Risk is fundamental to the investment process, but remains a concept that is not particularly well understood by most regular investors. For this reason, risk warnings - those vaguely worded, fine print disclaimers at the bottom of any investment documents and websites - are extremely important for both buyers and sellers.
Unfortunately, although there are many warnings out there, they often remain unread or are not sufficiently explicit. An investor needs a substantial level of experience and sophistication to know what is really meant, or an advisor needs to take the time to explain it to the investor carefully in person. Yet, all too often, these conditions do not prevail. Sometimes, sellers obviously prefer to keep people in the dark in order to make a sale. In this article, we will look at the nature of risk warnings in order to figure out what gets the message across properly, and what still leaves investors not truly knowing what they could be getting into.
Where Do These Warnings Appear and Why?
Mainly for legal reasons, firms generally publish some kind of warning in their brochures and on Internet sites. The objective is not only to explain to the investor the nature of the risks involved in the particular kind of investment being offered, but also to ensure that there can be no legal comeback. The warnings are either in a separate Internet link, or in a brochure. In the latter case, it may vary from a rather small footnote to a pretty explicit and large-print explanation of what can go wrong. The length tends to vary from one sentence to a couple of pages.
Examples of Written Warnings
Let's look at some actual written examples of how investors are warned of what might happen to their money. We will see what the firms say and just how useful it is.
Example - Too vague
"The capital value of units in the fund can fluctuate and the price of units can go down as well as up and is not guaranteed."
Warnings like these are very common, regrettably. The problem with these is that there is no quantification and the warning does not really hit home. Can you lose 5% or 25%? There is a big difference between the two. It is unlikely that this warning alone will ensure that the unwary investor knows what could potentially happen to his or her money.
Example - Not easily understood by non-experts
This certainly warns people to be careful, but how many investors really understand what is meant by "suitability" or would bother to double-check? In addition, if the investor trusts the seller, he will think he is being careful. The odds of an investor actually going to an advisor are low.
Example - Relativity and context given
"You should be aware that certain types of funds might carry greater investment risk than other investment funds. These include our Smaller Companies, Pacific Growth and Japan funds."
Now we are moving in the right direction. You can see from this that the same company has other, safer investments, which you may prefer. This is no longer a token warning, and points clearly to lower-risk alternatives.
Example - The losses can be BIG
"Investment in the securities of smaller companies can involve greater risk than is generally associated with investment in larger, more established companies that can result in significant capital losses that may have a detrimental effect on the value of the fund."
What is good about this one is that the investor is warned that the losses can be substantial. This is still not quantified, but the point that the investment is not for the faint at heart is clear enough.
Example - Now that's a warning!
"You should not buy a warrant unless you are prepared to sustain a total loss of the money you have invested plus any commission or other transaction charges."
No need for vast experience or a vivid imagination. It is quite clear that you can lose the lot.
Criteria for a Good Risk Warning
There are several criteria that a warning should fulfill if it is to get the right message across:
Quantification: Although this is not always possible, investors should have some idea as to the proportion of their money that they could lose.
- Warnings should be easy to follow: Any risk warning should be easy to understand. If you don't understand what the risk warning is telling you, don't assume that the investment is right for you just because you trust the seller. An inexperienced investor could easily be advised to buy anything, ranging from a basic stock fund to a highly complex packaged product.
Signing is important for both parties: If an investor has to sign the warning, this demonstrates its importance to him or her, and provides good protection to the firm. However, never sign anything you don't understand.
Internet warnings: On the Internet, it is all too easy to click away a warning and carry on with the deal. In a perfect world, the link and entry would be very clear and the investor prompted to take the warning seriously. This is not a perfect world, however, and it's up to investors to make sure they read the disclaimer before continuing.
- Personal explanations: This are the only way many investors will really understand the risks of a given investment. If the print warning does not meet your criteria, seek out personal advice. The explanation should be clear and give sufficient detail so you know what you could lose, and how, and what other products might be more or less suitable and appealing. The seller should also make a note of how the warning was presented and, if possible, get the investor to sign this too.
Ask Until You Are Sure
As a private investor, you need to request verbal and/or written information and explanations until you are sure you understand the warnings. Don't stop until you are fully aware, in quantitative terms, of what you stand to gain and lose, and what other potential investments there are with different risk/reward ratios.
The Bottom Line
It is essential that investment risk warnings be clear and sufficient not only to provide legal protection, but also to ensure that the message truly gets home. Firms and advisors should only sell products with a warning that conveys the real level of risk clearly. Unfortunately, what should be done and what is common practice are two different things. As an investor, it's crucial to know how much of your money you could lose and what circumstances could cause this to occur. If you are uncomfortable with the risks of the investment, remember there are always lower-risk alternatives.
More From Investopedia