As an expert in investment, people come to me with innumerable questions about where to invest their money, or which stocks to invest in, and my answer is never the same. This is because investment strategy is not one size fits all, there are many factors in play when deciding what the best course of […]

Why misunderstanding risk can damage your economic health

As an expert in investment, people come to me with innumerable questions about where to invest their money, or which stocks to invest in, and my answer is never the same.

This is because investment strategy is not one size fits all, there are many factors in play when deciding what the best course of action is for you.

 

What you see vs. what is actually there

Take driving on Sheikh Zayed Road for example. For the average British person, it may be perceived as extremely risky, however, for Italians, it may be considered as relatively safe compared to racing around Milan, while for the RTA, the risk is just average.

Herein lies the problem of assessing risks. We have a road that is rated average risk by the expert but both parties have completely opposite ideas, both of which are different from the RTA’s. This is due to the difference in risk perception. Your perception may not always be the reality and is often the result of a lack of financial literacy and being susceptible to news and television reports. This, in turn, will affect your investing behavior and could become a hindrance to achieving your financial goals.

 

The science in investing.

Here’s where the science comes in. Fortunately, there’s a way to measure your actual capacity for investing and the feasibility of achieving your goals, and that is through formulating your risk profile.

While your risk perception and tolerance to risk may be subjective, your risk capacity isn’t. Factoring in variables such as your age, experience, and goals, a psychometric approach is the best way to determine your risk capacity accurately, as well as your willingness to increase it if required.

This helps manage the risk perception and investment expectations on an on-going basis, which in turn will prevent disappointment.

 

Formulating your risk profile

Understanding one’s risk perception, capacity, and tolerance, is essential to be able to give an appropriate investment recommendation. This is why it is necessary to ask questions, evaluate the responses and create a risk profile before recommending a suitable investment structure and strategy.

Most risk profiling forms are not effective at predicting a client’s behaviour during volatile markets, which can lead to unhappy clients or even legal issues.

Reality vs. Expectation

Take, for example, your investment that has gone from 1 million to 2 million then down to 1.5 million. I might consider that  you have made 500,000, however you may feel that you’ve lost 500,000, the result: “unhappy client”.

Or perhaps another person’s investment may have gone to 1,300,000 and as such has no problem losing 200,000. In this instance, it may be seen as playing with money they never had, but if they had invested 1 million and lost 100,000 then that could be for catastrophic for them.

So even if the loss looks small, the way you or anyone else accepts this volatility or loss is different. This is because, when you decide to complete the questionnaire, you have a calm and rational mind. However, when this unexpected volatility comes in, you then begin to elicit an emotional response, everyone usually does.

It’s just how our primal instincts function. Thus, the difference between our rational expectations and our actual response to risky events. It’s these reactions that cause disappointment at a perceived loss, and most likely prevent you from achieving your goals, it is therefore our job to prepare you for such events and manage your expectations in your investment.

 

Conclusion

This is why risk profiling and financial literacy are important tools for financial advisers to help our clients understand that not all risk is a loss. Your adviser should be able to ensure that your expectations are realistic and are managed at a constant basis. Only then can you remain calm and survive volatile times, and still achieve your desired goals.

So when planning for investments, the correct risk analysis that covers risk tolerance, risk capacity and risk required, is of utmost importance. This requires not only a good risk profiling but also a good quality financial adviser that can help you spot the nuances.

Every person is different, and it is our job, as the tailors, to find the perfect fit for you.

 

 


23rd September 2018 by Gordon robertson

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