What Does Risk Averse Mean in Investing? (With Examples)

By Indeed Editorial Team

Updated March 28, 2022 | Published December 7, 2020

Updated March 28, 2022

Published December 7, 2020

Risk averse is a term that you may hear when talking about investment strategies and referring to the level of risk you are willing to accept. The term refers to an investor who avoids taking significant risks in their investments. When you invest, you have to determine how much risk you want to take on in exchange for the potential for higher returns. In this article, we will discuss the definition of risk aversion and examples of risk-averse investments.

What is risk averse?

An investor who is risk averse chooses to preserve their capital by investing in opportunities with lower risk, rather than taking on more risk through investments that might offer the potential for a higher return. In investments, risk equates to the volatility of a particular opportunity. Volatility is the measure of the rises and falls of a particular security or index over a period of time. For example, if a stock rises in value quickly, it is viewed as more volatile than one that increases slowly and steadily over time.

When you invest, the volatility of the investment ultimately determines the outcome or the return on that investment. A low-risk investment is stable, essentially guaranteeing some type of return, although it typically is not very high. However, most low-risk investments provide reasonable returns that may match or even slightly exceed the level of inflation. An investment that comes with higher risk also comes with the potential for a higher return. The investment's volatility level could produce high returns or cause the value to drop quickly and significantly.

Related: Guide To Rate of Return

What are risk-averse investors?

Investors who avoid volatility in favor of more conservative investments are described as risk averse. This type of investor generally passes up high-risk investment opportunities in favor of safer, more conservative investments. The opposite of a risk-averse investor is a risk-neutral investor, which is someone who evaluates investment opportunities solely on the potential gains, rather than looking at the risk involved. An aversion to risk in investing may come later in life when the investor is getting closer to retirement and wants to avoid losing money they will need during that stage of their life.

A risk-averse investor will evaluate the risks associated with an investment, which include the volatility of each opportunity. Certain investments have proven stability and slow, steady growth, which makes them unlikely to drop suddenly in value. The risk that comes with investing in this type of opportunity is low, and an investor can safely assume that, barring an unforeseen dramatic economic swing, their investment will be safe and generate a reasonable return.

Related: Five Key Risk-Mitigation Strategies (With Examples)

Risk-averse investment examples

Risk-averse investors tend to choose certain investment opportunities that are known for their stability and low volatility. Examples of lower-risk investments for the risk-averse person include:

Corporate bonds

A corporate bond is a debt security issued by a corporate firm and sold to an investor. This type of bond is usually a longer-term investment opportunity, requiring at least one year to mature. An investor who purchases corporate bonds lends money to the corporation issuing it in exchange for a legal commitment from the corporation to pay back the investment plus interest when the bond matures.

Municipal bonds

A municipal bond is a debt security issued by a government entity that is sold to an investor. The funds paid for this type of bund are used to fund public projects, including education, transportation and infrastructure and community healthcare initiatives. An investor who purchases municipal bonds lends money to the government entity issuing the bond to fund a project in exchange for a legal obligation to pay back the amount paid, plus interest.

Certificates of deposit (CD)

A certificate of deposit, also called a CD, is a financial product offered by banks, credit unions and other financial institutions that provides a premium interest rate in exchange for a fixed term length and date of withdrawal. Investing in a CD can yield a higher return than other low-risk investment opportunities, but the money invested is not accessible until the agreed-upon withdrawal date.

Savings accounts

A savings account is an account offered by a bank, credit union or another type of financial institution that stores the owner's money, providing a fixed interest rate and a secure storage method for saved funds. Savings accounts typically offer slow but steady growth, allowing the account holder to earn interest in exchange for keeping their funds in the account. Some savings accounts have restrictions on how often withdrawals can be made or minimum account balances.

Dividend growth stocks

Dividend growth stocks are investment opportunities that pay dividends to investors or regular payouts of their earnings to their shareholders. Dividends are typically only offered by publicly traded companies that seek to reward their investors for putting their money into the business. A dividend growth stock investment opportunity is viewed as less risky than other types of stock investment opportunities because investors can count on regular payouts from the companies they invest in, often based on a schedule issued by the company that offers the dividends.

Index funds

An index fund is a type of exchange-traded fund (EFT) or mutual fund that tracks or matches the components of a financial market index. Risk-averse investors often choose index funds because they track market indexes, which typically increase in value over time, and their potential losses and gains are not as volatile as funds that seek to beat the market, rather than track its patterns. Index funds rely on the investments from multiple investors to purchase bonds, securities and/or stocks that make up a specific market index.

Debentures

Debentures are debt securities that are not backed by collateral or assets but rather backed by the trustworthiness or security of the issuer. A company may offer debentures to invest in its growth or fund its operations, and investors who choose to take this investment opportunity will typically research the company and the people who lead it before investing. A debenture is issued to an investor in exchange for repayment with interest after an agreed-upon period of time.

Related: Guide To Understanding Expected Return

How to measure risk aversion

When measuring risk aversion, you may consider your own feelings on taking risks, both in your personal life and your financial life. Risk aversion can change over time, and the willingness to take on more risk may shift based on your experiences with taking or avoiding risks. Follow these steps to measure risk aversion in investing:

1. Absolute risk aversion

One method for measuring the level of risk an investor is willing to accept is known as absolute risk aversion. The Arrow-Pratt measure of absolute risk aversion is a formula that produces a curve, and the higher the curve, the more risk-averse the individual is when choosing investment opportunities. This formula is named after John W. Pratt and Kenneth Arrow, two economists who studied risk aversion and is also known as the coefficient of absolute risk aversion.

The formula is: A(c) = -u”(c)/u'(c)

When applying this formula, you can compare the constant absolute risk aversion, also called CARA, with the hyperbolic absolute risk aversion (HARA.) HARA is one of the more generalized classes of utility functions used to calculate risk aversion.

2. Relative risk aversion

Relative risk aversion, or RRA, can also be determined with the Arrow-Pratt measure of risk aversion. It uses a different formula to look at how much risk an investor is willing to consider and take on within their portfolio.

The formula is: R(c) = cA© = -cu”(c)/u'(c)

3. Portfolio theory

A less complex method for looking at risk aversion is available in today's portfolio theory, which measures the standard deviation of the return on the investment, or the square root of its deviance. Risk aversion in this method of calculation looks at the potential expected reward an investor would need to accept more risk.

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