NAILBA Perspectives Virtual Symposium Special Edition | Page 24

PORTFOLIO MANAGEMENT Estimating downside risk effectively Using outdated or oversimplified risk metrics leads to doubt and panic during market volatility. Joe Elsasser, CFP Joe is founder and president of Covisum, a financial tech company focused on creating software that improves lives through better financial decisions. Covisum helps financial advisors serving clients in or near retirement and powers some of the nation’s largest financial planning institutions. Contact Joe at [email protected]. More and more insurance producers are moving toward planning, specifically through the registered investment advisor route. For these advisors, the big question is not necessarily which portfolio should the client be invested in with all of their money, it’s how much of the client’s money belongs in investments, and how much money should be used to support basic needs with insurance products like annuities. These advisors can and should bridge the gap between the investment word and the insurance world. Weighing options For instance, if a client has a $1,000,000 portfolio that consists of 50% stocks and 50% bonds, their downside risk exposure is roughly $350,000. So, if the client can’t get through retirement with $650,000, then they should probably be invested differently in the first place. That’s the question of risk capacity. Alternatively, if the same client has $500,000 in a fixed annuity and the remaining $500,000 in the market, the potential loss is $175,000 rather than $350,000. While the annuity won’t potentially drive the same long-term returns, it may be beneficial because of its principal protection and lack of correlation to market moves. If the client can get through retirement with $825,000, after accounting for the lower potential returns, then incorporating an annuity into the client’s overall plan is likely a better path. Rather than changing the portfolio’s blend of stocks and bonds, retirement income advisors are increasingly considering how much is allocated to investments in the first place and how much is allocated to savings and insurance vehicles designed to guarantee a minimum level of income or return depending on product and case design. This is an example of using annuities to better manage client portfolios to the client’s risk capacity. Risk tolerance A second consideration is risk tolerance, which could be thought of as the maximum loss a client can handle before they capitulate and sell for fear that their investments could go down even further. Ideally, an advisor would never put a client in a portfolio that exceeds the client’s risk tolerance because even though it’s likely that the client would achieve higher long term returns in a more aggressive portfolio, if the client sells during inevitable dips, those higher long term returns would not be realized. In order to effectively plan for both risk tolerance and risk capacity, an advisor must have a good estimate of the downside exposure that is actually present in a client portfolio. Unfortunately, most risk software used by advisors doesn’t adequately capture the inherent risk in financial markets, primarily due to the methodology of these tools. Most risk estimates use a value at-risk methodology, coupled with a normal distribution (also known as a Gaussian distribution, or a bell curve). This methodology suggests that 95% of market returns fall within two standard deviations of the mean. While it’s the most common way of representing risk, markets don’t seem to fit this model very well. In fact, extreme market events happen with greater frequency and severity than the normal bell curve would predict. For instance, the bell curve would suggest that Black Monday should actually happen once every 100,000 times the age of the universe. 24 Perspectives Q3 Special Edition 2020