Risk averse - What is meaning, example and strategies

Risk aversion is the tendency to avoid risk. If someone is risk-averse, they prefer to keep their money safe rather than trying to make a lot of money quickly.
Risk averse
3 min
05-July-2024

Risk-averse investors have a tendency to avoid as much risk as possible. The Indian capital market is highly rewarding when it comes to making profits. However, there is always a chance that you may incur losses due to volatility and other technical or fundamental factors. Every investor has their own investment strategy, where a factor called risk appetite is included. It defines how much risk an investor can take while choosing investment instruments. Risk-averse investors look for investments that are low in risk. But does it mean that their profits are lower, too?

This article will help you understand what is risk-averse and let you choose your investment strategy effectively.

What is risk-averse?

Risk-averse meaning refers to a term used for investors and traders in the stock market who aim to invest in investment instruments with low risk. Such investors utilise the process of risk aversion to avoid as much risk as possible while investing. Risk-averse investors focus more on mitigating their loss potential than on earning profits, which are mostly associated with taking on high risk.

Risk-averse investors identify investments that are low risk and provide steady returns over time. Their main goal is capital protection, where they aim to protect the value of their initial investment and avoid a loss. Risk-averse investors avoid volatile investments even if they may offer higher returns than their low-risk investments.

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Examples of risk-averse behaviour

Risk aversion is a concept included in behavioural economics. As risk aversion entirely depends on the mindset of an individual, it is linked to their behaviour and how they think when they invest their money. The concept, called loss aversion, believes that ‘losses loom larger than gains’, detailing that losses would be more painful for a risk-averse investor than the pleasure of earning profits. Hence, risk-averse behaviour includes identifying low-risk investments that can offer returns slightly higher than the current inflation rate.

Some examples of risk-averse behaviour are:

  • An investor who puts their money in a fixed deposit (FD) rather than investing the amount in equities. Although there is a chance that equities can offer higher returns, a risk-averse investor feels more comfortable knowing that FD will provide regular guaranteed returns without the chance of any loss.
  • An investor choosing government bonds over other types of bonds as there are negligible chances of the government defaulting on interest payouts and principal repayment. Although other types of bonds may offer higher coupon rate (interest rate), a risk-averse investor chooses government bonds as they are safer.
  • An investor choosing debt mutual funds over equity mutual funds as debt mutual funds are lower in risk as they invest in fixed-income instruments, such as certificates of deposits, commercial papers, etc. On the other hand, equity mutual funds have higher risk as they majorly invest in equities.

Furthermore, some investment choices and attributes are associated with being a risk-averse investor. These include:

Risk-averse investment choices

Risk-averse investors identify investment instruments based on the associated risk. For them, risk should be lower, with zero to negligible chances of loss. Hence, they either keep their money in a savings account that offers no risk of loss and provides fixed returns through interest rates or invest in low-risk market instruments.

When it comes to investing in market-linked instruments, risk-averse investors invest in low-risk instruments such as government bonds, debt mutual funds, commercial papers, treasury bills, etc. If they invest in equities, they choose dividend growth stocks (stocks that provide regular dividends) rather than stocks with high growth potential, which makes them volatile.

Risk-averse attributes

Risk-averse investors have certain attributes associated with them that make them different from other types of investors. Also called conservative investors, such types of investors want to limit volatility in their investment as much as possible. They know that volatility is one of the main reasons for profits but can also result in losses. As their main goal is to limit losses and protect the value of their investment amounts, they invest in low-risk investment instruments even if they mean a lower profit.

They believe that their investments should not lose money, even if it means making no profit. This means that they want at least their initial investment amount when they sell the investments or make a withdrawal. Hence, they invest in investment instruments offering capital protection with the promise of fixed returns, which they take as a reward.

Also read about: What is a risk profile

Investment products for risk aversion

Now that you know risk-averse meaning, the next step is to understand what investment products risk-averse investors choose. Here are the investment products if you are looking for risk aversion:

Savings account

A savings account is a bank account provided by a bank that allows the storing of money. The banks set a predefined interest rate for savings accounts based on the amount stored in the savings account. At the date of interest payment, the bank pays interest on the balance of the savings account. Savings accounts carry no risk of investment losses as the account holder controls the deposited amount. Furthermore, RBI supervises the functioning of all the banks and ensures customers’ money is protected at all times.

Certificates of deposits (CDs)

Certificates of deposits are similar to a bank account and are offered by banks and credit unions with a promise to pay a fixed interest rate. CDs require account holders to deposit a lump sum amount in the account and leave it as is for a specific period. Risk-averse investors who do not need to use a certain amount use CDs as a deposit scheme where they earn regular interest. After the predetermined period is over, depositors can withdraw their amount easily.

Money-market funds

Money-market funds are a type of mutual fund that invests in highly liquid short-term debt, cash, and cash equivalents. Money-market funds are designed to be extremely low-risk but also offer low rates of interest to the investors. Risk-averse investors looking to invest their money for the short-term without any risk invest in money-market funds.

Bonds

Bonds are debt instruments that corporations and governments use to raise funds. Bonds provide regular interest to the bondholder with the promise of a principal amount repayment after the maturity of the bond. Bonds are ideal investment instruments for risk-averse investors, as credit rating agencies rate them based on their associated risk. Among bonds, risk-averse investors choose government bonds as they are the safest based on the government’s legible chances of defaulting on interest payment and principal repayment.

