What are the pros and cons of risk aversion for investing?

Mark is 23 years old. He had just started learning about investing when his friend proudly revealed he had doubled his money by buying a single AI technology stock that's trending on social media.

Meanwhile, his parents urged him to leave the money in a safer savings account instead. As a beginner, Mark wondered whether playing it safe meant falling behind.

Many of us are just like Mark or have been in the same position.

So, is it better to take a calculated risk or play it safe in investing?

Many would say avoiding risk is best. However, being too cautious may also prevent you from building long-term wealth.

This characteristic is called risk aversion. Understanding its pros and cons will help you build an optimal investment portfolio (the collection of your investment assets, such as stocks, bonds, cash, or real estate).

All investments carry risk. The level of risk differs from one investment to another.

Risk aversion happens when people avoid investments with high uncertainty and instead go for safer investments with more predictable returns (how much money you'll make as profit).

In general, investments with less risk have lower potential returns, while investments with higher risk have the potential for higher returns.

For example, a highly risk-averse person might choose to keep their money in a savings account, where they'll earn a small but predictable amount of interest (how much money will be rewarded to you periodically for saving your money). They might avoid buying stocks, whose prices can rise and fall quickly over time, meaning they have high market volatility.

Put simply, a risk-averse person prefers certainty over uncertainty, even if it means lower payouts.

• Lower-risk investments: In general, savings accounts, Guaranteed Investment Certificates (GICs), and government bonds typically have more stable and predictable returns. But these also tend to have lower interest rates and lower returns.

• Higher-risk investments: Individual stocks, cryptocurrencies, and startup investments usually have more unpredictable returns, with their prices going up and down over time. When these investments perform well, the returns can be massive, but when they perform poorly, the losses can be massive too!

Some benefits of risk aversion are immediately obvious:

1. Staying invested during market downturns.

Many investors "panic sell" their investments and abandon their long-term goal when the market crashes to protect their money. This causes a chain reaction as falling prices cause more selling. Prices then keep falling further, especially on riskier investments like individual stocks.

Having a less aggressive portfolio helps you stick to your investment longer because it's less prone to these sudden price swings and psychologically more comfortable.

2. Avoiding catastrophic loss.

If you panic sell during market crashes, you might find yourself selling your investments at a significantly lower price, making you lose money (e.g., buying a stock at $100 and selling at $50, losing 50% of your investment value).

Investing in an asset with less volatility can help you avoid this. For example, a savings account will likely be less affected during market crashes compared to individual stocks or cryptocurrencies.

3. Better sleep at night.

Investing is as much about psychology as it is strategy. If you are constantly anxious about your portfolio and market declines, risk aversion can help you sleep better and maintain your physical and mental well-being.

It might seem weird, but risk aversion can sometimes prevent you from achieving your financial goal. Why?

1. Lower long-term returns.

While being overly risk-averse may help you avoid large losses, it can also slow down how fast you build wealth.

For example, if you keep most of your money in a traditional savings account or short-term deposits, your portfolio is likely to grow more slowly than someone who invests more aggressively, especially when considering other types of risks.

2. Cash inflation risk.

Inflation happens when the value of money goes down over time. Inflation reduces your money’s purchasing power even if you never touch it, especially if you only hold cash. "Cash" in finance means any money that's available to use right away, including physical cash and funds in your savings/checking accounts.

If you have $10,000 in traditional savings with a 3% annual inflation rate, that money will only buy $9,700 worth of things the following year, even though the number will stay the same in your bank account, as traditional savings accounts generally give very little interest.

Because of inflation, you may find it difficult to reach your long-term financial goal if you are overly risk-averse in investing.

The key isn't risk aversion, but risk management. Adjust your investment portfolio according to your financial goals and risk tolerance, and aim to diversify your investments!

1. Always start from your goal.

What are your goals? How much time do you have? How big is your target? Short-term goals like building an emergency fund or putting down a down payment on a house usually need safer investments because you might need the money soon.

2. Avoid ruin at all costs.

Never take a risk if it can permanently ruin your financial condition. For example, investing all your emergency funds in high-risk stocks.

3. Don’t put all your eggs in one basket.

Spreading, or diversifying, your investments is a good method to avoid excessive risk. This way, if one of your investments takes significant losses, it will limit the impact on your overall wealth. How much money you put in each type of asset will depend on your goal and strategy.

Your friend is just starting out on their investment journey and seems to be risk-averse. They say, "I’m worried about losing money in the market, so I'm never going to invest in stocks."

What are some responses that you might offer them? Select all that apply:

A. "You seem to prefer more predictable returns over the possibility of higher gains."

B. "My uncle is a seasoned investor. He always says, "The higher the risk, the higher the reward."

C. "Choosing lower-risk investments may be a good initial strategy as you build knowledge and confidence."

D. "Do you have a clear understanding of your current financial goals?"

Photo by Joshua Mayo on Unsplash

Identify your investment risk profile!