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|Expert Forum for Knowledge Presentation|
|Preparing for the Future of Knowledge Presentation|
|Visualizing Uncertainty: The graphical representation of risk in investor communications|
© 2004 Wes Ervin
|Conference presentation Video|
|Keywords||Risk, risk representation, financial graphics|
all have an intuitive grasp of financial risk. It’s an intangible,
a possibility, both an opportunity and a danger. But one thing is certain:
without risk there can be no reward. “Nothing ventured, nothing
gained.” This article considers how information design can be
used to help laymen investors better understand and manage financial
risk. Risk has become a hot topic today. After the bubble burst in 2000,
investors fled to safer investments. Or so they thought. The recent
scandals roiling the US mutual fund industry are sure to rattle investors
even more. Many firms in the financial-services industry are doing an
admirable job of trying to educate the public on the question of risk.
But there’s much more that could be done. This article focuses
on the customer statement as an opportunity for education and guidance.
Very few statements include visual displays of risk. And when such charts
are used, often they are inappropriate or inadequate. This article proposes
one possible solution, a risk-reward scatter gram.
It used to be that only governments, institutions, and the wealthy had to worry about investment risks. No longer. America has become, for better or worse, a nation of individual investors. In 1980 only about five percent of U.S. households participated in the stock and bond markets through mutual funds. Today more than 50 percent of American households own mutual funds, mainly through Individual Retirement Accounts (IRA) and 401(k) retirement plans, so named after the provision of the US tax code. Yet how well do most of us understand this brave new world?
Kansas man, for example, had withdrawn his entire pension savings from
his employer at the market’s height in 2000 and invested it in
a variable annuity. His broker assured him he’d receive $2,800
a month in income without reducing his principal, until he was ready
to receive his Social Security benefits. All of this sounded low risk.
He didn’t realize that his money would be invested in sub-accounts
heavily exposed to high-growth, and hence high risk, stocks. When the
market plunged, he started loosing $20,000 a month. His nest egg of
$433,000 shrunk to $190,000 before he moved his money into low-risk
money market funds.
studies reveal that Americans, on average, spend more time each year planning
their vacation than they do planning their financial future. Only a small
minority actually meet regularly with a financial advisor to review their
portfolios and make adjustments. The financial services industry churns
out brochures, publishes investor newsletters, and sponsors educational
events like seminars, all aimed at helping laymen investors to better
understand the risks and rewards of investing. Many financial firms also
use their customer statements as vehicles for such information and education.
|Figure 1: Monthly statement|
1 illustrates a monthly financial account statement in which there is
a marginal message, titled “Experienced Investors Should Never
Stop Managing Risk.” The idea is to educate the consumer at the
very moment they are focused on their account, a kind of “just-in-time”
|Figure 2: Hybrid monthly statement-cum-newsletter|
few companies are taking the next step—targeting or tailoring
the information to the individual recipient. Figure 2 shows a hybrid
statement-cum-newsletter, produced by Securian Retirement Services,
one of the large US companies in the defined contribution, or 401(k),
industry. The first two pages of this customer communication provide
the account data (value, asset allocation, performance, etc.). The last
two pages are newsletter-style content. In this case, however, the content
can be varied, depending on criteria such as value of the account, the
asset allocation, age of investor, years until retirement, and so forth.
This is possible because the entire statement—transaction data
and educational content alike—is dynamically composed, i.e., page
composition is performed on-the-fly by a sophisticated document composition
engine (in this case, based on eXstream Software’s Dialogue).
The Fidelity Institutional Brokerage statement, to take another example,
uses on-statement messaging to alert the investor to changes such as
an upgrade or downgrade in a bond’s rating. These messages are
printed in the statement’s margin within the section where the
change has occurred.
The Pie Chart
statements the pie chart is used to show asset allocation, i.e. the diversification
of assets into various investment options, such as stocks, bonds, and
cash. Figure 3 shows a typical example: an asset allocation for a Balanced
Fund in which 53% is invested in stocks of large-capitalized companies,
39% in government bonds, 7% in stocks of companies with only small capitalization,
and the balance in cash.
|Figure 3: Asset allocation pie chart|
|Figure 4: Risk allocation pie chart|
companies use pie charts also to show risk allocation, i.e., diversification
of assets according to risk. One notable leader in this regard is Principal
Financial, which won an industry-award for its 401(k) customer statement.