Dividend growth stocks

Dividend growth stocks are stocks that offer regular dividend payouts to shareholders. Risk-averse investors choose dividend growth stocks over other types of stocks because they witness negligible volatility and offer steady returns through dividend payouts. Furthermore, most dividend growth stocks are from defensive sectors, which do not see the same level of volatility as other sectors.

Permanent life insurance

Permanent life insurance comes with numerous features, such as cash accumulation and tax advantages, that further increase investors' returns. For example, if you invest in life insurance, you are eligible for a tax deduction up to Rs. 1.5 lakh on the premium you paid in a financial year. Risk-averse investors choose permanent life insurance as it provides cash benefits while protecting the cash value, which grows over time.

Risk-averse investment strategies

Although there are risk-averse investment products that risk-averse investors specifically choose, they also employ a host of investment strategies that further lower their investment risk. One of the primary ways is diversification, which requires investing in multiple low-risk investment instruments to spread whatever level of risk there is among the investments. If one investment turns negative, the steady returns from other investments can offset the loss, maintaining the cash value of the investments.

Income investing is another strategy where risk-averse investors invest in instruments offering steady returns rather than earning profits through capital gains. For example, a risk-averse investor would rather choose a dividend growth stock that offers regular dividends than a stock that may increase in price but offers no dividend payout. Income investing is a primary investment strategy for retirees or individuals who do not have a primary source of income.

Also read about: What is risk profile

How to measure risk-aversion?

Risk aversion is measured through a utility formula. The formula is:

U = E(r) – 0.5 x A x σ2

Where:

  • U is the utility, also called the measure of satisfaction
  • E(r) is the expected rate of return of your portfolio
  • A is the risk aversion coefficient
  • σ2 is the square of existing volatility

Although the above is a mathematical equation to measure risk aversion, most investors and traders use their own determination of investment goals, time horizon, and risk appetite to determine risk aversion. For example, if you want to invest Rs. 1 lakh for 5 years and want to increase the value to Rs. 1.5 lakh, you can invest in low-risk investments such as debt mutual funds or bonds. However, if you want to have the same final amount in 1 year, your risk-aversion would be less, as you want to earn the amount in less time. Hence, most investors create their own risk-aversion measures based on their personal investment goals.

Advantages of being risk-averse

Here are the advantages of being risk-averse:

Aspect

Explanation

Safety and stability

Risk-averse investment products come with negligible or no chance of financial losses.

Peace of mind

Such investments reduce stress and anxiety associated with financial uncertainty and the chance of incurring losses.

Predictable outcomes

It is easier to predict financial earnings as most products offer fixed income with negligible volatility.

Consistent returns

Products offer consistent low-risk returns over time.

Capital protection

Risk-averse investment products prioritise capital protection over capital gains.

Financial security

Being risk-averse builds a financial plan that offers long-term financial security. 

 

Disadvantages of being risk-averse

Here are the disadvantages of being risk-averse:

Aspect

Explanation

Lower potential returns

Without much volatility, risk-averse investment products offer lower overall returns.

Missed opportunities

Risk-averse investors may miss out on potential higher earning opportunities by focusing on low-risk investments.

Inflation risk

Some risk-averse investment products may offer lower returns than inflation, effectively lowering investment value.

Limited growth

Slow and steady returns may result in slower wealth accumulation compared to investments that may build wealth quickly.

Lower financial growth

Overly conservative strategies can lead to lower financial growth and a lack of diversification.

Risk of default

There is always a possibility that an issuer may default on interest payments or principal repayment, drastically lowering the overall returns. 

 

Conclusion

Risk-averse investors always look to minimise their investment risk and identify low-risk investment options that can give them steady and stable returns. Their main goal is to limit volatility as much as possible and ensure capital protection, even when it means earning lower returns. Risk-averse investors choose investment instruments such as bonds, commercial papers, fixed deposits, savings accounts, etc., which come with a negligible risk of losing the initial investment amount.

Now that you know what is risk-averse, you can review your investment strategies and portfolio to consider if you want to include the process of risk-aversion to balance your portfolio and mitigate the chance of losses.

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Frequently asked questions

What does being risk-averse mean?
Being risk-averse means you do not want to take on risk while investing and want to invest in instruments that can offer you fixed and predictable returns without any or negligible associated risk.
What's the opposite of risk-averse?
Risk tolerance is the opposite of risk-averse, as it means the investor has a higher risk appetite and can invest in risky investment instruments.
What does excessively risk-averse mean?
Excessively risk-averse means that the investor limits investing in highly secure investment instruments, which may offer lower than inflation-beating returns, lowering the actual money value of the investment.
Is being risk-averse positive or negative?
Risk aversion is neither negative nor positive, and its impact depends on the investment strategies and investment products utilised by the investor. It provides safety and stability but may limit potential gains and growth opportunities.
What is the difference between risk-averse and risk adverse?
Risk-averse is a term used to describe investors with a low-risk appetite. Risk adversity is a negative term, which means being so conservative that it results in losses for the investors.
What is the formula for risk aversion?
The formula for measuring risk-aversion is U = E(r) – 0.5 x A x σ2.
Which types of people are more risk averse?
A majority of risk-averse investors are individuals who have retired and do not have a primary source of income.
Is it good to be risk-averse?
Yes. It is good to be risk-averse if you want to protect your investment amount and do not want to take much risk.
How can I tell if I am a risk-averse investor?
You can review your investment goals and determine your risk appetite based on your investment amount and time horizon. If your risk appetite is lower, and you can not lose even a small portion of your invested amount, you are risk-averse.
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Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.