Investor 'risk illiteracy' a headache for advisers

Advisers beware - most investors don't understand risk and greatly overestimate how much risk they are willing to tolerate, a researcher says.

Friday, February 10th 2012, 6:30AM 2 Comments

by Niko Kloeten

Aaron Bruhn from Australian National University is studying how financial failures affect the lives of investors, looking specifically at the collapse of Queensland-based advisory business Storm Financial, which left 14,000 investors about $A3 billion out of pocket when it fell over in 2009.

In a seminar for Auckland University's Retirement Policy and Research Centre yesterday, Bruhn said one of the themes that had emerged from his research was a general lack of understanding of risk by investors.

Advisers needed to make sure they explained risk in terms investors actually understood, and in many cases should emphasise the potential downside of investments ahead of the upside, the expat New Zealander said.

"Most people don't have any idea what risk means," he said. "We all talk about numerical illiteracy - don't underestimate how little maths most people can do properly - and financial illiteracy, but there's also a lot of risk illiteracy.

"What risk should mean to them [investors] is that things can go really badly for you. The more accurate thing is, there's a probability of ruin for you."

Bruhn, a former actuary, said most investors are "loss-averse", but they often don't realise this until things actually go wrong, such as in the case of Storm where hundreds of investors lost their houses after borrowing against them to invest in equities which subsequently fell.

"For the average everyday investor, should the probability of a big loss be emphasised over the probability of a big gain?" he said.

"If you ask investors, 'do you want the chance of a 20% gain versus a 20% loss or the chance of a 50% gain versus a 50% loss', the pain from the loss far exceeds any enjoyment you get from the gain.

"In other words I think it's okay to emphasise [loss] in the context of a person seeking financial advice. Loss should be emphasised above gain in many contexts - it's about time the financial services industry picked up on that one."

Another of Bruhn's findings was that, despite their role in the debacle, advisers aren't universally loathed by Storm investors - it seems the banks are the main targets of investor fury.

There was one exception, however: "One investor said if he'd had his gun with him his adviser would be dead."

Bruhn also noted that all the advisers involved in putting investors into Storm were fully licenced and met all the Australian regulatory requirements at the time.

Niko Kloeten can be contacted at niko@goodreturns.co.nz

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Comments from our readers

On 10 February 2012 at 10:08 am Nick said:

This is the very point: risk is the probability of LOSS, compared with opportunity, which is the probability of gain. When someone is told there is a risk, this shouldn't be seen as a 'You can gain and lose', but that the risk level solely deals with the tolerance towards losses. People should be advised by any financial adviser, rather than being told there's potential for a gain (which may be true, but must be linked to the actual risk involved and then measured against actual tolerance). This compares with the present approach that, at best, asks you things like, 'Do you mind your investments fluctuating over the medium-term', rather than asking, 'Do you mind losing all your money on an investment?'

On 10 February 2012 at 3:02 pm Andy said:

Well said, Nick.
Interestingly, "Bruhn also noted that all the advisers involved in putting investors into Storm were fully licenced and met all the Australian regulatory requirements at the time".
Like New Zealand, regardless of rules and regulations, there will still be finance company collapses while the legislation protects and restricts the adviser, rather than targeting the finance companies themselves!