Have you ever listened to an academic or a “quant” and found yourself wondering if you truly understood everything they said? Or, as an advisor, have you ever found value in listening to a smart, credentialed colleague and wished for an academic overlay to those well-founded comments?

The purpose of this ongoing series, which is exclusive to ThinkAdvisor, is to provide our readers with two distinct perspectives on the same topic – one from an academic, the other from a practicing financial advisor. In “The Advisor and The Quant,” we will pose one specific question to the advisor and the quant. You will see their responses here on ThinkAdvisor.

If you have a question or two, please send them to us using the form at the end of this article.

Learn more about The Advisor, Joe Elsasser, CFP, and The Quant, Ron Piccinini, Ph.D. 

QUESTION: A market crash is inevitable. What should advisors and their clients do now to be prepared?

JOE ELSASSER, CFP, PRESIDENT, COVISUM:

Few would argue with the old adage “Practice makes perfect.”

We’ve all been through a few market crashes: Black Monday, the tech bubble, the Great Recession … yet each one feels new. Why? Because our life circumstances were different at each point when we encountered a substantial market dip.

Let’s pretend I am 65 years old and on the cusp of retirement today. In that case, I was only 56 when Lehman Brothers collapsed. I may have been looking closely at what I needed to retire and pushing hard to get there, wondering if I’ll need to work a little longer or if it’s possible to retire a little early. I was only 35 for Black Monday and 45 while watching my tech stocks go in the tank. At each point, my life circumstances were completely different than they are today.

Now, at 65, I very well may be considering retiring from an income I would be unlikely to be able to get back if I had to return to work. My questions are completely different than they were years ago, and my anxiety level is much higher.

If I am considering retiring now, at age 65, I want to know if I’ll be OK if the market goes in the tank. Will I be able to continue to live my life the way I want to?

It is inevitable that another bear market will happen. If history is any indication, the likelihood is that it’s coming sooner, rather than later. The last thing 65-year-old me wants to do is watch the market dip to the point that I have to make major adjustments to my lifestyle, or possibly worse, sell out of my investments and forfeit the ability to recover.

How can I create a realistic way to evaluate real-life situations and have confidence that I will be OK, even if the markets turn against me at precisely the wrong time?

A well-equipped financial advisor can help clients “practice” for the inevitable downturn. New market risk software products help advisors reasonably assess the downside risk of an investment portfolio and test the client’s retirement income plan to determine whether or not the client would likely be faced with unacceptable changes in living standard. The beauty of a market at historical highs is that it is the perfect opportunity to do just that. And in the event the client can’t withstand the downside impact of their current investments, a good advisor can help them reposition to a portfolio that is more aligned with their ability to accept risk.

Keep reading for The Quant’s answer:

Ron Piccinini, director of product, Covisum

RON PICCININI, PH.D., DIRECTOR OF PRODUCT DEVELOPMENT, COVISUM:

There is risk and opportunity for advisors in the event the market corrects or crashes. From a risk management point of view, advisors need a game plan.

First, advisors need to estimate the impact of a market crash on their assets under management. For example, if stocks drop 50%, and most of the clients’ assets are in some variant of a 60/40 portfolio, then AUM would drop 30%. Moreover, if the remaining 40% in bonds is positively correlated to the market (most corporate bonds are), AUM could drop even more. This could mean significantly lost revenue for a while. Can your practice survive this reduction in AUM-linked revenue? The duration of the correction matters as well. A one-day crash with a quick recovery has a much lower impact than a situation where it may take 18 to 24 months to recover.

Second, it is likely that some clients will panic and will want to fire their advisors. This will lead to a further reduction in AUM. To estimate this effect, advisors ought to go back to their clients’ stated risk preference (from their risk tolerance questionnaires). Then they need to make sure that their portfolios’ downside risk is not higher than (and ideally, well within) their stated pain threshold.

Third, having a preemptive open and honest risk conversation with clients can work wonders in a crash. Ideally, clients should know what a bad scenario will look like. Most advisor software provides a 95% confidence level (2 standard deviations) — a good start, but unlikely to be sufficient. In 2017, risk professionals look at 99% confidence levels or higher, and use fat-tailed models.

The reason is because the standard Gaussian model is not suitable to estimate downside risk. Need proof? According to the old way, the 1987 crash should have happened once in 100,000 times the age of the universe. A drop of 10% in the Dow has a probability north of one in 50 billion. Advisors setting expectations using two standard deviations will look incompetent, at best, when a crash occurs. Clients who have proper downside expectations will be a lot more likely to stick with the plan and their advisors.

Finally, crashes can be fantastic opportunities to buy financial assets at a deep discount. Clients who understand this fact will keep some dry powder (liquid low-risk investments) now, to profit later.

– If you have a question or two, please send them to us using this form:

– Learn more about The Advisor, Joe Elsasser, CFP, and The Quant, Ron Piccinini, Ph.D. 

— Check out Black Swans, Trump’s Victory, DOL Rule: Black Swan Expert Explains on ThinkAdvisor.