Our New Normal
What were the odds of a virus reaching out of an obscure province in China to trigger mass isolation policies that devastated global economies, crashed markets, spiked unemployment and locked millions in their homes? While, individually, scenarios like this pandemic are extremely high impact/low probability events, advisors still need to help clients prepare for the reality that bad things do happen regularly. Each new crisis usually comes at us from a different place, so our planning for the worst must reflect that reality.

Just as we watch the news every day looking for factual updates on the pandemic's progress and for signals that the authorities have a plan to contain risks to health and strategies to infuse the economy, investors are looking to their advisors for reassurance and a plan for the future.

Advisors As Coaches
The advisor's value as coach in times like these is extraordinarily valuable and not easily supplanted by a discounted "Robo" model (which can assume that investors are always rational and acting in their own best interest). Quantifying the value of coaching is not easy but here is one way to think about it. In August 2015 the S&P 500 suddenly dropped around 11% on fears about slowing growth in China. That week logged record liquidations out of equity mutual funds and ETFs after which the S&P 500 fully recovered in 54 days and the market kept climbing for years after that. If an advisor was able to coach a client from bailing out that week, it would have taken almost one 186 years for the robo discount to match the value of the “lost” gains.

Be Consistent And Direct When Discussing Risk Tolerance
Investors looking at their portfolio statements today need their advisor to offer a realistic assessment and clear recommendations on what actions to take (or not). Advisors who are well prepared to have an intuitive and actionable conversation about risk that is backed by a structured process for monitoring portfolio risk, are more likely to inspire continuing confidence from clients. For example, an actionable recommendation might be: “This is not the time to sell based on fear and you are still five years away from retirement. If we are not fully recovered by that time, we can tweak your plan by having you work an extra year or maybe rent, rather than buy, that vacation house.” This conversation is much more tactical and actionable than simply reminding clients that stock market returns work out in the long-term. It also demonstrates how the plan is a living and flexible document with the client firmly in control of remedial options along the way.

From my perspective, the risk conversation is a critical one that should be an ongoing exercise that becomes a core component of the advisor’s value proposition to clients. In my continuing education risk classes for advisors, I suggest taking 10 minutes out of each client meeting to re-check the client's perspective on risk which can change with age, health problems, job change, divorce, the passing of a spouse, pandemic, etc. 

Those 10 minutes on risk are a good time to review the portfolio’s overall risk profile and highlight key risk drivers in terms of holdings and asset allocation. That does not mean that the riskiest holdings need to go—it only means that the advisor needs to flag them and explain why they are there. Holding an equity mutual fund is certainly riskier than holding cash but the potential long-term gains can help a client meet long-term goals. On the other hand, the client may be sitting on a large exposure in a former employer’s stock but hesitant to sell it and trigger capital gains taxes. The trade-off between tax avoidance and accepting the additional risk is a valid area for the advisor to probe.

The advisor can also use these risk conversations to periodically remind clients that diversification comes with tradeoffs. While the portfolio may be projected to lose less when the S&P 500 drops 20%, it would also be projected to gain less when the S&P rises 10%. Visualizing this tradeoff is important because it helps the client understand that they are not in a race with the stock market and also helps them stay calmer during periods of market stress, because they know that they are following their own plan. 

Risk Modeling And Client Expectations
When it comes to risk modeling, I am a believer that the best approach is simply asking a client a direct question, about a specific scenario, getting a direct answer and then logging that answer for automated monitoring. For example, by asking a client about a specific fear she previously raised, like a large market correction, the client may respond: “My husband and I are both two years from retirement. We are ok with losing 12% if the S&P drops 25% but would not want to lose the same percentage as the index since the 33% recovery could take too long at our age.” This level of tactical engagement is much easier when the client can focus on a specific scenario, think about how they really feel about it and provide clear, specific and useful feedback. 

How expectations are set on the front-end has an enormous impact on clients’ confidence and commitment to their financial plan during periods of stress. Educating clients on the limits of risk modelling helps increase their understanding of their portfolio dynamics and reinforces the advisor’s credibility. Anecdotally, clients understand that a one-day weather forecast is more accurate that 10-day weather forecast. They would quickly grasp that multi-year weather forecasts are a reach. As the expert in the conversation, the advisor needs to avoid overreliance on risk modeling based on rosy assumptions or the selection of benign market windows to model extreme events.

Additional Benefits To Risk Oversight
In addition to all of the advisor/client engagement benefits discussed prior, another key byproduct of the data, reporting and audit trail to support a structured daily risk oversight process, can also enhance the firm’s ability to comply with new regulations like the Care Obligation under the SEC Best Interest rules that take effect in June 2020.

No Perfect Way
There is no perfect way to model risk and no magic bullet for totally avoiding it in a diversified portfolio. Humility and intellectual honesty are critical when discussing risk projections with clients. The current pandemic is another object lesson that advisors and clients cannot control markets, but they can create flexible plans that allows clients to maintain control over their emotions and actions. Advisor/client risk conversations work best if they are early, frequent and based on facts—not hopes.

Aladin Abughazaleh is founder and CEO ATA RiskStation LLC.