Risk averse investors are those who fear or are intolerant of risk. Given a chance to pick from two investments with similar returns they will go with the one that offers the lesser risk. This is because risk averse investors do not like risk.
Because of this they will avoid investing in stocks and other investments that they consider to be higher risk. This means that they will likely miss out on greater rates of return as a result of their more cautious investing approach. These investors who look out for investments they perceive to be safer will tend to go with government bonds and index funds. Both of these typically offer lower returns.
Studies have been done that show investors will tend to avoid risk that is unnecessary. This is a subjective measurement because every investor has a varying definition of what is unnecessary risk. Those investors who wish to obtain a greater return will understand that a larger amount of risk is necessary. Individuals who are satisfied with a lower return would consider this type of investment strategy foolhardy. The overwhelming majority of economic players are risk averse enough to choose an investment that is less risky if it offers the same return as a riskier investment.
Risk averse markets are those which are afraid of geopolitical or economic events. When the markets are like this they favor safer havens such as gold and the precious metals, Swiss Francs, Treasury bonds, and U.S. dollars. In risk averse markets, investors tend to shun higher risk stocks and securities and try to preserve their investment capital from losses. The opposite of these are risk tolerant markets.
Risk aversion is the representation of individual’s and investor’s all around preference to have certainty over uncertainty. Because of this, they attempt to reduce the repercussions of the worst potential outcomes that lie before them. Risk aversion means that people will prefer to stay in a low paying job that offers perceived job security rather than to become an entrepreneur who has the chance to make a great amount of money as well as to lose all of the money and time that is invested.
Risk aversion will drive these individuals to seek out a lower rate of return with their investment and savings capital. They would rather have a savings account or certificate of deposit than equities. Even though equities offer much greater potential returns than these other instruments, they are far riskier and can deliver negative returns. A great number of risk averse investors will give extreme weight to the worst possible scenario. It does not matter that the probabilities of these occurring are low. They will shy away from these investments because losses could happen.
Studies have determined that risk aversion comes from an individual’s experience. This is particularly true of the economic situation they experienced while a child. Those who grew up in harder economic times are more likely to handle and invest their money far differently from those who grew up in prosperous times.
A classic example concerns Americans who grew up in the 1930’s Great Depression. This group has always tended to be extremely risk averse about career or job changes. They are typically extremely conservative with their money. They also avoid the stock market as much as possible as they remember the Black Thursday and Black Monday crashes of 1929.
Financial advisers and planners must understand the risk tolerance and aversion of their clients clearly. They can not recommend the appropriate investments and risk level without this. They will invest the money of a risk averse individual far differently than that of a person who is risk tolerant.