Putting aside recent market weakness, client portfolios have in a word been great since the Great Recession.
In fact, the average 401(k) balance has risen more than 450% since the March 2009 bottom, according to Fidelity Investments. But with things having gone so well for so long, it’s important to not be greedy let alone complacent.
Mike McDaniel, a former advisor and current co-founder and chief investment officer of investment software platform Riskalyze, likens stress testing to a lifestyle that includes regular exercise and a healthy diet. “It’s something you do so that you don’t have to bear something worse in the future.”
In a recent report, Matt Putnicki, executive vice president of Portfolio Management at PIMCO, foresees “increasing economic divergence and differentiation between and within asset classes,” and recommends stress testing portfolios to assess risks. “A synchronized global slowdown amid tighter financial conditions and increased political and economic uncertainties,” is likely, he writes.
A recent survey of 75 institutional investors surveyed by Wilshire Associates indicates that “geopolitical events are the most likely trigger for a sustained downturn.” And about 40% of those surveyed think U.S. and China trade tensions will be the “potential epicenter” for that swoon. Regardless of how it happens, here are four ways to limit risk.
1. Tech – Not Dreck
Even the so-called “best” technology can fall short if it doesn’t faithfully analyze the complexity of what it’s meant to assess. McDaniel says advisors need to be vigilant about making sure their technology systems aren’t providing a false sense of security. “You want to understand how the results [of the stress test] are calculated,” he says. “If the methodology is faulty and you are leaning on it, that’s a recipe for disaster.” Popular financial planning software programs include PIETech’s MoneyGuidePro, eMoney and Money Tree.
2. Keep Up With the News
Advisors need to be fully up to speed with what the latest twists and turns of what’s top of mind for investors be it corporate earnings, the Fed or Brexit. If not, it can be awkward making a recommendation when the client is better versed on a given topic. Even if an advisor doesn’t have a strong opinion on a topic, one should be able to explain what the market is expecting and to the extent possible assess the likely outcome of various scenarios. To clarify matters, Putnicki breaks down issues into those that are event-driven and economics-driven.
3. Have Clients Discuss Risk - Honestly
Despite being a four-letter word, “risk” is not a dirty word. Yes, scores of great businesses were born of tremendous risk. But for every dizzying success story we celebrate, a great many failures quietly and anonymously slink into oblivion. The best way to ensure that client and advisor are on the same page is the simplest: communicate. “Great advisors use consistent client engagement to focus on risk alignment,” says McDaniel.” A great recipe for reassuring clients, is to quantify how much risk they want, how much risk they need and then show them a tailored solution.”
4. Check Sector Exposure
If news headlines have taught us anything, it’s that sexy sectors, such as tech, attract the attention - and dollars - of clients. However, it’s an advisor’s job to replace the punch bowl with wheatgrass shots when necessary. “[A] good stress test is educational and depends on what lesson an advisor is trying to teach,” says McDaniel, who paints a scenario where, for instance, an advisor is trying to convince a client to not add more energy or technology stocks. A good stress test also would “highlight the risks associated with highly concentrated positions.” Though sleepy sectors, such as electrical utilities, often make the news for all the wrong reasons (a fire or massive power outage), they provide income, stability and downside protection. Sleepy sectors also offer another benefit. They help clients (and advisors) sleep at night.