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Visualizing the benefits of risk management

by May 12, 2021Advisor Interviews

Visualizing the benefits of risk management

by May 12, 2021Advisor Interviews

Behavioral research often talks about the power of “visualization.” For advisors, it is a way of reinforcing for clients the importance of risk management in adhering to their financial and investment plans.

In February, senior market strategist and wealth advisor Steve Deppe wrote about an analogy between the strategy in a Kansas City Chiefs 2021 NFL playoff game and investor behavior.

In that example, the point was how financial advisors could help their clients with the concept of “behavioral adherence,” or sticking with a well-constructed and risk-managed investment plan even when times get tough.

Mr. Deppe concluded, “Clients are far more willing to stick with an investment plan if a significant percentage of their portfolio incorporates active, or tactical, risk-managed strategies.”

NASA’s Mars mission

Another recent event prompted some further thoughts about analogies to principles of investment management.

After its landing on Mars, NASA’s Perseverance rover kept much of the nation transfixed with the remarkable images it sent back to Earth.

After the culmination of the spacecraft’s seven-month trip through space, acting NASA Administrator Steve Jurczyk said,

“Perseverance is just getting started, and already has provided some of the most iconic visuals in space exploration history. It reinforces the remarkable level of engineering and precision that is required to build and fly a vehicle to the Red Planet.”

Risk management is paramount for any space exploration mission and is implemented in many ways through exhaustive preparation and testing and numerous system redundancies.

A scientific article noted,

“For NASA, redundancy is all-important. … From the dawn of the Space Age through the present, NASA has relied on resilient software running on redundant hardware to make up for physical defects, wear and tear, sudden failures, or even the effects of cosmic rays on equipment.”

In our advisor interviews for Proactive Advisor Magazine, I often ask the question, “Do you ever use analogies with clients in explaining your firm’s approach to investment management, and, specifically, to risk management?”

I have never been told about an analogy to space exploration, but several advisors we have interviewed are former Air Force officers or airline pilots.

One told us,

“The Air Force teaches the importance of emergency training first. … Investments are much like that in that we always need to be prepared with contingency plans in case of tumultuous times in the economy or the markets.”

“You don’t start thinking about what to do when the wings are on fire in a jet. … You should know that already. Same thing with investments in terms of having active strategies that are already prepared to react to changes in market conditions.”

Making risk management relatable through visualization

Behavioral psychology research often talks about the power of “visualization.” In the case of behavioral finance, this can often refer to visualizing future outcomes, like the eventual purchase of that perfect retirement home in the ideal location. It is a way of reinforcing the importance of discipline in adhering to a financial and investment plan, with definite goals outlined for the future.

“Visualization” is also a well-known teaching technique, one often used by financial advisors.

A 2018 article in Investor’s Business Daily noted,

“Advisors spend lots of time explaining financial concepts to clients. And they have a secret weapon to demystify complicated ideas: the analogy.

“The ability to compare a highly technical concept to something that’s easy for laypeople to understand requires a command of the subject matter. It also involves stepping into someone else’s mind—and conjuring up an image or story that will resonate with that listener.”

One of the analogies I often hear related to investment risk management is about as simple as it gets.

Several advisors have told me that they will ask clients the question, “If you were standing on a railroad track and a train was bearing down on you, wouldn’t it make sense to get off the tracks?”

When they get the inevitable head nod “yes,” they go on to relate this concept to the practical wisdom of employing risk-managed investment strategies that can reduce market exposure partially or completely when market trends and indicators are pointing toward a potentially significant market downturn.

An advisor in the upper Midwest uses weather extremes to provide an excellent analogy to tactical money management. He told us,

“On the tactical side, [we have] some excellent client materials and presentations that help explain active management … market cycles, risk and return, the math of drawdowns, and the need to play both offense and defense with your portfolios. We look together at some numbers showing how portfolios protected against downside risk … can perform over time versus just sticking with the performance of a market index.

“I also use some simple analogies. My favorite involves a thermostat. I will ask my clients what their ideal temperature is in their house all year round. Let’s say they answer 70 degrees. In [our area], weather can go above 90 degrees in the summer and below zero in the winter. However, if you have a thermostat, a furnace, and an air conditioner, you can keep your home at a comfortable temperature all of the time.