The Principal Financial statement uses multiple pie charts to show how
an investor’s savings are diversified according to both asset class
and asset risk. Figure 4 shows an example. In this case the investor has
60% of the total bond holdings invested in high-quality corporate debt,
40% in Treasury Bills, and 10% in relatively risky non-investment-grade
bonds (aka “junk bonds”).
The beauty of the pie chart is its simplicity. It shows allocation of anything as parts of the whole. However, in this case the pie chart has its drawbacks. First, asset allocation is not the same as risk allocation. Two portfolios can have the same asset allocation but carry very different risk.
|Figure 5: Asset allocation table|
Figure 5. Portfolio A and Portfolio B both have the same allocation (80%
Large Cap Growth Fund, 20% U.S. Bonds), the same market value ($100,000),
and the same expected return (6%). Are they equally risky? To answer that
question we need to lift the hood and look at the underlying securities.
In Portfolio A the Large Cap Growth component consists solely of an indexed
mutual fund designed to track the S&P 500. The bond component is invested
solely in US Treasuries. In Portfolio B the Large Cap Growth component
consists of two technology stocks: Cisco Systems and Texas Instruments.
The bonds are a variety of long-term corporates with different ratings.
Let’s look at the risk associated with each component. A Risk Grade
is a measure of the price volatility of an individual security or a portfolio
as a whole. As it turns out, Portfolio B, containing two tech stocks,
is three times as risky as Portfolio A.
|Figure 6: Risk grade diagram|
the pie chart is a static snapshot. It can’t express volatility.
All securities fluctuate in price over time. The lower the fluctuations,
the less volatile and hence less risky. Figure 6 illustrates a portfolio
originally established in 1996 according to a “moderate” risk
model. Times change. Let’s say some of the underlying securities
become more volatile due to market conditions. As a result, what started,
as a “moderate” risk allocation may become “Aggressive”
or even “Speculative.” Yet the pie chart would have remained
the same all along.
|In financial terms risk is the uncertainty of the future value of a financial asset. It thus has two main parameters: return and volatility. Return is the “reward,” while volatility is a measure of the “risk.” The ideal investment is one that offers relatively high return with relatively low volatility.|
|Figure 7: Risk-reward chart|
Figure 7. This chart plots return on one axis and volatility on the other.
The return is usually measured as percentage increase or decrease. Volatility
is measured in several ways—the most common statistical methods
being Beta and Standard Deviation. Using these two values we can plot
an individual security, a fund within a portfolio, or an entire portfolio
within the risk-reward matrix. In this example we can see exactly where
our portfolio hovers in this risk-reward field.
|Figure 8: Risk comparison scatter gram|
8 comparable benchmarks are likewise plotted. The scatter gram thus enables
us to compare our investment with any number of benchmarks, like the performance
of the S&P 500 stock index or a major bond index. In this example
we can see instantly that our portfolio is a little more volatile, but
returns a slightly better yield, on average and over time, than the S&P
500. If our investor is thinking of retreating to a safer haven, like
T-bills, it is clear how much return will be sacrificed for that reduced
is a sophisticated science. The underlying math is formidable, the models
complex, and the predictions not always reliable (witness the debacle
of Long Term Capital Management in 1998). So far most of the tools which
have been developed by the big Wall Street firms, notably VAR (value at
risk), are only available to their big clients. But there are a handful
of companies, such as RiskMetrics Group (New York, NY), which are re-packaging
these sophisticated technologies for smaller investors. As information
designers we are the bridge. We need to find ways to explain and represent
this abstraction called risk to everyday, laymen investors. It is hugely
important. Their future security and well-being literally depend upon
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|Wes Ervin has worked in the field of financial information design for fifteen years. Prior to joining DST Output in 2002, he was managing director of Information Design Associates in New York City. Wes has presented papers at several VisionPlus conferences sponsored by the International Institute for Information Design and he hosted the IIID Expert Forum in Finance in 2002. Wes participates in several other associations, including the Communications Research Institute of Australia and the Electronic Document Systems Foundation.|
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