Instead of Modeling Risk, Why Not Control It?
“Risk comes from not knowing what you’re doing.” Warren Buffett
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To be more successful in helping investors the professionals that provide guidance to wealthy investors need to step up and take control of risk rather than sitting around figuring how to estimate risk using complex models and simulations. All models are necessarily based on a multitude of critical assumptions and if any of those assumptions are wrong, and a few of them always are, then the model is worthless and actually does more harm than good. It’s better to acknowledge that you don’t know the risk rather than to proceed under a false assumption.
Maybe, just maybe something is wrong with the model. Maybe there is nothing standard at all about risk. Maybe there is nothing normal about returns. Maybe risk is not like a little dial we can control on clients’ portfolios like we tune in a radio…Or maybe, just maybe, reality is wrong
Are you starting to feel a little uneasy about the “stay the course” assurances that worked for so long? Should you be? Is the buy-and-hold, strategic-allocation-with-regular-rebalancing style of managing investments (the one service that you actually got paid to provide) really good for all seasons? Or is MPT and its efficient market hypothesis overly simplistic and maybe even dangerous to your increasingly restless clients and to your business?
Advisors need to consider how catastrophic events could help portfolios outperform.
More than one year after the collapse of Lehman Brothers and the subsequent meltdown in the financial markets, many long-held investment tenets are now being questioned. The validity and utility of modern portfolio theory as the prescription for prudent portfolio management is being re-examined. Dealing with this issue and developing solutions to cope with the revelation of newly uncovered risk is imperative if we are to successfully guide our clients through this tumult. It is equally imperative for our own survival to meet this challenge directly and develop strategies to navigate the financial minefield.
With two major declines over the past eight years, the stock market is on pace to underperform every decade over the past century, including the 1930s. During this time, modern portfolio theory represented the investment methodology most widely employed by advisors. It mandated a strategy of allocating funds to a wide array of asset classes in an effort to lower risk. The Holy Grail was to identify lowly correlated or even negatively correlated assets that would allow a portfolio to withstand the most severe declines.
21 12 2009
Traditional asset allocation is dead. Advisors that adapt to this new climate will survive–those that don’t will go the way of the dinosaur.
By Chuck LeBeau,
Modern portfolio theory is based on the premise that volatility is the best definition of risk. However, like many popular assumptions, that may not be entirely true. The equity markets of 2008 and 2009 took a rollercoaster ride and were overshadowed with unprecedented volatility which forced many to re-evaluate the industry and assess the changes that have come forth over the past years.
Although the basic fundamentals and principles of investing have remained the same, and successful investors continue to be the ones who can balance the risk and reward trade-off, it is now apparent that investors can’t control the reward side and that controlling the risk side is the key to preserving equity. In fact, a survey conducted by Charles Schwab indicated that 45% of investors would choose an advisor who provides products which protect them against market risks over one that doesn’t. This article will demonstrate how increased volatility, as measured by Beta, can be harnessed to provide higher returns without a commensurate increase in risk
By Chuck LeBeau
These are obviously tough times for financial advisors and their clients as many are wary of what lies ahead for the markets. To add to this uncertainty, investors are questioning their advisors as many of them failed to properly protect their client’s portfolios from a downward spiral. Declines in portfolio wealth have been so well publicized that The New Yorker published a recent cartoon which depicts financial advisors being sacrificed to a volcano. In this environment successful advisors will be those who effectively rebuild trust and loyalty.