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November 15, 2016 at 09:43 AM
President-elect Donald Trump’s stunning win over Hillary Clinton was surprising indeed, but was it a black swan event?
Dr. Renaud “Ron” Piccinini, a risk authority and black swan expert, talked with ThinkAdvisor about the election, risk management and the DOL fiduciary standard rule. Basically, the answer is “No,” Piccinini says, a black swan did not take flight with Trump’s election.
Misleading polls and the unknown of whether “non-likely” voters would show up to cast ballots explain why last-minute predictions of an overwhelming Clinton victory were wrong, Piccinini says.
Co-founder of the risk consultancy, PrairieSmarts, the PhD wrote his doctoral dissertation on what are now known as black swan events three years before the bestseller, “The Black Swan” (2007), by Nassim Nicholas Taleb, was published.
Black swans are major, unpredicted events that typically wreak havoc.
Trump’s triumph over Clinton was not unpredictable. “Though the underdog won, a black swan event would have been if a third-party candidate, such as Gary Johnson or Jill Stein, had been elected,” Piccini says.
In our interview, the risk expert discusses why the polls got it wrong, while focusing broadly on more personal financial industry risks: the ones that face advisors as a result of the DOL fiduciary standard rule.
The regulation throws a harsh spotlight on need for risk management of both the client’s portfolio and the advisor’s practice. This entails reducing portfolio risk as well as accurately communicating risk level so that client expectations jibe with it.
First phase of the rule’s implementation begins in April of next year, though in light of Trump’s stated intention to decrease regulation, it might be eased or even stands a remote chance of repeal.
Today’s advanced computing power—especially cloud-based processing and storage – makes financial risk mitigation easier and more effective than in the past. Not long ago it cost millions to determine the risk metrics now available in software tools from companies such as PrairieSmarts. The firm works with advisors to determine and reduce portfolio risk, and how to communicate it to clients.
Before launching his firm in Omaha, Nebraska, in 2012, Piccinini, 39, developed risk models at TD Ameritrade and First National Bank of Omaha. Here are further excerpts from our interview:
THINKADVISOR: Do you believe that Donald Trump’s victory was a black swan event?
RON PICCININI: No, I don’t think it was a black swan event at all, even though the election result surprised some analytics groups.
What misled the pollsters, whom the media and voters were relying on for accurate information?
Polling in today’s age is a lot more difficult than it was 20 years ago – because of technology, cell phones, and so on. But if you look at “enthusiasm proxies,” such as yard signs and rally attendees, Trump clearly had the advantage. These same variables were predictive of Obama’s win. Two previous successful populist campaigns [like Trump’s] in Europe were, for example, Berlusconi in Italy and of course, Brexit.
What’s the reasoning behind the black swan theory, which goes back centuries?
One way of modeling the world is that if all swans in your sample are white, you can infer that no black swans exist because every swan you ever witnessed was white. However, if you observe that there are black horses, white horses, white geese, grey geese and so on, you may think that there are probably swans of different colors. Therefore, you should widen the possibility of [just] how bad things can go and not be surprised if they go there.
How much credence do you give to the black swan theory?
If, using the standard model, you define something that cannot be predicted as a black swan, then it’s a black swan event. But I would certainly welcome an example where you could not have assigned a decent probability to any market price move that we’ve witnessed in the last 50 years.
Supposing a black swan scenario of “how bad” things can go for financial advisors due to the DOL rule, what’s the biggest risk?
Losses in a portfolio that are behind the client’s expectation. With the rule, [not] documenting client expectations [poses a] new risk. Make sure that portfolio losses [would be] commensurate with clients’ expectations. Determine if they’re comfortable with that level; and if not, find a remedial solution.
Are there certain types of retirement investments that are best for FAs to recommend, given the rule?
Higher fee products have their place, but lower fee products are an expedient way to reduce legal risk. The DOL spin is that it’s got to be in the best interest of the client, and can you prove that.
There are several practice risks, including regulatory risk and reputational risk. Clients can take advisors to court, and there’s potential for class action suits. Please discuss the necessity for proper risk communication with clients.
