Risk Averse: Definition, Examples & Investment Options (2024)

Risk Averse Meaning

With regard to investing, the term risk-averse generally refers to an investor or category of investors who prefer low-risk investment securities to those associated with higher price volatility. A risk-averse investor tends to align more with the safety of principal objective than a growth objective.

When an investor is risk-averse, they tend to seek low-risk investments, which will typically produce low but more stable returns. For example, a risk-averse investor may accept some fluctuation in price in exchange for returns that can outpace inflation by a small margin. This would require taking on some market risk, specifically some short-term price fluctuation, but this risk would preferably be low compared to a stock investment.

Important: No matter what the degree of 'safety' associated with an investment security, all forms of investing generally require the investor to assume some degree of risk. For example, a US Treasury bond is widely considered to be a 'safe' investment because the security is backed by the full faith and credit of the US government. However, although the credit risk is extremely low, the inflation risk (i.e. the risk that the market price of the bond can go down in a rising interest rate environment) is still present.

How Risk Aversion Works

Risk aversion, as it is associated with investing, generally involves the reduction or minimization, but not necessarily the complete removal, of individual security or market risk to achieve an investment goal, strategy, or objective. Thus, risk aversion can be described as a priority or preference for an investor, rather than an absolute avoidance of risk.

Risk aversion may also be situational and not consistent across all of an investor's savings and investing goals. Thus, it depends upon the investor's tolerance for risk and the investor's specific goals in a given situation or account type.

For example, an investor may be risk-averse with their short-term investments, such as those used for goals with time horizons of less than three years. However, the same investor may be comfortable taking more risk with long-term investments, such as retirement or other goals, with time horizons longer than 10 years.

Note: There is a difference between risk aversion and risk avoidance. For example, a risk averse investor may accept a low degree of risk in an investment selection, whereas risk avoidance would have the investor forgo the investment altogether.

Examples of Risk-Averse Behavior

Risk aversion is related to the behavioral economics concept known as loss aversion, which holds that for most people, "losses loom larger than gains" (behavioraleconomics.com). That means that for these investors, the pain of losing tends to be much more powerful than the pleasure of gaining. For this reason, a risk-averse investor may select investments with minimal risk, even though such investments are expected to produce lower returns.

Examples of risk-averse behavior are:

• An investor who puts their money into a bank account with a low but guaranteed interest rate, rather than buy stocks, which can fluctuate in price but potentially earn much higher returns.
• A young, healthy person buying a life insurance policy, although the risk of dying prematurely is extremely low for them.
• On the game show, "Deal or No Deal," a contestant chooses to accept the guaranteed winning amount, such as $100,000, rather than take an unknown risk to win a much higher pot, such as $250,000, even though they came to the show risking none of their own money.

Investments for Risk-Averse Investors

Risk-averse investors tend to buy investments or use account types that are associated with safety or low market risk. Investment types that risk-averse investors tend to buy include US Treasury bonds, high credit quality municipal and corporate bonds, conservative allocation funds, dividend-paying stocks, certificates of deposit, and savings accounts.

• US Treasury bonds: Guaranteed by the full faith and credit of the United States government and extremely low risk of default.
• High quality municipal and corporate bonds: Municipal bonds are typically issued by state or local governments and corporate bonds are issued by corporations. High quality refers to credit quality, which implies low risk of default by the issuing entity.
• Conservative allocation funds: Diversified mutual funds or ETFs that typically consist of an asset allocation of roughly 30-50% stocks, 40-60% bonds, and 5-10% cash.
• Dividend-paying stocks: Tend to produce more stable returns than growth stocks but can still see significant price fluctuation.
• Certificate of deposit (CD): Most commonly offered by banks, CDs are deposit accounts that pay fixed interest rates for a specified period of time. CDs are insured by the Federal Deposit Insurance Corporation (FDIC), up to $250,000 per account owner, per financial institution.
• Savings accounts: Highly liquid, interest-bearing deposit accounts offered at banks. FDIC insurance guarantees the deposit up to $250,000 per account holder.

Bottom Line

Risk-averse investors tend to seek low-risk investments, which typically produce low but more stable returns. Risk aversion is not the same as risk avoidance. This means that a risk-averse investor may be willing to invest in securities that are not guaranteed, as long as the investments suit their low-risk objective.

Kent Thune