In investment management, risk is often equated with the uncertainty (variability or standard deviation) of possible returns around expected returns. However, investors do not think in terms of expected returns or standard deviation. More often, they rely on what is in the dictionary: the chance of loss. 

Most investment advisors are in agreement that it is more accurate to think of investors as typically being loss adverse rather than risk adverse. For example, the variability of returns that investors experience from one year to the next may not be particularly troublesome so long as there are no negative returns. Beneath the psychology of loss aversion lurks a conviction by some that negative returns represent permanent capital losses.

Another problem with the loss adverse psychology is that investors tend to think in terms of nominal rather than real returns. Many investors would feel better about earning 5% after taxes in a 12% inflationary environment than they would about losing 1% with a 4% rate of inflation. The positive nominal gain of 5% creates the illusion of getting ahead, although adjusted for the 12% inflation, the real loss is 7%. In actuality, the investor would be better losing 1% or a smaller real loss of 5%.

The task is to sensitize the investor to all of the risks that they may face, then to prioritize the relative dangers of these risks given the context of the situation. This is why we explore the impact of time horizon on the investment management process. It is only in reference to the relevant time horizon that we could determine whether volatility or inflation was the greater risk. For the long- term investor, volatility is not the major risk; inflation is.

Most investors do not know how to realistically assess the risks they face. By default, they tend to assume that the familiar and comfortable path is the safe path, whereas anything unfamiliar or uncomfortable must be risky. Many people who are heavily invested in real estate with high financial leverage consider themselves risk averse and fearful of common stocks. Yet, when the risk of such highly leveraged equity investing is pointed out, the usual response is "there is no risk because I understand it and am comfortable with it!" The real issue is the amount of volatility the investor can tolerate. Our task, at EMERALD, is to provide a frame of reference that enables clients to correctly perceive risks within the context of their situations.

For more information, contact:

Emerald Planning Services, Inc.
573 Millwood Road
Chappaqua, NY  10514-1317
914-241-0707 (voice)
914-864-2300 (fax)  

info@emeraldplanning.com

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