Scenario Analysis: "What-if" Stress Testing For Advisors
- Created: Tuesday, 10 May 2011 10:14
At the heart of investors' paralysis is a fear of the unknown, a fear of the many potential doom-and-gloom scenarios facing the US economy. Advisors can potentially ease clients' fears by quantifying them, and showing clients a realistic picture of the risks facing their investments. Many advisors have access to traditional risk analysis tools like Monte Carlo simulations and VaR (value-at-risk) tools. Unfortunately, these tools failed during the financial crisis. Monte Carlo and VaR suffer from the fact that they are backward-looking models which operate within the confines of "normal" markets - so that they cannot account for black swans like those we've recently experienced. While VaR models typically calculate the impact of a 2-standard deviation move in the markets, the financial crisis was at minimum a 6-sigma (standard deviation) event, and perhaps as much as a 16-sigma event!
Scenario Analysis provides a better way to address the big picture risks facing the economy today, the kinds of risks that keep clients (and advisors) up at night. Hedge funds and Wall Street trading desks have been modeling forward-looking scenarios for some time, and use these models to assess the risks (and rewards) of major macro events. HiddenLevers has now made this technology available to investment advisors, enabling advisors to stress test clients' portfolios through a range of "what-if" scenarios.
How does HiddenLevers Scenario Analysis work? We start by defining scenarios around macro themes like stagflation, rising oil prices, Euro Zone defaults, and more. Our economic research team creates assumptions around how economic indicators like GDP, inflation, interest rates, commodity prices, and more might react in these scenarios. HiddenLevers' analysis engine determines the correlations between stocks, ETFs, and mutual funds to the economic indicators. The HiddenLevers engine can then stress-test real client portfolios in each scenario, showing advisors where potential risks lie. While no projection is perfect, this approach enables advisors to tackle clients' fears head-on by looking
at real-world scenarios.
To learn more about HiddenLevers and Scenario Analysis, visit HiddenLevers and watch our upcoming webinar here at Advisors4Advisors on May 20th.