Risk and Uncertainty
At some point during a client conversation, the word "risk" will come up.
Maybe we've said it. Maybe the client said it.
We talk about it, because no matter how we invest, we're accepting some level of risk. In simple terms, we understand that stocks are usually riskier than bonds, and bonds are usually riskier than cash.
We take the time to discuss risk with clients. We help them weigh their options.
But there's a catch.
During these conversations, I've noticed that investors often confuse risk with uncertainty. We hear, "It's too risky." But ask enough questions, and we discover that investors really mean, "I can't predict what will happen." This confusion can make investing and behaving at the same time a challenge.
When uncertainty trumps the real risk, investors may end up making costly mistakes based solely on their fear of the unknown. "I can't predict what will happen" becomes the green light for making short-sighted decisions. Instead of working towards their future goals, investors focus on trying to control what's clearly outside their control.
For instance, even though stocks tend to be riskier than bonds or cash, we also have reason to believe investors will be rewarded for that extra risk. But we can't say with certainty what the reward will be. One percent? Twenty percent? We don't know.
Because we can't offer clients a guaranteed number, uncertainty masquerading as risk cancels out the reward of owning stocks. Instead of being an acceptable risk when compared to the reward, stocks fall in the category of too risky. This uncertainty explains, at least in part, why some people still stick cash under the mattress.
I understand why people like physical cash. We can see it and touch it. Even if we check it twenty times a day, the cash will still be where we left it. However, the certainty of cash under the mattress trades one risk for another risk (e.g., inflation).
Our clients need our help.
We can provide much needed clarity for them by drawing a cleaner line between risk and uncertainty. When a client appears to hesitate or seems unsure about investing, we need to ask ourselves, "Have we put the real risk in context?"
If the investment is a stock mutual fund, for example, how does that particular investment compare to other stock investments? If we're talking about a low-cost, diversified fund, the individual investor risk is less than a fund based solely on growth stocks. Once we've walked clients through the real risk, we can focus on other factors.
Does the client's uncertainty come from wanting to do something else with the money? A client may plan to invest some funds, but subconsciously, that money is earmarked for something more certain, like paying down the mortgage. Obviously, an extra mortgage payment or two will feel less risky compared to investing.
But clients are comparing apples and oranges when they weigh the risk of investing versus the certainty of an extra mortgage payment. We can help them understand the difference and make sure the final decision fits their plans and goals.
Risk and uncertainty can look like the same thing—at first.
However, as Seth Godin wrote:
"A portfolio of uncertain outcomes is very different from a large risk."
Clients can learn to appreciate this difference, but they need our help. So the next time we hear, "It's too risky," we need to do more than come back with a less risky option. We need to make sure the issue is really about risk and not a fear of the unknown.
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