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Investing in any market or venture carries the risk that the expected return on investment will not be realized or the initial investment will not be recovered. These risks may be ignored when the amount involved is negligible and if the loss cannot affect the financial health of the individual or business. However, in instances when the initial outlay involves committing large sums of money whose loss could negatively impact the going concern of an organization or the solvency of an individual, investors respond by being risk-averse (Zhang et al., 2021). Risk aversion means that an investor avoids committing funds to an investment where the chances of a loss are high. In addition to the fear of losing money, investors are risk-averse because some investments carry a lot of uncertainties. Uncertainty in the market or around a potential investment raises the risk that an investor will lose their investment and not realize the expected gains. Consequently, investors prefer investments whose outcome is certain despite having a lower rate of return.
Investors can deal with different degrees of risk in three major ways namely, portfolio diversification, asset allocation, and dollar cost averaging. Portfolio diversification means investing in multiple projects or shares from different companies so that no single investment can irredeemably negatively impact the portfolio (Brigham & Houston, 2021). In essence, diversification means that the losses in a single investment are absorbed by gains in other investments. Asset allocation means that an investor chooses different classes of investments to invest in (Brigham & Houston, 2021). In such a case, they may choose to invest in bonds, stock, or hold resources in an interest-earning savings account which spreads the risk of a loss. Finally, dollar-cost averaging can mitigate against the risk of loss in investment by committing particular amounts at certain time intervals depending on the performance of an already-held investment. Under dollar-cost averaging, new funds are committed only if returns from previous investments are within the set standard.
References
Brigham, E. F., & Houston, J. F. (2021). Fundamentals of Financial Management (11th ed.). Cengage Learning.
Grable, J., Kwak, E. J., Fulk, M., & Routh, A. (2020). A simplified measure of investor risk aversion. Journal of Interdisciplinary Economics, 34(1), 734.
Zhang, Q., Choudhry, T., Kuo, J.-M., & Liu, X. (2021). Does Liquidity Drive Stock Market Returns? the role of investor risk aversion. Review of Quantitative Finance and Accounting, 57(3), 929958.
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