Investors face a risk that has gone virtually unnoticed, unmentioned, unmeasured, and which from time to time destroys their capital. The risk arises from the complexity of investments. For simplicity’s sake, I refer to this as “complexity risk”.
Investment complexity is dangerous because it greatly increases the likelihood that investors, advisors, and sometimes even an investment’s creator will not fully understand the investment or how it will perform. In short, the more complex an investment is, the more likely it is to be subject to forces that were unanticipated and extremely difficult to predict.
Complexity risk is a completely new way of looking at investment risk. Traditional measures of risk have looked at the historical performance of an investment to measure its volatility. The higher the swings in the investments price, the more risky it is considered. These analyses have also been extended to portfolios of investments to see how baskets of investments behave.
In this paper, I show how investments have become increasingly complex over the past thirty years. I then show how individual investors are highly unlikely to understand complex investments. The reasons lie in the well-established literature of cognitive psychology and economic theory, and are proven by decades of empirical research. I have expanded on this research and applied the same techniques to investment-related issues and documents.
In addition to this white paper, Accelerant has developed a method to quantiatively rank the complexity of investments by analyzing their disclosure documents. This method can also be applied to entire portfolios of investments. Investors, advisors, fiduciaries, and securities attorneys should find these rankings very useful in helping them in evaluating their complexity risk.
For further information on complexity risk or our proprietary method for ranking complexity risk, please contact Jack Duval: email@example.com | 845.605.1007.
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