Question

Why are investors risk-averse? How can investors deal with different degrees of risk? Justify your answer.

Answer 1

Any rational investor invests in various instruments primarily to earn from dividend or capital appreciation on investment over a period of time. The objective may be profit maximization, which is short term or wealth maximization ,which is long term in nature. Investments are made to beat inflation and to maintain a certain standard of life style. If cash is kept idle in bank accounts then it will earn only nominal rate of interest which will not help to beat inflation ,hence the Investors look for alternate investments where they can get higher returns. In principal , higher the risk ,higher is the Expected Return. There are numerous avenues and financial products available for an investor according to his risk appetite. Debt Funds, Equity, Commodities, Real Estate are some of the lucrative investment options.

It is well known fact that power of compounding works wonder. A simple investment of $1000 per month for 10 years would grow on to $191,250 at 10% return. The idea behind investment is that your money should work harder than you. Although it is well accepted fact that investment and returns help to uplift one’s standard of living and full fill the life aspirations with regards to money matters , but it is also true that investments are risky too.

Many Investors are risk averse because they fear losing their capital. Specially after the Global financial crisis of 2008 when the big corporates failed miserably, and many people lost their life long savings which they had invested in the exotic financial instruments hoping for a better return. Another reason of being risk averse is not being able to understand the financial product and gauge one’s risk taking capacities.Lack of financial literacy also keeps investors away from investments.Credit Default Swaps(CDS), Collateral Debt Obligations(CDOs),Futures and Options, Derivatives are some of the complex financial instruments which an investor would keep their hands off because of the complexities involved.Even equity investments are risky if you donot understand the business in which the company deals in, the management ,their financials,product line, etc.

Therefore to sum it up, Investors are risk averse because –

• They donot want to lose money
• They lack financial literacy
• Not understanding one’s risk appetite
• Frauds happening around due to greed by large banks, hence its better off to stay away

The best way to deal with different types of risks associated with investment is to first understand the nature of risk and also find out one’s risk appetite .A diversified portfolio investing in stocks of stable companies along with growth companies and a mix of debt funds would help to mitigate the risk of downside rather investing the entire corpus in just one company or financial instrument.

One can also explore financial products like Credit Default Swaps, Hedging tools – Futures,derivatives,etc to minimize losses in case of adverse movement in the investments.

Even countries default in payment of coupons on bond issued by it so it is very difficult to find an investment which is risk free.Hence risk cannot be completely eliminated, but risk management is an better option to counter the down side of losing on investment.