• 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.