Risk aversion is a tendency to seek out investments that come with fewer risks, in the interests of avoiding losses. People who are risk averse are conservative investors and weigh risks carefully when making investment decisions. While some caution is advised with investments to avoid making clearly poor investment decisions, risk aversion can become a hindrance for an investor and may limit possibilities for profits.
When an investor is faced with two investments that have similar returns and different risks, the investor usually chooses the less risky investment. As the stakes change and the returns go up on a risky investment while decreasing on a less risky one, risk aversion can come into play. The risk averse investor will reach a point where the risks are not worth the returns much more quickly than a less cautious investor.
Risk averse investors tend to stick with low risk, low return investments live government bonds, reliable stocks, certificates of deposit, and other types of simple investments that have minimal risks attached. Investors who are willing to take risks will engage in more exotic financial activities, including speculation, where high risks are accepted as part of the investment environment.
Every investor has to make a personal decision about how to balance risks. Very conservative investors may not end up generating enough funds to meet their needs, while investors who take significant risks can also take heavy losses. Some investors strive for a balance, maintaining a mixed portfolio of low risk and high risk investments and possibly changing the mixture over time as their needs change.
Investors who are not risk averse are not necessarily foolhardy. They use tactics like diversification to spread out their risks so that in the event that one investment does not pay out, they still have other investments to rely on. High risks are not necessarily as dangerous when they make up only a small percentage of a portfolio. The investor still needs to monitor the market with care to adapt to changing conditions quickly.
For funds managers and financial advisors who handle money on behalf of others, risk aversion is an important concern. Managing funds for clients requires making decisions for them and these decisions include evaluating risks. Some risks an investor might be willing to take personally could be viewed as unacceptable when taken as part of an investment fund or other investment scheme, and a more risk averse approach is expected from people who are handling funds for others.
