Was it Worth the Risk? Shouldn’t We Evaluate the Rewards of our Risk.. Even in the Good Times?
I raised a high-risk kid. You know, the confident three-year-old who jumps from the top of the jungle gym and nails the landing–every time. Parents would shoo their children away from us while flashing me agonizing looks saying ‘Stop your child – he’ll get hurt!’. I didn’t worry, though, because I was there to catch him and prevent it from going too far. I subscribed to the philosophy that life isn’t about avoiding all risks and coming through ‘un-hurt’. However, I still find it valuable to be informed of the risks being taken and the value you’re getting for the risk.
If you think about it, our lives are all about risks. Whether it’s driving, flying, or choosing foods you eat, you weigh risks all the time. Yet it doesn’t seem as though we are having regular conversations about risks and rewards with investors. Out of 18 million reports run from four of the largest wealth managers in 2019, only 1.08% of the reports generated contained risk/reward information.
It is appropriate for risk to be discussed with the investor at the strategy or program level, unless the investor varies from the program. The evidence in our data shows a very significant number of custom benchmarks being used, which points to many investors not following the strategy. This begs the question, do they really understand the risk they’re taking to achieve their returns? It’s in the advisor’s best interest to have this conversation regularly so there are no surprises. Having this review regularly also provides an opportunity for the advisor to show their value.
It may come down to the conversation itself and perhaps a lack of presentations to support the dialog. There are a few approaches advisors can take to reveal risk and reward to their clients. One example would be to take several return periods and show the returns for the portfolio with and without an asset class (ex.: Alternatives). Another option is demonstrating a risk measure, like Standard Deviation or the Sharpe ratio, for each period. The advisor can present the difference in return and risk for the portfolio with and without the class. With that additional information, the investor can easily see whether it was worth the risk in the additional return they achieved. Imagine the reaction of your investor when you communicate they earned more return for less overall portfolio risk by diversifying into alternatives!
A great example of a risk to reward conversation was when a First Rate client developed a risk/reward report that wasn’t just a scatter plot, but it actually reported the dollars invested at each point along a slanted line of least risky to most risky. What if those plot points were proportional to the percentage of the portfolio invested at a level of risk? That would be illuminating!
Personally, I get VERY excited to see returns at or above my target. If I’m also outpacing my goal, my response is to hit the gas – not the brakes. On the contrary, if my risk of losing everything was front and center when I was working with my advisor, I might choose a slightly more prudent route.
Let’s not shy away from the conversation. Surely, there is something meaningful we can do. I’m interested in hearing from you on this subject! Connect with me on Linkedin or email me your thoughts!