Behavioural Finance - Combating risk illiteracy
The biggest single hindrance to consumers in getting to grips with their own finances is a lack of basic numeracy skills.
Often the capability to add, subtract and understand probabilities is taken for granted by the financial services industry but for many thousands of men and women around the UK, these mathematical processes do not come very easily or even make much sense.
In fact, many consumers suffer what is termed as ‘maths trauma’, where anything to do with maths is associated with tension, apprehension and fear. Such individuals can feel a profound sense of confusion and often have a general aversion to figuring out sums of any kind, even when they are clearly pertinent to the process of planning for their financial future.
In order to make informed decisions regarding which funds to invest in, individuals need to be aware of both the benefits and pitfalls of different investment strategies. Unfortunately, when it comes to investing, many people lack a basic understanding about investment risk and return, commonly referred to as risk illiteracy. Consequently, effective risk communication cannot take place thereby making informed decisions virtually impossible.
Already there are a large number of investment products available on the market but as the range and complexity of these products increase, individuals will need to keep up with, and understand, the corresponding investment risks. It is not surprising, therefore, that individuals who are not clear about investment risk tend to avoid making any decisions about their finances at all.
Successfully communicating risk is one of the key challenges currently faced by the financial services industry. But understanding risk is essential in understanding investments.
Consumers have long needed to be informed of what really matters when it comes to investments and what options are accessible to them. Unfortunately, the tools available have not always been up to the job.
The difficulty lies in explaining all the different types of risk and the potential rewards available in a clear and engaging way.
Thankfully, there are now a range of solutions available that can illustrate and communicate risk in a variety of different ways. The basic idea is that everyone should be able to find a way of making sense of what is often quite complex financial information and in-depth data on investment prospects.
One way of explaining investment risk is by looking at the possible highs and lows of each asset class or combination of asset classes using stochastic modelling. By providing such information, stochastic forecasts help investors to understand how investing in different types of assets can affect the potential future return on their investments.
Communicating the link between an investor’s attitude to investment risk and the investment strategy used to illustrate the relative outcomes is crucial in helping make informed decisions about the relative merits of a proposed investment.
Visual presentation of key information can also help individuals to overcome any maths trauma they may suffer by focusing on imagery and ideas that make sense to them and which clearly illuminate the essentials of important investment equations.
Undoubtedly, there is still plenty of work to be done when it comes to simplifying financial information and making it accessible for everyone. However, through technological changes and greater understanding we are, as an industry, at least on the road towards overcoming the very widespread and crucial problem of risk illiteracy among many individuals.