Guest Blog – Risky Business: Why Financial Advisors Need to Discuss Risk

Today, we welcome a guest blog post from Potomac Fund Management’s Manish Khatta, President + Portfolio Manager (www.potomacfund.com). As an asset management firm for independent financial advisors, Potomac is another firm that believes risk isn’t just a sexy buzz term but is something that your firm should be considering very carefully! Thank you, Manish, for joining us today!

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The financial world has many ways to talk about risk—alpha, beta, Sharpe ratio and so on—but at the end of the day, how much do clients, or frankly most financial advisors, really understand about these terms?  The answer is, not much.

No one really understands risk, so advisors and clients don’t talk about it and the consequences are significant. Only one in four clients say their financial advisor has talked about how much their investments may decline if the market crashes, per an investor survey by FinMason, a financial technology firm.

We like to think our advisors are different and constantly talk about the risk factors in the market using tools like our recent resource report on maximum drawdown.

We need to talk… about risk.

There is no good reason for advisors to avoid client discussions about risk. Unless you promote passive investments in which case you should avoid the risk discussion like the plague!

People think about risk and reward trade-offs nearly every day, most often outside of the context of the investment markets.

Consider these choices:

  • “Should I buy life insurance?” People weigh the risk of paying too much premium for a life policy, versus the reward of knowing their beneficiaries get some degree of financial protection.
  • “What should my car insurance deductible be?” You may reward yourself with lower premiums by choosing a higher deductible, but you risk paying more out of pocket if you have an accident.
  • “Should I go to the gym or stay on my couch?” You risk the poor health consequences of a sedentary lifestyle for the reward of easy entertainment.

I think all the sophisticated ways to measure and discuss investment risk make the discussion more complicated. Financial advisors need to keep it simple. The one risk measurement clients care about the most (whether they realize it or not) is maximum drawdown risk—how much can they potentially lose in a catastrophic market downturn?

Dear Financial Advisor:  Keep it simple stupid…

To us, maximum drawdown is the only risk barometer that really matters, for two primary reasons: First, maximum drawdown is easy for clients to understand—it’s all about how much pain they are willing to endure to seek adequate returns.

Second, maximum drawdown can’t be changed, obscured, hidden or beautified by other performance statistics. With any peak-to-trough drop in investment value, what you see is what you get. There’s no hiding or smoothing over the consequences of a significant loss.

For example, let’s look at the performance of one of the biggest funds in the market, Dodge & Cox Stock Fund (DODGX), during the years of the financial crisis and Great Recession (2007-09). Looking only at calendar years, this fund suffered a -43% decline in 2008, falling along with the overall stock market and most other stock funds, but rebounded with a 31% gain in 2009.

What these annual returns can’t hide is the whopping -63% maximum drawdown this fund suffered from its peak in 2007 to its trough in 2009. (See chart below.)

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The question that a financial advisor should ask a client interested in a fund with this kind of track record is, “Are you willing to tolerate the pain of a -63% drop in the value of your investment?” or even simpler “Are you ok with losing -63 % of your investment at any given time?”

Only the most aggressive investors would answer yes to this question yet trillions of dollars have recently poured into passive investments. In our opinion the aggressive investor is usually the first to freak out and sell everything, at the worst possible time. Most clients would recoil in pain over a catastrophic loss of this magnitude and be averse to investing their money at this level of risk.

How Potomac can help.

That’s why we believe a tactical strategy to manage risk and avoid catastrophic losses is suitable for all investors. (That would even include the most aggressive investors, when they’re ready to dial down their greedy impulses.)

We also believe all financial advisors should put maximum drawdown at the forefront of the discussions they have with clients about risk management. Using the pain of significant losses to frame the discussion about investment risk can help clients provide honest assessments of their true risk tolerance. Financial advisors can then use this assessment to place clients in an appropriate investment strategy.

We just published a resource report on maximum drawdowns for financial advisors and their clients. It shares more examples of the impact that drawdowns and catastrophic losses can have on investment portfolios to help clients get a better sense of their true risk tolerance.

To download Potomac’s Resource Report on Maximum Drawdown, click here and learn more.

Disclosure:

This information is prepared for general information only and should not be considered as individual investment advice nor as a solicitation to buy or offer to sell any securities. This material does not constitute any representation as to the suitability or appropriateness of any investment advisory program or security. Past Performance does not guarantee future results. There is no guarantee that an investment in any program or strategy will be profitable or will not incur loss. This information has been compiled from sources believed to be reliable but are not guaranteed as to their accuracy or completeness.

At certain places on our website we offer links to other Internet websites. These sites contain information that has been created, published, maintained or otherwise posted by institutions or organizations independent of Potomac Fund Management, Inc. (PFM). PFM does not endorse, approve, certify or control these websites and does not assume responsibility for the accuracy, completeness or timeliness of the information located there. Visitors to these websites should not use or rely on the information contained therein until consulting with their finance professional.

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