BackDe-jargoned: Risk aversion
It is a strong disinclination to take any kind of risk
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Suppose you have 1 lakh and you want to invest in an instrument that gives capital protection as well as some return, you have options available such as Public Provident Fund and bank fixed deposits. Now assume you want to invest in an instrument that gives you over 20% returns and at the same time you want capital protection. This is not an easy one. Here is when your risk appetite comes into picture. If you go to any financial planner or financial adviser, she will ask you to fill a form wherein you will be asked things such as your investment habit and financial goals. Based on your response, the planner will find out your risk appetite. In the process she will tell you whether you can take risk or are risk averse.
What is risk aversion?
Risk aversion, as the name suggests, is a strong disinclination to take any kind of risk. It is a concept that is predominantly used to understand your investment behaviour at times when you are exposed to uncertainty.
In general, people are willing to handle a bit of uncertainty while investing. Risks exist with the potential of high returns. However, if you are one of those who are not willing to stomach any kind of variation in returns or erosion of capital, you are a risk-averse investor. For instance, you may want to invest in equities, at the same time don’t want to see your capital getting eroded or even negative returns. Or say you are tempted to put more money than you should when equity markets increase continuously as you might be buying at a high valuation or the prices may be moving faster than warranted.
These are examples of a risk-averse investor. Risk aversion is also referred to as the willingness to pay (in terms of returns that you sacrifice) to avoid picking a risky investment option, even when the expected value of it is in your favour.
How to find out if you are risk averse?
Not everyone can cope with financial losses in their lives. For example, you might think you have enough risk appetite to invest in stocks but suddenly if the stock crashes and there is a huge loss then you might lose sleep over it.
This means you are not tolerant to such risks. Check whether you are comfortable doing an investment that can dip 30% and at the same time has the potential to give you 50% profit. There are questionnaires available with financial advisers and other tools on the Internet that can help you gauge your risk tolerance.
While investing in a financial product you basically look at risk and return. Investing in bank fixed deposit is a no risk investment option. A risk-averse investor is usually better off investing in debt or fixed-income instruments such as fixed deposit and tax-free bonds. However, too much risk aversion leads to an opportunity loss in terms of making higher returns.
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