Somnath Basu writes about more layperson user-friendly terms that investment advisors could use to describe risk. He points out that common ways to describe investment risk, such as standard deviation, are based on statistics. These statistical descriptions of risk and loss aversion can be difficult for advisors to fully comprehend themselves and adequately explain to investors.
Basu examines what earning an average rate of return of 8% over 5 years might actually look like in dollar amounts. He points out that using rough estimates, there is a 25% possibility that the investor will earn $0 in each of those 5 years. There is a 75% chance of earning money in each of those 5 years but a 12% chance of also losing money in each of those 5 years. As Basu points out, investors can better gauge their loss aversion by asking themselves how they would feel if the worst case scenario happened to their investment – especially in the year before
the money is needed.
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