Risk-averse signify a reluctance to take on risks, and an investor is termed as being risk-averse when they prefer a low return investment with known risks as opposed to a higher return investment with unknown risks. All forms of investments carry a level of inherent risk, and a risk-averse investor is one who is averse to the risks associated with uncertainty.
Who is a Risk-Averse Investor?
A risk-averse investor opts to avoid risks altogether in his/her investment. Such an investor aims to protect the investment made and is likely to choose instruments that offer certainty in the payback whilst carrying the lowest level of risks. Although all investments carry a certain level of inherent risksInherent RisksInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization., such an investor chooses an investment that carries a minimal level of known risks – the degree of uncertainty is maintained at a minimal level. This type of investor is not attracted by lucrative returns from risky assets and prefers to earn lower returns with a secure investment.
The kind of investments chosen by risk-averse investors usually contain the following features –
- Guaranteed Returns – On the principal as well as the return (either interest or profits);
- Easy liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.
- The lower level of return as compared to the market return;
- Degree of Uncertainty – minimal.
Types of Investments Risk-Averse Prefer
The investment options chosen include –
- Savings Account
- Certificate of DepositCertificate Of DepositCertificate of deposit (CD) is a money market instrument issued by a bank to raise funds from the secondary money market. It is issued for a specific period for a fixed amount of money with a fixed rate of interest. It is an arrangement between the depositor of money and the bank.
- Municipal BondsMunicipal BondsA municipal bond is a debt security issued by a national, state, or local authority to finance capital expenditures on public projects related to the development and maintenance of infrastructures such as roads, railways, schools, hospitals, and airports.
- Treasury BillsTreasury BillsTreasury Bills or a T-Bill controls temporary liquidity fluctuations. The Central Bank is responsible for issuing the same on behalf of the government. It is given at its redemption price and a discounted rate and is repaid when it reaches maturity., Notes, Bonds
- Treasury Inflation-Protected Securities (TIPS);
- Money Market Funds.
Advantages of Being a Risk-Averse Investor
- Loss of Principal: The fundamental risk in any type of investmentType Of InvestmentStocks, bonds, and cash equivalents are the three main forms of investments. Investment, in general, refers to the purchase of anything for future use with the goal of generating a regular cash flow or increasing the value of something over time so that it can be sold for a higher price than it was purchased for, i.e. capital gains. is the risk of loss of capital. Such an investor is the one who ensures a guaranteed return in his/her investments, and therefore the risk of loss of capitalLoss Of CapitalCapital Loss is a loss when the value of the consideration received from the result of the transfer of capital assets is less than the aggregate value of the cost of acquisition & cost of the improvement. In simpler words, it can be stated as the loss derived from the transfer of capital assets. is minimal.
- Lower Risk: They take a lower level of risk by choice of investments as opposed to other kinds of investors. Although this results in a lower income, it is much safer.
- Steady Income: Retired people are most likely to be risk-averse as their intent is to ensure a steady income with minimal risks. Low-risk investments offer steady periodic income to the investors.
One of the main disadvantages is the high opportunity cost. This type of investor is more likely to choose steady and safe investments and, in the process, gives up opportunities to invest in other forms of lucrative instruments. The opportunity cost is fairly high.
Each investor’s risk appetite Risk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation. and investments preferences vary. Although being risk-averse provides certain advantages, the opportunity costs are extremely high. The purpose of investment is to earn maximum profit at minimal risks. A certain level of risk needs to be undertaken to earn a decent level of return. Therefore, it is better to be risk diverse.
This refers to portfolio diversificationPortfolio DiversificationPortfolio diversification refers to the practice of investing in a different assets in order to maximize returns while minimizing risk. This way, the risk is kept to a minimal while the investor accumulates many assets. Investment diversification leads to a healthy portfolio. wherein the investments are spread across industries and companies, and therefore the portfolio does not stand to be affected by any volatility in any particular industry. Another way to ensure that the optimum returns are earned for the portfolio is to seek the advice of financial experts. Although seasoned investors invest based on their knowledge and experience, it is always advisable to take into account the views of a financial expert as well prior to making any investments.
This has been a guide to what is risk-averse, and it’s meaning. Here we discuss who is a Risk-Averse Investor and their investment preference along with advantages and disadvantages. You can learn more about portfolio management from the following articles –