Risk compensation theory is a simple principle: namely that people behave less cautiously in situations where they feel safer or more protected. However, the point is that what you feel is not what is real.

The original application of this principle was to objects like car seat belts or bicycle helmets, which may lead to "self-defeating" behavior. The fact that people feel safer leads them to be more reckless, so that they may in fact be no better off. This principle applies only too well to the investment industry. There have been attempts to apply this to risk control in business and investment, but this article moves beyond the usual approaches and considers very specifically what "feeling safe" is all about for both investor and broker.

IN PICTURES: What Is Your Risk Tolerance?

Lack of Risk Compensation
The issue at stake is twofold. For an investor, you can feel safer than you really are with a particular investment, but a broker can also feel safe – rightly or wrongly - because they think they can get away with taking risks with somebody else's money. These are two sides of the same coin; they are interrelated but not the same thing. So let's look at them one by one.

The Investor Who Feels Safe, but Isn't
There are various ways in which investors may acquire an illusion of safety. Some investments may be deliberately (and less frequently) presented as safer than they really are. Investors who want to believe the publicity and are tempted by promises of high returns may fall for it, or they may truly not know any better. After all, it is not their job to know that they are being given bad advice.

Then there are controls that may not work, or at least not as well as you think. Take the classic stop-loss order. These can vary from extremely effective to pretty useless. So their mere presence in your portfolio does not necessarily mean you should be sleeping well. It sounds great to put a limit to losses, so that you can theoretically invest in equities and not worry. However, in practice, a fast-moving market can move past the stop before you know it, and if the stop is too high or low, or never gets changed, it's not very effective either.

The same applies to guarantee funds. The amount of security they really offer is extremely variable, and comes at the price of reduced returns. Indeed, these funds are prime candidates for causing just that sense of false security that risk compensation theory is all about. There are certainly good guarantees, but don't count on it. For one thing, guarantees always cost money, such as in higher costs or lost dividends. Also, some guarantees are very limited and may simply not apply when you really need them.

Third, there are the Securities and Exchange Commission (SEC) ombudsmen and courts, which are all theoretically there to help you if your investments go wrong. However, the realities of all three are that they do not provide anything resembling a sure-fire way of getting justice at a reasonable cost and effort. Regulatory bodies like the SEC and ombudsmen services are frequently accused of not really being objective or fair. There are constant allegations of ignored evidence, a refusal to investigate properly, illogical decisions and so on. Their presence in the investment world most certainly does not justify taking excessive risks. It is often prohibitively expensive to take a broker to court, and no matter how sound your case, it can still go wrong. (For more on the SEC, take a look at Policing The Securities Market: An Overview Of The SEC.)

These three sets of factors can lead investors into a sense of false security - people tend to rely on them too much.

Who Is the Safe Seller?
Sadly for the man in the street, conversely to the situation for the investor, brokers and other sellers seem to get away with just about anything. For precisely the same reason that it is not easy for investors to get justice, it is commensurately easy for those on the other side of the market to feel safe and really be safe.

Managers in all sectors of the economy, particularly when it comes to money, do not always get into trouble when they should. In statistical terms, big-time risk-taking often pays off. For the seller, risk (for someone else!) is a good bet financially. For example, your broker will typically earn more from putting 75% of your money in stocks than in bonds, through commissions. For you, however, this is a risky business. According to risk compensation theory, such brokers act rationally, but unethically, by being risk-friendlier than they should be. They do so because the odds are they will not pay the price if things go sour. (For related information, see Evaluating Your Stock Broker.)

An Unhappy Situation
The scenario described above is one of a market that is often fraught with risk, but in which buyers all too often think things are OK. And sellers are happy to leave them in blissful ignorance, as long as the going is good. This precarious interaction is exacerbated by the fact that things may turn out all right after all and, if they don't, the results may not be immediately apparent. It could take years before any nasty substances hit the proverbial fan, and by then the perpetrators might be dead or drinking cocktails under both an umbrella and an assumed name in the Bahamas.

The Solutions
Once again, we get back to the familiar issues of information, education, regulation and integrity. There needs to be as much of all these elements as possible. The more that people know and understand, the less the delusions of security there will be. Likewise, the more that sellers are forced to reveal, the more investors will understand what they could lose.

As for integrity, there are honest people out there too, but they are not always easy to spot. There have always been dubious characters in every line of business, and there always will be. One can only hope that the information age will ultimately prevent people from being compensated for taking excessive risks with someone else's money.

Risk is at the heart and soul of investment. But risk compensation theory tells us that safeguards are not all that safe, and may simply make people more risk-friendly. Many forms of protection against risk are more illusory than real. These two distinct (but related) problems can lead to very ugly losses. The solution is to make sure that you do not let a little bit of protection sweep you away into the land of big losses. (For related reading, also take a look at Be Risk Diverse, Not Risk Averse.)

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