Is Risk A Four-letter Word
Risk means different things to different people, particularly when used in the context of financial planning. Often advisors are too quick to label investors, particularly women and young professionals, as conservative, when in fact a more moderate or aggressive profile would better suit their objectives.
Risk means different things to different people, particularly when used in the context of financial planning.
Yesterday, a young woman came to see me for my advice after meeting with her accountant. She was very nervous about coming to our offices and was quite unsettled and squirmy. As soon as we sat down, she blurted out, “I need you to know that I am not good with money, I don’t understand money and I am scared of it.”
I replied that this is not an unusual sentiment for people who meet with me. She immediately reached into her bag and produced scribbled notes and random financial documents. I told her I would like to know a bit about her first.
She gave me a short description of her life. Then I asked more probing questions and explained that money is part of a whole life. Before we can talk about it, we need to understand her situation and what her money needs to accomplish. Eventually, we had a good chat.
After I grasped her objectives, I asked her specifically what had brought her to my office. She replied with wide eyes that her accountant had looked at her portfolio and expressed alarm at her investment strategy.
I asked for the account statements, but she didn’t have any. She had account opening documentation and three pages of scrawled handwriting explaining the kind of registered account she had with various numbers and percentages thrown around and a large expanse of illegible words and crossed out phrases.
What was the accountant worried about? I was confused. There were no statements.
She replied that she was 29, and her accountant told her that she was identified on the documents as a moderate investor and that was too high risk. The accountant warned her that if 2008 happened again, she would lose all her money.
No wonder she was agitated.
I asked her a few more questions. What is the purpose of the money? Is it short or long term? Do you have any particular situations that might put you at risk? Health? Family? Relationship? Career? She answered no to these questions.
And your accountant thinks that you are not a moderate investor?
Hmmm. Deep breath. Let’s review risk and risk tolerance.
Risk, in financial terms, is an expression of uncertainty.
In colloquial terms, risk means danger. If someone tells you that you are at risk and to not continue to walk down that alley or head into that bar, you understand it to be a warning. Risk in financial terms means something different. Not different enough to be easily understood, but close enough to be confusing.
Risk, in financial terms, is an expression of uncertainty. It is a measure of variance around a mean. If something is supposed to behave in a certain way, the variance is the measure of how much it veers off the norm.
Something can be off the norm and be so by achieving abnormally excellent results — it varies from the norm but in a positive way. Or it can be in line with the norm but the norm is crazy or may have bad returns.
To summarize this concept, risk, as measured by a standard deviation, is not a quantification of whether there is danger or even a measure of the probability of you losing money. (I can’t tell you how many times I have heard bankers use standard deviation in this way when they are selling mutual funds). It is a measure of variability and because of the variability, there is an assumption of unpredictability.
This is why financial professionals might label investments as high risk. Because there is high degree of uncertainty as to how that specific investment will behave.
There are some things people don’t want to face because they make us uncomfortable.
There are some things people don’t want to face because they make us uncomfortable. For example, the concepts that we will die one day, or that all marriages will end in some manner, are emotionally unsettling. And the sticky problem is that there is a high correlation between the degree of upside and the degree of risk taken in terms of not knowing an outcome — both in life and in money.
In everyday terms, we know that every time we give birth, let ourselves love or start a new job, we are incurring huge amounts of uncertainty. We hold a communal kind of wisdom within us that says “nothing ventured, nothing gained,” and we willingly take on these unknowns because we understand at our core that life will be very boring and very unrewarding without risk and uncertainty.
However, when it comes to finance, we often want to make great returns without incurring any volatility or uncertainty. And we believe that not taking these risks is somehow a better choice.
This is especially true for inexperienced investors. They commonly self-assess as being risk averse and are almost always evaluated by their advisors as conservative. By putting our money in a GIC or Money Market account, we feel safe. And indeed, with nothing ventured, we will prevent a horrific loss. But we are also certain to attain losses because for the last decade the returns of these cash and cash equivalent instruments have been below the rate of inflation. So, in reality, there is no risk. That is because there is a certainty that in the long run you will lose money. Your deposits will not keep up to inflation and your buying power is diminished in the long term. For most middle-income wage earners, this virtually guarantees that they will not have enough money to create wealth or achieve long term objectives like buying a home or financing a business.
The idea of risk becomes re-framed into the concepts of sustainability and probabilities.
So, the idea of risk becomes re-framed into the concepts of sustainability and probabilities. One must be able to sustain themselves financially for the duration of their life. We don’t want a long life to be a liability. We want the money to last as long as the person does. So, if we factor in that life expectancies are increasing (especially for women) and older women frequently are left with no one to look after their health care needs, and add to this diminished lifetime earnings, we run the real danger that investing conservatively is the riskiest course of action.
A strange corollary of this is the insipid, entrenched idea that somehow, we are incapable of handling volatility, and that we should be protected from it. The irony is that these acts of protection leave us in a weakened state. We leave ourselves open to the financial instability that we are trying to avoid.
One financial company recently “upgraded” their risk assessment tool. Examples of the questionnaire, which are actually statements of self-evaluation, are as follows:
I understand investment concepts easily.
Well, we know from the research that many, women in particular, consistently underestimate their knowledge and ability as investors and men consistently over-estimate theirs. We also know that confidence is not correlated with reality. So what is this really measuring? Arrogance? Ego?
I feel at ease with regard to investing in the stock market.
Can any intelligent investor honestly support that statement? I am a seasoned financial advisor who has worked in the capital markets in both the US and Canada for the last two decades and even I can’t say I’m at ease. I don’t think ease is what we are looking for. You have to be ignorant to be at ease.
Or how about this one?
I am comfortable assuming large investment risk to earn large returns.
What kind of person is “comfortable” with assuming large risks?
This means that if I have a degree of self-awareness, or am particularly sensitive to feelings, I am going to score as a risk-averse investor. And we know that people who have more physiological sensitivity to their emotional states and are better able to articulate their feelings will answer these questions conservatively. This risk tolerance questionnaire will yield legions of conservative investors and will play into the whole circus of sensitive people being perceived as intolerant of volatility and fearful, when truthfully, they are just wise and astute about their feelings.
This questionnaire is incredibly biased and I am frustrated with it.
We need to look at risk from a new perspective.
Financial firms should use language like “I can accept that higher amounts of volatility are associated with the probability of higher returns.” Or, “I am willing to experience some volatility in my portfolio to achieve long term objectives.” Better yet, “I understand and accept that my portfolio will have short term variations in value to achieve long term results.”
We need to look at risk from a new perspective. We must be informed enough about our investment choices to evaluate the downside and upside of any given decision. And we must understand and be committed to establishing our long-term goals.
However, the concept that risk is bad is bogus. We practice risk-taking every day we leave our beds! We are capable and competent investors when we are approached in a manner that takes our wiring and language into account.
On the glorious day the world of finance adapts to a more holistic way of thinking, we will no longer be seen as conservative for being wise and emotionally intelligent. And we will embrace that risk is not a four-letter word but the portal for wealth and a bigger life.