Transparent Investment Risks

Transparent Investment Risks

Interest rates are at an all-time low and setting money aside in a savings account will generate very low returns. Investors have to decide whether or not they are willing to take investment risks in their search for higher returns. The concept of risk and the trade-off between risk and expected return are extremely complex for most individuals though. It is well known from the  academic literature that many people provide inadequate answers even to simple questions such as

Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow: [more than $102, exactly $102, less than $102? Do not know, refuse to answer].
Text by: Theo Nijman

Annamaria Lusardi (who used to teach in Tilburg some 20 years ago) is the world-wide expert in financial literacy. Her research revealed that only 46% of Dutch respondents answered all her three questions of this complexity adequately.  Approximately 10% answered incorrectly on all three questions. As an aside, the Netherlands did better than all other countries, apart from Germany (but fortunately nowadays we win in soccer…).

A well balanced decision on how much investment risk to take is much more complex than these simple questions. Econometrics has to play an important role here. Many individuals prefer return guarantees when investing, probably because of the option it offers to avoid to really think about risk.  Guaranteed future income is a key point in the reform discussion on supplementary pensions in which Netspar is very involved. In 2011 a farewell to guarantees was proposed to be able to better exploit investment opportunities. The labor unions initially agreed, but later referred to the lack of guarantees as “casino pensions” and the proposed reform was cancelled. The irony of history is that this lack of guarantees is now a corner stone in the new contract for supplementary pensions as proposed by the labor unions. For now the negotiations on this agreement were stopped because of disagreement on the speed of adjustment of the retirement age, but the proposed contract is likely to be reconsidered. Econometricians will have to play a key role in explaining the cost and benefits of guarantees.

The econometrics toolbox contains many instruments to model investment risk. At the highest level of complexity, the Netherlands has a great tradition of so called ALM models (Asset-Liability Models)  to model and aggregate all the different risk factors that affect pensions. A model developed in Tilburg is used often in this context and is prescribed by the pension supervisor (DNB) for use in deciding for example whether or not pension benefits are to be cut.

At the level of straightforward individual investment products, such as equity or bond investments, the legislation requires reporting of the 5% quantile of the future value of the investment. The underlying methodology is based on first year’s statistics, assuming i.i.d. normal returns with known standard deviations and correlations.  Although many students would rightfully argue that returns are fat-tailed and heteroskedastic, I am convinced that this simple tool is very valuable for individual investors who do not understand risk. For more complex products, such as those including derivatives, the Dutch supervisor adopted a model developed in Tilburg that more advanced students could recognize as the Expected Loss above VaR model. Again I am convinced that these models are useful to alert individuals about investment risks.     

And in case you would still be wondering what the right answer to the Lusardi question, referred to before, is: In exams the first answer will be most appreciated. However, I am afraid the questions you will get actually get in the exams are substantially harder.  

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