The Downside of Managing Risk

Risk management is an often used term in the financial industry, by providers of financial products, analysts, and financial advisors. It is often an integral part of many advisors’ investment process. But what does risk management really mean? And what is the downside?

Call a Spade, a Spade

Risk management is somewhat an ambiguous term, but sounds really good. Given the choice between two financial products (or advisors), it is likely that an investor would select the one that purports to “manage risk.” When we say we are managing risk, what everyone is referring to is limiting the amount of downside movement. We are attempting to minimize temporary losses.

While managing risk sounds good, there are two inherent and implicit problems.

Minimizing Losses

One problem is we imply that we can somehow anticipate both when the market will go down and when it will stop going down. How else could we minimize losses without giving up any upside? Remember, when we talk about minimizing or managing risk, everyone is thinking about limiting the downside without any mention of upside. So the expectation is that the investor will achieve upside returns while limiting the downside.

No wonder investors get upset at advisors and bail on financial products when things go down or when they fail to meet or beat index returns. Investor expectations are out of whack. And the financial industry is partly (mostly) responsible because of our irresponsible use of the term “risk management.”

Minimizing Returns

The reality is no one knows when the market will go down and when it will stop going down. So if we are truly “managing the risk,” we are also minimizing the return. If we want investors to have the right expectations, they need the whole truth. And not just the good stuff.

The only way to limit temporary losses is to reduce exposure to assets that may produce temporary losses (i.e. equities). Since we don’t know when the market will go down and when it will stop going down, such action naturally results in lower exposure to assets that produce permanent gains. If we outperform on the way down, the investor needs to be told to expect to underperform on the way up.

Real Risk Management

Since the greatest financial threat to an investor is outliving their money, the real risk advisors should be focused on is the risk of permanent underperformance. Unfortunately, advisors spend a great deal of time reducing temporary losses and placating investor emotions. Advisors could do a much better job by telling investors the truth upfront. “Managing risks” means they will underperform equity indexes over the long term.

I work with many financial advisors – applying behavioral finance in their practice to obtain better results. Many have reported that clients are upset by YTD temporary losses. They want all the upside and none of the downside. This is thanks to the financial industry – the result of not telling the entire truth.

The industry won’t change. But advisors can. We can start telling the entire truth to our clients. They may not like it at first, but it will ensure they have proper expectations. And having the right expectations improves both investor and advisor experience.

Related: Signaling Your Value Through Your Fee Schedule