In the face of a relentless bull market in equities, advisors have the difficult task to justify balanced allocations to clients who have grown increasingly ambitious on returns. As the memories of the 2008 crisis start to fade, investors have become less realistic and more greedy.
Financial advisors have stated that some their clients at the start of 2014 have demanded of them why don¹t you allocate more of my portfolio to stocks? Advisors have naturally justified their choices by pointing to the allocations agreed upon in the policy statement. Often this reasoning is insufficient to preserve the client¹s trust and satisfaction.
A mid-year review in 2014 now brings on the same line of questioning as financial advisors must manage their clients risk and expectations in a bull market. A recent study of mass affluent investors by AssetMark finds critical gaps in knowledge and expectations between advisors and their clients. Nearly half of the study respondents say they would risk 25 percent to 100 percent of their portfolios for commensurate returns, yet the vast majority claims to be moderate to low risk takers.
On a positive note, the study reveals that investors want to be more educated about risk by their advisors. However risk is difficult to measure and communicate. What is the best way to explain risk, negotiate risk/reward tradeoffs and set realistic expectations? Or would you rather have your client educate themselves on social media? After conversing with many financial advisors on this topic, it appears that judicious use of portfolio analytics backing your arguments with easy to understand metrics and rich visuals may significantly improve your communication and trust with clients. To create this valuable opportunity, you must become a story-teller to your client. The following three visual analytics will greatly educate your clients in a bull market:
• Present risk/reward visuals for long term periods. Over a 10 years or even 20 years horizon, balanced allocations have done nearly as well as pure equity portfolios but with less volatility. The risk/reward visual is simple to understand and puts risk and return on an equal footing. The risk metric used is typically the portfolio volatility. Astute investors may point out that volatility of investments going up in value (like recent equities) is a good thing. Explain that the faster an investment has gone up, the faster it can go down, so high volatility - even on the upside is a still a sign of risk. To drive the point home, highlight investments with high volatility on the upside in the tech sector of the stock market just before the crash of 2000.
• Emphasize the maximum drawdown on return charts. The maximum drawdown is the amount of loss from a portfolio peak value, to the portfolio lowest value within a given period. Since this is a measure of the actual amount of money lost, the client can relate to this better than volatility. The maximum drawdown is best shown on a return chart. To emphasize the loss, highlight not only the depth of the draw, but the length of time it takes to recover from the draw. Ask the client if they will have the nerve to cope with a steady decline over several months or even years.
• Stress test the clients portfolio. This may be the most effective visual to remind clients that adverse events (black swans) causing crashes can happen at anytime, and by nature these events can't be forecasted. To quantify the effect of adverse events, present the client with a portfolio stress test. How much would the portfolio lose in case of a currency crisis? a war? a liquidity crisis? Portfolio stress tests have been used by institutional investors for years. More recently, stress test features have been made available in more affordable and easy-to-use packages for financial advisors. With these packages you can construct hypothetical scenarios, but for simplicity you may also use historical scenarios such as the tech bubble in 2000 and the financial crisis. Historical scenarios have the advantage of requiring no setup, they can be presented in seconds for any portfolio and they are easy to relate to. A side-by-side A/B comparison of portfolios is always the most powerful way to educate the client.
At the end of this presentation, your message to the client should express, "Let us construct a strategy that conforms to your long-term goals, not to a hot market." Successful advisor-client relationships is a two-way street. Just as clients seek educated financial advisors to manage their investments, advisors should seek resources that not only provide safe returns to clients but educates them as well.
Christophe Gauthron, CFA, is founder of Kwanti, a software provider serving financial advisors and investment managers.