After a volatile week in the markets, the S&P 500 on Monday opened 7% lower, a big enough drop to trigger a 15-minute trading halt. A couple of weeks ago, we saw the worst stock market slide since the financial crisis of 2008.
We are in the midst of a perfect storm that was partially created by increasing fear surrounding COVID-19, the 2020 election and a Saudi-Russian oil price war. I’m sure that many people are panicking. But panicking at the wrong time costs people money. They panic and sell, which is why risk discussions with your clients prior to a market dip are so important. But it’s not enough to have a conversation about risk; the content of your risk discussion is equally important.
Most advisors have risk discussions with clients. However, the focus of the conversation is often on a range of reality for normal markets instead of market stress. This makes sense because unfortunately most tools focus on risk in normal markets. Market stress should be the real focus of any discussion about risk. There are two ways to have this conversation.
Historical Stress Test
It can be helpful to examine the client’s current portfolio against a previous market downturn. For example, how would the client’s portfolio have performed in 2008? This can give the client a better idea about what they are actually risking with their current portfolio and help determine if you’ve invested them in a way that actually aligns with the risk expectations you’ve set. The challenge with this approach is many of their holdings may not have existed at the time.
Use a Model that Predicts Risk
There are a lot of great financial technology options available to help advisors predict risk. However, it’s important to remember that most risk models focus on two standard deviations, in theory covering 95% of market situations. The biggest problem with this process is that it dramatically underestimates both the frequency and impact of the major events.
Consider this hypothetical situation. Let’s say 95% of the time you earn between -6% and 10% in the next year, but 2.5% of the time you earn between 10% and 60% (right tail) and 2.5% of the time, you lose between 6% and 90% (left tail). If you follow the traditional method of talking about risk, you’d be talking about the range of reality between -6% and 10%, with an irregular chance that your returns will be outside that range.
Your clients that are in the retirement transition and beyond are less concerned about normal markets than they are about the “left tail.” They want to know, “if it gets bad, how bad could it get?” In the traditional method of explanation, you might say, “worse than -6.” That’s not a great answer, because it doesn’t prepare them a potentially rough ride. A better way to answer the question is to take the average of all the possibilities inside the “left tail” instead of just focusing on when the left tail begins. This idea of looking at the average of bad scenarios is called an “expected tail loss” methodology and is likely a better way of talking about risk with clients.
This all assumes that the bell curve above is actually representative of market returns, when in fact we know it is not. In 1964, famed mathematician Benoit Mandelbrot observed that market returns exhibit “heavy tails.” In other words, big events, whether positive or negative, happen far more often than the bell curve would predict.