FinPlan Friday: Are You Using Quality Risk Metrics?

Better Risk Discussions

The current market volatility is a good reminder about the importance of making a good estimation of the downside risk that is inherent in our clients’ portfolios. Using quality risk metrics allows advisors and clients to practice and prepare for a down market, so the client isn't tempted to pull their investments when the market gets rough. Learn more about how to have better risk discussions in our FinPlan Friday conversation with Joe.

FinPlan Fridays

In our video blog series, FinPlan Fridays, Covisum^® Founder and President, Joe Elsasser, CFP^®, offers his take on the issues financial advisors see every day. Joe is a practicing financial planner with a unique perspective into the challenges for which Covisum provides technology solutions. Join us on the first Friday of every month for FinPlan Fridays, and get helpful tips to grow your financial planning practice. 

Transcript

Risk Tolerance

Welcome to another FinPlan Friday. Today we're going to talk about the importance of quality risk metrics, and what I very specifically mean is making a good estimation of the downside risk that is inherent in our clients’ portfolios. In other words, if I get a really bad market given this combination of stocks, bonds, and mutual funds, how much is my portfolio likely to be down? The reason that question is so important is because it allows us, with our clients, to both practice and prepare. Those are the two key elements, practice and preparation. In other words, I want to have had the conversation in advance with the client about their panic point. What is the point at which if your portfolio is down by this much, you'll say, "I have to go to cash." I want to make sure that I invest them in such a way that that situation is extremely unlikely to ever be realized. And the reason for that is the worst thing that they can do, as we all in this space know, is bail at the bottom of a down market and miss any recovery that may happen. So, that's the first element that practice and preparation allows us to handle, the risk tolerance discussion.

Risk Capacity

Now, the second aspect that it allows us to handle appropriately is the risk capacity discussion. In other words, if we get a really bad market, what happens to my plan? Am I still able to enjoy the retirement than I expected to enjoy when I retired, when we sat down and put this plan together? When we think about practice and preparation, there's nothing more likely to tank a financial plan than pulling out of the market at the bottom of a decline. That's probably one of the biggest behavioral challenges that advisors face, is keeping clients focused on the plan and not what's going on with the inevitable gyrations of the market. But being able to have a solid estimate as to what a really bad case looks like and being able to say in advance. Here are the contingency plans that we will put in place. Maybe we will plan to cut spending. If that kind of bad scenario materializes, maybe we will no longer pursue one of the client's goals. Maybe we will have set aside cash on the sidelines that will be put to work in that particular event or maybe buffer assets that we didn't plan to use, but we'll use in that event like a home equity line of credit. Any number of contingency plans can be put into place, but in order to put them in place, we have to have had a good risk estimate on the front end.

Heavy-Tailed Model

Now, let's talk about the risk estimates that are out there in the marketplace today, because the majority of advisors facing advisor level risk estimates are still based on the normal distribution or the bell curve or the Gaussian distribution. Those are all synonymous terms. But the shape is one that you would recognize and that shape is the shape of a bell curve. The challenge is that the normal distribution dramatically underestimates extreme events in the market that happen on a really pretty frequent basis. Now, let me put it this way. If you were to look at a normal distribution, say, how often should Black Monday 1987 happen? That model would tell you that that should happen about once every 100,000x the age of the universe. In other words, it simply shouldn't happen, and yet it did. Or when we looked to more recent history, how often should a 30 percent decline happen in a single month? That number, under a normal distribution, is once out of every 34,000,000 years. Again, it really shouldn't happen.

Now, if we were to use a different sort of model called a "heavy-tailed" model, the outside edges both to the negative and to the positive happened far more frequently and with greater severity than the normal distribution. A heavy-tailed model would predict that that sort of event should happen about once every 37 years. In other words, it's not common, but it does happen. And so it would be well within the realm of possibility that we as advisors should be preparing our clients for. So, that's the first key element of a quality risk metrics and that is a heavy-tailed model.

Estimated Tail-Loss Methodology

The second key element of a quality risk analytics is what you might call estimated tail loss methodology. In a normal distribution, and the way risk has historically been communicated, it's all about where do normal markets end? In other words, once we get two standard deviations out, what is that line? Now, those models don't try to estimate what happens once we get beyond that line. They simply tell us when a bad market starts. They don't tell us how bad it could get. And that's the real question that our clients have. It's the real question we as advisors should be asking, because what we need to be able to do is prepare clients for if a bad market happens, what do we do with our plan? How do we put contingency plans in place? And so estimated tail loss methodology, rather than just being concerned with where the bad market starts, instead says given that we're now in a bad market, what is the average of all those possible bad markets? We don't want to be doom and gloom, but we do want to adequately represent the risk that is in the client portfolio. And when we've incorporated both a heavy-tailed model with an estimated tail loss methodology, we've achieved a really reasonable estimate as to the downside exposure in the client's portfolio. When you bring that back into the financial plan and you test their goals against that sort of market decline, you're really capable of preparing and practicing for the next bear market.

So, for those advisors who are watching, who hadn't been having these conversations in that way ahead of this most recent bear market, this is probably a very good indication that it's time to start. Those advisors that are having these conversations through times like this are actually reinforcing their client relationships. They're putting their clients in exactly the position their clients hired them for. They're putting them in a position of confidence to be able to move through the ups and downs that are absolutely inevitable in markets with confidence and with a plan that will allow them to make changes, not out of reaction and not in a situation of panic or fear, but instead out of confidence. And ultimately, that's what we want to deliver to our clients, that well-founded confidence that their plan is on solid footing.

How Can Covisum Help?

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