Risk Avoidance vs. Risk Reduction: What's the Difference?

Risk avoidance and risk reduction are two strategies to manage risk. Risk avoidance deals with eliminating any exposure to risk that poses a potential loss, ... TradingSkills RiskManagement TableofContents Expand TableofContents RiskAvoidancevs.RiskReduction RiskAvoidance RiskReduction ProsandConsofEach FAQs RiskAvoidancevs.RiskReduction:AnOverview Riskavoidanceandriskreductionaretwostrategiestomanagerisk.Riskavoidancedealswitheliminatinganyexposureto riskthatposesapotentialloss,whileriskreductiondealswithreducingthelikelihoodandseverityofapossibleloss.Thisarticlewillexplorethedifferencesbetweenthetwoapproaches. KeyTakeaways Riskavoidanceisanapproachthateliminatesanyexposureto riskthatposesapotentialloss.Riskreductiondealswithmitigatingpotentiallossesbyreducingthelikelihoodandseverityofapossibleloss.Forexample,arisk-avoidantinvestorwhoisconsideringinvestinginoilstocksmaydecidetoavoidtakingastakeinthecompanybecauseofoil'spoliticalandcreditrisk.Meanwhile,aninvestorwithariskreductionapproachtothesameoilstockswoulddiversifytheirportfoliobykeepingtheiroilstocks,whilebuyingstocksinotherindustriesthatcouldhelpoffsetanylossesfromtheoilequities.Inordertoengageinriskmanagement,apersonororganizationmustquantifyandunderstandtheirliabilities. RiskAvoidance Riskavoidanceisnotperforminganyactivitythatmaycarryrisk.Ariskavoidancemethodologyattemptstominimizevulnerabilitiesthatcanposeathreat.Riskavoidanceandmitigationcanbeachievedthroughpolicyandprocedure,trainingandeducation,andtechnologyimplementations. Forexample,supposeaninvestorwantstobuystockinanoilcompany,butoilpriceshavebeenfallingsignificantlyoverthepastfewmonths.Thereispoliticalriskassociatedwiththeproductionofoilandcreditriskassociatedwiththeoilcompany.Ifaninvestorassessestherisksassociatedwiththeoilindustryanddecidestoavoidtakingastakeinthecompany,thisisknownasriskavoidance. RiskReduction Ontheotherhand,riskreductiondealswithmitigatingpotentiallossesthroughmoreofastaggeredapproach.Forexample,supposeaninvestoralreadyownsoilstocks.Thetwofactorsdiscussedearlierarestillrelevant:thereispoliticalriskassociatedwiththeproductionofoil,andoilstocksoftenhaveahighlevelofunsystematicrisk.Asopposedtoariskavoidancestrategy,thisinvestorcanreduceriskbydiversifyingtheirportfoliobykeepingtheiroilstockswhileatthesametimebuyingstocksinotherindustries,especiallythosethattendtomoveintheoppositedirectiontooilequities. Inordertoengageinriskmanagement,apersonororganizationmustquantifyandunderstandtheirliabilities.Thisevaluationoffinancialrisksisoneofthemostimportantandmostdifficultaspectsofariskmanagementplan.However,itiscrucialforthewell-beingofyourassetstoensureyouunderstandthefullscopeofyourrisks.Ifyouhaveseveralstreamsofincome,forinstance,losingonestreamwon'thurtasmuchifonly25%ofaperson'sincomecomesfromthatstream. Financialdiversification