Sometimes when you've been building a skyscraper, it helps to go back and look at the architect's drawings to remember what it was he had in mind.

That's what Libby Mihalka, a CFA and founder of Altamont Wealth Management in Livermore, Calif., said she was thinking while listening to Stanford Professor, Nobel Prize winner and asset management guru William F. Sharpe, as he addressed a crowd of NAPFA members in San Diego in late-September .

Sharpe took a break from academia to break bread with advisors in the trenches and talk to them about post-retirement strategies in markets that have gone up, down and sideways. It's a world where convictions in buy-and-hold investing have been dashed for many people after the market crash in 2008, and where a traditional strategy like distributing 4% a year from assets, feels increasingly dicey in volatile markets. It's a strategy that could require clients to eat into principal since stock and bond yields are frustratingly thin. Meanwhile, clients face longevity risk as more baby boomers ponder living into their nineties or longer.

What Sharpe offered was both funny and scary. Funny because he delivered it with self-deprecating humor, in a presentation replete with such visual aids as the painting American Gothic, with the famous old couple sporting cell phones, pagers, golf clubs and an SUV.

It was scary because despite all the backward-looking data Sharpe said he can accumulate as an academic, the future is uncertain, and advisors still have to share this unfortunate news with clients. The data advisors give them is always going to be subjective, and the risks of failure are still going to be more than some investors can deal with. If the market has no memory, there's no reason 2011 couldn't be like 2008, 2000, 1973 or 1929. The more he knows, Sharpe said, the more he realizes he doesn't know.

The job of financial advisors, he said, is not only to suggest a course of action, but to frame it-and that in itself can prove ethically challenging when you're using history to predict the future. "You're using a particular history," he said, "over a particular period of time for a particular country with a particular index and projecting the frequency with which things happen."

"Now it gets metaphysical," he said. "What's the client's best interest when the way they choose is framed after the fact?"
The best you can do, he says, is both assess probabilities and then communicate probabilities.

"You can get estimates and models and programs," he told the crowd, "but in a sense your value add in large part is helping your clients understand the implications of different strategies in the capital markets and what sources of uncertainty bring to the equation."

He listed a number of different uncertainties that advisors have to factor in: the risk of living longer (and outliving money), the risk of poor investment returns, the risk of poor health (and health insurance), the risk of inflation (despite the constant drumbeat of news about deflation), the risk of government programs such as Social Security and Medicare coming up short or being cut back. Sharpe adds counterparty risk, as well-the chance that those companies helping you shore up your high upside investment product, perhaps a company like Lehman Brothers, might not be there to help out if they go belly up.

When you show the clients these risks, you have to frame them in ranges of outcomes, he says, whether you're showing them markets using analytic distributions, such as a fat-tailed bell curve with really ugly surprises, or using scenario analyses, where you look at the last 50 years and ponder what might happen if next year were anything like one of the last 50.

"They could be historic episodes [you factor in] or it could be things you just write down, and then you assign probabilities to those and you run them back," he says.

You also have to decide whether to show your clients a market that's serially correlated, uncorrelated or both, he says.

"Economists were comfortable for many years with the assumption that markets have no memory," he says. "In other words, that the probability of a higher or lower return next year is the same as the probability was last year-no matter what happened last year. Others, Jeremy Siegel [author of Stocks for the Long Run] would be sort of an extreme case, say, 'No, no no. If the market does really badly'-he won't say it this way, but I will-'If the market does badly it feels quite badly for those investors and it will work to do better next time.' If on the other hand, the market is giving you a lot of money it will say, 'Hey, they don't need it all the time. Maybe next time won't be as good.'"

While he says you can choose a positively correlated model like this, he argues that more economists would say it's better to assume that they are uncorrelated-that the probability of distribution of stock returns will be the same next year no matter what happened last year.

There's also a regime switching model you can embed in your assumptions, he mentioned, in which you can factor in a 95% chance the market will be normal this year, and a 5% chance it will come a cropper like it did in 2008.

Your job, says Sharpe, is to decide what models of the capital markets you're most comfortable with and which your clients should assume. That means choosing a set of assumptions, then running several different outcomes through a computer with your clients and seeing which of those disparate sets of outcomes they are most comfortable with.

"And believe me, the strategy you choose will depend radically on that particular set of assumptions," he says.

Sharpe suggests picking three different strategies-for example, a strict 4% distribution every year, or a managed payout fund from a company that resets the payout every year. To these strategies you can add capital market characteristics that you're most comfortable with, perhaps by using vendor software. You put the whole shebang through a Monte Carlo engine that will generate "zillions" of future scenarios with outcomes for the various salient factors. Then show the ranges that each of the three different strategies yields and find out which of those ranges a client is most comfortable with.

"In other words, focus the client on the outcomes-but on the range of outcomes, not a single outcome or a single outcome per year. Because as you know, that doesn't capture the reality."