A colleague just forwarded me an article about how Investors and Financial Professionals both think about risk differently:
This is something we see every day and it manifests itself in two main areas:
1. Financial professionals think of risk in terms of standard deviation while investors think of risk in terms of drawdown and loss.
So when financial professionals look to reduce the risk of portfolios they look for non correlated asset classes to reduce portfolio volatility. This creates a portfolio that appears to diversified but often does nothing to reduce drawdowns or losses as having asset classes like commodities and different stock sectors offers little, if any, protection during a crisis.
Investors always remember their high water mark. No matter how much money they have made, if they are under their high water mark they will not be happy. Portfolios should be designed that keep drawdowns to absolute minimums.
2. Financial professionals assume that risk tolerances are static but investor risk tolerances seem to change based on the current market.
So when financial professionals attempt to deduce a client’s tolerance for risk, little if any emphasis is placed on the current environment. In real life though, when you ask an investor how comfortable he is with loss in March of 2009 when the market has just gone down 60% you are very likely to get a different answer than if you asked that same client today.
In reality, most investors want absolute returns in a down market and relative returns in an up market. Any approach to minimizing drawdowns needs to take this into account. For example, you could potentially minimize drawdowns in a stock portfolio by adding bonds. This can reduce drawdowns in a crisis but it usually also reduces the upside in a bull market.