Updated July 14, 2023
Definition of Risk Averse
Risk averse refers to investors who prefer lower risk over a high rate of returns. They choose to invest their money to earn a guaranteed return, even if it is less, so there remains little or no risk of loss. Generally, the rate of returns remains the same or exceeds slightly depending upon inflation for risk averse investors.
Explanation
Risk averse describes the attitude of the investors willing to get a guaranteed return. There is always a risk in investment, but higher returns also attract higher risks. Some investors don’t want to risk their savings getting subsumed with any kind of loss. Hence, they prefer to invest in such investments where they can constantly earn, no matter low or high. The high rate of return does not attract these kinds of investors but gets facilitated by the idea of earning constantly, and due to their lower risk appetite, they want to take a very low risk.
Example
Consider investments like fixed deposits, certificate deposits, or other fixed-income instruments. These kinds of investments offer fixed returns with no or very low risks. An investor who is risk averse would consider such investments for the portfolio to maintain the risk at the lowest level possible.
Types of Investors Risk Averse
There are three types of investors depending upon their way of dealing with the risks:
- Risk averse: Such investors avoid risk as much as they can. They prefer a lower rate of return with no risk rather than a high rate with higher risk, as they are afraid to bear any loss in their investments.
- Risk Neutral: Such investors neither take too much risk nor avoid risks. They take a calculated risk because they don’t want to bear heavy losses. They usually take medium risks to get a medium or high rate of return.
- Risk Loving: Such investors love to take risks, and they look at investment as a gamble in which they can earn a huge rate of return or bear huge losses. They are not afraid of losses because they always get lured by the high rate of returns.
Measures of Risk Averse
Measures of Risk Averse are:
1. Absolute Risk Averse (ARA)
When the risk is high, u(c) curvature will also get higher. However, there is a measure ‘Arrow-Pratt measure of absolute risk aversion that stays constant with respect to these transformations. It is named Arrow Prat measure after the names of the economists Kenneth Arrow and John W. Pratt. It is defined as
A (c) = – un (c)
u1 (c)
Where,
u1 (c) and un (c) stand for first and second derivatives with respect to (c)
2. Relative Risk Aversion (RRA)
The Arrow-Pratt measure of relative risk aversion (RRA) is defined as
R (c) = cA (c) = –cun (c)
u1 (c)
where,
u(c) represents the utility curve as a function of wealth being “c” It is not like ARA, whose units are $-1; the RRA measure is a dimensionless measure due to which it is applied universally. This measure of risk-averse is still valid.
The implication of increasing/decreasing absolute and relative risk aversion: The implication of increasing or decreasing absolute and relative risk aversion helps form the portfolio with one asset risky and the other risk-free. If the investor’s wealth increases, then there is an increase in the risk asset; likewise, if there is a decrease in the investor’s wealth, the investor will choose to increase the risk-free assets.
3. Portfolio Theory
According to the Portfolio Theory, investors can assume risk aversion as an additional reward that can be achieved if they are willing to take extra risks. The Portfolio Theory defines risk aversion as an important concept in investment decision-making.
A=dE(c) / dσ
An = dE(c) / d nõn
Advantages
Some of the advantages are given below:
- Investment without fear: A risk averse investor can invest without any fear of getting losses as the money invested here provides a return guarantee. This attracts investors who don’t want to bear any kind of loss in investment.
- Constant return: Risk averse investors enjoy the constant return on their investment. They get almost the same or similar returns.
- Low risk: There is a very low or almost no risk for risk averse investors.
Disadvantages
Some of the disadvantages are given below:
- Loss of opportunity: The main fallback of risk averse approach is that the investor loses the opportunity of earning a high return as they are not ready to take any significant risk.
- Almost No Increase in Return: The returns the investors get are almost the same as there is no increment in the return, or a very little increase in return can be seen.
- Dependent On Inflation: The increase in the rate of return for risk averse investors is dependent on inflation, which means the rate of return increases only when there is inflation in the country.
Conclusion
Every investor has their own preference for investments. Risk averse investors are those who are not attracted by high returns or a chance of getting a huge profit. They just don’t want their investment to bear any kind of loss; they want guaranteed returns on investments regardless of low returns.
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