Having a Formula One racecar with the braking system of a normal sedan wouldn’t be a problem—if the racecourse had no turns. In that case, flooring the gas pedal might get the racecar fastest to the finish line. To navigate through the corners of a typical racecourse, however, a driver needs a sophisticated braking system to not only avoid catastrophe, but also maximize the chances of winning.
A similar situation holds true with investment management: Having a portfolio full of fast-growing assets might be enough if life were a straight line with 100% visibility into the future. But just as a Formula One racecourse has tight corners, undulations and unexpected obstacles, the investment journey presents risks—both knowable and unknowable—that can disrupt the attainment of an investor’s goals if not proactively managed.
Unfortunately, over the past 10 years of economic growth and rising markets, simple “set-and-forget-it” strategies have frequently become the norm. And these strategies are insufficient, especially for wealth managers supporting high-net-worth investors with more complex needs. Sophisticated portfolios require that financial advisors possess not only the right mindset but also the risk management tools—the high-performance braking and other control systems as it were—to help their clients to achieve their investment objectives
Effective risk management of an investment portfolio is much more than just setting asset allocation constraints. Just as a racecar driver needs to master both the gas pedal and the brakes simultaneously throughout the race, risk needs to be monitored as dynamically as performance is—and in an integrated way. Here’s what advisors should consider as they build their risk management capabilities.
Risk Management Shouldn’t Be A One-Off Exercise
All too often, risk management is a check-the-box task that financial advisors focus on at the start of the client relationship but infrequently revisit, if ever. The reality is, of course, that market conditions, priorities and goals all change: risk is fluid and advisors must proactively monitor and manage it throughout the client life cycle.
Just as a racecar driver applies the gas and the brakes differently through the corners than down a straightaway, an investment portfolio should also be managed appropriately to the economic conditions—whether recessionary or expansionary. It must be managed by looking ahead and not behind so that risk can be mitigated when entering the corners, but still allow for optimal acceleration when coming out of them.
Similarly, an investor’s time horizon or how far away they are from achieving their goals at any point will have an impact on the way their investments should be risk managed. A few missteps due to over aggressiveness at the beginning of a race can be justified if it means improving the chances of getting out front. But, with a few laps to go, the perspective will change depending on how successful the driver has been to that point. If the racecar is well ahead of the pack with a high likelihood of meeting their objectives, a good driver will adjust and handle the car much differently, taking less risk than if the car was far behind.
Tools To Manage What Lies Ahead
While advisors can’t predict the future, they should equip themselves with the appropriate analytical tools to gain a better understanding of the risks the future could present to their clients—and on an ongoing basis Once the exclusive domain of the largest banks, hedge funds and asset managers, these institutional-grade risk management and scenario analysis tools can now be leveraged by firms who invest in next-generation digital wealth management platforms.
But risk is not about a single number no matter how sophisticated that number might be. Even institutional investors have been guilty in the past of overly relying on one metric such as tracking error or value-at-risk. As useful as these measures might be, good risk management must be much more holistic than that.
It requires interpreting a vast array of information and synthesizing a range of tools and analytics. A successful racecar driver would never just set their car on autopilot and call it a day. They dynamically monitor a range of instrumentation and, importantly, are constantly looking ahead for the unexpected. Similarly, investment portfolios must be monitored on a forward-looking basis—in terms of “black swan” events—as well as the risks that normal market downturns, could present.
As an example, scenario analysis—applying factor analysis to assess how today’s investment portfolio would likely behave if events were to unfold similar to previous market downturns—is an invaluable tool in assessing the resilience of portfolios under extreme events.
Races Are Won In The Corners
Anyone can accelerate in the straightaways to gain the initial advantage in a race. But most races are won by the drivers who know how to navigate the corners with precision. The ones who slow down react to the car’s movements and focus on stabilizing their car so that they can accelerate out of the corner with as much momentum as possible. They win because they understand that the exit from the corner is just as important as the entry—if not more so.
Similarly, it is short sighted for advisors to focus solely on returns while paying short shrift to identifying, assessing and mitigating risk. Risk and performance must be linked together at all stages of the investment journey for clients to maximize the chances of achieving their goals, and financial advisors must be as exacting and diligent in building out their risk management capabilities as they are in pursuing growth.
Dr. Andrew Aziz is executive vice president of d1g1t, an enterprise wealth management platform powered by institutional-grade analytics and risk management tools for family offices and high-net-worth-focused RIA firms.
