While rationally we know that the next downturn or market crisis will probably not be the worst ever, a large percentage of investors will always remain convinced that financial doom lies just around the corner. Behavioral science provides some explanation for this, since investors tend to overemphasize and fear unknown future risks while downplaying the emotional impact of financial upheaval once it is in the rear view mirror. (This cognitive bias is sometimes referred to as “hindsight bias,” the sense that we ‘knew it all along.’)

In another sense, though, this common perception of impending catastrophe is also due to our industry’s own persistent lack of preparation in the face of unfamiliar risks and predictable unpredictability, thanks to a critical failing in traditional approaches to asset allocation. In short, many managers mistakenly conflate diversification—which can help reduce volatility under some market conditions—with true risk management, which may require a significant shift in a fund’s tactical and strategic outlook in order to protect investors when bear markets or unforeseen “black swan” events occur.

As more and more financial advisors elect to outsource some of the routine day-to-day functions of investment management to third-party asset management platforms, or TAMPs, the divide between platforms that feature robust, quantitatively-driven risk management measures and those that continue to adhere strictly to traditional asset allocation approaches will only become more pronounced—and will drive profound consequences for both advisors and their clients.

Check Your Assumptions

While we drone on to investors that “past performance is no indication of future results,” most traditional asset allocation models are still built on the assumption that correlation between various asset classes will look the same next month as it did last year.

The problem is that, in reality, correlations can change drastically when market conditions shift. As the most recent financial crisis demonstrated, this blind spot in traditional allocation models can leave investors and fund managers in panic mode when correlation between disparate assets suddenly goes to one.

Advisor Due Diligence—What To Look For In A TAMP

In order to select the best TAMP for their practice and their clients, it is incumbent on financial advisors to subject potential platform partners to a rigorous due diligence process founded on a new approach to asset allocation and risk management. What should advisors be looking for as part of this process?

1. Top-down approach to asset selection—not 60/40 or any other “conventional wisdom.” Traditional allocation models too often assume that, depending on an investor’s age, he or she should own a set percentage of stocks, bonds and other securities, with no consideration given to the overall attractiveness or unattractiveness of those asset classes at the time. (In some cases, managers are even prohibited from breaking with prescribed allocation percentages.)

Too often, this hidebound approach leads to portfolios that are not built to capture attractive current opportunities or protect investors adequately against risks, since it rests on the shaky idea that diversification alone can provide sufficient downside protection.
 Financial advisors looking for a TAMP with both sophisticated risk management capabilities and the ability to pursue compelling investment opportunities should start by asking if potential platform partners have the macro-economic expertise and analytical insight to gauge the risk / reward balance of a range of asset types, as well as the flexibility to build portfolios accordingly—regardless of what traditional guidelines may say.