What is a Risk Discount?

A risk discount is an investment strategy in which the investor chooses to settle for less of a return on a given investment opportunity in exchange for taking on a lesser degree of risk. An investor who chooses to use this type of strategy is usually identified as a conservative investor, or an investor who is risk averse. While the returns are reduced in order to minimize risk, this approach can tend to be ideal for anyone who wishes to increase the value of their holdings over time, rather than attempt to generate a more spectacular return in a shorter time frame.

The concept of the risk discount is the opposite of what is known as the risk premium. With a risk premium, the investor is willing to take on additional risk in order to possibly generate a larger return, often in a shorter period of time. Investors who use this approach are often referred to as speculative investors or risk lovers. Depending on the nature of the investment, using a risk premium approach may yield a significant return within a short period of time. This is especially true if the investor buys and sells the investment at just the right time.

One of the main benefits of the risk discount approach is that an investor can make a decision to buy, then allow that investment to quietly and incrementally earn a return over the long-term. Rather than spending time constantly monitoring the market movements of the asset, the investor can confidently focus on other investments, since this safe investment carries such a low rate of volatility. For investors who want to create portfolios and then manage them with a minimum of effort, employing a risk discount strategy is often a wise choice.

There is one drawback to consistently relying on a risk discount strategy. While investors can take comfort in the fact that the investments are likely to generate consistent returns, the amount of those returns is somewhat limited. The very nature of a safe risk-return tradeoff means that investors can only expect to earn so much from each asset acquired. For this reason, it is not unusual for investors to create a solid foundation of low-risk assets within a portfolio while also engaging in a few investment options that are somewhat more volatile. This approach makes it possible to have the security of investments that will perform well in most economic climates while also having the advantage of occasionally earning a more spectacular return on some investment that is held for a shorter period of time.