A Tale of Two Definitions
Asking someone built for short-term survival to become a long-term investor is a bit like trying to paint a room with a hammer. You can do it, but it’s not pretty.
– Daniel Crosby
Investment experts feel that managing risk is the most important aspect of making investment decisions. But when it comes to defining what risk is, it’s typical for advisors and their clients to speak different languages.
Advisors, who are trained in the intricacies of creating investment portfolios, use standard deviation to measure the risk of an individual stock or a stock portfolio. They believe standard deviation makes sense as a risk metric because it measures the volatility of an investment’s returns.
No doubt you’ve had the “what is your risk tolerance” discussion with your clients. You’ve probably even offered hypothetical investment-based examples of risk to gauge their comfort with declining investment values. While those discussions are valuable in terms of “what ifs,” there’s a big difference between discussing a hypothetical situation “when nothing is really happening” and reality. For clients that understand what standard deviation means, they are typically comfortable experiencing it as a “theoretical.” Investors tend to think rationally when they’re discussing possibilities. However, when they’re watching their investments decline in value, they’re anything but rational.
The fact is most investors don’t know a standard deviation from a standard transmission. Unlike advisors, they define risk as the loss of money. As humans, we’re not built to sustain any discomfort. We’re more inclined to do the thing in the short-term that will give us the most comfort despite the fact that, intellectually, we know investing is a long-term undertaking.
Given the differences between experiencing risk and talking about risk, it’s imperative that advisors:
- Dig deeper into how their clients define “risk”
- Set expectations by explaining that there is a high likelihood that their stock investments will decline in value over the short-term but appreciate over the long term
- Explain that according to Wharton’s Jeremy Siegel, one of the most highly respected investment experts in the country: “Even when looking at periods that ended in the bottom of the Great Depression, stocks had a positive real return if held for 20 years.” Siegel, added, “You have never lost money in stocks over any 20-year period.”
Even before those three points, tell your clients from the outset that investment volatility is inevitable. Then, tell them it is perfectly natural that you will need to remind them of that fact plenty of times over the course of your relationship.
This material is for investment professional use only.