What Is Risk Averse?
Risk aversion is the tendency to avoid risk. 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 more 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 can be contrasted with risk seeking.
- Risk aversion is the tendency to avoid risk and have a low risk tolerance.
- 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.
Risk-Averse Investment Products
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.
Certificates of Deposit (CDs)
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.
Money Market Funds
A money market fund is a type of mutual fund that invests in high-quality, short-term debt instruments, cash, and cash equivalents. These funds are very low-risk and are structured so that each fund share is always worth $1.00. Because they are conservative, they tend to pay relatively low rates of interest to investors.
Treasury securities, or the debt issued by the U.S. federal government, are considered to be the safest of all securities. Investors can access Treasuries via mutual funds or ETFs, or directly through the government's TreasuryDirect website.
State and local governments as well as corporations also 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 can 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.
Permanent Life Insurance
Permanent life insurance products like whole life and universal life come with cash accumulation features, tax advantages, and living benefits that make them attractive for risk averse investors. Cash value in a life insurance policy cannot ever lose value and grows over time. Policy owners can withdraw or borrow against that cash value at any time (but this may reduce the policy's death benefit amount).
Risk Averse Investment Strategies
In addition to individual assets or asset classes that cater to risk averse investors, there are also a number of risk-averse investment strategies that can be employed to minimize losses.
One way is through diversification of your portfolio. Diversification means including assets and asset classes that are not highly correlated with one another. This way you are not putting all of your eggs into one basket, and if some securities fall in a given day, others may rise to offset those individual losses. Mathematically, diversification allows you to maximize your expected return while minimizing your overall portfolio risk.
Income investing is another strategy that focuses on holding bonds and other fixed-income securities that generate regular cash flows, as opposed to seeking capital gains. Investment income is especially useful for retirees who no longer have employment income and cannot afford to experience losses in the markets. Income investing does come with certain other risks such as due to inflation or negative credit events. Bond and CD laddering along with inflation-protected securities can help lower your overall fixed income portfolio risk.
Saving is very low risk, but it is not investing. Investing means that your money is inherently at-risk, whether you are buying a stock or lending money in the form of a bond.
Advantages and Disadvantages of Being Risk Averse
Exhibiting risk aversion means to shy away from risk, and in terms of investing means avoiding risky securities. Risk averse individuals should seek out investments and strategies that fit this low risk tolerance. As such, one advantage is that the risk of losses are minimized. Investing in low-risk products like fixed-income securities can also mean guaranteed cash flows and constant positive returns over time.
However, with low risk comes low expected return. In fact, the risk-return tradeoff does not favor a risk averse investor who shies away from stocks and other risky assets. Such risk averse investors will tend to enjoy lower total returns, especially over long time horizons. Risk aversion can also lead people to irrationally avoid otherwise good opportunities and may stay away from the markets entirely, putting them at a disadvantage when saving for things like retirement. Moreover, money kept idle in savings or "under the mattress" will lose buying power over time as it is eroded by inflation.
Pros and Cons of Being Risk Averse
Minimizes risk of losses
Can generate steady income
Guaranteed cash flows
Much lower expected returns, especially over time
Missed opportunities (opportunity cost)
Inflation erodes buying power of savings
Which Types of People Are More Risk Averse?
Research shows that risk aversion varies among people. In general the older you get, the lower your risk tolerance is, especially as investment time horizons for things like retirement draw near. On average, lower-income individuals and women also tend to be more risk averse than men, all else equal.
Is It Good to Be Risk Averse?
Being risk averse is a double-edged sword. On the one hand, you greatly lower your chances of losses, but you also can miss good opportunities and greater returns on riskier investments.
How Can I Tell If I Am a Risk Averse Investor?
You can gauge your risk tolerance for investing by taking any number of risk profiling questionnaires available online. When you sign up for a brokerage account or financial advising relationship, you may also be required to take such an evaluation.
Is Risk Aversion the Same As Loss Averson?
No. Risk aversion is one's general attitude toward avoiding risk. Loss aversion is instead the asymmetric propensity to feel the pain of a loss more than the pleasure from an equivalent gain (e.g. losing $100 feels usually worse than gaining $100 feels good). Being risk averse can be completely rational given one's personal situation. Loss aversion, however, is an irrational tendency identified by behavioral economics.
The Bottom Line
Risk averse investors tend to favor capital preservation over capital gains and seek out more conservative investments than more risk-seeking individuals. Such investments may include savings products, CDs, highly-rated bonds, and blue-chip stocks. Being risk averse reduces one's chance of experiencing losses, but also comes with opportunity costs, missing out on good opportunities and sacrificing greater expected returns earned elsewhere.