By Renaud "Ron" Piccinini, PhD
Why should advisors care about explaining risk?
Clients typically don't know how to feel about their portfolio returns. If they made a 5% return last year, should they feel good or bad? The answer to that question lies in the amount of risk that has been taken. Think about it like this — a young man comes home and tells his parents that he earned $500 last week. How should they feel about it? It depends. If he earned it mowing lawns, his parents should be proud. But, if he won a bet with his friends on a game of Russian roulette, his parents should have a much different response.
Knowing the risk involved in the return changes the way clients feel about their money. This is the basis of risk tolerance. Clients can't make informed decisions about their money if they don't have the entire picture. Effectively estimating a client's risk can help them avoid behavioral mistakes, significantly impacting their bottom line.
Additionally, advisors should care about explaining risk because helping your clients avoid the classic pitfalls that can destroy retirements builds a stronger, more trusting relationship.
What are heavy tail risk models?
The "tails" refer to the probability of something rare happening. In regular life, you would rarely see a 7-foot-tall man. However, it is possible and has actually been documented. Similarly, a one-day 10% drop in the S&P 500 index is also possible and has been documented. The model used to explain the drop in the S&P 500 index is called heavy-tailed because it places a higher probability of something unusual occurring.
How is risk estimated today?
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