Investors need to know the true nature of risk

A few months ago, the Securities and Exchange Commission unveiled Investor.gov, a website devoted exclusively to investor education.

A press release quoted SEC Chairman Mary Schapiro as saying, “Investing information is available from thousands of online resources — some good, some not so good. Through Investor.gov, we are adding our own online voice to provide investors with unbiased and factual investing information.”

This effort is to be applauded. With the burden of funding retirement rapidly moving from institutions and to individuals, investor education is needed now more than ever.

It is the presence of two key adjectives in Ms. Schapiro’s statement that makes this initiative so momentous: “unbiased” and “factual.” These aren’t words to throw about lightly.

Having spent the bulk of our careers studying financial economics in an effort to differentiate between fact and fiction, we were inspired by these words to reflect on the principles that should govern any program of investor education. Without question, the first guiding principle must be the doctrine of “primum non nocere”: First, do no harm.

Strictly speaking, unbiased and factual information is that which is 1) fairly presented without selective omission, and 2) supported by science and empirical evidence.

Guidance that violates the first part of this definition falls into the “not so good” category (to quote Ms. Schapiro). Guidance that violates the second part is just plain wrong.

Violations of either type are misleading and carry potentially devastating consequences for investors.

Investing and life cycle finance are complex subjects, making the line between sound guidance and misleading guidance difficult for the untrained investor to detect and understand.

Alarmingly, many professional practitioners also appear to have difficulty understanding it — at least if the information, tools and guidance that appear on many of their websites is any indication. Or perhaps they do understand it but are just biased.

Either way, the need is clear for sources of educational material that is both factual and unbiased.

Guidance that goes against the current scientific body of knowledge is commonplace.

The following are four examples of misleading statements found repeatedly on investor education sites:

The risk of investing in risky assets decreases with the length of the holding period, and therefore, stocks are safer in the long run. Financial economists have long shown this to be a fallacy. That this may not be immediately intuitive is no excuse. Risky assets remain risky, no matter how long one holds them. Time doesn’t diversify risk.

Stocks are effective as a hedge against inflation. The truth is that stock returns are largely uncorrelated with inflation. The safest and most effective hedges against inflation are inflation-indexed bonds backed by the federal government. Of course, the expected return on these bonds is relatively low — a trade-off for their safety.

This tool computes the “probability of success” for your financial plan and should guide your investment decision making. This is a dangerous half-truth that confuses the science of probability measurement with the science of risk measurement. The probability of anything is never a complete measure of its risk. Risk measurement is concerned not only with the probability of events but also with the consequences of those events. Using the probability of success as a risk measure can mislead investors into using an overly aggressive investment portfolio, because the severity of the downside goes unaccounted for.

Retirees need a significant allocation to stocks in the retirement years to provide growth in order to offset inflation and address longevity risk (the risk of outliving the portfolio). This is true only in the absurd. It is analogous to saying that those unable to pay back a debt “need” to visit a casino to “address” the risk of defaulting. The better advice is not to get oneself into such a predicament in the first place. The suggestion that people need to place their financial futures at risk is irresponsible. Risk taking is a choice, not a requirement.

Notably, each of these items errs on the side of excessive risk taking.

Is it merely coincidental that many investors have suffered unexpectedly large losses in their retirement accounts, just when they could scarcely afford to bear these losses, or did the guidance they received make it inevitable?

By no means are we saying that investors should shun stocks or other risky investments.

We are just saying that investors (and practitioners) need to understand the true nature of the risks involved in investing and financial planning. Only then can wise decisions take place.

The central thesis of investor education shouldn’t be based on the principle of taking risk first and worrying about the consequences later. Rather, it should be based on the principle of safety first.

Start by educating consumers on what is possible with minimal risk taking, such as with a diversified portfolio of guaranteed, inflation-protected income annuities. Then proceed to discuss the risk/reward trade-off of other investment alternatives — and be sure to use a scientifically sound risk measure that accounts holistically for both its probability and its severity.

Richard K. Fullmer is a senior portfolio strategist at Russell Investments and chairman of the methodologies committee for the Retirement Income Industry Association. Zvi Bodie is the Norman and Adele Barron Professor of Management at Boston University.