Risk Management Not Like Car Shopping

11 Mar Risk Management Not Like Car Shopping

Article repost and edited from original, Why Risk Management Isn’t Like Car Shopping | ThinkAdvisor. https://www.thinkadvisor.com/2015/02/26/why-risk-management-isnt-like-car-shopping

quant risk management has gone mainstream.

From risk systems for advisors to algorithms used by firms like Wealthfront, quant risk management has gone mainstream. These systems have gone from being housed on supercomputers at large institutions to cloud-based systems with calculations that cost almost nothing. However, as cheap risk modeling revolutionizes how everyone invests, it is essential to remember one crucial two-word question: “So what?”

Quantitative risk estimation on Wall Street has always been about attempting to hit the proper risk level. In the world of wealth management, this is equivalent to hitting the investor’s appropriate risk tolerance.

As robo-advisors and human advisors adopt risk management systems, they are focused on the risk tolerance aspect of risk system implementation. But risk tolerance is only one aspect of the answer to the ‘So what?’ question. The other one must be why an investor wants to take the risk in the first place.

After all, nobody wants any risk; in an ideal world, we would get a return with no risk (and as advisors know, some investors demand that). Risk-taking is our sacrifice to achieve our goals. So, a risk system that doesn’t directly address the impact on investors’ goals leaves out the most essential value it could deliver.

I like to use car shopping as an analogy to the investing process. When we buy a car, we are after certain things like performance, handling, etc. In order to obtain these things, we must incur risks. Vehicles are usually measured using crash test ratings from the Insurance Institute of Highway Safety. Let’s imagine what it would be like to buy a car with a view only to target our risk tolerance and forget why we are tolerating risk.

Car Shopper: “I am considering these two cars. Can you explain to me the difference between them?
Car Salesperson: “Sure thing. When hit from behind, the one on the left will give you a whiplash, and the airbag will break your nose. The one on the right will break several bones, including a collar bone, and may give you back pain for a good long while. Now, which risks are you ready to tolerate?

Car Shopper: “I’ll take the broken nose, please…”
It seems absurd, yet something like this happened when risk management systems created to target specific levels of risk for institutions began to be used by advisors, humans, and robots alike. Admittedly, some risk management is much better than none, and I commend advisors who are pioneers in using this new technology.

However, risk management in an advisory practice must rise to the critical next level. It must answer the ‘So what?’ question for the client, i.e., “Why am I incurring this risk? If I risk a large loss in a junk debt collapse or equity deleveraging, which specific goals am I reaching for? And if I reduce my risk, which goals do I need to give up?

Advisors already answer these questions for their clients. We advocate that they connect financial planning to the rigorous risk management process. Risk tolerance is a fundamental concept but not the only aspect of risk management.

While we agree that its importance far exceeds 10%, it is essential to address objectives, horizons, taxes, and the like to truly add value.