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.
FAQs
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, while risk reduction deals with reducing the likelihood and severity of a possible loss.
What is the difference between risk reduction and risk avoidance? ›
Risk avoidance and risk reduction are both risk mitigation strategies. Risk avoidance means you're trying to avoid compromising events as a way to eliminate liability exposures. Risk reduction is a way to help you control the damages to your business, like claims or losses.
What is the difference between risk avoidance and risk acceptance? ›
Acceptance usually has a very low cost associated with managing the risk (or zero cost), but can have a very high cost in the aftermath of a disruption. Risk avoidance is a strategy in which the risk is completely avoided. This might include shutting down critical systems and moving them in advance of a hurricane.
What is the difference between risk reduction and prevention? ›
Risk Reduction is what is measured and is PRECISE terminology ... “Prevention” is NOT measured & is obtuse fuzzy terminology. IF u tell a parent that you're protocol is going to “Prevent” their child from an injury and THEN they have an injury you have ☝Risk of legal liability!. Twitter. 2022.
What is the difference between risk reduction and risk management? ›
The policy objective of anticipating and reducing risk is called disaster risk reduction (DRR). Although often used interchangeably with DRR, disaster risk management (DRM) can be thought of as the implementation of DRR, since it describes the actions that aim to achieve the objective of reducing risk.
What is an example of risk reduction? ›
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.
What is the meaning of risk reduction? ›
What is Risk Reduction? Risk reduction refers to identifying and implementing measures to reduce the chances of damage from a particular activity or situation. This can involve identifying potential hazards, implementing safety measures, and developing contingency plans to mitigate the impact of unexpected events.
What is an example of a risk avoidance? ›
An example of risk avoidance might be a manufacturing business not using certain hazardous materials or chemicals due to the dangers of handling and storing them; or, an organization limiting the type of customer data it stores on its computers in case of a cyberattack.
What is the relationship between risk avoidance and risk elimination? ›
While the complete elimination of all risk is rarely possible, a risk avoidance strategy is designed to deflect as many threats as possible in order to avoid the costly and disruptive consequences of a damaging event. Risk avoidance is a specific type of approach to managing risk, requiring a methodical process.
What are the 3 focuses of risk reduction? ›
Risk reduction processes are focused on the generation of alternatives, cost effectiveness, and management involvement in the decision-making process.
One of the main benefits of risk avoidance is that it reduces or eliminates the potential negative impact of a risk on the project objectives, scope, quality, cost, or schedule. By avoiding a risk, you can save time, money, and resources that would otherwise be spent on mitigating or transferring the risk.
What is the difference between risk avoidance and risk retention? ›
Avoidance means not participating in activities that could harm you; in the case of health, quitting smoking is a good example. Retention acknowledges the inevitability of certain risks, and in terms of health care, it could mean picking a less expensive health insurance plan that has a higher deductible rate.
What are examples of risk reduction management? ›
Reducing exposure to hazards, lessening vulnerability of people and property, wise management of land and the environment, and improving preparedness and early warning for adverse events are all examples of disaster risk reduction.
Why is risk reduction important? ›
Natural hazards (such as extreme weather, wildfires or earthquakes) may be inevitable, but disasters – with loss of life and high economic costs – are not. This is why disaster risk reduction is important. It lowers the probability that a hazard or man-made event has disastrous consequences.
What is an example of risk avoidance? ›
An example of risk avoidance might be a manufacturing business not using certain hazardous materials or chemicals due to the dangers of handling and storing them; or, an organization limiting the type of customer data it stores on its computers in case of a cyberattack.
What is the difference between risk aversion and risk avoidance? ›
Note: There is a difference between risk aversion and risk avoidance. For example, a risk averse investor may accept a low degree of risk in an investment selection, whereas risk avoidance would have the investor forgo the investment altogether.
What is the difference between avoidance and risk control transfer? ›
TL;DR Risk avoidance is not taking on the risk in the first place by not investing in the product that has the said risks. Risk transfer is akin to buying insurance. You make the investment, are exposed to the risk, but are protected if it happens.
What is the difference between risk assumption and risk avoidance? ›
This option accepts the potential risk and continues assuming the contingency plan lowers the risk to an acceptable level (low cost). Risk Avoidance: We can circumvent the risk by removing the cause or reducing the consequences (some cost).
