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.