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Tail Risk – Your Clients Don’t Understand It … Yet

Tail Risk – Your Clients Don’t Understand It … Yet

If you thought the last few weeks in the markets were bad, you did not go to bed very happy Monday evening on March 3rd. Market breakers got triggered, and it was a historic day in the stock market one way or another. There is no way your clients are sitting comfortably at home this week, and there is always another advisor trying to convert them to their clients. What can you do?

Let’s first understand what has happened. Treasury yields dropped to less than 0.5% on the 10-year for the first time in history, futures markets hit their lower limit trigger, the DOW dropped over 2000 points, and oil markets crashed over 20% after OPEC and non-OPEC allies (OPEC+) failed to agree on terms of deeper supply cuts. Basically, we saw a series of extremely unlikely events actually happened in reality. We call these tail events. A tail event is defined as an extreme event that has a very low probability of occurring. Your clients likely won’t care how you define it.

Now, the thing Advisors usually tell clients and prospects is that building a properly diversified portfolio will allow you to have the greatest long-term returns because when some things decrease in value, others go higher. The beauty of negative correlation leads to your portfolio being along the efficient frontier of returns.

That’s great for a normally distributed set of returns over the long run but what happens to a properly diversified portfolio in tail-events like the one we are in right now? A properly diversified portfolio in this kind of an environment will still have lost a significant amount during the last few weeks as the markets have collapsed, save for if you have a substantial amount in gold, which has its long-term issues.

For example, using our internal diversification score, a portfolio might have a strong diversification risk rating like the picture above. That is generally what your advisor software will spit out when you plug in your portfolio, and it is a good strategy; it just doesn’t encompass what happens in, say, a sharp sell-off.

Tail Risk – Your Clients Don’t Understand It … Yet

So how do you get around this problem? First, you need to understand how risky your portfolio is including your exposure to tail risk. Then it would help if you educated your clients on what their portfolios will do during these events, so when the time comes as it inevitably does, they will not blame you for uncontrollable things. Times like these are never fun to go through, and your client base is likely to get stressed. With our software, you can prepare them for these events by setting expectations appropriately, and it will be easier to keep them to their designed financial plan or investment policy statements if you have prepared them properly.

The number one thing is client retention in the business, as it’s much easier to keep a current client than to find a new one. Shouldn’t you do yourself the service of being prepared? Our technology allows advisors to easily measure the impact of these events and quantify it not only for themselves but for their end clients (and compliance departments) as well. Trust is not easily earned, but easily broken, and is the most valuable commodity in this business. Being crystal clear with risks will help keep that trust intact during these difficult times.

Akhil Lodha Author
Co-founder & CEO StratiFi Technologies

Building the industry standard for understanding portfolio risk through cutting- edge technology at Stratifi.

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