Risk-averse or aversion is a popular term used by companies and investors. It involves the prioritization of safety over profit. The opposite of risk-averse is risk tolerance.
While risk-averse protects your investment from a steep fall and in turn, may guarantee little profit, risk tolerance is a strategy used in measuring an investor’s limit in terms of risk-taking.
Both concepts are effective when it comes to investing. It all comes down to knowing what is best for every situation.
The goal of this article is to ensure you know what both terms stand for in the investment world and when best to use them.
What is Risk Averse?
Risk-averse is an investment concept designed to provide maximum security to your investments. In other words, a risk-averse investor is more concerned about the state of their investment than the profit it tends to generate.
This strategy is known for generating little profit and protecting your fund from a steep fall. On the bright side, companies offering risk aversion also rarely fold up.
What is Risk Tolerance?
Risk tolerance is the opposite of risk aversion. It is an investment concept that measures the degree of risk an investor is willing to take.
In other words, a risk-tolerant investor is someone with a long-term view of making a higher profit even if their capital suffers a few losses along the way.
Fund houses and managers use risk tolerance levels to build their portfolios and decide which instrument works best for them.
What Are The Types of Risk Tolerance?
Based on risk tolerance level, there are 3 major types of managers. They include:
1. Aggressive investors
This type of investor is very aggressive with their investments. They expect high returns or profits from every investment within a short time.
Aggressive investors have high-tolerance levels and are usually open to investing substantially. To be an aggressive investor is to constantly follow market trends and have a good knowledge of every happening.
They adopt risky market strategies and primarily invest in equities and derivatives. This type of investor is not interested in a low-return investment like bonds.
Hence, when things go according to plan they are handsomely rewarded. They also suffer big losses when things go south.
2. Moderate-risk investors
On the scale of risk tolerance investors, moderate risk investors play second fiddle to aggressive investors.
These investors adhere to the path of caution than aggressive investors and are candidates for lower returns.
In other words, a moderate investor has a safer return portfolio and primarily invests in equities, derivatives, ETFs, and bonds.
Moderate risk-taking investors also engage in volatile markets, however, their investments in such markets are always negligible.
They focus and invest more heavily in less volatile markets and are okay with moderate returns. This means their portfolio rarely sees a large upward and downward swing and will remain in a safe zone irrespective of how the market moves.
3. Conservative investors
Conservative investors are not interested in anything risky. They are more interested in a safe and steady inflow of returns on every bond, bond fund, and ETF investment.
Conservative investors avoid risky assets like equities and instruments with a high degree of uncertainty.
When you see a conservative investor’s portfolio, all you will notice is slow and steady growth with maximum protection and low risks.
Factors Affecting Risk Tolerance
When measuring your ability to take risks as an investor, they are quite a lot of factors to consider:
1. Impact by investment horizon
The investment horizon or time is how much time an investor is willing for his investments to roll. As a risk-tolerant investor, if you plan to allow your investment to play out over a few years, you can employ a high-risk-tolerant approach.
On the flip side, if your objective is to allow your investment to last just a few months to get a certain profit, a less risky high-tolerant approach is ideal.
In essence, a higher or a longer investment horizon accommodates higher risk better than a lower investment horizon.
2. Age of the investor
The age of an investor plays a significant role in how much risk he or she is willing to take. Generally, it is believed that the older you become as an investor, the lower your interest in taking risks.
This is because young investors have age on their side and can recover their losses regardless of fluctuations.
3. Characteristics of portfolio
The shape of your portfolio tells a lot about your risk tolerance as an investor. If your portfolio comes off as one with enhanced stability and security, it means you adopt a less risk-tolerant approach.
However, if your portfolio reveals huge profits and returns, there is a huge chance your methods involve high risks. The greater the size of your portfolio, the greater your tolerance level as an investor.
This is because bigger portfolios can afford to take more hits on their way to glory (profit-making) than smaller portfolios.
In other words, if you have a small portfolio, stick to a low-risk-tolerant approach. Otherwise, stick with a high-risk-tolerant approach.
FAQs
What is an example of a 60/40 portfolio structure?
A 60/40 portfolio structure represents 60% investment in stocks, 30% in bonds, and 10% in cash.
This type of structure is often exhibited by a moderate-risk investor.
What is a risk-neutral person?
A risk-neutral person is someone who focuses mainly on the potential profit of an investment with little or no concern for the risks involved.
What is the difference between risk capacity and risk appetite?
Risk capacity is the degree and type of risk an organization can support on the journey to profit making.
Risk appetite, on the other hand, is the amount or type of risk such an organization is willing to accept in pursuit of profit-making.
Conclusion
One major way to determine the type of investment most suitable for an investor is to carry out a risk tolerance assessment.
Risk-tolerant investors are open to more profitable deals and organizations love them. Risk-averse investors, on the other hand, only get exposed to conservative investments.
It is your responsibility as an investor to know which works for you best.
I hope you found this article helpful. If your portfolio or business is doing well, you might want to check out the effect of incentive management on business.
Thanks for reading.
