Risk aversion is an investor’s preference for avoiding uncertainty in their financial investments.
Due to this attitude towards risk, this type of individuals directs their investment portfolio to safer financial assets even though they are less profitable.
The phenomenon of risk aversion implies by definition a certain level of risk rejection by a person who invests in financial markets . A person may face a risk aversion situation, be risk neutral or be risk prone.
When qualifying an individual as opposed to the risk in the world of investment decisions, it is necessary to assess their preferences as a crucial aspect to keep in mind. That is why the work of a financial advisor and his professionalization in shaping the risk of a client is decisive.
It is usually considered that there are at least two differentiating features common in all types of investors:
- They have a rational behavior that leads them to desire the greatest possible benefit, assuming risk.
- They are usually enemies of risk and avoid having to assume it to the best of their ability.
The basic idea that can be extracted and that summarizes the concept of risk aversion is that if two options or alternatives are presented at the time of investing, an individual classified as “risk-averse” will opt in most of the occasions for which Present less risk. The latter does not necessarily mean that risky alternatives are always discarded or waived.
The idea of risk aversion implies at the same time that in the field of financial investments, the riskiest ones must be accompanied by a greater degree of profitability so that they are authentic eligible options, that is why there is a relationship between profitability, risk and liquidity . Due to this coexistence between risk and expected profitability, risk-averse investors are usually divided into several groups depending on their degree of risk aversion.
Levels of risk aversion
The main levels are:
- Low risk:People with a high risk aversion identify themselves with a very conservative profile in terms of investment and choose low-risk but stable financial alternatives with a lower level of profitability although safer. The letters of the treasure or some pension plans that invest in fixed income or cash pure short – term assets, are examples of this type of risk. Normally your investment portfolios will have a balance of maximum 30% equity and 70% fixed income or even higher fixed income.
- High risk:At this other level of risk, more risky investors who choose products with a higher level of uncertainty can be placed, even though they are more unstable and that the losses fit as much as possible. Examples of this type of investment are bonds and investment funds from sectors such as banking, energy or natural resources. In this case, investment portfolios will have a balance of 70% equity and 30% fixed income or even higher equity.
The degree of aversion of the investor is usually directly related to various observable aspects in the profile of the person making an investment, such as their age, their experience in finance.