Risk Management Planning for the New Normal

How to convert rapid change and uncertainty into powerful business-building forces

by Michael T. Carpenter

Michael T. Carpenter is a 35-year veteran of the investment business and the founder and principal of Carpenter Associates (www.MCarpenterAssoc.com ), a Boston-based strategy, sales, and marketing consulting firm. He consults and conducts workshops and seminars on risk management for advisers and their clients. He is also the author of the new adviser and investor book The Risk-Wise Investor: How To Better Understand and Manage Risk, published globally by John Wiley & Sons, Inc. Contact Mike at MikeCarpenter@MCarpenterAssoc.com.

As much as we'd like to think so, there's no such thing as "normal" anymore. Our world is continuously evolving. The "new normal" we've been hearing about is not a new period of stability either. Instead, it's a spectrum of continuous, universal, accelerating change where the longer almost anything appears stable, its eventual change is more sudden and dramatic.

Living and investing as we do in the most rapidly changing period in human history on all fronts, increases the uncertainty of all our futures and demands that we better understand, plan for, and more effectively manage the uncertainties and risks we'll face. If not, with what's at stake never more important, we'll suffer potentially severe consequences that could have been minimized or avoided with understanding, planning, and preparation. People worldwide have never faced our current level of broad-based, rapid change before. Of course, we humans do not accept change readily and dislike and are stressed by rapid change. This leads to people resisting change, not identifying or understanding the risks they face or how to effectively manage those risks, further elevating their uncertainty, anxiety, and fear.

Unbridled changes are occurring in every aspect of our lives and businesses, creating new challenges for investors and new opportunities for financial planners to meet that new, growing, and critical need. With the pace of increasing worldwide change continuing to accelerate, stimulating even more investor uncertainty, helping investors identify, understand, and manage uncertainty and risk in a user-friendly way they can understand will become an increasingly important part of full-service personal financial planning.

Risk Management for a less Certain World

More than 150 years ago, Ralph Waldo Emerson gave us all some sound advise on how to successfully confront the challenge of helping investors tackle the anxieties, concerns, and fears associated with uncertainty and change when he observed, "Knowledge is the antidote to fear." However, recognizing that truth and putting it into practice are not the same.

Major corporations began addressing the issue directly more than 10 years ago, when in recognition of the numerous benefits of comprehensive, proactive risk management, they began establishing the new C-suite position of chief risk officer (CRO). In that role, the CRO manages the firm's various forms and levels of risk across the entire enterprise's spectrum of activities. In effect, the thousands of firms now with CROs are saying that the job of risk management is too important to their success to be managed by anyone other than a C-suite executive dedicated to the task full time.

The big question is: Where can individual investors find their own, personal chief risk officer? Who can individuals seek out to help them understand, prepare for, and manage the risks they're most concerned about and those they face but don't recognize? Who can help them understand and address those risks in a comprehensive and direct way both right now and in the future? For the vast majority of individual investors the answer is no one.

That common problem for individuals is an enormous, worldwide opportunity for financial planning professionals everywhere. Imagine the potential in meeting the immense and growing need for personalized risk management planning services, combined with personalized financial planning. The two services are highly complimentary. Since financial planners are involved and familiar with both short- and long-term risk issues via their experiences virtually every day of their professional lives, planners are more perfectly positioned to fill that unmet need and help investors identify, understand, and manage all their risks than any other group of professionals.

Planners who meet this large and expanding unmet investor need will not only help reduce their clients' fears and anxieties, they'll also help clients improve the likelihood of reaching their financial objectives. Combining comprehensive risk management planning with financial planning will also help clients develop more realistic expectations and plans, while also build more open, deep and trusting adviser/client relationships. As a byproduct, those planners will generate more revenue, attract more referrals, and gain a strong competitive advantage. Every global trend now suggests that personalized risk management planning will become more vital and more important in the future.

In thinking about the possibilities, two questions must first be addressed:

How is the personal risk management planning described above different from the portfolio-level risk management already built into asset allocation and diversification methods already used by most planners?
How can personal risk management planning be integrated into an existing planning practice and process?

Holistic Risk Management Planning

The personal risk management planning I'm suggesting is broader that just portfolio risk management. This holistic, "Risk-Wise" method is founded on the power of knowledge, understanding, and preparation; not just statistics. It's based on the fact that for risk management to succeed, it must first be understood and accepted in our brain before being implemented in our portfolio. Integrating the qualitative risk management practices that take place in our brains (and that we use constantly in our daily lives) with the quantitative methods of modern finance that are implemented at the portfolio level is a more effective alternative. It is more effective because it applies the basic fact that it is extremely unusual to be harmed by the risks we know about, understand fully, and thoroughly prepare for both mentally and in our portfolio.

There are numerous examples outside the investment field that prove the outstanding value of studying risks, thinking ahead, and preparing for them. They serve as outstanding, real-world risk management models that financial planners can use very effectively with their clients. The success if this method is based on:

Identifying risks,
Understanding those risks, and
Thoroughly preparing for those risks, in advance.

Examples of Effective Risk Management

Following are just a few examples that illustrate the power and success of this risk management method, and how it can convert risks that actually do occur from potential disasters into inconveniences.

1969: In a triumph of stunningly successful risk management, focused effort, technical achievement, and historical import for all mankind, President Kennedy's 1961 challenge to "land a man on the moon and return him safely to Earth by the end of the decade," was spectacularly achieved, in just under eight years.

2002: A major earthquake struck Alaska along the Denali Fault, which passes directly under the trans-Alaska oil pipeline, carrying up to a million barrels of oil per day. Yet, because of successful risk management in truly understanding the risks, design of the pipeline system to address them, and the quality of the maintenance, surveillance, and emergency preparedness, not a drop of oil was released and a potential catastrophe was averted. This event serves as a powerful example of the many beneﬁts and cost effectiveness of properly executed risk management.

