Taking on too much risk?

The Death Toll at Mount Everest Reminds Us; A lot of people don’t know risk and often get into something too dangerous.

This year, at least 11 people have died trying to climb Mount Everest – double the number from the year before. And 9 of those 11 died on the way down, overcome by altitude sickness and exhaustion in the dangerous atmosphere above 28,000 feet – the highest mountain on Earth.

According to a BBC analysis, the odds that a person climbing Everest will die are about 1 in 60. And it’s worse for older climbers – they have a 25% risk of dying. And as this year has proven, the most dangerous aspect of climbing Mount Everest is not trying to reach the summit – it is trying to get back down. 

Makes one wonder how good we really are when it comes to evaluating risk. And when it comes to investing, the answer is: not very good.

Investors Stink at Evaluating Risk

Individual investors are not very good at gauging risk. In finance, it’s not always easy to tell when you are getting into something dangerous.

Here is an example of an all-too-common conversation between a financial advisor and prospective client to prove a point:

A financial advisor gets a call from a man who exemplifies an alarming overconfidence in his own investing acumen. Early in the conversation, he said the advisor should consider him financially savvy because most of his peers did. He did not say who his peers were, or on what basis they could judge him.

He asked the advisor whether they do hedges, options, futures or shorts. When the advisor responded that the firm doesn’t ordinarily pursue those strategies, he told the advisor that they were constraining themselves.

“European government bonds are yielding two percentage points more than the equivalent U.S. Treasuries, and the dollar is definitely going to continue to go down against the euro, so why aren’t you just buying those European bonds?” he asked.

Advisors Ask the Hard Questions

Ordinarily, this might be a good question, especially since many advisor firms do buy both U.S. and European bonds through funds that hedge for currency risk. But the advisor asked him two relatively simple questions about the risks involved in his idea, concerning:

1.    the relationships between interest rates and currencies, and

2.    the relationship between bonds yields and their prices.

Guess how this played out? He couldn’t answer. He hung up in a huff.

Questions like this are important. A butterfly can flap its wings in one country and cause a hurricane across global markets. In finance, small changes that you might never think of can sink your investment.

In this fellow’s case, a fluctuation in currency exchange rates might decrease the value of his European bonds to a greater extent than he expected. For a paltry extra yield, he was ready to take on a lot of risk, and he didn’t even know it.

Taking on Undue Risk is Not Uncommon

Financial advisors have conversations regularly with people who have no knowledge or experience with finance and investments, and who try all kinds of risky strategies. We see divorce lawyers trading options, doctors shorting stocks and plumbers that day trade. They compound their problems greatly by not even knowing that what they are doing is risky.

Financial matters are complicated. Most investors have little or no training. They don’t learn finance in grade school or high school, and most people don’t take it in college. Most typically learn about it from our families and the media, neither of which necessarily has any particular expertise.

This makes it difficult to judge our own competency. Investing is difficult for consumers to figure out. The gamut of available financial products keeps expanding, and much of the decision-making framework keeps changing.

Also, when it comes to trading on your own account, keep in mind that even the smartest guys in the room make huge mistakes too. Some of the best fund managers make awful bets and lose money too. Their track record doesn’t bode well for the amateurs with limited knowledge.

Financial Advisors are Sherpas

This is another reason most people are better off working with a competent, independent financial advisor, who can disabuse them of their half-baked investment theses and keep risk in their portfolios at the right level.

Consider your financial advisor to be your Sherpa. Would you climb Everest without one?