There is a very simple way to approach investment decision making. To start with, begin by asking yourself some basic and preliminary questions such as what is the investment for (to buy a house, to fund a kid’s education, or is it to fund retirement and the like) and how long these investments will last ( for example, up to 40 – 50 years sometimes when one starts planning for retirement early).
Once these basic questions are answered then ask this $64 million dollar question of yourself: Over your planning time horizon, how much of this money are you willing to lose? For example if you are trying to accumulate $100,000 for a house, how much could you afford to lose and still not lose your bearings. What if it is a five-year plan and in the 4th year you lose 50% of your accumulated funds with only one more year to go. How would you feel? This is the critical question in any investment decision. Typically you will not hear an adviser talk in such terms.
When planners talk about conservative investing, they couch the same idea in terms of risk and return. In the language of these experts such measures are often quantitative and difficult to understand for the average investor. While return on investments seems like a fairly straightforward concept (8% or 11% for example), risk is mentioned usually in terms of standard deviation, a statistical terminology difficult both to explain and to understand. Hence, most investors are pretty much in the dark when it comes down to making the decision itself since it is their sole responsibility. Thus, the investor is left with no other choice but to decide on whether the suggested investment return sounds attractive or not. On this track, the higher the return, the more attractive the investment seems. Further, planners may suggest that a return such as 8-10% is a conservative rate whereas 12-15% is aggressive. Hence if an 8-10% based investment is being suggested, the investor is likely to go with what she/he thinks is the most conservative decision, being the conservative investors they believe they are. (As an aside, there is a whole theory about investors being conservative and risk averse)
To unwind this basic mystery, simply ask the planner the likelihood of various amounts of losses in any single year including the last year of the investment. Could half your funds be wiped out in any year including the last year? What is the likelihood of such an event? What is the likelihood that it could be 25% in any given year? Suppose your planner shows how your $100,000 will grow to $150,000 in five years if you were to earnings the average rate of 8% per year for five years. Under such a scenario, what is the likelihood that you could lose half your accumulated funds in the last year and come out with a negative investment return even though you still earned that 8% average rate over the five years? As we know now such possibilities not only exist but are not uncommon either; as an extreme case in point consider the 2008-09 financial debacle. If your investment was maturing in 2009, the outcome would have been a lot worse.
This concern of loss is what should drive us in our investment decisions. Most planners are unable to explain this concept of loss aversion to their clients because they themselves are not adequately educated to understand the concept themselves. However, as mentioned before, the solution is simple. Now reconsider the example above of earning an average annual rate of 8% over 5 years. While it sounds conservative on the surface, it is actually quite aggressive. Earning 8% a year for five consecutive years (or averaging out over the five years to an 8% rate) is a very tall order. To do so, especially under most circumstances, one would actually be exposed to a large amount of loss in any given year.
Without getting into the details of how the standard deviation measurement of risk converts into the loss propensity and using very rough estimates, another way to view the 8% investment opportunity is to understand that in any year, you may not even earn a dollar (0%) and this could happen in each and every year. The likelihood of such an outcome is astonishingly high – about 25%. Thus, the investment decision is about whether you are willing to bet where the odds of loss is one to four (25%) every year for each of the five years. Of course the reverse is also true that in each of the years you have a 75% chance to earn a positive return on your investment and the earning rate itself could be anywhere from zero to the highest rate imaginable. Further, there is a 12% chance that you could be actually losing 8% a year for each of the five years! In prolonged economic downturns, which are not so uncommon, such are the outcomes. Now ask yourself this question: If you were told about these odds of losses, would you still consider the 8% investment opportunity to be conservative? Hopefully not, especially when you feel unsettled about the existing economic state of affairs. Further, would you consider a 10% return to be attractive and conservative if you were rejecting a 15% investment and choosing the 10% one?
As discussed earlier, this idea of loss aversion is probably the most powerful tool in the investor’s bag. Once you understand the implications of loss from any investment decision, then the loss aversion approach to making this decision is a dimensional shift, something that can be easily understood and applied by all investors. Further, if most investors behaved similarly, collectively we would make the investment market a much safer place. Unfortunately for now, there are no known ways of educating all investors about this critical aspect since the tools that currently exist are all based on statistical concepts of risk and return which make little sense to most lay investors.
Thousand Oaks, CA