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.

A simple heuristic model in conjunction with the basis of diversification and client subjectivity will produce portfolio structures that will perform at least as well as any solution MPT can provide. Consider the Life Cycle Hypothesis (LCH) of investments as such a heuristic model. For example, imagine that the decision is to use the LCH to save and fund a retirement plan. Under this heuristic, a new career individual would generally be aggressively invested (in small caps, emerging markets, high-yield bond funds, etc.) as they tend to grow their wealth over the longer run.

As these clients age, they would slowly move over to less aggressive investments such as large-cap stocks and begin buying into income/balanced funds or into fixed-income products. Finally, in their late careers they'd be mostly in fixed-income type conservative, income-producing securities (bonds of all types, fixed annuities, TIPS, etc.) with a small amount in equities (that taper off with time) left for a little growth over the retirement years. Using these guides, one might start putting together portfolios but incorporate other asset classes (beyond global equities and fixed income) into the portfolio mix.

For example, a 60-year-old working his last five years before retirement may have a current allocation of 60% fixed income and 40% equity. This allocation can be augmented in general with reallocations into real estate, commodities, currencies and cash. The benefits of diversification will follow automatically without the need to use any explicit model of diversification. To fine-tune the exact allocations, the individual client's subjectivity requires consideration.

A more conservative retiree may start with a 70% fixed income allocation and then switch to a mix of 65% in fixed income, 20% in equity and 15% in other asset classes. Further, the retiree's attitude to loss can be explicitly incorporated. For example, if a client answers that he cannot absorb a total portfolio loss of 10% in any given year, he would have a much more conservative portfolio structure than one who could live with a 15%-20% loss. Another important client-specific input leading to a better allocation would be the amount of accumulated savings that were already in the fund or the state of the family's health and longevity. Advanced planners ask many of these questions as part of their routine to make better allocation decisions.

If most clients of advisors had followed these simple guidelines, then the ravages of the previous financial crisis would have been considerably mitigated. Older investors would mostly be in fixed-income type, well-diversified portfolios. Younger people would buy and hold their positions and weather out the downturn and witness portfolio value rebounds. Instead, the fear of losing more after a crash (!) causes all sorts of reactions like selling out low and then buying into CDs and other expensive savings products with long-lasting destructive impact.

What is remarkable about this approach is that the need to structure portfolios based on historic means and standard deviations and their resulting problems becomes unnecessary. This should be considered a benefit. The main reason for this benefit is that the concept of LCH is firmly rooted in the concept of loss aversion. Moving from equity to bond holdings is nothing more than a reflection that problems from larger losses at old age that are much more difficult to fix are being avoided through this mechanism.

A critical examination of the results of the 2008 financial crisis and its fallout will surely reveal that clients today are more unified by fear of further significant losses than by a willingness to earn higher returns by buying riskier assets and securities. Advisors would be able to relate to this new state analogically through their own client experiences. This new environment is thus also engendering this new vision of personal money management as advisors struggle to understand the ground realities of loss aversion.

Loss aversion generally will lead to portfolio structures that are in general more conservative than those based on risk-return strategies. One of the effects of more advisors structuring loss-averse portfolios will be to bring down long-term portfolio expected returns to a more meaningful 6%-10%. It is worthwhile to note that an average annual return of 8% over 15 or more years will in general produce very satisfactory financial outcomes. A related macro-economic benefit is that if advisors are disciplined in this approach, then the effects of the series of bubbles and crashes in various financial markets would be considerably reduced. The discipline would reduce or prevent markets from reacting when investors run as a herd, chase returns or demonstrate some other troublesome group behavior.

Finally, for advanced planners, loss aversion may be managed by the use of derivatives. This approach is consistent with the loss-aversion approach in insurance. Just as we buy home or auto insurance to pass the risk of loss to the insurance company, we can structure portfolio investments to contain an investment element. Consider the following simple example: Let's assume that a portfolio is worth $1 million and is invested completely in a domestic large-cap equity index fund like the S&P 500. Also assume that the one-year premium on an at-the-money call option on the S&P 500 is 8% and the risk-free, one-year money market rate is 3%.

Instead of investing the entire $1 million in the index fund, invest 90% in the money market fund and the other 10% in the call option position. This is akin to insuring the portfolio for a year at a cost of about 5.3% (the 8% option premium minus the 3% earned on 90% of the money). The portfolio could not lose more than this amount. On the upside, this portfolio would have the same performance as the index fund minus the 5.3%. Thus, if the market moved 12% up in the year, the gain would be 6.7%. If the market moved down 12%, losses would still be fixed at 5.3%. The strategy would be rolled over every year.

Note that this strategy can be bought from most financial producers as a structured note. However, structured notes have acquired a bad name because these commercial products are often bundled with toxic elements and prohibitive terms and fees. However, the underlying compulsion to buy these products is still an indicator of the power of loss aversion and the need for some participation on the upside.

The last technique is the use of derivative collar strategies. In these portfolios, derivatives are used to structure floors and ceilings. For example, a collared portfolio may have a maximum return of 18% and a maximum loss of 6%. However, when the volatility measures are impounded in the returns, it can easily be seen that the Sharpe ratios in collared portfolios easily dominate the same ratios as portfolios that have been conventionally structured. Hopefully, the advanced planners of tomorrow will use such techniques as a nation's money managers set out to find these new horizons in loss management.