“That is the goal of tactical money management—to make your investing experience less volatile. Sometimes you need to run the furnace and other times you need the air conditioner. It is nice to have a thermostat to help keep things comfortable and under control. I try to relate this back to the markets and the fact that you cannot do the same thing in all market conditions—it just does not make practical sense.”

Seeing analogies come to life

I have heard many different types of analogies from advisors describing active risk management, with common themes revolving around sports, stormy weather, safeguards in building construction, farming, going on a trip, driving a car, or piloting a boat. They all have merit.

One phrase I particularly like is, “Having a risk-managed portfolio is like bowling with the bumper or guard rails raised on the lane.”

It also is gratifying to see risk-management concepts come to life, in real time.

Last year presented such an opportunity for financial advisors and investors.

2020 started at the tail-end of the longest bull market in history. In March, the coronavirus pandemic swiftly and unexpectedly plunged major equity indexes into a bear market.

Then, almost as quickly, the markets recovered, ending the year in a new bull market and making new all-time highs.

In speaking with several advisors about their experience navigating 2020 for client portfolios, those using the services of third-party managers who employ an active, “risk first” investment philosophy said they were quite pleased with the results.

An advisor from the Southwest told us,

“Our fee-based asset-management platform provides a variety of risk-managed investment choices to help retirees secure a better retirement. We believe in tactical asset management, where strategies can go ‘risk-off’ to cash, taking advantage of trends in the equities market whether it goes up or down. …

“Basically, all of our managers have offered timely webinars and other communications during this period. While I appreciate those efforts, I am much more interested in how their strategies are performing and if they are managing risk in the way they were structurally designed. I am happy to say that has usually been the case.

“I am also very interested in any tools that our managers can provide related to reporting and illustrating to clients how their portfolios have performed during this difficult and volatile market period. One of our managers has a user-friendly illustrative tool for each client’s portfolio performance, tracking their investments versus a predetermined personal benchmark. As I reviewed first-quarter [2020] performance with clients, they could see not only the overall trend for their investments versus the benchmarks but also how their portfolio allocations may have changed since the beginning of the year. That is very reassuring and easy to understand for clients.”

A California-based wealth manager said,

“I use a third-party unified management account platform that has a good number of tactical managers. I have been very impressed with most managers’ performance. When the market was performing strongly before COVID-19, my clients were generally outperforming the overall market indexes. Since the decline started, their drawdowns have been less than major indexes.

“Some managers have been doing very well in this market [first quarter 2020], not just mitigating losses but seeing positive returns. Working with several different money managers allows clients to have exposure to sophisticated investment philosophies and different strategic approaches, all developed by some experienced and capable people. That is, in my opinion, a way for me to add value for clients.”

However, financial advisors and their clients do not only want to mitigate drawdowns for their investment portfolios. They also want to employ risk-managed strategies that can take advantage of upside opportunity when financial markets rebound off lows.

One advisor on the East Coast reviewed his overall investment performance on behalf of clients for the entirety of 2020 (with the caveat that performance would vary by each client’s investment plan, risk profile, and time horizon.)

He said,

“I work closely with a specific third-party money manager to construct risk-appropriate, diversified client portfolio allocations for our clients. This manager uses quantitative, rules-based strategies that can encompass multiple asset classes, rotate between different sectors, and adjust market exposure based on the current environment.

“Our clients saw the benefit of this approach in 2020. Market risk was well-managed during the first quarter of 2020. Performance for the entire year, speaking generally across clients, was very good. Clients saw much lower drawdowns than the major indexes, yet total portfolio returns for the year were competitive with the S&P 500’s return, and in many accounts exceeded that index’s return.”

***

While it would be a pretty big stretch to compare a quantitative approach to investment management to a NASA scientific mission, they both do share a belief in the concepts of exhaustive data analysis, sophisticated algorithms and models, computing power appropriate to the task at hand, and “redundant systems” for managing risk.

According to NASA, the Perseverance rover mission is just one step in the Mars Exploration Program, “a long-term effort of robotic exploration.” Congratulations to all those involved for a job well done!

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.

Image by NASA/JPL-Caltech

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