What Are The Risks And Benefits Of Investing In Emerging Markets? – Risk aversion is the tendency to avoid risk. The term risk aversion describes an investor who prefers capital preservation over the potential for higher average returns. When investing, risk equals price volatility. A volatile investment can make you rich or eat away at your savings. A conservative investment will grow gradually and steadily over time.
Less risk means more stability. A low-risk investment guarantees a reasonable or modest return, with almost zero chance of losing any of the original investment. In general, the return on a low-risk investment will equal or slightly exceed the level of inflation over time. A high-risk investment can win or lose a bunch of money.
What Are The Risks And Benefits Of Investing In Emerging Markets?
The term risk-neutral describes the attitude of a person who evaluates investment alternatives, focusing only on potential profits without considering risk. It seems counter-intuitive – valuing reward without considering risk seems inherently risky.
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However, given two investment options, a risk-averse investor only considers the potential returns of each investment and ignores the potential downside risk. A risk-averse investor will miss out on the opportunity to make big gains in favor of safety.
Risk-averse investors invest their money in savings accounts, certificates of deposit (CDs), municipal and corporate bonds, and dividend growth stocks. All of the above, with the exception of municipal and corporate bonds and dividend growth stocks, virtually guarantee that the amount invested will still exist if the investor decides to withdraw the money.
Dividend growth stocks, like all stocks, go up or down in value. However, they are known for two main characteristics: they are stocks of mature companies with proven results and stable income, which regularly pay dividends to investors. This dividend can be paid to the investor as additional income or reinvested in the company’s stock to grow the account over time.
Risk averse investors are also known as conservative investors. By nature or circumstances, they are unwilling to accept volatility in their investment portfolios. They want their investments to be very liquid. This means that the money must be intact when it is ready to be withdrawn. There is no waiting for the market to swing again.
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The largest number of risk averse investors can be found among older and retired investors. You may have spent decades building a nest egg. Since they are using it now, or plan to use it soon, they are not willing to risk losses.
A high-yield savings account at a bank or credit union offers a steady return without investment risk. Federal Deposit Insurance Corp. (FDIC) and the National Credit Union Administration (NCUA) insure the funds in these savings accounts with generous limits.
However, the term “high performance” is relative. The return on money should match the level of inflation or be slightly higher.
Risk-averse investors who don’t need direct access to their money can invest in a certificate of deposit. CDs typically pay a little more than savings accounts, but they require investors to keep the money in for a longer period of time. Early withdrawal is possible, but comes with penalties that can wipe out all investment income or bite into the principal.
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An important risk for CD investors is reinvestment risk. That is, when interest rates fall and the CD matures, the investor’s only option is the CD at lower rates than before. If the value of the CD exceeds $250,000, there may also be a risk of bank failure.
CDs are especially useful for risk-averse investors who want to diversify the cash portion of their portfolios. This means they can put part of the money in a savings account for immediate access and the rest in a longer-term account that gives a better return.
A money market fund is a type of mutual fund that invests in high-quality, short-term debt instruments, cash and cash equivalents. These funds have very low risk and each fund share is always worth $1.00. Being conservative, they pay relatively low interest rates to investors.
Treasury securities or debt issued by the US federal government are the safest of all securities. Investors can access Treasuries through mutual funds or ETFs or directly through the government’s TreasuryDirect website.
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State and local governments, as well as corporations, regularly raise money by issuing bonds. These debt instruments pay investors a fixed stream of interest. Bonds typically offer less risk than stocks. Note that bonds are associated with risks – Russia defaulted on some of its debt during the 1998 financial crisis. The global financial crisis of 2008-2009 was caused in part by the collapse of bonds backed by subprime borrowers.
In particular, the agencies responsible for rating these bonds must be assigned ratings that reflect the risks of the investments. They were “junk bonds” marketed as safe bonds. Risk-averse investors buy bonds issued by stable governments and healthy companies. Their bonds receive the highest AAA rating.
In the worst case of bankruptcy, the bondholders have first installments to return the liquidation proceeds. Municipal bonds have one advantage over corporate bonds. They are generally exempt from federal and state taxes, improving the investor’s overall return.
Dividend growth stocks can be attractive to risk-averse investors because their anticipated dividend payouts help offset losses even in declining stock prices. However, companies that increase their annual dividends each year typically do not exhibit the same volatility as stocks purchased for capital appreciation.
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Many of these are stocks in the so-called defensive sectors. This means that companies have stable incomes that are less affected by the general downturn in the economy. Examples are utilities and companies that sell consumer goods.
Investors generally have the option of reinvesting dividends to buy more shares of stock, or they have an immediate dividend payment.
Permanent life insurance products such as whole life and universal life have money accumulation features, tax benefits and lifetime benefits that make them attractive to risk-averse investors. The cash value of a life insurance policy can never lose value and grows over time. Policyholders can withdraw or borrow this cash value at any time (however, the premium amount may be reduced in the event of death).
In addition to individual assets or asset classes that cater to risk-averse investors, there are also a number of risk-averse investment strategies that can be used to minimize losses.
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One way is to diversify your portfolio. Diversification means including assets and asset classes that are not highly correlated. That way, you won’t be putting all your eggs in one basket, and if some stocks go down on a given day, others may rise to offset those individual losses. Mathematically, diversification allows you to maximize your expected return while minimizing overall portfolio risk.
Income investing is another strategy that focuses on holding bonds and other fixed income that generate regular cash flows, rather than seeking capital gains. Investment income is especially useful for retirees who are no longer employed and cannot afford losses in the markets. Investing income carries some additional risks, such as inflation or adverse credit events. A ladder of bonds and CDs, along with inflation-protected securities, can help reduce the overall risk of a fixed-income portfolio.
Saving is very low risk, but investing is not. Investing means that your money is inherently risky, whether you buy a stock or borrow money in the form of a bond.
Being risk averse means avoiding risk, and when it comes to investing, it means avoiding risky securities. Risk-averse individuals should seek investments and strategies to accommodate this low risk tolerance. Thus, one of the advantages is to reduce the risk of losses. Investing in low-risk products such as fixed income securities can provide guaranteed cash flows and consistently positive returns over time.
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However, with low risk comes low expected return. The trade-off between risk and return does not really favor the risk-averse investor who avoids stocks and other risky assets. Such risk-averse investors will experience lower total returns, especially over the long term. Risk aversion can also cause people to irrationally shy away from other good options and avoid the markets altogether, putting them at a disadvantage when saving for things like retirement. Furthermore, money in savings or “under the mattress” will lose its purchasing power over time, as inflation erodes it.
Research shows that risk aversion varies between people. In general, the older you are, the lower your tolerance for risk, especially when it comes to investment time for things like retirement access. Lower-income people and women are, on average, more at risk than men, all else being equal.
Risk aversion is a double-edged sword. On the one hand, you significantly reduce your chances of losing, but you can also miss out on good opportunities and higher returns on riskier investments.
You can assess your investment risk tolerance through online risk profile quizzes. When you register with a broker