Investment risk refers to the heightened probability of capital loss and its negative impact on an investment portfolio. This situation is what risk-averse investors try to eliminate by focusing on ‘safe’ investments.
Risks are always present in the investment market and exposure to it can maximise gains, but risk-averse investors tend to avoid investments that can decrease or lead to a loss in capital. Some simply accept smaller gains over time by allocating ‘safe’ investments to their portfolio.
What makes investors risk averse?
A person’s risk tolerance is an important consideration when creating a portfolio, and it can also determine their approach to investing. There are many risk-averse investors, but the reasons why they exhibit a low tolerance for risk usually depends on each of their personal circumstances.
For most, their aversion to risk is rooted to their experiences—not necessarily their age. One example of this are people who personally experienced great economic collapses, such as the Great Depression and the 2008 Global Financial Crisis.
Since they felt what it was like to lose a huge amount of their capital or income firsthand, they developed the tendency to focus on capital preservation because further exposure to risk could mean a higher potential for financial loss.
Benefits investors receive from risk-averse strategies
Despite passing up opportunities for high growth, investors can still benefit from employing risk-averse strategies.
Here are three advantages:
- Lower risks
- Guaranteed safety
- Regular income
Risk-averse investors carefully strategise their portfolio to lower their exposure to various market risks that can lead to financial loss.
This also means they are more likely to doubt promises of high income from get-rich-quick schemes and scams, especially when they have safer options for their capital.
Aversion to risk forces investors to look at the worst case scenarios of their chosen investments, allowing them to assume and deal with potential risks. A low exposure to risk can also give a sense of security—that their capital will stay intact as it earns income through interest or dividends.
Because of this, risk-averse investors can be certain that they are guaranteed, at the very least, their minimum expected returns.
Most risk-averse portfolios focus on capital preservation as well as income generation. Returns do not need to be big as long as the income will surely arrive.
Risk-averse investors are fine with missing out on potentially greater rewards if it means not opening up their portfolio to greater exposure.
Common types of securities in a risk-averse investor’s portfolio
Some investment products that risk-averse investors favour capital preservation and regular, albeit lower, income.
Some of these risk-averse investment products are:
- High-interest accounts or Certificates of Deposit
- Government bonds
- Blue chip or preferred shares
- Low-cost funds
High-interest accounts or Certificates of Deposit
Risk-averse investors may open savings accounts, certificate of deposit (CDs) and other financial products from deposit-taking institutions because they are usually insured up to $250,000. Depositors are also guaranteed a regular and stable income from interests earned.
Out of all the offered debt securities, experts always rank government bonds with a high credit rating.
Because of this, investors who do not want to risk their money by lending it to risky bond issuers flock to government-issued bonds to ensure that they will receive coupon payments and the face value once mature.
Blue chip or preferred shares
Some think that risk-averse investors avoid the stock market because of volatility, but there are some types of shares that give assured returns.
Investors can allocate blue-chip shares to their portfolio because the underlying companies have stood the test of time and are usually dividend-paying stocks. They may also purchase preferred shares because these give the shareholder priority to dividend income over common shares.
Those who still find it risky to select stocks on their own may purchase units of professionally managed low-cost funds. These may be mutual funds, index funds, exchange-traded funds or listed investment companies that have show a stable rate of return over the long term.
Managed funds allow risk-averse investors to rest easy since the risks in their underlying investments are managed by trained professionals.
Downsides of risk aversion
The biggest downside to risk aversion is the loss of high growth opportunities that investors pass up out of fear that they could lose their capital.
The best way to ensure that fewer opportunities are lost is to properly diversify one’s portfolio and seek the advice of financial experts if needed.
This information has been sourced from the ASIC’s Moneysmart and Investopedia.