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Thursday, October 25, 2012

The Perception of Risk

Financial Advisors and Planners require a risk profile for all of their prospective and existing clients. The impression of risk has undergone many changes due to the ever-changing economic environment.
The investment climate can no longer rely on the former principles that existed right up until 2008. Since that time the financial arenas have become unrecognizable. Investors have grown skeptical and weary of their losses. The modern portfolio theory can no longer offer the protection once relied upon.
The past was driven through a buy and hold methodology and a Ibbotson model. All one had to do was hold and simply make adjustments to their portfolio based upon the long standing principles of diversification and rebalancing. Nice in theory but the game has changed and with it a new normal.
A large part of this belief system is found in something called the normalcy bias. The normalcy bias, or normality bias, refers to a mental state people enter when facing a disaster. It causes people to underestimate both the possibility of a disaster occurring and its possible effects. This often results in situations where people fail to adequately prepare for a disaster, and on a larger scale, the failure of governments to include the populace in its disaster preparations. The assumption that is made in the case of the normalcy bias is that since a disaster never has occurred then it never will occur. It also results in the inability of people to cope with a disaster once it occurs. People with a normalcy bias have difficulties reacting to something they have not experienced before. People also tend to interpret warnings in the most optimistic way possible, seizing on any ambiguities to infer a less serious situation.
 Late 2007 we saw a financial disaster impact our former comfort zone. Most of the public responded to this by electing a President who promised he was outside the normal politics of the federal government. The public bought this due much in part to the normalcy bias. Most of the populous had never faced a frightening economic climate such as that of the past 4.5 years. The normal response is to interpret these events in the most optimistic way possible and to hold tight to the belief that everything will return to the way it once was. The everything old is new again mindset. Unfortunately, we will never return to the economic circumstances of old.

The sooner the population faces this fact the sooner and better will be the economic recovery. Much of this response can be altered by fresh viewpoint on the principle of risk. If you are not willing to make the necessary change in perception and thought process then we will face a much greater financial disaster. By taking a refreshed strategic process for investing we can successful alter the course of our history.

In the past alternative investments were part of the highest risk level possible, and now if an investor ignores alternatives in their portfolio they will be doomed to no growth and the ongoing liquidation of their asset base.