{"id":25,"date":"2022-05-05T01:46:00","date_gmt":"2022-05-05T06:46:00","guid":{"rendered":"http:\/\/wealthmanagementrisk.net\/?p=25"},"modified":"2023-01-26T09:33:39","modified_gmt":"2023-01-26T14:33:39","slug":"three-steps-to-growing-financial-advisory-practice-with-portfolio-crash-testing","status":"publish","type":"post","link":"https:\/\/rixtrema.com\/blog\/three-steps-to-growing-financial-advisory-practice-with-portfolio-crash-testing\/","title":{"rendered":"3 Steps to Growing Your Financial Advisory Practice With Portfolio Crash Testing"},"content":{"rendered":"

What is Risk Management?<\/span><\/h2>\n

Risk management<\/a><\/span> is top of mind for RIAs and their clients these days. No longer an exclusive province of quant managers, it is discussed regularly in the popular press. From the shortcomings of value-at-risk to the latest stress tests imposed by the Fed on banks, risk management has gone mainstream.<\/span><\/p>\n

But what is risk management? Many market observers and a surprising number of financial professionals seem to think that risk a manager must somehow know the future, peer into the crystal ball with some magic mathematics, or possess inborn clairvoyance.<\/span><\/p>\n

This is a fundamental misconception that drives people to devise ever new ways of predicting the nature and especially the timing of future crises. However, only a very small percentage of people have any ability to time the crashes, and inevitably risk management gets a bad reputation.<\/span><\/p>\n

The best metaphor for understanding risk management is that of car crash testing. The tradeoffs between performance and safety are analogous to the world of investment management, and the consequences of getting the balance of these two wrong can be dire both in driving and investing.<\/span><\/p>\n

Risk management is not about knowing the timing of the events or even what the event will be like in detail. Institute of Highway Safety does not forecast the detail of each possible accident. For example, if we are studying a frontal impact, we are not concerned with the specifics of accidents that this car might get into. We are simply concerned with the category of the frontal, rear, side, rollover impact and vehicle\u2019s vulnerability to it. How can this be related to portfolios?<\/span><\/p>\n

Importance of Stress Testing<\/strong><\/span><\/h2>\n

Stress testing is widely used by institutional investors. However, with recent advances in computing power this tool has become accessible to advisors as well. Stress testing allows the user to specify different scenarios and to measure how they will impact the portfolio return. It is a perfect tool for financial advisors to educate their clients about risk and improve portfolio construction decision making.<\/span><\/p>\n

The main reason stress testing is useful to advisors is that it is not a rear view mirror tool \u2013 it is a forward looking tool. For example, stress testing can show what is likely to happen to the portfolio when rates rise, something we haven\u2019t seen in decades. Adoption of stress testing is also crucial because investors do not want to hear statistical jargon (e.g. standard deviations or Value-at-Risk quartiles). They want to hear clear explanations of the strengths and weaknesses of each portfolio.<\/span><\/p>\n

For example, a portfolio can be hurt by interest rate changes, by interest rate changes and stock movements, by commodities prices; or by changes in diverse geographic markets, such as the US, Europe, Japan or emerging markets. RIAs need to design for all of these impacts to see how the portfolio responds. Combinations of any of these stresses and magnitudes manifest themselves in scenarios that can be named in a math jargon-free manner, using every day descriptions such as Global Stock Crash, Inflation, Global Recovery, Euro Meltdown, etc. Most clients will understand what these scenarios mean and an effective measurement and discussion of risk tolerance can take place.<\/span><\/p>\n

What exactly must advisors do to understand the risk of client portfolios? How can they use this information to add more value to clients and prospects? How can they communicate the results to the client to demonstrate that the value that has been added?<\/span><\/p>\n

We will consider three steps that advisors must take to incorporate risk management, specifically stress testing, into their daily process. These steps will introduce structure and predictability into the process, and add significant value for clients in a way that they can observe and appreciate.<\/span><\/p>\n

Incorporating Stress Testing Into the Client Interaction Process<\/strong><\/span><\/h2>\n

FINRA states in Rule 2111 that \u201c\u2026a customer\u2019s investment profile would include the customer\u2019s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs and risk tolerance.\u201d<\/span><\/p>\n

We could generalize these points into two categories:<\/span><\/p>\n