What is a Risk Lover?
A risk lover is an investor who is willing to take on additional risk for an investment that has a relatively low additional expected return in exchange for that risk. Risk lovers will seek out extremely risky investments that are prone to a return distribution with excess kurtosis. Excess kurtosis in a return distribution means there is a frequent instance of high standard deviation outcomes with the investment returns. Simply put, risk lovers often choose investments that are prone to very low or very high returns.
- Risk lovers gravitate towards investments with extremely high potential payouts even if the potential for loss is comparatively larger.
- The types of investment a risk lover is willing to consider are the same ones that common valuation methods filter out.
- Risk lovers play an important market function by helping de-risk the market for more conservative investors.
Understanding Risk Lovers
A risk lover is a stark contrast to the most common type of retail investor mentality—risk aversion. Risk averse investors tend to take on increased risks only if they are warranted by the potential for higher returns, and sometimes not even then. A risk loving investor does not need to see a pattern of high returns which compensate for the extra risk to take on a risky investment. This approach can improve overall portfolio returns, particularly if the risk lover is experienced in filtering companies for fundamental signs or technical signals. However, the probability of success over the long-term is naturally lower than other techniques due to the increased uncertainty introduced by the excess risks.
The Function of Risk Lovers in the Market
There is always a risk/return tradeoff in investing. Lower returns are associated with lower risk investments like certificates of deposit or money market funds. Higher potential returns are associated with investments of higher risk, including derivatives and individual stocks. This is simply because the market needs to compensate the investor for taking on additional risk. However, that compensation is not always fair according to particular valuation techniques. It is ultimately the investor's call on whether the skew towards downside risk is worth the potential upside returns. Valuation models simply flag this skew as an issue.
By taking fliers on some of these less attractive investments, risk lovers play an important role in the market. Because the majority of investors tend to be conservative, there has to be a way to shave risk off an investment to make the majority of the investments fit this mold. This is often done through pooling and derivatives, with risk being passed between parties in a way that most investors will never need to understand. Ideally, however, the market participants chewing up some of the excess market risk are well capitalized entities using only a small portion of their portfolio for risk skewed investments. When an entire portfolio, or even just a significant portion, is dedicated to risk skewed investments, then all it takes is a period of bad luck or poor timing to wipe out that portfolio and lose another market participant helping de-risk things for everyone else.
Dealing With Risk Lovers Professionally
Risk lovers tend to balk at many of the conservative portfolio management techniques. This is their choice when they are managing their own investments. If a risk lover is using a financial advisor, however, it can be very challenging for the advisor to deal with. Some advisors devote significant time to dealing with cognitive or emotional bias before engaging with the client's portfolio. Risk loving is not something to be cured or eliminated, but rather targeted at a portion of available capital to avoid going all in. This is, of course, where the idea of risk capital comes from. Financial advisors will have additional work to do in finding a valuation method for allocating that risk capital in a way that satiates the client's higher risk tolerance while staying within acceptable limits of a risk-reward tradeoff.