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Risk is an inherent feature in the financial markets. How we discuss risk with clients can be the difference between making good decisions and those that are very costly. If the investor makes a costly decision, we will simply blame them. But what if we never addressed risk in the appropriate way and with the right perspective?
Defining Risk
How do you define risk? How does Client A define risk? What about Client B? The truth is that risk has many interpretations. And if your clients have incorrect interpretations or perceptions when it comes to risk, they are bound to make poor decisions at some point. And what if your definition is different from theirs? That is the recipe for misunderstanding – and that is your (the advisor’s) problem.
Some may define risk as outliving their money, others may define risk as a drawdown beyond some percentage, and others may define risk as uncertainty. It is imperative that you and your client speak the same language – which means has the same interpretation of the word risk as we discuss it. This has an easy resolution – just ask your clients. If their interpretation/definition is not yours, then discuss which one you will use going forward…and do it!
Avoiding Risk
Many investors would love to avoid risk. For some reason they seem to believe you can avoid risk (fluctuation, temporary loss) in equity markets and still participate in the gains. That is one of the greatest deceits in investing.
Avoiding risk in the markets is no different than avoiding the risk of a plane crash. If you really want to avoid the risk of a plane crash, you just don’t get on the plane. Similarly, the only way to avoid equity risk (if defined as temporary losses or fluctuation) is to not participate in the markets. Therefore, risk avoidance is synonymous with return avoidance. Such a statement should be repeated ad nauseam to investors.
Controlling Risk
While avoiding risk ensures investors avoid returns, controlling risk is an entirely different ballgame. When you control risk, you acknowledge it exists and simply find the level you are comfortable with. Risk control is primarily a function of investment allocation, frequency with which the investor evaluates the performance, and the patience/discipline of the investor. All things that are in our individual control!
Helping investors understand how to think about risk is the advisor’s responsibility. If investors have the wrong understanding or interpretation, that is the advisor’s fault. Why? Because we are all fallible. We are subject to unconscious mental shortcuts and emotions. It is incumbent on the professional, the one who knows (or should know) about these pitfalls to discuss with their clients and help them choose wisely. If you want to help clients make wise decisions, it starts with making sure they have the correct understanding and perception of risk.
Related: The Benefits of Failure