Investment Risk Warnings: Navigating the Uncertain Terrain

By John Lindsay, FLMI MBA

Large investment firms diligently emphasize that investing in their funds carries inherent risks. You’ve likely heard taglines in audio ads like “you could lose money.” Interestingly, automobile manufacturers don’t have to explicitly state, “your car could break down” or “your vehicle will depreciate by 25% as soon as you drive it off the lot.”

Despite these earnest disclaimers, investment firms managing billions of dollars for clients still find themselves needing to provide ample warnings. But this isn’t necessarily their fault.

Let’s explore three types of investors:

1. Traders: These adrenaline-fueled market enthusiasts trade anything from cars to sports cards to crypto coins. They thrive on risk and embrace the blur of market gyrations.
2. Long-Term Investors: They wince during market downturns but trust that markets eventually rebound. However, they often underestimate the energy and time required to recover. For instance, losing 30% means needing a 43% gain just to break even.
3. The Rest of Us: Even a modest 5% market downturn feels gut-wrenching. We’ve poured effort into earning those invested funds, and any loss hits hard.

Now, let’s consider advisements from one of the world’s largest fund managers:

• “Mutual funds and ETFs are not guaranteed. Their values change frequently, and investors may experience gains or losses. Past performance may not be repeated.”

This warning is clear and fair. Yet even long-term investors can feel discomfort when assets suffer losses exceeding 10%. To mitigate unexpected setbacks, some fund companies offer protective strategies.

Remember, investing involves navigating uncertainty, and understanding risk is crucial.

Please note that while investment disclaimers are essential, they often remain unread or insufficiently explicit. It’s crucial to ensure that the message truly gets through to investors.

This fund company proposes the use of “derivatives to implement a disciplined options-based strategy designed to provide downside risk mitigation. The strategy used by the fund, while designed to offset or mitigate a decrease in the value of the fund’s investments, does not completely eliminate downside risk. Using an options-based strategy carries no guarantees, and options can expire worthless, meaning that the fund can lose the entire amount of the premiums that are paid to purchase those options.”

Yikes! Downside risk mitigation does not completely eliminate downside risk! Would long term investors be happy with a market loss of 10% instead of say 15%? Risk-averse investors don’t want a market loss of even 5%.

So the big question is: how do investors get into investments that experience market losses of 5 to 10% when they can’t tolerate these losses which when viewed by the “traders” are considered as minor variations?

Marketing hype is partly to blame but savvy investors know that the long-term effects of inflation even at 2.5% (G7 Central bank targets) and taxes on capital gains or interest at a mere 20% translates into a minimum returns of about 4.5% to only stay even with inflation and taxes. “Even” is not growth but rather keeping the value. Growth means accruing more for the future after consideration for inflation and taxes.

Investors venture into volatile waters knowing they have to get better than taxes and inflation. In general investors feel mutual fund companies offer returns greater than taxes and inflation over the long term.

Or do they?

How about an investment that offers:

1)???????? 100% guarantee on your deposit for life,

2)???????? 100% guarantee from market losses, for life,

3)???????? Tax sheltering for life,

4)???????? Annual inspections for capital adequacy for unit holders by states not federal administrators

5)???????? Double digit returns over the long term. Most of this is done by never having market losses. Long-term tracking of the S&P is about 10% without protection for years 2004-2023. Not bad. However, Long-term tracking of the S&P with protection is about 14%.