bonds that were backed by mortgages made to subprime borrowers.
Notably, the agencies tasked with rating those bonds should have assigned them ratings that reflected the risks of the investments. They were "junk bonds" marketed as safe bonds. Risk-averse investors buy bonds issued by stable governments and healthy corporations. Their bonds get the highest AAA rating.
In the worst-case bankruptcy scenario, bondholders have first dibs on repayment from the proceeds of liquidation. Municipal bonds have one edge over corporate bonds. They are generally exempt from federal and state taxes, which enhances the investor's total return.
Dividend Growth Stocks
Dividend growth stocks appeal to risk-averse investors because their predictable dividend payments help offset losses even during a downturn in the stock's price. In any case, companies that increase their annual dividends each year typically don’t show the same volatility as stocks purchased for capital appreciation.
Many of these are stocks in so-called defensive sectors. That is, the companies are steady earners that aren't as severely affected by an overall downturn in the economy. Examples are companies in the utilities business and companies that sell consumer staples.
Investors generally have the option of reinvesting the dividends to buy more shares of the stock or taking immediate payment of the dividend.
Certificates of Deposit
Risk-averse investors who don’t need to access their money immediately could place it in a certificate of deposit. CDs typically pay slightly more than savings accounts but require the investor to deposit the money for a longer period of time. Early withdrawals are possible but come with penalties that may erase any income from the investment or even bite into the principal.
A key risk faced by investors in a CD is reinvestment risk. This is when interest rates fall and when the CD matures, the investor's only option for a CD is at lower rates than before. There can also be bank failure risk if the value of the CD is greater than $250,000.
CDs are particularly useful for risk-averse investors who want to diversify the cash portion of their portfolios. That is, they might deposit some of their cash in a savings account for immediate access, and the rest in a longer-term account that earns a better return.