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September 01, 2006 at 04:00 AM
Research: What do affluent investors most need to understand about risk?
Sonnenfeldt: Very often, a security’s volatility is the proxy used for risk, but in a sense, that’s like driving down the road and seeing that the road behind was smooth even though you’re approaching a cliff. The risk that most people think about has to deal with the historical dimension, but in reality, risk is all about what might happen in the future.
Most people also believe that risk is objectively measurable. In fact, most of our members who have built significant wealth did it through a series of transactions that were priced in a manner that would objectively indicate high risk, and yet they were successful with it because they assessed it not according to the market but through their own skills, expertise, social network and so on.
Finally, all sorts of financial instruments are pedaled to both unsophisticated and perhaps sophisticated buyers that claim they are shedding one type of risk or another, when in fact what they’ve done is shifted the risk elsewhere. A lot of these products have areas you don’t want to look at too closely because the risk is still in there somewhere, and when it does occur, it can create dramatic results.
How does geopolitics play into investment strategy?
Global instability has risen, both through interconnectedness — technology, especially communications — and the potential of global infection on the disease front, as well as threats to greater portions of humanity because of weapons of mass destruction. In that sense, the more integrated the system, the more exposed the system becomes to threats that could have systemic impact.
First and foremost, this environment demands a more thoughtful approach to investing and an appreciation of the pitfalls that many people don’t acknowledge until it’s too late. You know that you should change the tires on the car every 60,000 miles. You know they won’t pop at 60,001, but that doesn’t mean you can drive forever. The world is more fragile. It’s difficult to know where the individual tipping points are, but it becomes a more serious business the more the world becomes interrelated.
Have ETFs made the markets more or less volatile?
