The ongoing financial crisis has shown that many individuals had no game plan in place to protect themselves in the event of such an occurence. Very few investors were prepared for the extent of the recent impact on a wide range of financial instruments. Those with diversification and minimal leverage and long-term asset allocation strategies have suffered, but not to the deep extent of those who were not prepared. That is why risk management strategies are essential in dealing with risk exposures -- from large corporations to individuals.
Part of a financial advisor's duty is to provide an environmental scan of potential risks for clients. It is vital to know people's ability to suffer losses and tolerate risk in their portfolio. According to Nassim Taleb, author of "The Black Swan" and speaker at the 2009 Society of Actuaries' Annual Meeting, the goal of risk management and environmental scanning is to turn a lack of knowledge into tools that aid decision making.
A recent actuarial survey on emerging risks conducted by the Joint Risk Management Section, jointly sponsored by the Society of Actuaries, Casualty Actuarial Society and Canadian Institute of Actuaries, revealed insights that are not only relevant to corporations but also to individuals.
Rudolph states, "Emerging risks can be thought of from two perspectives: completely new risks that have never been seen before, and risks that are evolving in unexpected ways. Examples of the former include the release into the human population of the AIDS virus and the development of a previously unknown weapon, while the latter would include the home mortgage market in the United States."
This emerging risk survey was conducted in late 2008, and a total of 89 responses from risk managers were received. Rather than developing a unique set of emerging risks to consider, a set developed by the World Economic Forum (www.weforum.org) was chosen as reasonable. The 23 risks developed by the World Economic Forum fall into the following categories: Economic (5), Environmental (5), Geopolitical (7), Societal (4), and Technological (2).
The top responses for the emerging risks with the greatest impact over the next few years resulted in these top five responses:
- Blow up in asset prices/excessive indebtedness (64%)
- U.S. current account deficit/fall in U.S. dollar (48%)
- Oil price shock/energy supply (39%)
- Middle East instability (34%)
- International terrorism (29%)
There were also a variety of questions that were unique for current topics from a personal standpoint. In response to a question on personal investment portfolios prior to fall 2008, 67 percent said "same as usual," while 18 percent were more conservative with investing and 15 percent were more aggressive. By comparison, the responses for current personal investment portfolios were 26 percent more conservative than usual, while 54 percent said they would act the same as usual and 20 percent planned to be more aggressive with investing than usual. When looking to 2009, it comes as no surprise that 60 percent of respondents rated poor expectations for the global economy, 35 percent rated moderate and three percent good.
The survey also asked about enterprise risk management-focused activities in 2009. Given the current environment and the background of the participants as risk managers, 65 percent expected the activities for their organization or clients to increase.
These survey results can help in understanding the amount of risk your clients can tolerate. It is imperative that clients must be disciplined before another storm comes. They must look at a long-term strategy that fits with their risk appetite. For actuaries, it is important to look at not just the best estimate, but the adverse scenarios. Propose several theoretical adverse scenarios to your customers and see their reaction to turbulence. This survey showed that 64 percent saw the largest emerging risk as a "blow up in asset prices/excessive indebtedness, personal assets, such as housing, collapse in the U.S. and Europe, fueling a recession." Unless you consider the implications of the worst case scenario, you have not fully protected your client.
Second, diversification can be a powerful tool, as noted in the survey. Investors nearing retirement that had an equal balance in fixed income and stock could have suffered a 20 percent decline in their portfolio in 2008, versus a person who had an all stock portfolio that suffered at least a 40 percent decline. That portfolio that saw a 20 percent difference last year could make the difference between leaving the workforce in retirement and continuing to work.
Third, be careful about overreacting to the current situation if you have a long-term view. Shunning stocks after a large decline is the wrong message from past history. "Markets tend to overshoot in both directions," wrote the late financier Leon Lacy in his memoir, The Mind of Wall Street
. "Just as we saw stock prices rise far above the value of the companies, we are likely to see the reverse. Stocks will then be undervalued, and there will be new opportunities for the investors."
The timing of the recovery is uncertain. During the Great Depression, equity investors suffered a negative 20.2 percent real return from 1929-1932. However, the stock market soared 66.7 percent in 1933. Young investors bold enough to gamble in stock during the Depression's dark days would see their funds grow ten-fold by retirement in the late 1950s. Note that in this survey, most actuarial risk managers are keeping their own personal portfolios constant even though the vast majority are predicting that 2009 will be a poor year for the economy.
Finally, as a financial advisor, this is a very important time to work with your clients on a systematic rebalancing approach. It is during volatile times that a consistent plan that forces dollar cost averaging can pay off. It pushes the investor away from timing the market with the volatility that there can be further erosion in asset prices. It is important to realize that we have had downturns and crises previously, and the markets do eventually recover. Many customers are now underweighted in equities following the market decline; however, rebalancing the entire portfolio on one date is likely not prudent. As a financial advisor, you can help to create the right personalized plan and personal risk management strategies to enable the customer to slowly and consistently rebalance to their long-term allocation.
Just as a chief risk officer of a company must carefully prepare his firm to succeed across a wide range of scenarios, this is the time to act as a personal risk management strategist to make sure your clients are ready for emerging risks. Leading them during this volatile time will ensure that they are ready for emerging risks that have not been seen before. This truly is a time to add enduring value to customers that will solidify your relationship for many years into the future.