Also, he says, don't put too much emphasis on Monte Carlo simulations, which can scare clients by showing them, for instance, that one out of 20 times, the money doesn't last as long as they do. On the plus side, the simulations often inspire 401(k) defined contribution plan participants to save more for retirement.

Markowitz cautions against "model risk." If you are using a specific type of investment model that tells you how to invest using fundamental, economic and/or technical data, the model may ignore or downplay the possibility of large losses that have a 1-in-20 or 1-in-40 chance of occurring, he says.

It's also important, he says, for financial advisors to identify their clients' risk exposure using five dimensions: their time horizon, their liquidity needs, their net income, their net worth and their investing knowledge and attitude toward risk. Educate clients about the risk exposure of their portfolios, he suggests.

"At any point in time, we look back at the past, and make our estimates and decisions for the future," Markowitz says. "The future is always uncertain. We should make our best estimates for 'the next spin of the wheel,' and then choose an appropriate point from the implied risk-return trade-off curve.

"Depending on our risk capacity, perhaps we will select a more cautious portfolio, loaded with lower beta securities or asset classes; or conversely, we will choose a point higher on the frontier, with higher yield, but with higher beta securities or asset classes.

"If the market goes up dramatically, those with high beta portfolios will be happy; if it goes down, they will be sad. You pays your money and you takes your choice!"


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