Risk-averse investors choose to preserve capital rather than receive a greater-than-average return. Investing is about price volatility. Volatilities can either make you wealthy or eat away at your savings. A conservative investment will grow steadily and slowly over a period of time.
Low-risk investment means stability. Low-risk investments guarantee a moderate, if not spectacular, return and a nearly zero chance of losing any initial investment. The return on low-risk investments will generally match or slightly exceed inflation over a time frame. High-risk investments can lose or gain a lot of money.
Understanding Risk Aversion
Risk-neutral refers to an individual who evaluates investment options by focusing only on the potential gains and not the risk.
Pure risk neutrality is unrealistic, of course, even for CEOs.
This may seem counterintuitive, but considering rewards without taking into account risk is risky.
However, the risk-neutral investor will only consider the potential benefits of each investment opportunity and overlook the possible downside risks. The safety-conscious investor will sacrifice the chance for a substantial gain for safety.
Kinds of Risk-Averse Investments
High-yield savings account at a bank/credit union offers a steady return and virtually no risk of investment. These savings accounts are insured by the Federal Deposit Insurance Corp. and the National Credit Union Administration.
However, the term “high yield” is not absolute. The inflation rate should be equal to or slightly higher than the return on money.
Municipal and Corporate Bonds
Corporations and state and local governments routinely issue bonds to raise funds. These debt instruments provide steady income streams to investors in the form of interest. Bonds are also less risky than stocks. There are risks associated with bonds. Russia defaulted on some debts in the 1998 financial crisis. Due to the collapse of bonds backed by subprime borrowers’ mortgages, 2008-2009 was a global financial crisis.
Notably, rating agencies assigned these bonds should have given them ratings that reflect the risk of the investments. These bonds were marketed as “junk bonds,” which are considered safe bonds. Bonds issued by stable governments or healthy corporations are a good choice for risk-averse investors. They receive the highest AAA rating.
Bondholders are entitled to repayment of the liquidation proceeds in the event of a bankruptcy. One advantage over corporate bonds is municipal bonds. Investors will enjoy a higher rate of return because they are exempted from both federal and state taxes.
Dividend Growth Stocks
Dividend growth stocks are attractive to risk-aversion investors as their predictable dividend payments can offset potential losses, even when the stock price drops. Companies that pay out higher annual dividends every year tend to have less volatility than stocks purchased for capital appreciation.
These stocks are often in the so-called defensive sector. These companies are stable earners and are not as affected by a general downturn in the economy. Companies in the utility industry and those that sell consumer staples are two examples.
Investors have two options: reinvest the dividends to purchase more stock or take immediate payment.
Certificates of Deposit
A certificate of deposit is quite a good option for risk-averse investors who don’t want to have immediate access to their money. CDs are generally more expensive than savings accounts, but they require that the investor deposit the money for more extended periods. You can withdraw early, but you may face penalties or lose any income.
Reinvestment risk is a crucial risk for CD investors. When interest rates drop, investors have no other option but to buy CDs at lower rates. Bank failure risk can also exist if the CD’s value exceeds $250,000.
CDs can be an excellent option for risk-aversion investors looking to diversify their cash portfolios. They might put some cash in a savings account to have immediate access and the rest in an account that offers a higher return.
Types of Investments Risk-Averse Investors Choose
An investor who has a good risk-taking behavior and is cautious about taking on higher risks like stocks, options, or futures, tends to steer clear of riskier investments. They will stick to investments that offer guaranteed returns and low-to-no risks. These investments include Treasury bills and government bonds. Below are two lists that classify investments as lower or higher risk preference. While the relative risk levels for different investments are generally constant, a low-risk investment may have a higher risk than others.
Safer, low-risk investments
Certificates of Deposit
Investment Grade Corporate Bonds
A company can issue any debt instrument, which is considered safe and low-risk. These debt instruments can be used to invest in a risk-aversion strategy.
These instruments have a lower risk, at least partially due to their absolute priority. There is a clear order of payment to creditors and investors in the event of the dissolution or bankruptcy of a company. The law states that the company must first repay its debtors before paying preferred shareholders or common shareholders (equity investors).
Higher risk investments
Financial Derivatives (Options, warrant, futures)
Difference between Risk averse and Risk neutral
In many terms, the difference between risk averse and risk neutral can be explained as a difference in expected value or return on investment. Put simply, when you invest in an asset, such as a stock or bond, the amount that you are going to get in return is your expected return, while the risk that you will incur in the process of investing it is called risk. In terms of finance, risk is something that you can get into if you don’t manage it well; so, for example, if you own a house, you will run the risk of losing it if you neglect to pay your monthly rent, or if the building collapses. When you have a guaranteed return, such as a savings account, the risk associated with it is minimized and therefore the expected return is higher.
The difference between risk averse and risk neutral is that the risk adverse, which we are looking at here, will take any given initial investment and reduce it by some percentage. It is similar to the way that you would take a high interest rate risk and reduce it by one percent by getting a low risk high interest rate portfolio. The risk averse will also take into account the fact that you might lose the money that you are putting into the portfolio, but the alternative is that you may also lose everything. Therefore, it is important for a manager to identify where the risk level is greatest and take steps to mitigate that risk so as to minimize the adverse effects on the overall portfolio and, hence, the return.
So, how should a risk averse manager identify the difference between risk-averse and risk averse? They need to first understand what their risk control parameters are. This will allow them to set up a portfolio of assets that they feel is high risk and is therefore likely to incur large potential losses. Once they have identified these high risk areas, they will then need to look at their risk control plan in order to make sure that they do not exceed their loss ceilings. Of course, they will also need to make sure that they do not exceed their profit ceilings.