One of the common investment concepts is that of the reward an investor receives for taking risk. When an adviser discusses risk with a client, oftentimes this reward – the participation in the potential upside – is cited as a reason for investing in equities and alternatives or other similar investments. More staid investments such as treasury bonds, some corporate debt and the like do not offer that potential upside, certainly not to the extent possible with an investment like a small cap stock.
The risk discussion also often addresses just how much of the total investment portfolio an investor would be able to face losing if markets were adverse. This hypothetical loss is usually stated as a percentage of the overall investment and is discussed at, say, ten percent, twenty or twenty-five percent and the like. Further, the hypothetical loss is described as occurring once in a period of years, which may vary according to the model and its assumptions.
Of course, human nature being what it is, investors focus first on the possible reward and next on the stated unlikelihood of the hypothetical loss. That loss, after all, only is presented as occurring once in a while and is seen as only a distant possibility. So the real test of that investor is what they do when a loss actually materializes and they see that they have lost some meaningful portion of the value of their investment. There are not a lot of investors who shrug that loss off, understanding the nature of the risk at stake. More often there are questions, complaints, recriminations and at the far end of the spectrum claims and lawsuits against the investment adviser.
So how might we improve investors’ understanding of risk and discovering their real tolerance for it? One step might be to emphasize not just the potential reward aspect of investments involving risk but the possible penalty or loss that is also associated with the same investment. That doesn’t mean another fine print disclosure but an actual discussion and thought. Don’t let that investor brush you off; make sure the investor really understands what losses are possible. Avoid simplistic examples using hypothetical percentages – have your examples come from real stocks and real history and involve actual dollar amounts. That makes the example more real and forces that investor to acknowledge the risk in a more meaningful way.