Equities  

Model behaviour

Clients are being advised to be ready to pull out of global stock markets at short notice, or when the “fruit starts running dry”, in light of the challenges to the world economy.

The report suggests that it is “momentum” driving stock markets, with price driving returns, not earnings. “Rising correlations between bonds and stocks are making well diversified ‘safe’ portfolios riskier than they appear”.

The report also outlines what has generally been accepted, that markets “cannot deal with tapering”, highlighting the uncertainties that central bank intervention brings.

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These escalating concerns point to the need for advisers to have a greater handle on the risk that their clients are exposed to than ever.

BlackRock presents its forecast for 2014 in probability terms – 55 per cent ‘low for longer’, 25 per cent for the ‘bull’ market case, and 20 per cent for ‘bear’.

Of course “pulling out of markets” goes against the orthodoxy of investing for the long-term – “time in the market”, not “timing the market”.

Nobody is suggesting that advisers who represent investors should adopt speculative strategies. But equally, as markets continue to evolve in new ways that cannot be aligned with previous experience, then the assumptions that derive from examining volatility on the context of past performance will only get you so far.

Volatility is not what it used to be. For example, the consensus of experts, including BlackRock, is that bonds are very expensive, and investors should be factoring in the likelihood of high volatility in these markets should a correction ensue.

Nobody can predict the future absolutely, but what an adviser can do is consider the full range of possibilities and put strategies in place that are optimised through diversification to perform across different possible outcomes.

Volatility

Modern portfolio theory’s concept of the ‘efficient frontier’ based on volatility measurements is no longer sufficient in the light of what we have learnt in recent years. But if volatility can only take you so far, how else can investment outcomes be modelled?

I believe this is the role of the stochastic modelling – estimating the probability of outcomes within a forecast to predict what conditions might be like under different situations.

If an adviser uses a stochastic model, then a couple of things happen. First of all the adviser must have faith in the model. If so, the adviser has a comprehensive ‘qualitative’ measure for risk that can be included with the ‘qualitative’ research on which they normally rely.

This is significant because, as many advisory firms attest, it is difficult to acquire an objective measure for risk. Because there is no ‘qualitative overlay’, there is a consistent process for assessing risk. Secondly and most importantly, the basis now exists for a comprehensive discussion with the client about risk.

It might go something like this: “Mr/Mrs Client, according to our risk model, which has been proven to be accurate in the past, we can predict the growth of your holdings over, say, the next 10 years. You can see that there is a 5 per cent possibility of losing up to 15 per cent of your portfolio in a bad year (we call this the ‘capacity for loss’ figure).