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
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%.
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.
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:
Planning Services, Inc.
573 Millwood Road
Chappaqua, NY 10514-1317
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