A new thought permeating financial advisory services is the focus on averting client wealth losses of moderate to large sizes. This is a significant departure from the last 40 years of thought and practice on averting risk rather than loss.
Increasingly, advisors are finding out that disasters and calamities like the 2008 financial crisis, or lesser ones like the dot-com crash and other steep contractionary GDP cycles, wear very poorly on client portfolios in the longer run. This is especially true when clients react to disasters by pulling out of equity-type securities near market lows and transfer into CDs, no matter how long the investment objective was to begin with. This is especially relevant for the retirement management industry since retirement marks a point of increasing loss aversion.
For clients close to or at retirement, moderate to large wealth losses are especially painful. However, the pain is not restricted to retirees only. A loss of 25% of wealth in a single year would be a fairly disastrous event for even a 35- to 40-year-old (mid-career) client.
There are two additional complications accompanying this new focus. One has been the mantra being spewed by those who consider all financial decisions to be made rationally. Over the last 40 years, terms such as risk/return, beta, alpha, efficient markets, modern portfolio theory (MPT), etc. have dominated money management in practice and financial services in general. The theoretical models that have evolved and have been wholeheartedly embraced have also propagated this idea that managing risk is the key in financial decisions.
While the models (like MPT) are considered theoretically sound, they have been based principally on the idea of averting risk. However, the large losses and subsequent fallout of the last two severe downturns have convinced many advisors that now is the time to focus on loss rather than risk management. Unfortunately, the tools for financial decisions based on loss aversion are either not well developed or mainly exist in the insurance sector only.
The second complication is the way the global economy is changing and has changed since the 2008 financial crisis. The economy of today is more global than ever before and in a sense it is quite new to us as well. There are many similarities between today's economy and the one that emerged after the Great Depression. One complication is the emergence of the Bureau of the Consumer Protection Agency under FINREG.
This law could impose as much oversight as the SEC has in the last 80 years. The principal aim of this bureau will be to prevent and redress the sale of unsuitable personal financial products and services, especially in the lending/advisory businesses. A more severe consequence for advisors would be if the benchmarks we have used to make financial decisions change.
The current unemployment rate may stick around 9% for a while, and also low GDP growth rates may linger. Inflation rates continuously but subtly threaten. Volatility in the equity markets has increased nearly 33% since the crash, while expected equity returns on large-cap stocks have turned much lower than their traditional historic rates. Bond prices have been at historic lows for over eight straight years. These changing dynamics may curtail the performance a financial advisor can deliver and make the advisor's job that much more difficult.
In a sense, the use of MPT has provided advisors with talking points that most clients do not understand well. For example, jargon like asset allocation, efficient frontier, Sharpe ratio, etc., are quite meaningless for most investors. In a very different and harsher sense, MPT is probably more useful for generating artwork-pie charts of optimal allocation, tables of expected money growth, etc.
In general, we can summarize that MPT may be useful to get the asset allocation process started, but we must streamline and fine-tune the MPT solution subjectively for each individual client by using some heuristic techniques.