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Why Standard Risk Measurements Don't Add Up


This article is adapted from a new white paper, "On Risks: Econs, Humans and the Perception of Risk." Download the full version.
For most people, bad surprises loom larger than good ones, but that fact is missing from risk measures like standard deviation. In a new paper, the Center for Behavioral Finance investigates how people perceive risk and what it means for investors.

Our world is full of uncertainty; financial markets are no exception. During the dot-com bubble of the late 1990s, the S&P 500 Index peaked at 1527—and then, over the next few years, lost half its value. Right before the financial crisis of 2007–2008, the S&P peaked at 1565 before, once again, losing more than half its value, bottoming out at 676 on March 9, 2009. And yet by May 2015, the S&P tripled and passed the 2100 mark. That is a lot of highs and lows—a rollercoaster of ups and downs.

Given this never-ending variability, we'd like to pose a question: What do we perceive as "risk"? Put another way, what kind of financial results make us nervous?

To help us zoom in on the psychology of risk, we'd like you to consider two hypothetical investments:

Investment A almost always provides a 9% return per year, but there is also a small chance of 1% to double your money.
Investment B almost always provides an 11% return, but again, there is a small chance of 1% for things to be different, in this case to lose half your money.

Assuming an investment horizon of one year, which investment, A or B, feels riskier to you? Most industry measures of risk suggest that Investment B is actually safer than A. In other words, the one that might lead you to lose half your money is the safer investment.

But do these standard risk measurements add up?

Loss aversion and investment decisions
To illustrate the role of loss aversion in investing decisions, we surveyed a group of financial advisors and plan sponsors. But before we get to the results of that survey, let's take a closer look at these two hypothetical investments.

Investment B has a higher expected rate of return—it is almost 10.5% (10.39%) versus about 10% for investment A (9.91%). In addition, and this is probably the surprising part, Investment B also has less variability. The numbers are clear: The gap between the best and worst outcomes for B is just 61%, but for Investment A it is actually 91%. This means that B is safer than A, at least according to calculations based on the variance or standard deviation of the two investments. Because B has a higher return and lower risk, it also has a much higher Sharpe ratio, which means that by most traditional measures B is simply a superior investment to A.

And yet, most financial advisors and plan sponsors we surveyed selected Investment A and felt that B was riskier, not safer. In our sample of advisors, 92% selected A, and 94% felt A was less risky. For our sample of plan sponsors, 80% selected Investment A and 90% felt A was less risky than B.

How can we reconcile the huge disconnect between common industry measures of risk and the fact that 90% of plan sponsors think Investment B is actually the riskier investment? Standard risk measurements don't add up because they fail to address that we are loss-averse.

What to do about our loss aversion
The question, of course, is what should we do about our loss-averse tendencies? To help financial advisors, pension consultants and plan sponsors incorporate loss aversion into their day-to-day activities, we came up with four key questions to ask:

1. How do the limitations of standard deviation and Sharpe ratios factor into your strategy?
2. To what extent does your investment strategy balance loss aversion and gain seeking?
3. Are you assessing the magnitude and likelihood of potential losses?
4. To what extent does your approach account for differences among individuals and their sensitivity to loss?

Learn more
Read more about the nuances of loss aversion, the perception of risk and its impact on investment decisions in our new white paper.



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