Instead, investors might ask: Could half their funds be wiped out in any year, including the last one? What is the likelihood that could happen? Or what is the likelihood that 25% could be wiped out in any given year? Suppose your planner shows how your $100,000 will grow to $150,000 in five years with an average return of 8% per year during that time. Under these circumstances, what is the likelihood that you could also lose half your accumulated funds in the last year and come out with a negative investment return, even though you still earned that 8% average rate over the five years?
As we know now, such possibilities not only exist but are more common than we thought. An extreme case in point is the 2008-2009 financial debacle. If your investment was maturing in 2009, the outcome would have been a lot worse.
This concern about loss is what should drive our investment decisions. Most planners are unable to explain this loss aversion to their clients because they are not adequately educated to understand the concept themselves. However, as we mentioned before, the solution is simple. Reconsider the example above of earning an average annual rate of 8% over five years. While it sounds conservative on the surface, it is actually quite aggressive. Earning 8% a year for five consecutive years (or averaging out over the five years to an 8% rate) is a very tall order. To do that, in most cases, one would actually have to be exposed to a large amount of loss risk in any given year.
Without getting into the details about standard deviation and the propensity for loss, we can use estimates (very rough ones) to view the 8% investment opportunity another way. It means understanding that, in any given year, you may not even earn a dollar. Also, be prepared, because this could happen every year. The likelihood of such an outcome is astonishingly high-about 25%. Thus, the investment decision is about whether you are willing to bet that the odds of loss are one in four every year for five years. Of course, the reverse is also true: In each of those years, you have a 75% chance to earn a positive return on your investment, and the earning rate itself could be anywhere from zero to the highest rate imaginable. Furthermore, there is a 12% chance you could lose 8% a year for five years!
In prolonged economic downturns, which are not so uncommon, such are the outcomes. Now ask yourself this question: If you were told about these odds of loss, would you still consider the 8% investment opportunity to be conservative? Hopefully not, especially when you feel unsettled about the existing economic state of affairs. Nor would you consider a 10% return to be attractive, considering yourself conservative just because you rejected a 15% return.
As we discussed earlier, this idea of loss aversion is probably the most powerful tool in the investor's bag. Once you understand the implications of loss in any investment decision, you can make a dimensional shift, offering something easily understood and applied by all investors. If most investors behaved that way, collectively we would make the investment market a much safer place.
Unfortunately for now, there are no known ways of educating all investors about this critical aspect since the tools that currently exist are all based on statistical concepts of risk and return that make little sense to most lay people.