What Is Risk Averse?
How Risk-Averse Investors Work
The term risk-neutral is used to describe the attitude of an individual who may be evaluating investment alternatives. If the individual focuses solely on potential gains regardless of the risk, that person is said to be risk-neutral. Such behavior, to evaluate reward without thought to risk, may seem to be inherently risky.
A risk-averse investor would not consider the choice to risk $1,000 loss with the possibility of making $50 gain to be the same risk as a choice to risk only $100 to make the same $50 gain. However, someone who is risk-neutral would. Given two investment opportunities, the risk-neutral investor only looks at the potential gains of each investment and ignores the potential downside risk.
A risk-averse investor, on the other hand, dislikes risk and, thus, stays away from high-risk stocks or investments and is prepared to forego higher rates of return. Investors who are looking for "safer" investments typically invest in savings accounts, bonds, dividend growth stocks and certificates of deposit (CDs).
A risk-averse individual has a low risk tolerance or a high risk aversion. These conservative investors are willing to accept little to no volatility in their investment portfolios. Often, retirees who have spent decades building a nest egg are unwilling to allow any type of risk to their principal. A conservative investor targets vehicles that are guaranteed and highly liquid.
- Risk-averse individuals shy away from risk and prefer low volatility investments.
- Risk aversion means that investors will tend to purchase safe assets like highly rated bonds and CDs.
- Risk-averse individuals seek capital preservation over growth, which may actually be detrimental for those who are younger.
Investment Strategies for the Risk Averse
Depositing money into a high-yield savings account at a bank or credit union provides a stable return with almost no investment risk. Risk-averse investors can take assurance knowing that government agencies, such as the Federal Deposit Insurance Corp. (FDIC) and the National Credit Union Administration (NCUA), partially insure funds held in savings accounts.
The downside of keeping money in a savings account is the return; most high-yield savings accounts provide a lower return than most other investments. Investors are also subject to interest rate risk. For example, if interest rates fall, investors receive less interest on their savings.
Risk-averse investors may want to invest in corporate or municipal bonds. These debt instruments pay a steady dividend to investors. Corporate bonds are issued by established companies, while municipal bonds get issued by state or local governments. Risk-averse investors may have a preference for municipal bonds, as they have more financial stability than corporate bonds.
However, corporate bonds are still safer than investing in common stocks, because even if the issuing company becomes insolvent, bond investors receive the first payment of leftover money after the company’s creditors. Municipal bonds may also offer superior returns to investments with similar risk, as they are exempt from federal and state tax.
Dividend Growth Stocks
Dividend growth stocks appeal to risk-averse investors because, even if a stock’s price falls, predictable dividend payments help offset losses. Companies that increase their annual dividend each year typically don’t show the same volatility as stocks purchased for capital appreciation.
Stocks in defensive sectors, such as utilities and consumer staples, usually show continued dividend growth, as these companies can consistently make money in most economic environments. Investors may also have the option to reinvest dividends to buy more shares.
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 return slightly more than savings accounts, however, to receive higher interest rates, investors need to lock their money away for longer periods and may be charged a withdrawal fee if they want to exit early. For example, a five-year CD may earn 2%, while a one-year CD may offer an interest rate of 0.75%.
CDs are particularly useful for risk-averse investors who are trying to diversify the cash portion of their portfolio.