I’ll Flip You For It: Understanding Your Risk
It has been my experience that most investors are either taking too little or far too much risk. As my colleague Jeff Deiss, CFP® pointed out in last week’s wealth commentary, for those taking too little risk it can be due to the fact that excess cash makes most people feel better. Another reason for taking an inappropriate amount of risk is because investors have difficulty quantifying risk. Narrowly focusing on individual securities, sectors or impervious information (media) can distract investors from their actual status of risk and derail the best laid plans.
Nobel laureate Paul Samuelson once posed the question: would you accept a bet in which you win $200 if the coin lands on heads and lose $100 if lands on tails? Most people rejected that bet, as the potential pain of losing money wasn’t worth the pleasure of the bigger gain.
But here’s his follow-up question: Would you play this same bet twice? Not surprisingly, more people found the second offer even less appealing. The logic is simple: They didn’t really like the single bet, so why would they want to play it multiple times?
Let’s pose Dr. Samuelson’s second gamble in a different fashion. You now have a 25% chance of winning $400, a 50% chance of winning $100 and a 25% chance of losing $200. Would you accept this bet? Most people found this wager more appealing. However that last gamble is the same as playing the coin flip twice!
This exercise provides us the proper way to look at the bet (risk). With coin flips there’s a 25% chance of getting two heads, a 50% chance of getting one heads and one tails, and a 25% chance of getting two tails. This new description more than doubled the number of people who would take a similar gamble. If you were to stay fixated on the 50% chance of losing money you would normally not move on to the second bet. However, when the overall odds are described for you, it’s much easier to see that the gamble is quite attractive. Understanding the risk helps you to move forward.
For investors, such narrow focus can lead to serious mistakes and missed opportunities. Taking too little risk can have investors outliving their assets and too much risk can be disastrous.
For clients of our firm, we frequently review the risk that each client’s overall investment portfolios are taking. This is accomplished by running real-time analysis and longer-term scenarios of different levels of risk to their long-term plan.
Please allow us take a look at your portfolio and we will give you our objective assessment of the amount of risk you are taking. My investment team takes an economic approach to assessing the current and longer term opportunities and risks in the markets. Guided by our Chief Investment Officer Dr. Charles Lieberman, we will look at your portfolio’s individual holdings, sector weighting as well as interest rate and liquidity risks. We will then recommend any alterations that we believe would get you on the right path. I hope you will take us up on this complementary and most important service.
Advisors Capital Management, LLC is an investment advisor registered with the United States Securities and Exchange Commission. Registration does not imply any degree of skill or training. All investing carries risk, including the potential for the loss of principal and past performance is no guarantee of future results. This content is for informational purposes only, can change at any time without notice, and is not investment advice or a recommendation to trade any security. Indices are not available for direct investment. We only provide services in jurisdictions where we are registered. Our disclosure brochure (ADV Part 2A) and customer relationship summary (ADV Part 3) are available at https://adviserinfo.sec.gov and upon request.
