Risk behavior defines the characteristics of an investor. The risk behavior can be closely linked with the personal behavior of investors. However, many other factors also influence and shape risk behavior.
Let us discuss what is risk behavior, risk aversion, and different types of risk profiles.
What is Risk Behavior?
Risk behavior refers to the behavior or response of investors when dealing with investment risks.
We can broaden the concept from investment risks to financial risks, business risks, and any other type of economic risk. The behavior (risk management) is the way an investor would prepare, implement, and respond to unexpected outcomes.
Risk is the unexpected or unwanted outcome that differs from the expected (or calculated) outcome. Therefore, risk behavior is the treatment of the risk in different ways.
Fundamentally, the higher risk is associated with higher returns in finance and lower risk with lower returns. However, there is no assurance of higher returns when taking higher risks.
Therefore, investor behavior reveals different risk management courses that individual investors seek albeit knowing the basic risk-reward relationship.
Risk Behavior and Types of Investors
Naturally, investors would behave differently towards financial and investment risks. The risk-reward relationship would play a different role for every investor. Thus, there will be different categories of risk behaviors and investor types.
Here are four main categories of investors based on risk behavior.
A preserver is a type of investor who prefers to preserve wealth rather than take a risk and make more money than average returns.
Preservers behave possessively and they do not like to risk their investments. Their risk behavior remains defensive and possessive.
A preserver would rather invest in a security that offers lower and guaranteed returns than an uncertain and higher return. Therefore, a preserver would often follow the tried and tested investments rather than trying new ones.
Preservers are always cautious about their investment decisions. They deliberately take time to make investment decisions. Often, they resist proposals that offer risky scenarios out of fear of losing money.
A preserver’s risk behavior leads towards preserved financial objectives like maintaining the status quo and loss aversion.
Followers are investors who tend to follow “winning” investment strategies adopted by others. They often follow the most successful investors and try to imitate their investment strategies.
Follower investors often create short-term investment strategies. As they follow the investment styles of market leaders, they do not create long-term investment plans.
One of the main distinctions of the follower investors is they would make different investment decisions when presented with the same type of risks.
The risk behavior of followers is similar to preservers in many ways as well. They also tend to make conservative investment decisions frequently. However, unlike preservers, the followers would make risky decisions without knowing the true extent of the risk.
The risk behavior of the follower investors is usually to follow the advice of experts. They do not like to pursue their own investment ideas.
Independent investors tend to take more investment risks than preservers and followers. They make their own investment decisions and are more likely to take risks than others.
Independent investors often take quick investment decisions. They often follow short-term investment strategies without planning for the long term.
The risk behavior of independent investors is often risky but logical. They adopt an aggressive investment strategy after carefully evaluating the potential investment.
Independent investors also make quick and spontaneous investment decisions. That is why independents are more likely to achieve their investment goals than preservers and followers.
In short, the risk behavior of independents follows a higher risk tolerance than average investors. However, it can become a disadvantage for them as they make aggressive but irritational investment decisions sometimes as well.
Accumulators are investors who want to accumulate wealth and increase their earnings. They do so by taking a higher risk attitude when making investment decisions.
In this sense, accumulators are the highest risk-takers of the four categories discussed here. They can accomplish their financial objectives of accumulating more wealth by making aggressive investment decisions.
Since accumulators follow a high-risk investment methodology, their risks of losing money are also higher. They follow the conventional risk-reward investment relationship.
Accumulators also make more investments than other types of investors. It means their total costs of trading and perceived risks would be higher than normal.
What is the Risk-Averse Behavior?
Risk-averse behavior is the preference of certain results over uncertain results due to higher risk.
In simple words, a risk aversion behavior is the avoidance of higher-than-normal risk. It is the behavior that leads investors to take a more possessive investing approach.
Risk aversion can also be measured in terms of investment volatility. As a general rule, higher volatility leads to potentially higher risks.
That in turn, leads to a higher risk-reward correlation. A higher risk would mean higher returns and vice versa. A risk-averse approach will be to take an average and calculated investment position that does not exceed the average investment volatility.
A risk-averse investor would prefer a lower but certain return on investment against higher and uncertain returns.
Therefore, a risk-averse investor would arguably invest in low-yield investments rather than risky ones. These investors would often sacrifice a potentially high-rewarding opportunity for a safer one.
Common examples of risk-averse investments include a certificate of deposit (CD), Savings Accounts, Corporate Bonds, and dividend growth stocks.
A common attribute of all these investments is these choices do not offer high volatility. These investments offer a conservative return on investment.
Risk-averse investors also invest in highly liquid investments. As they invest in conservative investments, they want their investments to remain liquid so that they can convert them into cash whenever needed.
The preference for a liquid investment is in line with their choice of conservative returns against aggressive returns.
The risk-aversion behavior is commonly associated with investors looking for guaranteed income. For example, retirees looking for a stable monthly income through High-Yield savings account or dividend stocks.
Risk-Averse v Risk-Seeker
A risk-seeker is an investor who is willing to take higher risks for higher returns. In terms of investments, a risk-seeker would prefer a volatile investment over a predictable instrument.
Risk-seekers prefer taking advantage of short-term price anomalies. They formulate their investment strategies around the conventional risk-reward relationship.
Risk-seekers would actively invest in a bullish market when the market goes through an upwards trend generally. They would prefer taking a risky approach in anticipation of continuing growth trends rather than investing in steadfast securities.
A risk-seeker investor would demonstrate a higher risk tolerance than a risk-averse. Also, the risk appetite of a risk-averse investor would be higher than a risk-averse investor.
In practice, a risk-seeker would add more risky securities to the portfolio. However, it does not mean they do not diversify or balance their investment portfolios.
Risk-Averse v Risk-Neutral
A risk-neutral is a behavior where the investor is undecided about risk on investment opportunities.
In other words, a risk-neutral would be focusing on other factors influencing the investment decision than risk. It is often observed for situational decisions when investors seek quick and short-term gains.
A risk-neutral approach is closer to the risk-averse approach as it also leads investors to make possessive investment decisions.
A risk-neutral investor would mainly focus on potential gains rather than risks associated with an investment.