Second, a scenario does not affect “the market” uniformly. Depending on what occurs, different parts of the market, different risk factors will bear the brunt of the effect. In order to understand how a specific portfolio will evolve under a scenario, we must look at the underlying risk factors.
To see the important risk factors, consider one scenario of growing current concern: inflation. Companies with high leverage will be at high risk because many may need to refinance at a higher interest rate. Similarly, smaller companies will be at higher risk because they tend to have less bargaining power to pass on their rising costs.
Third, the event does not occur in one fell swoop. It follows a course over time: the time to the bottom ... or top, the time to the recovery. So the scenario should reflect possible responses over time. As an illustration, we show an ensemble of 100 of these possible realizations of how the U.S. market, as represented by the S&P 500 index, might respond in an inflation scenario.
Toward the top are possible paths where the event occurs and its effect fizzles, at the center of mass the educated best guess of the most likely path based on the historical investigation, and toward the lower part are the cases with a large impact. Advisors need to be able to discuss with clients the range of possible worlds, so to speak, that might develop over time. Not one number for a market drop, for example, and not even just the distribution of that drop, but also the time dimension for how the scenario might unfold.
Forewarned Is Forearmed
This scenario-based rehearsal of the ebbs and flows of investment markets is crucial since it not only affects clients’ actual financial prospects but also their willingness to take further risks. As advisors, we serve our clients by providing a “pre-mortem” of material events that might occur and how those could affect their portfolio and consequently how they affect attaining their goals. We use scenarios as a prime tool for doing this, scenarios framed in terms of a narrative that engages the client’s rational decision-making and that helps to overcome overly emotional responses.
Rick Bookstaber is co-founder and head of risk at Fabric. He previously held chief risk officer roles at Morgan Stanley, Salomon Brothers, Bridgewater Associates, and the University of California Regents and served at the U.S. Treasury in the aftermath of the 2008 crisis. He is the author of The End of Theory (Princeton, 2017) and A Demon of Our Own Design.
Tim Kochis is advisor to and an investor in Fabric. He is co-founder and former chair and CEO of Aspiriant. He previously led personal financial planning at Deloitte & Touche and Bank of America. He co-founded the Personal Financial Planning program at UC Berkeley and has written several books, including Managing Concentrated Stock (2d Ed. Bloomberg, 2016).