Risk Tolerance Vs. Aversion in Investing

January 15, 20235 min read
Risk Tolerance Vs. Aversion in Investing
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Key Highlights:

  • An investor’s tolerance for risk can determine the type and sum of the investment.
  • Although risk tolerance and risk aversion are polar opposites, in some ways they are intertwined.
  • The advantages of being risk averse can include lower loss though this can be offset by reduced performance.

In general, there are two types of investors: those who are willing to tolerate risk so they can potentially gain more significant rewards and those who tend to avoid risks to preserve capital. While essentially opposites, the concepts “risk tolerance” and “risk aversion” are in some ways two sides of the same coin when it comes to investment decisions.

Below is a look at risk tolerance vs. aversion in investing.

What is Risk Aversion?

In the context of investing, risk aversion, as with risk tolerance, has to do with an individual’s approach to investing. Being risk averse means preferring investment portfolios that are on the conservative or defensive side.

Risk averse investors typically opt for more stable investments with the understanding that doing so tends to result in lower returns. Examples of lower-risk assets include government bonds, fixed-interest accounts, term deposits, cash, blue-chip shares and investments in property trusts. Dividend growth stocks, certificates of deposit, money market funds, and permanent life insurance products also attract risk-averse investors.

What is Risk Tolerance?

An investor’s risk tolerance is defined by the potential for loss and the degree of market volatility they are open to accepting. Risk tolerant investors are guided by the philosophy that long-term gains can potentially offset short-term losses. Derivatives, equity funds, and exchange-traded funds are among higher-risk investments because they tend to be more volatile.

How is Risk Tolerance Determined?

The Standard Risk Measure sets the risk level of an investment according to its annual returns over any 20-year period. A low-risk investment is one that can anticipate one negative year over that period. In contrast, a portfolio of high-risk holdings can experience as many as four or five negative years during a similar timeframe.

Several online risk profiling questionnaires are also available to help individual investors gauge the potential risk of an investment.

Factors Affecting Risk Tolerance Levels

An investor’s tolerance levels are usually influenced by factors including their age, long-term goals, and their need for liquidity.

Generally, the longer cash is invested, the more likely it will be able to absorb negative fluctuations and achieve growth. Thus, it would make sense for people with looming time horizons such as retirement to emphasize lower-risk investments. Meanwhile, investors with longer time horizons have the potential to reap higher returns with higher-risk assets.

Sometimes, investors are moved to employ risk-averse investment strategies to mitigate losses. Portfolio diversification — having a variety of assets and asset classes — is one such strategy. This permits the investor to maximize their anticipated return while diminishing their overarching portfolio risk.

Investor Profiles

Within risk tolerance are three types of investors:

  • Aggressive. These investors are typically market savvy and tend to prioritize capital appreciation over income or preservation of principal.
  • Moderate. Moderate investors want their money to grow, but do not want to lose much doing it. Using what’s typically a “balanced” strategy, these investors typically hold a 50/50 or 60/40 mix of stocks and bonds and are relatively less risk tolerant than aggressive risk investors.
  • Conservative. Such investors, who can be labeled risk averse, will only accept limited volatility in their investments, if at all.

Loss Aversion

People can be illogical when it comes to purchases, donations and choosing service levels because of cognitive biases. One such bias is loss aversion, in which they ascribe more value to small likelihoods with the belief they are protecting themselves against losses.

According to the Nielson Norman Group, when a choice must be made between losing $900 and taking a 90% chance of losing $1,000, most people go with the latter, even though the expected outcome in both cases is equal.

For example, when one buys health insurance for a healthy puppy, even though the likelihood of an expensive event is minute, they are opting for a smaller, guaranteed loss – their insurance payment – rather than risk a major expense. In other words, the “perceived” probability of a significant health issue is greater than the actual probability that such an event will occur.

Herd Behavior

Generally, an investor prone to herd behavior leans toward the same or similar investments others have made, instead of following their own analyses.

In the past, such instincts have sparked expansive, unfounded market rallies. A prime example of the consequences of herd mentality can be seen in the dotcom bubble of the late 1990s and early 2000s. Internet stocks were widely perceived to have exceptional potential and their valuations soared—until reality set in.

When is Risk Aversion a Negative?

The drawbacks of risk aversion can include markedly lower expected returns over time, missed opportunities and the erosion of the value of capital due to inflation.

Alternative Investments and Risk Aversion

One strategy for minimizing volatility is portfolio diversification. Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened several carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

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