Past performance is not a guide to the future. Prices can go down as well as up. You may get back less than you invested. It is impossible to spend long around financial advisers or fund advertising without running into these and many similar truisms. Investing will always be a risky business; just look at what happened to the punters who piled into the fast rising Shanghai and Shenzen stock markets in the spring. Not even the mighty Chinese government could halt the headlong collapse in prices.
I’ve always found risk one of the hardest parts of investing to comprehend, partly I think because of the way the professionals tend to talk about it. Most of the time they present it in terms of volatility, suggesting that the risk of an investment depends on how violently its price gyrates. In this formulation, shares bring with them the greatest dangers because they are the most volatile assets over time.
This approach is rooted in the idea that we find it very hard to endure sharp falls in the value of our investments—such as we can periodically expect from the stock market—and as a result we tend to panic when this happens and sell at the worst possible moment, guaranteeing ourselves a loss. Among the professionals, this is known as puking.
Bitter experience confirms that this is indeed the way things often go, but as a framework I’m not convinced it really helps me to understand or manage the risks that I take as an investor. Volatility has become the favoured way for financial advisers to discuss risk with their clients because it offers an empirical way to quantify and illustrate one of the perils that they must face—you can map it with a line on a graph—but I can’t help feeling that concentrating on it places too much emphasis on short-term price movements at the expense of long-term performance. Shares are indeed volatile but over more than a century they have also provided superior long-term returns after inflation.
Mark Fenton O’Creevy, professor at the Open University, argues that while the financial services industry espouses volatility, most of its customers look at risk through a different lens. The key factors for them are familiarity and controllability, he argues.
This is a much more helpful framework. First, it explains why people tend to regard savings accounts as a safe home for their money and to ignore the risk that inflation will erode its value over time, leaving them with less spending power than they will need to get by. The comforts of a financial product that is familiar and controllable obscure the dangers of remaining too heavily invested in cash. On the other hand, the stock market appears inherently uncontrollable and unfamiliar to most people, and so they instinctively feel it is not a safe place for them and their money.
The professionals are clearly right to suggest that one of the biggest risks we run as investors is the impulse to flee when the going gets rough. However, they face a tougher challenge in persuading most people that the financial products they regard as safe might actually turn out to be dangerous if they cling to them for too long.
The virtue of Fenton O’Creevy’s formulation is that in discussing risk it starts from the right place: the individual, not the market. The way to understand risk isn’t to focus on some abstract phenomenon such as volatility, which is entirely beyond our control. Instead, we need to look to our own opinions and biases, which we may be able to influence. I strongly suspect that a litmus test allowing for notions of familiarity and controllability will serve me better than any amount of time spent computing standard deviations.
