A risk-averse investor is someone who prefers to emphasize security over potential gains. Their portfolio is built to preserve capital and prevent losses first and pursue growth second. This isn’t to say that risk-averse investors see no gains. This is still an investment and they still would like to grow their money over time. Instead, this simply describes the investor’s priorities. They invest to protect what they have and grow it when possible. Here’s what you need to know. You may also want to hire a financial advisor who can manage your risk for you.
What Is Risk Aversion?
Risk aversion is a strategy where you emphasize preventing loss over making gains. This approach is tied closely to the overall issue of risk and reward in investment. As a general rule, assets with higher potential returns (reward) also have a higher chance of potential loss (risk). Assets with lower potential loss tend to have lower potential returns.
To a significant degree, this is by definition. When a safe asset will generate more money, people will pay more to buy it. That pushes the price higher, which reduces the asset’s overall returns (the money it generates relative to the price you pay for it). Lower-risk assets tend to generate lower returns because people bid the price up until they do.
A related concept is the issue of uncertainty. Risk-averse investors don’t just seek to invest in safer assets, they also tend to seek assets with less uncertainty. From a technical standpoint, this means that the asset is less volatile. Its price changes less frequently and less dramatically, instead staying within a defined band and typically closely tracking the overall market.
From a fundamental standpoint, this means that there are fewer unknown issues with the asset. You can generally know what issues will affect the performance of the underlying product, its leadership and its business model.
Risk-averse investors don’t eliminate all returns from their portfolios. Instead, this is a matter of priorities. This investor will emphasize safer, known assets. They will seek to maximize their returns within that band of safety, but they will sacrifice greater returns for greater protection against loss.
What Do Risk-Averse Investors Buy?
When you’re seeking risk-averse assets, a good rule of thumb is to look for volatility. Risk-averse investors will generally invest to avoid volatile assets and instead will seek steadier and more stable ones.
The result is that risk-averse investors typically will avoid speculative, more uncertain products like:
These are all individual-asset products characterized by high volatility relative to the market at large and a significant risk of loss. Junk bonds are a small outlier on this list, but a risk-averse investor will typically avoid them because they are defined by high-interest payments made to compensate the investor for a greater risk of loss.
Risk-averse investors will typically seek out stable products with a predictable return. These tend to include:
Debt, annuities and banking products are all characterized by their guaranteed rate of return. These are products that make interest payments, rather than the speculative gains of equities or equivalent assets. As long as the underlying issuer is creditworthy, you can count on getting your money… although you will almost certainly get less money from a successful bond than from a successful stock or real estate transaction.
Funds, like ETFs and mutual funds, are the subject of greater debate. Some investors categorize them as higher-risk because they typically are made of riskier assets, usually individual equities. By investing in an ETF or a mutual fund you expose yourself to the volatility of their underlying assets.
However, we have included them as a lower-risk category due to their inherent diversification. A fund is a collection of assets, frequently selected specifically to mitigate the risks inherent in volatile investments.
For many funds, the entire point is to smooth out the risks of something like stocks or commodities by holding a basket of diversified investments. By investing in, say, a stock market ETF you can capture some of the gains of investing in equities while eliminating both the lows and the highs that come from buying individual stocks. The upshot is that most funds exist specifically to mitigate risk, making them a potential target for risk-averse investors.
How To Be A Risk-Averse Investor
While beyond the scope of this article, investors who would like to dive more into the issue of risk and reward should research the issue of alpha and beta. Alpha measures an asset or portfolio’s performance relative to the market at large, essentially reflecting the degree to which it outperformed comparable assets.
Beta measures an asset’s sensitivity to the market at large, reflecting how volatile it is relative to comparable assets. Generally speaking, beta reflects an asset’s risks and alpha reflects the asset’s rewards. Beyond that, investing toward risk aversion means balancing your priority to preserve capital against your need for growth. A risk-averse investor wants to make sure that they don’t lose money.
However, by nature of investing, they also do need to make some gains. While there are many ways to go about this, you can start with two good rules of thumb: risk-first and returns-first.
With this approach, first, select a basket of potential assets that meet your need for stability. For example, you might decide that you would like the safest possible portfolio. So that might mean investing in Treasury debt, annuities and FDIC-insured banking products.
Then, from that basket of assets, select the ones that will give you the best return or that otherwise meet your needs. This is a risk-first strategy because you define potential investments by their risk profile, then choose the best return you can get from those options.
With this approach, you want to take the most risk-averse strategy that still meets your investment goals. Here, you start by determining what kind of a return you want or need. Then you create a basket of potential assets that can provide those returns.
From that basket of assets, you then select the ones that best mitigate risk. You do so despite the fact that other, higher-risk, assets might provide a better return. As long as an investment can meet your minimum needs, you prioritize stability and loss prevention. This is a returns-first strategy because you define what you need to get from your investments, then select the safest assets that can give you that return.
The Bottom Line
Risk-averse investors prioritize keeping their money safe, then try to grow it as best they can. This typically means avoiding high-volatility, high-uncertainty products in favor of income-based assets and well-diversified portfolios. Those who are very risk-averse may want to work with a professional in order for their concerns to fully be met.
Risk Management Tips
- While this can seem overwhelming, you don’t have to go it alone. A financial advisor can help manage your risk throughout your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Balancing risk and reward is, ultimately, at the heart of investing. When it comes to risk tolerance, it’s all about your personal needs.
Photo credit: ©iStock.com/Victoria Gnatiuk, ©iStock.com/fizkes, ©iStock.com/Inside Creative House