2009: The miracle on the Hudson River: On the afternoon of Thursday, January 15, Captain "Sully" Sullenberger, pilot of U.S. Air flight 1549, and first officer Jeffrey Skiles, accomplished a perfect emergency "splash" landing of their Airbus A320 aircraft with 155 people on board on the Hudson River, adjacent to midtown Manhattan's 48th Street. Along with the incredible preparedness and actions of the New York City and New Jersey emergency services response teams, everyone on the aircraft survived, and the incident was universally declared a miracle.

More than a miracle, the entire incident was a remarkable testament to the importance and the beneﬁts of implementing the proven risk management principals of identifying, assessing, planning for, and thoroughly preparing for risks in advance.

Just a few examples:

Captain Sullenberger's skills and judgment gained in 19,000 hours of ﬂight experience and service as an aviation safety expert combined with first officer Skiles and their ﬂight crew's emergency situation training, turned a potential disaster into a frightening inconvenience. (Crew preparation included ﬂight attendants trained to only open an aircraft's front doors in a water landing, because opening the back doors, which one passenger attempted, can make the aircraft ﬁll with water and sink much faster.)
A320s are equipped with a ditch button in the cockpit, so just prior to a water landing the cockpit crew can hit that button and seal up the plane's fuselage, allowing the plane to stay aﬂoat longer; the planes are also equipped with passenger escape chutes at all aircraft doors, which also function as life rafts in case of water landings.
In another example of thoughtful emergency contingency planning, the A320's builders also installed an emergency power generator, called a ram-air turbine, which is designed to supply emergency power to a plane's ﬂight control systems in the rare event that both engines stop working. Had that in-ﬂight, emergency power generator not been on board or not been deployed, the pilot would have been unable to control the plane and the outcome would have been a disaster.
The continuous emergency response training and immediate actions of the Hudson River ferry crews, the New York City and New Jersey police, fire, EMTs, Coast Guard, plus all the other emergency responders was critical, given the freezing weather and ice cold water conditions. As one ﬁrst responder, a ferry captain, said, "We train, train, train, and this is where it pays off."

How to Implement Risk Management Planning in Your Practice

Integrating personal risk management planning into your practice is likely to be much less complex than managing the risks of traveling to the moon, managing earthquake risk for the Alaska pipeline, or commercial airline safety practices. It can be as simple as beginning to describe your service as both risk management and financial planning. Explain that your planning process incorporates risk management planning, because a major element of helping your clients plan for and achieve their investment goals is minimizing the likelihood and impact of negative surprises/risks that can happen along the way. Then, it's an easy step to ask clients and prospective clients if they'd like your help in creating their own personalized risk management plan and integrating it with their financial plan, if they desire.

Of course, many people, including your clients, have financial plans. But how many have personal risk management plans? Doesn't living and investing successfully in the most rapidly changing period in human history require both? The comprehensive identification and assessment of the risk faced by each client, very early in the planning process, makes planning, investment policy, portfolio design, and asset allocation easier and more effective.

The heart of this change is to insert a thorough personal risk identification and analysis session into the beginning of your client fact-finding and discovery process. The steps go in this order:

1. Discussion. This is not a brief, simple risk quiz or a cursory questionnaire. This is a detailed, two-way interview and identification by investors of the risks that concern them now and in the future.

2. Follow-up. Continue the discussion of the specific risks of greatest concern of each client, as well as the risks that you know clients will likely face and should plan for, even if those risks are not mentioned initially by the client.

3. Prioritization. Help the client to prioritize those risks based on the potential personal impact, even if the likelihood of the risk(s) occurring is low. Also, agree on risk management strategies for each risk.

4. Agreement. Gain agreement about the importance of integrating those risks and risk management strategies into the financial planning process and the financial plan document.

The "Risk-Wise" Personal Risk Management Planning Steps

Define risk (making sure both adviser and client agree on what risk actually is)
Identify risks (risks the client is most concerned about and those that must be addressed)
Understand those risks (likelihood, impact, and contexts in which they occur)
Prioritize risks (which risks to avoid, which to accept and manage, which to accept with no risk management)
Review risk management strategy options (understand both strengths and weaknesses)
Make your decision (as to which risk management initiatives to use/not use)
Implement
Ongoing monitoring (schedule regular ongoing plan reviews, which are easy to incorporate into your regular investor review meetings)

As with financial planning, after the initial risk management and financial plan is completed, a risk and risk management review should be part of the ongoing financial plan review process.

The Future of Risk Management Planning

Thirty years ago, financial planning was just getting started. There were very few planners, and there were very few people with financial plans. Even those people who had plans often didn't fully implement their plans, or they didn't monitor or update them as they should have. In 2010, things are very different. A financial plan is considered by almost everyone as the first, critical, and absolutely necessary step to achieving long-term financial success.

Comprehensive risk management planning is at the same stage of development today that financial planning was 30 years ago. With the continuously accelerating pace of change, increased volatility of all assets, further globalization, and both risks and opportunities coming at us faster and faster, we will soon see comprehensive risk management planning become much more common. Implementing comprehensive risk management planning into your practice will help you convert the forces of accelerating worldwide change and clients' natural anxieties about uncertainty and risk from business challenges to your clients' benefit and your own business advantage.

Editor's Note

This article is part of a Trends in Investing Special Report, which will appear in the June 2010 Journal of Financial Planning. For complete coverage of the Special Report, click here.

Related Events

Life-Cycle Investing for Financial Planners: July 26-29, 2010
Join the distinguished faculty of Zvi Bodie, Susan Fournier, Rick Miller, Robert Powell, and Paula Hogan at Boston University's Executive Leadership Center for this exclusive four-day event.