Is “Risk Aversion” Causing Investors to Lose Sight of Real Risk?

Understanding “new financial conservatism” was the subject of a recent Bank of America Merrill Lynch Webcast.   

Merrill Lynch Global Wealth & Investment Management (GWIM) President Sallie Krawcheck was the moderator among a panel of experts, including: Bill Gross, Founder, Managing Director, and Co-Chief Investment Officer of PIMCO;  Meir Statman, Professor of Finance at Leavey School of Business, Santa Clara University; Richard Stengel, Managing Editor of Time magazine; and Christopher Wolfe, Chief Investment Officer, Merrill Lynch Private Banking and Investment Group.

Krawcheck opened the discussion by describing a tug-of-war many investors are facing – a desire to be more cautious about their investments, coupled with wanting to ensure they will be able to lead a comfortable retirement.  “How can investors today achieve greater financial security in light of their new conservative mind-set?” asked Krawcheck.  “Can you redesign your portfolios to reach your goals while at the same time incorporating newfound feelings about risk? And, could this feeling of uncertainty be with us for years or possibly even generations to come?”

When a client comes to an adviser with these worries, Wolfe recommends going back to the drawing board and analyzing what “risk” means to them and to reset expectations accordingly.  It’s important to keep in mind that there are investment products for every type of investor – Wolfe pointed to structured products with some downside protection for the more wary investor, and to managed futures or hedge funds for those willing to get back into the game somewhat more aggressively.   

But a conversation about investment options and risk aversion with clients will not be easy, the panel said. We’re dealing with an economic situation that has caused great fear among investors, said Statman, who specializes in behavioral economics.  Investors have lost money and they do not know what will happen next.   

Stengel expanded on the topic of fear by pointing out that consumer confidence and optimism levels are at 40-year lows, and saving rates are on the rise.  He said that consumers feel that the system isn’t working for them; in fact, it’s kind of rigged.  But when you consider that more than 70% of the country’s GDP is fed by consumer spending, “there’s a dichotomy there that people can’t make sense of,” said Stengel. He said that with stagnant wages and nearly 10% unemployment, where is that spending supposed to come from?  He suggested that the country may need to figure out a way to make adjustments to how we view the GDP.   

Risk Aversion for the Wrong Reasons 

Statman described how people tend to think of risk in terms of losses. And while many people did sustain severe losses during the recession, the real risk, he says, is to not be able to achieve your goals. For instance, if young people only invest in Treasury bills for ultimate security, he said, by the time the reach retirement, they will be saddened to discover their money did not grow as much as they hoped it would.   

But considering what the younger generation of investors has seen in their lifetime, Stengel pointed out that advisers shouldn’t be surprised by this. The Baby Boomer generation worked in a time when the stock market was understood to always go up, and the belief was the value of real estate will always go up – now, people in their 30s or 40s aren’t so sure that’s the case, he said.  They’re looking at the economy as undergoing a structural change, rather than a natural and understandable cycle.

Krawcheck echoed this realization by saying if someone’s first impression of the market was the Internet bubble burst in the 1990s, and now they saw the real estate market crash – they’re not left with very good impressions.  Nevertheless, she said, young investors and older investors needs to invest differently.  Statman said the most important thing to keep in mind is what they’re ultimately trying to achieve.  Fear is not a good teacher, he said; it can make someone withdraw entirely.   

Moving forward? 

Krawcheck asked the panel where advisers should lead their clients next – are traditional securities (stocks, bonds, cash) dead?   

Gross said they are not dead, especially because Baby Boomers are still very much around.  Wolfe agreed, and said the basic building blocks are still there, but they may be used differently.  Statman agreed, and said “diversification cannot do what it cannot do,” which is preventing an investor from losing money.  Statman fears that people will say “diversification failed,” and will start to jump in and out of the market, doing more harm than good.  Statman said diversification is as important as ever because  we don’t know what exactly will happen next.   

Krawcheck said how challenging it will be to convince investors of this, now that they can log-on and see their total net worth fluctuating day by day; it can make it very difficult to keep the long term goals in mind.