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Are You Educating Your Clients on Tail Risk?

In February of 2020, markets experienced an event that nobody had predicted.

Responding to the fears around the impact of COVID-19 (Coronavirus) the markets fell over 10% within 5 business days, which we call a “tail-event” – an extreme event that has a very low probability of occurring.

Since most systems assume a normal distribution of returns, they ignore tail-events. This gives the appearance that a portfolio is well-diversified and will do well when markets fall.

This chart measures how well diversified a portfolio is by measuring its correlation to different asset classes like equities, fixed income, commodities etc.

The problem with this approach is that when markets fall suddenly and sharply, seemingly diversified portfolios that may have been carrying moderate levels of risk experience more losses than theory suggests as correlations tend to go to 1 and most securities start behaving as the market does. 

This results in catastrophic losses. 

The tricky thing about tail events is that it is not the probability of the event that matters, it’s the severity that matter.

To understand the impact of tail events, it is important to isolate them and measure their impact on the portfolios to see whether or not a portfolio would break down under extreme stress. 

This chart measures the losses in the portfolio under tail-event scenarios and quantifies them on an absolute basis as well as relative to a benchmark to see how the portfolio performed.

StratiFi makes it simple for advisors to measure the impact of such events and quantify it for themselves as well as their clients. 

It means that you can educate clients on such risks and earn their trust while protecting themselves.

You: “Remember John, when we talked about tail risk in your portfolio? We just experienced a tail-event in the markets and your portfolio behaved the way it was expected. We are monitoring the markets closely but you don’t need to panic. We had accounted for this in our plan!”

Client: “Yes, Mike. I remember you telling me about tail risk. I am so happy you warned me because I don’t know what I would have done otherwise. Thank you for looking out for me!”

Are clients thanking you for educating them about tail risk?

Karan Motreja Author

I help make life easier for financial advisors. With our PRISM Ratings Tool, your clients can finally understand the risks associated within their portfolio, giving you the ability to take concrete action to lower these risks, while giving your clients peace of mind.

Additional Advisor Resources

Bob Veres features StratiFi in ‘Inside Information’ February 2022 Edition

Bob asks, “Is it really possible that a portfolio risk assessment tool for wealth managers could be as sophisticated as the algorithms that institutional teams are using?”

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