Risk Avoidance vs. Risk Reduction: An Overview
Risk avoidance and risk reduction are two strategies to manage risk. Risk avoidance deals with eliminating any exposure torisk that poses a potential loss, while risk reduction deals with reducing the likelihood and severity of a possible loss. This article will explore the differences between the two approaches.
Key Takeaways
- Risk avoidance is an approach that eliminates any exposure torisk that poses a potential loss.
- Risk reduction deals with mitigating potential losses by reducing the likelihood and severity of a possible loss.
- For example, a risk-avoidant investor who is considering investing in oil stocks may decide to avoid taking a stake in the company because of oil's political and credit risk.
- Meanwhile, an investor with a risk reduction approach to the same oil stocks would diversify their portfolio by keeping their oil stocks, while buying stocks in other industries that could help offset any losses from the oil equities.
- In order to engage in risk management, a person or organization must quantify and understand their liabilities.
Risk Avoidance
Risk avoidance is not performing any activity that may carry risk. A risk avoidance methodology attempts to minimize vulnerabilities that can pose a threat. Risk avoidance and mitigation can be achieved through policy and procedure, training and education, and technology implementations.
For example, suppose an investor wants to buy stock in an oil company, but oil prices have been falling significantly over the past few months. There is political risk associated with the production of oil and credit risk associated with the oil company. If an investor assesses the risks associated with the oil industry and decides to avoid taking a stake in the company, this is known as risk avoidance.
Risk Reduction
On the other hand, risk reduction deals with mitigating potential losses through more of a staggered approach. For example, suppose an investor already owns oil stocks. The two factors discussed earlier are still relevant: there is political risk associated with the production of oil, and oil stocks often have a high level of unsystematic risk. As opposed to a risk avoidance strategy, this investor can reduce risk by diversifying their portfolio by keeping their oil stocks while at the same time buying stocks in other industries, especially those that tend to move in the opposite direction to oil equities.
In order to engage in risk management, a person or organization must quantify and understand their liabilities. This evaluation of financial risks is one of the most important and most difficult aspects of a risk management plan. However, it is crucial for the well-being of your assets to ensure you understand the full scope of your risks. If you have several streams of income, for instance, losing one stream won't hurt as much if only 25% of a person's income comes from that stream.
Financial diversificationis one of the most reliable risk reduction strategies. When your financial risk is diversified, the adverse side effects are diluted.
Suppose the investor diversifies his portfolio and invests in various sectors of the market. However, he currently faces systematic risk due to an economic downturn. The investor may reduce his risk through a hedge. For example, the investor can protect his long positions and reduce his risk by buying put options for his long positions. He is protected from a potential drop in his portfolio value because he is able to sell his stocks at a predetermined price within a specified period.
The investor who avoids the risk forfeits any potential gains the oil stock may have. On the other hand, the investor who reduces his risk still has potential gains. If the stock market goes higher, his long positions will appreciate in value. However, if his positions decrease in value, he is protected by his put options.
Risk Avoidance vs. Risk Reduction Pros and Cons
Prevention vs. mitigation strategies when it comes to an investor who wants to avoid risk should be equally weighed. It may come down to just the level of risk involved, and how an investor ultimately diversifies his portfolio. Here are some pros and cons of risk avoidance vs. risk reduction:
Risk Avoidance
Safely guarantees that returns will not be lost or jeopardized
Closes the door on opportunities for future gains, especially potentially higher returns on investment
Simple way to focus on steady streams of income
Risk Reduction
Seeks a "best of both worlds" approach to mitigating risk, while exposing yourself to potentially high returns
Can be riskier financially, if risks come to fruition
Requires a more complex approach to investing, including full understanding of your liabilities
Risk Avoidance vs. Risk Reduction FAQs
Which Is Better Prevention or Mitigation?
Each investor should weigh the scenario at hand, level of risk, and decide whether prevention vs. mitigation strategies are the best fit for the investment style and portfolio.
What Are the Types of Risk Mitigation?
A few kinds of risk reduction strategies include diversifying your portfolio to balance out risks and reducing risk through hedges.
What Is the Relationship Between Avoidance and Elimination?
Risk avoidance and elimination are frequently grouped together: unlike risk mitigation, investors who choose to avoid risk altogether will divest from certain investments and choose to switch strategies altogether.
