Justin Blesy, Asset Allocation Strategist, PIMCO:In the last five years, we've had, you know, very low volatility environment. You can almost be lulled into sleep about forgetting about the potential downside of these portfolios.

So, so Steve, maybe to start us off, how do we think about kind of building in, uh, some of these stress scenarios into the way we construct portfolios?

Steve Sapra, Client Solutions & Analytics, PIMCO:One thing maybe I'll address first is, is complacency, and this sort of gets to some of the kind of behavioral issues.

You know, if you look at kind of what market volatility has been like for the last five or so years, it's actually been relatively low, certainly low by, by historical standards. And this is exactly the type of environment where investors can get complacent. You know, "Why am I not keeping up with the S&P 500?" You know, "Maybe I need to take more risk."

And this is why we utilize, actually, very long-term volatilities, 20-plus-year volatilities when we construct, uh, when we construct our model portfolios.

If you think about the last 20 years, there's a lot of stress periods in there. Obviously, everyone is familiar with 2008. There was a recession in 2001. There was the Asian financial crisis, the Russian financial crisis, the dot com bubble. There's been a number of stress periods.

And so, when you, when you build portfolios based upon long-run volatilities, typically you get more conservative portfolios, given the objective.

In terms of stress testing, this is another way to look at risk. You know, sort of the traditional academic way is standard deviation. But, but there's obviously other ways to look at risk too, and one of those is stress testing. And stress testing entails decomposing the portfolio into its constituent risk factors and seeing how those risk factors would have performed in historical stress periods, say the 2008 financial crisis, maybe the taper tantrum when interest rose—interest rates rose dramatically during the second half of 2013.

So, you want to look at risk, uh, in multiple ways, not just things like standard deviation or volatility, which most people do, but also get some idea about how the portfolio would be expected to perform under kind of different historical stress periods.

Justin: Maybe, uh, maybe for Mary and Mark — You know, and Mark, you mentioned it was a shock to clients — but what do you do with that information once you have it and you see what the portfolio could do in these different market environments?

Mark: Yeah. quite often it's a pretty eye-opening experience for advisors when they see it. And really, then, how do you communicate that appropriately to your client? So, with the home offices are trying to provide both the tools and then the, the mechanisms to allow for that, to facilitate that conversation. Is it an adjustment in the allocation? Is it thinking about their withdrawal rates differently? Is it thinking about tax management or planning a little bit differently?

So there's a lot of, uh, conversations that really jump off. As, as Mary sort of mentioned, it really starts with that plan. And it's always, if your home base is that financial plan, then you can adjust the portfolio, you can change in and out of strategies, you can outsource to solution providers much easier because, again, the objective is trying to meet the plan and the goals of the, of the client's plan.

Mary: And that modeling also helps train the client. Most of these home offices have, equipped their advisors with some really good, uh, financial planning software that employs stochastic modeling.

And so, the conversation becomes, "What does this portfolio behave like through sustained great markets or sustained bad markets or normal markets?" And advisors, the good ones I work with, really hone in on those sustained bear markets. And can we still meet the goal? What is the probability of success if your portfolio had to endure these sustained down markets?

And so, if the answer is yes, great. But when those things happen, the, the traditional emotions come through, but the advisor can go back and say, "Remember, we had this conversation, and look, everything's still on course, stay the course."

So the financial planning modeling is the science, but the art — and this is where advisors do, in fact, earn their fees — the art is holding the hands of the client even with the numbers in front of them that say, "You're going to be okay." And advisors are getting much better at training clients.

I just did a panel of advisors this week about that, and the market was very volatile. The question from the audience was, "Your phone must be ringing off the hook because of the crazy markets." And every advisor on the panel said, "No, not at all. We've trained our clients to expect this. Their plans can ride through it. And it's one day of volatility. And if that one day turns into one week, we might get one or two phone calls."

So, it's been an interesting engagement to watch advisors really evolve their way they do business with clients.

For more insights and information, visit pimco.com

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This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

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