One of the more difficult communications challenges for financial advisors is getting across the idea that a number means so little. For example, is 4% a good return or a bad return? If you take minimal risk and get 4%, then it is probably a good return. If you take a great deal of risk and only get 4%, then it is probably a bad return. A more meaningful number would be how much risk did you take, which is impossible to quantify.
I met an advisor who had a clever way to explaining this concept of risk-adjusted returns. Suppose your son gets a new job. On his first day, he realizes there are two logical routes he can take to drive home. One route takes him through gently-rolling countryside of well-maintained roads with little traffic. The other route takes him through an urban area known for gang wars and car-jackings, travelling on poorly-maintained roads and decrepit bridges.
That afternoon, he puts the roof down on his Mustang convertible and enjoys a leisurely drive through the countryside, arriving home in 27 minutes. The next day, he puts the roof up on his Mustang convertible, keeps a pistol on the passenger seat, while making jack-rabbit starts through the slums but still arrives home in 27 minutes.
Which is the better route, and why can't you quantify the difference in risk?
I met an advisor who had a clever way to explaining this concept of risk-adjusted returns. Suppose your son gets a new job. On his first day, he realizes there are two logical routes he can take to drive home. One route takes him through gently-rolling countryside of well-maintained roads with little traffic. The other route takes him through an urban area known for gang wars and car-jackings, travelling on poorly-maintained roads and decrepit bridges.
That afternoon, he puts the roof down on his Mustang convertible and enjoys a leisurely drive through the countryside, arriving home in 27 minutes. The next day, he puts the roof up on his Mustang convertible, keeps a pistol on the passenger seat, while making jack-rabbit starts through the slums but still arrives home in 27 minutes.
Which is the better route, and why can't you quantify the difference in risk?
