Modern portfolio theory — with its focus on volatility– can make risk assessment a rote exercise. It should be no surprise that this theory came of age in the 1950s, during a period of extended market tranquility.
While this traditional approach still has merit, it has limitations, especially when assessing the impact of market-rattling, black swan events like the ongoing COVID-19 pandemic. Over the years, it has become clear that doing that requires a broader set of risk analytics and data sources.
Enter scenario analysis. Not long ago, this approach was limited to the institutional world. But as artificial intelligence and data science continue to penetrate fintech, it’s now possible for wealth management firms serving high-net-worth investors to access solutions that allow them to incorporate it into their processes.
TELLING A STORY
Scenario analysis cannot wholly inoculate an investor against significant market losses. Instead, the idea is to drive a better, more rational decision-making process while using history as a guide.
In that sense, it’s a form of storytelling. For illustration, think about how markets reacted to other recent black swan events, such as 9/11 or the financial crisis.
If someone wrote a book about the fallout from each, the first chapter might cover a sharp market and economic downturn. The second would go over a series of “head-fake” rallies that bred both a false sense of optimism and greater uncertainty. A third chapter would detail the eventual sustained rebound.
Too often, though, scenario analysis doesn’t go beyond the first chapter — the initial shock — to explore the other parts of the story. That’s a problem because before advisers can positively influence their clients’ decision-making processes, they must consider all facets of these kinds of cautionary tales.
Doing that requires not only providing that additional context but being able to access the right analytical tools that can quantify the potential impact of a range of possible scenarios and then apply them to the unique concerns, goals and investment horizons of individual clients.
As most everyone in this business can appreciate, for 30-year-old clients with their highest-earning years ahead of them, a prolonged market downturn may not be the end of the world. In fact, it could present an attractive buying opportunity.
But for someone closer to retirement, it likely makes more sense to consider what asset protection strategies are available. Is modern portfolio theory enough? Or is it better to consult a robust scenario analysis process that considers the possibility that it could take years for the market to rebound?
PUTTING IT ALL TOGETHER
By definition, a black swan event entails something so extreme that it almost tests the boundaries of someone’s imagination. That’s why drawing upon history to look forward — and capturing all chapters of a story — is so important.
But even the best cautionary tales aren’t enough without the analytics to back them up. For advisers, that means taking a more quantitative look at client investment strategies and portfolios to beef up their advisory process.
Andy Aziz is the executive vice president of business development at d1g1t, a Toronto-based enterprise wealth management platform.