What risk really means to a client

by Richard Allum on 10 December 2009

This is a very interesting article (with good links) from Morningstar in the US. In the investment industry, we think risk equals standard deviation. Therefore, risk can be measured, and the amount of risk we take can be controlled. It’s a nice, clean way to fit risk into our models. If clients can handle more risk based on their answer to our “risk tolerance” questionnaire, we just turn the dial, and increase their allocation to equities. The problem is that when real people, in the real world, think about risk, I am almost positive they don’t ever use the term standard deviation. Can you imagine a client losing sleep because they are thinking about the high level of standard deviation in their portfolio?

Real people lose sleep because they are worried about not having the money to fund their most important goals. They lose sleep thinking about not having the money to send kids to collage or retire. To real people, risk equals not meeting their financial goals.

We are measuring their tolerance for fluctuation, while they are worried about running out of money.

Now, maybe you can make the claim that standard deviation (using Monte Carlo analysis) is one way of quantifying the possibility clients have of not reaching their goals. However, if you use a “risk tolerance” questionnaire WITHOUT the context of the client’s goals, how would you know?

{ 1 comment… read it below or add one }

Sean Fernyhough 6 January 2010 at 10:18

Standard deviation is a dangerous measurement of investment risk.

1) It’s difficult to understand.
2) It’s difficult to explain.
3) Even when it’s a small number it is actually still a big number.
4) It is based upon mathematics which states that knowing the average (arithmetical mean) and knowing the standard deviation of a distribution of outcomes is all you need to know. This does not correctly characterise the investment world.

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