isoneofthemostreliableriskreductionstrategies.Whenyourfinancialriskisdiversified,theadversesideeffectsarediluted. Supposetheinvestordiversifieshisportfolioandinvestsinvarioussectorsofthemarket.However,hecurrentlyfacessystematicriskduetoaneconomicdownturn.Theinvestormayreducehisriskthroughahedge.Forexample,theinvestorcanprotecthislongpositionsandreducehisriskbybuyingputoptionsforhislongpositions.Heisprotectedfromapotentialdropinhisportfoliovaluebecauseheisabletosellhisstocksatapredeterminedpricewithinaspecifiedperiod. Theinvestorwhoavoidstheriskforfeitsanypotentialgainstheoilstockmayhave.Ontheotherhand,theinvestorwhoreduceshisriskstillhaspotentialgains.Ifthestockmarketgoeshigher,hislongpositionswillappreciateinvalue.However,ifhispositionsdecreaseinvalue,heisprotectedbyhisputoptions. RiskAvoidancevs.RiskReductionProsandCons Preventionvs.mitigationstrategieswhenitcomestoaninvestorwhowantstoavoidriskshouldbeequallyweighed.Itmaycomedowntojustthelevelofriskinvolved,andhowaninvestorultimatelydiversifieshisportfolio.Herearesomeprosandconsofriskavoidancevs.riskreduction: RiskAvoidance Safelyguaranteesthatreturnswillnotbelostorjeopardized Closesthedooronopportunitiesforfuturegains,especiallypotentiallyhigherreturnsoninvestment Simplewaytofocusonsteadystreamsofincome RiskReduction Seeksa"bestofbothworlds"approachtomitigatingrisk,whileexposingyourselftopotentiallyhighreturns Canberiskierfinancially,ifriskscometofruition Requiresamorecomplexapproachtoinvesting,includingfullunderstandingofyourliabilities RiskAvoidancevs.RiskReductionFAQs WhichIsBetterPreventionorMitigation? Eachinvestorshouldweighthescenarioathand,levelofrisk,anddecidewhetherpreventionvs.mitigationstrategiesarethebestfitfortheinvestmentstyleandportfolio. WhatAretheTypesofRiskMitigation? Afewkindsofriskreductionstrategiesincludediversifyingyourportfoliotobalanceoutrisksandreducingriskthroughhedges. WhatIstheRelationshipBetweenAvoidanceandElimination? Riskavoidanceandeliminationarefrequentlygroupedtogether:unlikeriskmitigation,investorswhochoosetoavoidriskaltogetherwilldivestfromcertaininvestmentsandchoosetoswitchstrategiesaltogether. CompareAccounts AdvertiserDisclosure × TheoffersthatappearinthistablearefrompartnershipsfromwhichInvestopediareceivescompensation.Thiscompensationmayimpacthowandwherelistingsappear.Investopediadoesnotincludealloffersavailableinthemarketplace. Provider Name Description RelatedArticles RiskManagement Howarenegativecorrelationsusedinriskmanagement? RiskManagement LearntheCommonWaystoMeasureRiskinInvestmentManagement PortfolioManagement HowtoAdjustandRenewYourPortfolio SustainableInvesting InvestingInPollutionControlandWasteReduction RiskManagement WhatAreSomeCommonExamplesofUnsystematicRisk? RiskManagement DeterminingRiskandtheRiskPyramid PartnerLinks RelatedTerms WhatIsMarketRisk? Marketriskisthepossibilityofaninvestorexperiencinglossesduetofactorsthataffecttheoverallperformanceofthefinancialmarkets. more WhatIstoDe-Hedge? Tode-hedgeistoremoveanexistingpositionthatactsasahedgeagainstaprimarypositioninthemarket.Readabouthedgingandtheroleofhedgefunds. more WhatIsaRioHedgeinTrading? "Riohedge"isatongue-in-cheektermreferringtoatraderthatputsonariskytradeandmayneedtoescapetowntoRiotoavoidanyfinancialresponsibility. more ShortSelling Shortsellingoccurswhenaninvestorborrowsasecurity,sellsitontheopenmarket,andexpectstobuyitbacklaterforlessmoney. more AcceptingRisk Acceptingriskoccurswhenabusinessacknowledgesthatthepotentiallossfromariskisnotgreatenoughtowarrantspendingmoneytoavoidit. more Hedge Ahedgeisatypeofinvestmentthatisintendedtoreducetheriskofadversepricemovementsinanasset. more