Blog Invest Risk Aversion vs Risk Tolerance: Choosing the Right Strategy

Risk Aversion vs Risk Tolerance: Choosing the Right Strategy

date November 6, 2020 time 6 min read 1044 views

One of the biggest mistakes you can make as an investor is signing up for a financial product without understanding your own risk aversion and risk tolerance. Most negative feelings surrounding investment come from unexpected gains and losses from an investment that was not well researched. We’re going to talk about some of the risk factors of investment and how to assess if they are too much for you.

What’s your investing risk tolerance like ?
What’s your investing risk tolerance like? (source: investmentexecutive.com)

Stock trading apps like Robinhood and eToro have gained huge popularity among new investors, but that doesn’t mean they’re always safe to use. 

Aimed at young people, the apps give beginners access to sophisticated trading tools and claim to simplify the investing process — but many don’t realize or understand the risks involved.

The stock market can be a thrilling place to make (and lose) money. Financial advisors and stock analysts spend years studying the stock market and even then, they can only make educated predictions as to whether stocks will go up or down. 

Before investing you need to understand risk aversion or risk tolerance and choose investment products that reflect your personal preferences. Generally speaking, the higher risk — the higher the reward and the lower the risk — the lower the reward.

Risk can sometimes seem like a ‘scary’ word — but it doesn’t have to be. Let’s take a deeper look and find out if you’re open to risk, or keener to play it safe.

What are investor risk aversion and risk tolerance?

Risk tolerance describes how much change you’re willing to accept in your investment returns. The more tolerant of risk you are, the less it concerns you if your investment value takes a sudden dive.

Risk aversion refers to an unwillingness for variation in returns. Risk-averse investors would prefer to know their money remains relatively stable over time while it’s invested.

Let’s put these terms into context.

Options for risk-averse investors

If you are risk-averse it’s important to remember investing will always involve some degree of risk. The whole point of investing your money instead of leaving it under your mattress is that you are entrusting someone else to create value from it

As a risk-averse investor, you may be interested in putting the majority of your funds in things like a high-yield savings account, CDs, or government bonds. However, these days the returns may fail to beat inflation.

You can also reduce risk by investing over a shorter period. Short-term investments that let you cash out quickly are a good way to test the waters of an investment type before going long.

Another way to reduce risk is through diversification. Investing in a single stock, cryptocurrency, or asset class exposes you to greater risk than having hundreds of different investments. The more investments you have, the less it impacts you if one fails.

Options for risk-tolerant investors

When kept within reason, investors benefit greatly from a little risk tolerance. Risk tolerance has a wide range of levels and tends to vary based on the percentage of savings invested. You’re much more likely to feel okay with a risky investment with a 5% chunk of your savings than 50%.

A risk-tolerant investor would want to put their assets into a range of more volatile assets with a higher potential for return. For example stocks, cryptos, business ventures, etc.

Everyone considers risk factors for investment differently
Everyone considers risk factors for investment differently (source: thenonprofittimes.com)

How to measure the risk of an investment

You can see past returns

Whether you’re investing in a fund, stock, or other type of asset, you should be able to find out core financial data about it. Although past returns don’t guarantee future success, they can give you a rough idea of how volatile an asset is.

If an asset value dipped 10% one month then gained 30% the next month, it’s safe to say that it’s volatile. But, if it gains or loses very little each month, it’s better suited to those with a stronger risk aversion.

Keeping a close eye on the ebbs and flows of a stock, or the value of an asset is crucial to understanding how it will react in the future.

It has good security

Another good indicator is checking what security measures the firm has in place. Is it regulated? Does it use other ways to protect your money, such as collateral?

You can also assess risk by assessing your own understanding. Could you explain what you’re doing to a five-year-old? Or does it hide what it’s doing through overly complex language.

On the other hand some platforms or products may lure you into a false sense of security, making the investment process feel like a game. This is the trick used for ponzi schemes for time immemorial.

To make things a bit bolder, let’s take a deeper look at some popular high-risk and low-risk investment options.

Some classic high-risk investments

Crowdfunding — if you hop onto a crowdfunding platform you’ll read through countless business pitches — some better than others. Investing your money in a business that becomes successful is a win. But if the business goes bust — your investment is gone. Fortunately, a growing number of crowdfunding platforms these days do reply some form of reimbursement if things go badly.

Real estate — you’ve probably been told from a young age that buying a home is ‘the most important investment of your life’ — and in many ways that’s true. But real estate is highly prone to volatility. Take property in the three top cities in the US for example. Who could have predicted in 2019 that property values in New York, Los Angeles and Chicago would be turned upside down the following year? And in 2020 we’ve actually seen an exodus into the countryside?

Collectables — vintage cars, costume jewelry, artwork. These things might have value and even grow in value over time. But unless you’re holding genuine van Gogh, these items can be difficult to appraise and even more difficult to sell if you need a cash conversion quickly. If you do invest in collectables, make sure to diligently research the item(s) you’re collecting to make sure there’s a market.

Low-risk investments:

Certificates of deposits (CD’s) — while they might not make you gobs of money, bank CD’s are safe and insured by the bank. You give the bank your funds and they lock them into a term (anywhere from 3 months to 5 years). During the term your money will earn anywhere from 0.22% to 0.40%. Keep in mind, most banks will charge you a fee if you withdraw your money early. 

Money market funds — these are pools of CDs, short-term bonds and other low-risk investments grouped together to create diversification without much risk, and are typically sold by brokerage firms and mutual fund companies. Compared to a traditional CD, money market funds don’t usually incur a fee for premature withdrawals. 

Peer-to-peer lending(P2P) lending platforms connect investors directly to borrowers by pooling their money and cutting out the middleman. Sites like Zopa, Prosper and MyConstant let investors enter term periods with interest rates averaging 7% APR. Borrowers then request loans and are given interest rates based on their credit scores — usually.  

Some might view P2P as ‘risky’ since the borrower might never return the money and the investor is left holding the bag. But newer sites like MyConstant, use liquid crypto currency as collateral to offset the risk of loan defaults. 

It’s best to weigh up the risk factors of an investment
It’s best to weigh up the risk factors of an investment (source: pixabay.com)

Hate risk? Give MyConstant a try for fully collateralized rates of 7% or more

At MyConstant, we want you to sleep well at night. That’s why we offer products that limit risk as much as possible while maximizing profit. And we outline everything about our service to you in detail on our blog.

For the least risk-tolerant investors, our collateral-backed account offers an annual return of 4% with minimal risk. You’ll lend out your money to borrowers who could default, but we reduce the risk involved by making borrowers put down 200% collateral. You can even withdraw your money at any point.

If you’re a slightly more risk-seeking investor could try our Crypto Lend feature, which gives you an annual return of 9%. This product is riskier since you’ll also be lending to decentralized exchanges outside of the platform, but we take care to vet the third parties and keep your money safe.

Like the sound of either option? Create your free account today.

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George Schooling

George Schooling

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