Losses & Risk Tolerance

[The Wealthy Boomer]

Why does the investment industry prefer the word "risk" to "loss?" Does this euphemism affect the way people and advisors design their portfolios?

[Feeonly.ca]

Why does the investment industry prefer the word "risk" to "loss?"

With investing people relate "Risk" with Return. The idea of return is pleasant even if it means taking risk.

With investing people relate "Loss" to pain. They hate thinking about pain even if it is a superior way to think about risk.

Does this euphemism affect the way people and advisors design their portfolios?

IMO, advisors and the clients are often overconfident about the ability to tolerate risk. I think investing to your maximum risk tolerance is a flawed approach. Your actual tolerance for risk is always unknown until you pass that point and then it's usually too late for rational thinking. Panic selling at or near the bottom of a market swoon is one of the most common and costly errors people make.

A more prudent approach is to consider your Investment Policy [the cash/bond/stock allocation] based on an estimate of the actual return required to meet your objectives.

Then consider if you can accept the expected volatility and potential loss in dollar terms associated with that investment Policy.

Take investment risk based on what you need not on the maximum amount you think you can handle. There is a high probability that you will miscalculate your threshold for sustained pain and the price of getting it wrong could be devastating to your portfolio.

PS. Advisors are people too ,

[jiHymas]

Why does the investment industry prefer the word "risk" to "loss?" Does this euphemism affect the way people and advisors design their portfolios?

Why do you assume it's a euphemism?

I don't care whether or not my portfolio goes up or down, as long as it outperforms whatever it is I want to buy with the proceeds, whether that's groceries or pension liabilites or the index.

There was a long discussion of this in the thread Risk = ??

[The Wealthy Boomer]

Thanks, must have missed that thread when it was live.

Piece on this -- Risk-taker or loser? -- in FP Weekend. Or see www.journalfp.net and look for the article by Fred Kirby.

[Bylo Selhi]

Piece on this -- Risk-taker or loser? -- in FP Weekend.

Now also available in the Liberated Post: Risk by any other name is loss.

[smelly]

When many average folks say risk, what they really mean is regret. It's not a concept they think about in any certain context up front but rather a word they use in hindsight and to characterize why the investment was a mistake. If the term is used by the investor prior to making an investment they may say "Is it risky?". To which an advisor should respond by saying "That depends on what risk means to you. Let's define the word and then I can answer your question". If that isn't done, some time in the future, the client will say that the investment was too risky because the investment is worth less than it was yesterday, last year, less than his/her brother-in-law claims his did, less than the guy at the bank said it would have been if he was running the portfolio, less that Jon or Rob or Gord said it would have been if they would have taken their advice ... even though it's done well in the long term and pretty darn close to what I projected it would do on average even down to the ranges of best and worst returns over 1, 3, 5, 10 years as the IPS suggested.

So when they say the investment was too risky they mean they regret making the investment.

[gyrfalcon]

"Why does the investment industry prefer the word "risk" to "loss?" "

If the term "higher risk" is used properly re investing, it means a higher probability of BOTH higher returns and lower returns, compared to some "lower risk" strategy. Therefore, risk does not equate to loss in any grammatical sense.

"Panic selling at or near the bottom of a market swoon is one of the most common and costly errors people make. "

I agree. If academics & leading investment figures spent as much time researching the best means to investor education & investor self-control as they do on dry analyses of median results, they might assist investors to a higher long-term return.

IMHO. gyr.

[smelly]

And that's why DSCs and 8 year holds on LSIFs are a good thing. They sometimes stop people from doing dumb things.

[Shakespeare]

They sometimes stop people from doing dumb things.

I thought that was what the advisor was for?

[nadreck]

Why does the investment industry prefer the word "risk" to "loss? Does this euphemism affect the way people and advisors design their portfolios?

Do they? Does it? I think both loss and risk are terms that are used incorrectly, particularly by the media. As well I think the term risk is often used to negatively affect the judgement of clients of investment professionals. Both terms have heavy negative connotations to those who are not comfortable with the mechanisms and lexicon of investing.

Now while I feel that from an investing point of view the concept of 'risk' being able to be assessed by looking at past volatility relative to some volatile standard is absurd and instead rather than using an assessment of 'risk' I make calculations for the potential of gains or losses going forward based on business fundamentals, sectoral and systemic conditions, and potential for growth.

However the term "risk" is often used to scare investors into a desired behaviour, "risk" has the trappings of technique, methodology, and science behind it so an authoritative dismisal of one option over another based on relative 'risk' is quoted by some professionals from time to time to their clients. Clients do equate risk with loss when markets are down, and risk with gain when markets are up. Loss is absolute, risk is relative. I don't see one being used as a euphemism for the other in the industry or the media, but I often see both used incorrectly.

If academics & leading investment figures spent as much time researching the best means to investor education & investor self-control as they do on dry analyses of median results, they might assist investors to a higher long-term return.

IMHO. gyr.

I would second this one vociferously. I would only want to add that some thought has to also be given to motivating more people to thinking that they can manage money. I know a number of otherwise smart individuals who have no motivation to learn how to take care of their finances.