Do You Understand Investment Risk?

By Brian Bloch AAA

A study conducted by England's Financial Services Authority (FSA) in 2004 called "Consumer Understanding Of Financial Risk" has shed some light on how well people understand their investments. Such understanding or, in some cases, the lack of understanding, leads to specific types of behavior. It is important for both investors and providers to be aware of the differences. In this article, we'll go over this study and what it can teach investors about their own understanding of their personal finances.

Tutorial: Risk and Diversification

Types of Investors
The respondents in the study were divided into three main groups:

  • Trusters were defined as unsophisticated investors who primarily rely on their advisors.
  • Partners are those with an intermediate level of sophistication who work together with their advisors to some extent.
  • Controllers are sophisticated and often experienced investors who rely on their own understanding and make their own decisions.

This simple categorization provides considerable insight into the nature of investors, what they do and expect, and the associated risks and opportunities that exist for both buyers and sellers. (Learn more in What Is Your Risk Tolerance?)

Education and Financial Sophistication Are Not the Same Thing
It is important to note that general or even business education doesn't necessarily translate into specific knowledge about the world of investment. A business graduate is certainly likely to know something about investments, but this knowledge may be very theoretical and, therefore, less applicable to the graduate's own experiences. Conversely, a doctor who happens to be very interested in getting the most "bang for his buck" on his investments may turn out to have a relatively sophisticated understanding of investing. Likewise, retired people with no formal financial education or qualifications may spend hours pouring over the financial pages of the newspaper every day. In this case, they may know more than their advisors about day-to-day developments.

Let's look in more detail at each of the three groups.

Trusters Rely On Others
Not surprisingly, the lower the level of sophistication, the less people understand about the risks to which their money is exposed and the more naive they tend to be about what their advisors or investment companies can really do for them. The FSA study points out that this naiveté can lead to excessive reliance on people in the industry, which can open the door for potential abuse. Alternatively, it may lead nervous and distrusting people to adopt a "savings approach", which may be too risk averse to benefit the investor. (For related reading, see Determining Risk And The Risk Pyramid.)

When investors lack understanding of their investments, this often means that they are uninformed about what is meant by high, medium and low risk, the three standard categories prevalent in much of the investment literature. The problem is compounded by the failure of many brokers to present people with clear options with clear risk labels. Investors often think that anything to do with shares is risky, or that fund managers generally buy shares with such astuteness and expertise that there is little risk involved. Generally speaking, the reality is that the greater the value of equities that an investor has in his or her portfolio, the greater the amount of risk the person is taking on compared to leaving that money in a savings account.

While many investors understand the principles of diversification and risk well enough to know it is bad to "put all of their eggs in one basket", they do not always know how to avoid this in practice. Trusters, for example, were shown to have a poor understanding of asset classes and very little, if any, awareness of the range of products available in the market. As a result, they tend to delegate most of the responsibility to others, which predictably leads to somewhat mixed results. (For more insight, see Introduction To Diversification and The Importance Of Diversification.)

Partners Make Mutual Decisions
Partners tend to have a medium level of sophistication and often want to be involved in the decision-making process. They generally read newspapers or magazines in and attempt to follow the markets. They also rely on advisors for help, but certainly not for the basic-level financial matters. They are interested in the "second opinion" that brokers or advisors provide, and also seek professional assistance to ensure that paperwork is completed correctly and that they understand any applicable legal jargon.

The main difficulty with partners is finding the right balance between control and delegation. While some advisors do not welcome client input, and others tend to think customers know more than they really do, it is essential for the investor-advisor roles to be quite clear to both parties. It may be best to have some form of written agreement - even if it's an informal one - that highlights the nature of each player's respective roles.

Controllers Want to Run the Show
Controllers are sophisticated investors (or at least think they are!) and prefer to take charge of the investing process. They are very interested in the financial sector and have a good understanding of both products and markets. They are aware of and understand the array of products that are available and they know what they want. They also spend a considerable amount of time researching products and markets, and they actively send off for financial statements, buy the latest books, and even attend investment seminars and conferences. This does not necessarily make them risk friendly, but they understand risk and know how to construct an optimal portfolio. Such investors often purchase on execution only, which means that they don't seek an advisor's advice.

With respect to controllers who think they are sophisticated, there are certainly those who ought to delegate more of their investing tasks to a professional. Investors who seriously overestimate their knowledge or abilities can get into trouble.

Who Are You and Who Are You Dealing With?
The FSA study reinforces the need for informed financial planning; it also suggests the vulnerability of investors who are either too trusting or not trusting enough. For trusters, and to a lesser extent, partners, ease of understanding is fundamental and checks need to be built into any investment process to ensure that people's personal and financial circumstances and willingness to take risk are taken into account. If investors are to be served well, what they know and, more importantly, what they do not know, must form a fundamental component of the advisory process. Advisors must take the level of investor knowledge and understanding very seriously.

Looking for a financial advisor? Read Find The Right Financial Advisor, Shopping For A Financial Advisor and Choosing An Advisor: Wall Street Vs. Main Street.

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