Risk aversion describes the tendency of investors to prefer certainty over uncertainty, choosing investments with lower potential returns in exchange for reduced risk. Risk-averse investors prioritize the preservation of capital over the pursuit of high returns.
Risk-averse investors typically favor safe instruments like government bonds, certificates of deposit, and savings accounts. For example, given a choice between a stock with potential 15% returns (but also potential 15% losses) and a bond yielding a guaranteed 4%, a risk-averse investor would choose the bond.
While risk aversion protects against losses, being overly risk-averse can mean missing out on higher returns that are necessary to outpace inflation and achieve long-term financial goals. Finding the right balance between risk and return is key to successful investing.