A key risk objective for advisors is to prepare their clients for different outcomes, so they are pre-armed in terms of expectations and planned responses. We know that the market is not going to progress smoothly. There will be bumps in the road, negative and positive, whether from economic fundamentals, periods of “irrational exuberance,” tax and regulatory changes, or geopolitical shocks. Understanding that such scenarios are likely to occur at points along the client’s journey helps the client temper the reflexes of fear and greed that afflict many investors.

Coach Clients To Become Market Pros
The client can approach those inevitable disruptions with the perspective ... and behavior ... of a pro: “Yeah, I’ve seen this movie before; I know what to do” rather than overreacting to events in the moment. Both the advisor and the client already have a plan for what to do ... and what not to do.

This is especially important if a disruptive event occurs late in that journey, with little time remaining for recovery. For example, the global financial crisis of 2008 saw many portfolios decline nearly 50%. Recovery was fast, in historical terms, but it still took several years to accomplish. If clients panicked, as some did, and “cut their losses” by greatly reducing their risk/return postures in March of 2009, that total “recovery” has still not arrived.

Effective advisors help clients manage the risks from these critical events by rehearsing future possible scenarios: “what if” exercises that move the discussion outside the frame of everyday ups and downs of the market and into the realm of market dislocations that could be truly significant for the client.

These scenarios are more than numbers; they are narratives of how things might unfold, how they might progress over time, with the host of uncertainties and market effects. This is what a client wants to know, and what is needed to assess the implications for the specific client. It is what is needed to provide a personalized discussion based on the client’s interest and financial expertise, on the specifics of their portfolio, risk tolerance and risk capacity, as well as where they currently are in achieving their financial goals. This means looking at scenarios in the context of how long they might take to resolve, what parts of the markets will be most affected, and how bad (or good) the scenario might be.

It Was The Most Bullish Of Times, It Was The Most Bearish Of Times ...
To understand how a scenario is a narrative, think of it like a novel, a story that drives forward with twists and turns. A scenario has an opening chapter with the event that gets the action going; it has the current market environment as its setting. It has a main character that threads itself through the story plotline, tracing out the path of the relevant markets as the scenario gathers force and then dissipates. And just like novels, potential negative scenarios rest within various genres. Those might be driven by overstretched fundamentals, by market forces of leverage and illiquidity, by the macro cycles of recession, and by non-economic shocks like geopolitical instability.

To start building a scenario we identify the catalyst event, the “what if.” And we do this avoiding the shotgun approach of listing everything under the sun. Doing that is not very helpful; risk management has to be more than, “Be careful, anything could happen.” In fact, at any given time there are probably only a handful of material events to consider when building scenarios. Still, there can be market disruptions that seem to come out of nowhere, so astute advisors will want to consider the ill-defined “black swan” event, just in case.

Three Elements Of A Solid Scenario
A scenario is dynamic and multi-dimensional. A well-specified scenario, one that is open for a narrative, has three components:

First, there is a cloud of uncertainty around the impact an event might have on the market. The consequent market movement is uncertain, and will vary based on the vulnerability of the market. Without understanding the market environment, we can’t get a good read on the market implications of a scenario.

So once we have determined the type of scenario, we need to put it into the current market context, adjusting its magnitude for the current market reality. Unfortunately, almost all of the current approaches for projecting forward risk use historical returns. For these, the assessment of risk will only be useful insofar as the future is reflected in the past. But there can be no certainty about that. The obvious remedy for this weakness is to look at the market now rather than in the past, to include current market data in the development of scenarios. For example, if there is more leverage or concentration in the market than in the past, it will be more vulnerable. The leverage will amplify any need to sell, and the concentration will lead there to be more investors running for the door.

First « 1 2 » Next