Risk: The four letter word

As an adviser, we were expected to educate the investor about the Risk of investing in the financial markets. In today’s environment of transparency, we assume that investors want to know the truth, so don’t hide it.  And hence we inundate them with the idea of Absolute and Relative risk, Systematic and Unsystematic risk, Default Risk, Geography Risk, Interest rate risk, Liquidity risk, and what not.

I totally understand why people talk like that. First, there’s an assumption that lettered person makes better adviser. Second, being able to talk like that makes adviser seasoned, someone who has gone through the rut and his idea is now chiseled out.

In reality most of the time these jargon-laden definition makes an investor more confused. It’s not that investor doesn’t understand the risk but not the way we convey it. This commonly used “four letter word” is the most abused word in the investing annals.  It may have totally different meanings for different individuals. To many investors, risk means the cost of making a mistake.  It could be financial, social, psychological, or even emotional. The risk is about fear of change.

Financial Experts judge risk in terms of quantitative assessments whereas most people’s perception of risk is far more complex, involving numerous psychological and cognitive processes. To assume people perceive risk pertaining to their life, family, career, and profession differently than their investment risk is a false assumption.

People tend to be intolerant of risks that they perceive as being uncontrollable, having catastrophic potential, having fatal consequences, or bearing an inequitable distribution of risks and benefits. Can we overcome this resistant by simply disseminating more and more information about the product and assets we are proposing? I don’t think more data supported by evidence of past and validated by external sources reduces the resistant.

In Investment industry, the assessment of Risk Tolerance of investors is either intuitive or based on risk profiling tools. Most risk profiling tools are based on psychometric test built in the nineties. Most tools are based on inadequate statistics, such as using historic volatility as the key metric for measuring risk and that could lead to “flawed outputs”. The probable consequence of inadequate or poor risk profiling is an investor making investments that are not suitable for their objectives, financial situation, and needs. The results of such a tool should only provide a starting point for a conversation about investment risk, not an ending.

In my last two decades of dealing with investors, I find equity is the most resisted asset class. Some investors find the volatility unnerving; while some dread the probability of absolute loss; some has bad experiences in the past; and some wants a regular income. As an adviser, one need to be persevering. One can’t do a risk profiling of an investor in a session or two. The true assessment of risk tolerance, capacity for loss assessment and a risk required analysis can be done over a period of time. Till such time your proposal should align with the risk perception of the investors.