Risk Aversion Helps Limit Your Losses and Improve Your Gains

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Risk aversion is an investing term used to describe feelings towards risk, volatility, and variability of returns (how much you win and lose).

The general definition is "an investor that prefers a lower level of risk for an expected rate of return."

In English, that means you would prefer to invest in a certificate of deposit (CD) that is expected to return 5% instead of a futures contract that is expected to return 5%.

In either case, the expected return is 5%. And for the CD, the actual return will also be 5% (unless you do something). But futures contracts are very volatile, so the actual return could be 100% or more...or you could lose all your money.

Not sure which risk profile describes you? Take a risk tolerance quiz and find out!

Just as long-term success requires the use of different methods at different times, you approach to risk can change over time, for different trading accounts, and can change as you achieve personal financial goals.

Financial advisors can take advantage of you if you aren't careful. I am very risk averse, and every quiz I've taken says so. But that doesn't mean I only invest in low-return investments.

Don't fall for the all or nothing approach. Personally, I am an aggressive investor and a very conservative investor at the same time, and even in the same account. It all depends on the goals I am trying to reach.

Remember: risk is defined by your position sizing. If you take a small position in something that has high volatility, your risk of loss is low because you don't have much to lose in the first place!

Aggressive Investor Type = Low Risk Aversion

An aggressive investor is willing to put a lot of money into the market, using a variety of investing strategies and investment instruments (stocks, bonds, real estate, etc.).

These investors have a high risk tolerance, meaning they can handle large amounts of money being "at-risk" or in the market, large losses, or a combination of both. An aggressive investor is comfortable with a high level of volatility. This means that they are ok with large losses (15%+), because they expect to make large large profits (15%+). They are willing to put a lot of money into investments in exchange for the chance to make a lot of profit.

Typically, aggressive investors use investing strategies and tactics associated with speculation. You'll often hear them say things like "no risk, no reward".

Moderate Investor Type = Moderate Risk Aversion

A moderate investor is willing to put some of their net worth into investments, but is not comfortable with high levels of volatility.

This investor type will tolerate average losses (~10%), in their attempts to generate above average profits (~10%).

Generally speaking, moderate investors use a large number of growth and income strategies when making investments.

They will also use some preservation of capital techniques for certain accounts (such as emergency savings), while limiting speculation to 5% or less of their total portfolio size.

Conservative Investor Type = High Risk Aversion

Conservative investors want growth, but are not willing to put a large amount of money at risk to get it. This type of investor focuses on reducing volatility.

Investors with this risk tolerance tend to select investments and strategies that have long track records of good performance, with as little volatility as possible year-over-year (e.g. utility companies).

This type of strategy generally creates small losses (<5%), and combines capital growth with income to generate profits (>5%).

Income and preservation of capital strategies tend to be favored by conservative investors. They may have some portion of their portfolio in growth strategies.

Ultra Conservative Investor Type = Very High Risk Aversion

The ultra conservative investor is focused on getting the absolute lowest volatility in their investing returns.

These investors choose instruments and strategies that offer "guaranteed" results (Investing in Certificates of Deposit, for example).

They accept the fact that guaranteed returns are low compared to the potential returns from other investments (sometimes even lower than inflation) in exchange for the knowledge that the returns are fixed and predictable.

This means that as long as they do not lose money, any return is okay (0%-5%).

This investor type has no stomach for volatility. They are solely focused on preservation of capital strategies and avoiding loss.