INDUSTRY INSIGHT
FINANCIAL PLANNING
Hampton
WEALTH MANAGEMENT
F
or the past 15 years, many investors have become disenchanted
with the stock market, spending most of their time recovering
from losses and very little time actually growing. They are feeling
the pain of loss much more acutely and have become more concerned
about avoiding losses than they are about achieving potential
gains. They sense that the financial markets are shifting with global
monetary policies diverging while growth rates around the world
are converging in a new era. How does one navigate the increasingly
turbulent cross-currents without getting pulled out to sea by the
undertow?
At the root of the problem is the fact that during one of the most
tranquil periods in stock market history, most traditional risk models
have failed during times of stress. All of the key pillars of “Modern”
Portfolio Theory were put into place between 1951-1973 during one
of the most tranquil period in US stock market history (“Prediction of
Systemic & Specific Risk in Common Stocks,” by Barr Rosenberg, 1973),
thereby incorrectly basing assumptions about future correlations on
recent past performance.
In the real world, these theoretical correlations are asymmetric
and unstable: observed correlations have actually declined during
bull markets and have actually increased during bear markets. In
other words, Modern Portfolio Theory breaks down in extreme
environments.
At the institutional level, world central banks are using proven
portfolio crash testing risk engines. An entire library of plausible
“what-if” scenarios have been developed by professional risk
managers based on today’s economic, financial, and geopolitical
circumstances, in order to analyze how portfolios would react under
different headline events.
Forward-looking stress tests overlaid with a behavioral finance
framework have become the answer to backward-looking risk
models - and are now available to individual investors through select,
technologically-evolved, financial advisors. Rather than fight the forces
of human nature, we can harness the natural instinct of risk aversion
to go get an investor’s “fair share” of the upside in the financial
markets, rather than at the casinos. These algorithms can be applied
to 401(k)’s, 403(b)’s, as well as accounts held away at any financial
institution. Custom risk mitigation strategies from over 1,000 variables
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can be assembled to create a worst case scenario for even privately
owned family businesses, real estate holdings, and/or executive stock
options/grants. The stress test results can provide clues where hidden
correlations lie that are NOT apparent during more normal times.
They enable a savvy financial advisor to work towards proactively
decreasing the effects of major drawdowns while keeping the investor
on track. (To be clear, stress tests do not predict the future, nor assign
probabilities to different states of the world.)
Despite the return of choppiness in what still remains unchartered
waters, the end result is an informed investor who confidently reaches
her financial planning goals, with the collaboration of today’s cyborg
financial advisor.
Michael Lynn went to Shady Side Academy and holds a BA in
Economics from Franklin & Marshall College, an Executive MBA from
University of Pittsburgh, and numerous securities and insurance
licenses, as well as financial planning designations. He resides in
Hampton with his wife, Judy Lee, and son Edric.
Hampton | Spring 2016 | icmags.com 15