Part 2: The Importance of Clear Communication in Achieving Investment Objectives and Managing Risks

– Clear communication is crucial in the investment process to ensure objectives are understood and risks are managed effectively.
– Traditional investment decision frameworks often rely on mean-variance optimization (MVO), which uses standard deviation as a measure of risk.
– However, standard deviation may not accurately capture the risks that investors are most concerned about, such as losing money.
– Investors often prioritize avoiding their maximum allowable loss or “loss limit” rather than focusing on relative returns or standard deviation.
– MVO frameworks may not align with investors’ loss limits and can lead to decision-making challenges, especially for non-investment professionals.
– Standard deviation also fails to capture tail risks, sequence risks, and depletion risks, which are critical for making informed choices about risk.
– Standard risk metrics lack context and may not convey sufficient meaning to decision makers.
– Vague references to risk in investment policies can lead to poor decision-making and regret.
– An alternative approach to decision-making among competing objectives will be explored in the next article in this series.