Risk Averse

What Does Risk Averse Mean?

Risk averse describes an orientation that favours certainty over risk, regardless of the more attractive potential outcome. Investors who are risk averse tend to focus on capital preservation rather than capital appreciation. However, that doesn’t mean they would entirely avoid risk, but instead would prefer a more stable and slow growth approach, which in some cases might be in-line or just over the rate of inflation. To achieve this, risk averse investors tend to look at lower-risk asset classes such as cash equivalents (i.e. money market funds) and fixed income, but depending on their risk profile could also integrate riskier securities such as blue-chip stocks into their portfolio. Higher risk assets such as small cap equities, derivative products, or crypto currencies typically fall outside the investable universe for risk averse investors.

3 Types of Risk Averse Investment

Investment risk is typically categorized into different grades to help investors understand the level of risk associated with an asset. Below are three examples of a lower risk investments that risk averse investors might typically consider.

Certificates of Deposit

Offered by financial institutions such as banks and credit unions, certificates of deposit (or CDs) typically pay slightly higher interest than savings accounts, but in return investors do not have access to their funds for a pre-determined period (ranging from three months to a few years, depending on the product). The way interest is distributed also depends on the terms set by the issuing institution – some pay interest at regular intervals (for example monthly, quarterly, or annually) while others accumulate the interest and pay it as a lump sum at the end of the term.

Treasury securities

Also knows as “Treasuries,” these are fixed income securities issued by the US Department of the Treasury. The funds raised are used for government operations and to pay existing debt. As they are very safe investments (regarded as “risk-free”), the yield investors can achieve is typically low.

Treasuries are divided into three categories:

• Treasury bills – short-term securities maturing in one year or less
• Treasury notes – medium-term securities maturing in two to ten years
• Treasury bonds – long-term securities maturing in 20 to 30 years

Although treasuries are a very low risk investment, they can still be impacted by inflation and changes in interest rates.

Investment Grade Corporate Bonds

These are debt instruments issued by companies with high credit ratings, meaning that the chances of default are very low. Depending on the credit rating agency, these bonds are rated BBB- or higher by Standard & Poor’s and Fitch, or Baa3 or higher by Moody’s. Investment grade (IG) corporate bonds typically generate higher returns that government bonds, while at the same time offer regular interest payments.

The below chart illustrates how these investments rank in terms of risk.

Source: PIMCO

What is the Opposite of Risk Averse?

The opposite of risk aversion is risk tolerance. Investors who are comfortable with and are willing to take on higher levels of risk (meaning higher potential loss) are risk tolerant. By definition, they tend to choose investments that offer higher potential returns, despite the increased likelihood of unfavorable outcomes. Such investments may include micro and small cap equities, venture capital, and derivatives, or short-selling strategies.

What is the Difference Between Risk Seeker and Risk Averse?

The main difference between risk averse investors and those who are seeking higher risk is attitude towards risk and their investment choices. To draw a clear line between the two, an investor’s ability to take risk should be assessed. This is typically done by evaluating the investor’s time horizon, liquidity needs, and capacity to accept loss.

According to a paper by the CFA Institute that investigates investment risk profiling, the two most common approaches used to measure risk tolerance are psychologically derived risk-tolerance questionnaires and economics-based revealed preference tests.

Below in an example of a preference test.

Source: CFA Institute

Risk Averse Investment Strategy

Aside from the above-mentioned lower risk assets that appeal to risk averse investors, there are also risk averse investment strategies. Some of these include:

• Income investing – this approach is popular with individuals who are retired or approaching retirement due to the lower risk and opportunity to generate income. The strategy focuses on holding a portfolio of fixed income securities (and/or some dividend stocks) that should generate stable and regular cash distributions. Capital growth is not an objective.
• Holding a well-diversified portfolio – this strategy entails holding a diverse mix of assets that are less correlated with one another and are expected to react differently in specific market conditions. By doing this, investors would expect to optimize the risk and reward of their portfolio over a longer-term

Risk Averse Excel Example

What is Risk Neutral?

An investor who focuses solely on potential returns, regardless of associated risk, is described as risk neutral. This contrasts with both risk averse and risk seeking investors. There are a few factors that could invoke a risk neutral mindset, for example a change in the price of an asset. As the current price of an asset essentially represents the present value of its expected future returns, this calculation often results in a current price below the expected return as most investors are risk averse (meaning they are concerned more with losses than profits). This results in a point of equilibrium below a more accurate expected future return on this investment. Modelling this effect requires adjusting for risk aversion (typically by using probability measures also known as theoretical risk-neutral measures).

For example, an investor wants to invest $20,000, and has the following options:

1. Bank deposit with guaranteed 5% interest.
2. Speculative investment that may allow the investor to double his or her investment, but also carries the risk of losing the entire amount invested.

In this case, we can classify investors into three categories. Those who:

1. Choose the safe investment (risk averse)
2. Accept the risk and choose the second option (risk-seeking)
3. Those who would need more information about the second opportunity and then decide (risk neutral)

Risk neutral investors need to know the probability of doubling their money (should there be only a 50% chance, they might consider the expected return as zero since there is an equal possibility of losing everything). However, should the probability of doubling increase to 65%, then those willing to consider the second option would have created a risk-neutral mindset since they were focused on the probability of making a profit and no longer focused on the risk.

Pros and Cons of Being Risk Averse

Pros

• Risk averse investors focus on capital preservation, which generally implies lower levels of volatility and (in most cases) less stress
• These approaches tend to generate stable and more predictable returns, both in terms of income and capital growth
• Conservative investors typically have a long-term investment horizon that incorporate goals such as retirement planning

Cons

• Risk aversion naturally leads to lower returns and these investors can miss out on potential opportunities for profit
• Lower risk investments may not always deliver returns above or in line with inflation, therefore reducing purchasing power over time
• Avoiding riskier areas of the market could also expose investor’s portfolio to lower levels of diversification

Conclusion

Risk averse investors generally have low risk tolerance and tend to focus on preserving their capital by holding low risk assets such as cash instruments and high-quality bonds. Despite the potential for higher returns that riskier assets such as small cap equities may offer, risk averse investors prefer a lower yielding but predictable and stable asset that may also generate additional income. Holding a well-diversified portfolio of assets that exhibit low correlation with each other is a popular strategy to avoid losses during market turbulence and over the long-term.

Additional Resources

Portfolio Management Certification