A risk averse investor is one who does not like taking risks, he or she prefers lower returns instead of higher ones, because the lower return investments have known risks, while the higher return ones have unknown risks.
The term is also used outside the world of business and finance, as in this phrase: “She believes that attitudes today to children’s play are too restrictive and risk-averse.”
An investor with risk aversion, when presented with a number of investments giving the same return but with different level of risks, will always opt for the least risky ones. A risk-seeking investor, on the other hand, will do the opposite.
Humans’ attitudes to risk are not consistent. Some people are risk lovers when it comes to sports and hobbies, but are risk-averse when deciding where to invest their money, and vice-versa.
Risk averse investor avoids risk
Put simply, a risk averse investor avoids risk and stays away from more speculative investments. Such investors like index funds, government bonds and debentures.
Risk-averse consumers are less likely to accept a bargain if the payoff or benefit is uncertain, and will tend to choose the same product at the normal list price if the payoff is certain.
When choosing a second hand car to buy, a consumer with risk aversion will prefer to purchase one from an official dealer who offers a six-month guarantee, rather than a much cheaper car (same model etc.) but with no guarantee.
According to Macmillan Dictionary, a risk-averse person is: “Opposed to taking risks, or only willing to take small risks.”
Risk averse vs. risk loving
A risk averse investor: would accept a certain payment (certainty equivalent) of, for example $50, rather than gambling and possibly receiving $100+ or nothing.
A risk loving investor: would probably opt for the riskier choice – choose the one that might give him or her more than $100 or nothing.
A risk neutral investor: is somebody who is totally insensitive to risk. This type of investor is extremely rare.
The expected value – the average payoff of the gamble – is $50. The amount that the risk averse individual would accept rather than gambling is known as the certainty equivalent, and the difference between the expected value and certainty equivalent is the risk premium.
For people with risk aversion, the risk premium becomes positive, for risk-loving investors it becomes negative, while for risk-neutral people it is zero.
It’s all in our brains
People’s risk behaviors and attitudes have attracted interest in the fields of behavioral economics and neuroeconomics.
Previous studies have suggested that activity in the right inferior frontal gyrus of the brain correlates with risk aversion, with more risk averse individuals – those having higher risk premia – having greater responses to safer options.
Other studies have detected a link between activity in that part of the brain and participants making risky or cautious choices.
Our enigmatic risk behaviors
The following quote comes from a web page of the Leonard N. Stern School of Business, part of New York University:
“In a world where people sky dive and bungee jump for pleasure, and gambling is a multi-billion dollar business, it is clear that human beings collectively are sometimes attracted to risk and that some are more susceptible to its attraction than others.”
“While psychoanalysts at the beginning of the twentieth century considered risk-taking behavior to be a disease, the fact that it is so widespread suggests that it is part of human nature to be attracted to risk, even when there is no rational payoff to being exposed to risk. The seeds, it coud be argued, may have been planted in our hunter-gatherer days when survival mandated taking risks and there were no ‘play it safe’ options.”
On the other hand, there is evidence that humans try to avoid risk, both in financial and physical pursuits.
The same person who risks his life climbing cliffs may refuse to get into a car that does not have seat belts, or invest in the stock market because he considers the activity too risky.
Our attitudes to risk vary depending on the situation – the same person might take great risks in sporting events, but be risk averse when deciding where savings are invested.
Out risk behaviors also appear to change as we get older, wealthier and start having children.
According to economists, we make choices to maximize expected utility rather than wealth.
Video – What is risk aversion?
This Investors Trading Academy video explains in simple and easy-to-understand terms what risk aversion is.