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How Much Can Your Clients Afford to Lose?

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John Paulson is a hedge fund hero, and deservedly so. In 2007, he anticipated the collapse of subprime mortgage securities. At exactly the time that most of the financial world was blowing up, his portfolios were shooting up to the stratosphere. Paulson’s complex debt trades enhanced his personal fortune to the tune of $3.5 billion in 2007 and enriched investors in his Credit Opportunities fund, which gained 590% that year.

But Paulson gave most of that back last year. Institutional Investor estimates his personal investments in his own funds decreased in value by $3 billion. His biggest funds by assets lost 36% and 51% in a year in which the S&P ended flat and the Dow was up 5.5%.

Indeed, 2011 was a year that rewarded the most conservative investors. The S&P/BG Cantor 7-10 Year Treasury Bond Index and the S&P North American Utilities Sector Index surged 15.60% and 14.83%, respectively. So widows and orphans bested high-net-worth hedge fund investors by more than 66 basis points in some cases. And it wasn’t just Paulson’s fund but the entire hedge fund industry which underperformed. As a group, hedge funds turned in their worst performance since 2008, falling more than 4% on average, according to hedge fund tracker Hennessee Group.

None of this is to denigrate Paulson, one of the most brilliant investors around. But there is a tendency on the part of investors to impute omniscience to iconic managers that the past year newly demonstrated they lack. Every hedge fund strategy underperformed the zero-return S&P 500 last year.

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As if on cue, a mostly unrewarding investing year came to a close along with the entrance of a new book called Risk Less and Prosper by Boston University professor Zvi Bodie and financial advisor Rachelle Taqqu. In an interview with AdvisorOne, Bodie argued that “you shouldn’t think you’re going to earn a potential risk premium without taking risk. It was always a crazy idea to think that you could, but that idea was drilled into people’s heads by a whole industry campaign.” He and Taqqu are trying to revive the old-fashioned idea that investors start by covering their basic needs first and then look at worst-case scenarios before putting their savings at risk.

Nobel Prize winning economist Robert Merton, in his foreword to the new book, suggests a role here for financial advisors: “Households have been left with the responsibility for making important and technically complex microfinancial decisions involving risk — decisions that they did not have to make in the past, they are not trained to make in the present, and they are not likely to execute efficiently in the future, even with attempts at education.” 

Ordinary investors need not feel underprivileged for lack of access to more exclusive investment opportunities. And poor recent equity returns and record-setting daily volatility are fresh reminders that the dream of triple-digit returns comes at a cost that most investors can ill afford.