What is risk averse? Definition and meaning
Risk averse investors do not like taking risks. They prefer lower returns instead of higher ones, because the lower return investments have known risks. The higher return ones, on the other hand, have unknown risks.
We also use the term outside the world of business and finance. Look at this phrase: “She believes that attitudes today to children’s play are too restrictive and risk-averse.” In other words, the thinks adults are over-protecting children.
When you present investors with risk aversion with several investments giving the same return but with different level of risks, they will always opt for the least risky ones. Risk-seeking investors, on the other hand, will do the opposite.
Risk averse investor avoids risk
Put simply, risk averse investors avoid risk and stay away from more speculative investments. Such investors like index funds, government bonds, and debentures. In fact, even with bonds, those who do not like risk probably favor laddering.
Laddering means purchasing several bonds with different maturity dates. It is a strategy that reduces risk and helps maintain a regular income.
Risk-averse consumers are less likely to accept a bargain if the payoff or benefit is uncertain. They will also tend to choose the same product at the normal list price if the payoff is certain.
When choosing a second-hand car, a consumer with risk aversion will purchase one from an official dealer. Especially a dealer who offers a six-month guarantee, rather than a ‘bargain’ 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 seeker
Imagine you offered two people either a certain payment of $50 or the chance to receive $100. However, the $100 option also carries the risk of receiving nothing. How would a risk-seeker and risk averse person react?
A risk averse individual would choose the certain payment of $50.
A risk seeker, however, would probably opt for the riskier $100 or nothing choice.
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. 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, however, it becomes negative, while for risk-neutral people it is zero.
Risk neutral investors are people who are totally insensitive to risk. This type of investor is extremely rare.
Human attitudes to risk
Our attitudes to risk vary depending on the situation. Mary, for example, may take great risks in sporting events. However, she might be risk averse when deciding where to invest her savings.
Our 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.
According to Diffusion of Innovations theory, innovators are the least risk averse adopters of new products or technologies. Laggards, on the other hand, are highly skeptical of anything new, i.e., their risk aversion is high.
Video – What is risk aversion?
This Investors Trading Academy video explains in simple and easy-to-understand terms what risk aversion is.