Applying scenario planning to portfolio and financial risk: 6 steps to better risk management

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Back in the late 1990s I did considerable work applying scenario planning to financial risk management, using qualitative approaches to managing risk as a complement to quantitative methodologies such as Value at Risk. However financial institutions were generally very slow to acknowledge the value of anything not fully quantified, so I shifted my attention to broader strategic issues. I wonder if the finance industry is now more ready for these kinds of approaches.

Here is an article I wrote in 1998 in Corporate Treasurer magazine in the wake of the Asian financial crisis of 1997. The article has not dated, and remains completely relevant today. Just replace Asia crisis with the recent financial crisis of your choice.

Did You Forecast Asia? Scenarios In Portfolio And Risk Management

Did you forecast and respond effectively to the ongoing impact of the Asian crisis? The debate continues on whether or not the crisis was predictable, however the reality is that it was not effectively predicted. One of the major reasons is the strong bias in financial markets to making single-point forecasts. By their nature these cannot encompass anything except what is perceived as the most likely outcome, and thus blind us to the unexpected rather than help us to prepare for it.
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US equities: zero gains over the last 12 years, how about the next 12 years?

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In my misspent youth I worked in international equities sales for Merrill Lynch. That was when I was first introduced to the Capital Asset Pricing Model that still underpins investment analysis today. Aong other things the model suggests that the return on an investment needs to be commensurate with its risk to attract investors.

Through the last century the empirical evidence on equity market investment was that its returns relative to other asset classes was broadly in line with its volatility.

As shown in the chart below, for the last 12 years, since 1998 or 1999 depending on the index, there have been zero gains in US equity markets. It is important to note that this does not account for dividends, which currently yield approximately 2% annually for S&P 500. However there is an important psychological issue in zero gains in the index. And it is clear that dividend yields do not justify the exceptional volatility of equity markets over the last decade or so.


Click on the image for full size
Source: Google Finance
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Futurist conversation: Ross Dawson and Gerd Leonhard on the future of money

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My friend and fellow futurist Gerd Leonhard, who runs The Futures Agency (which I am part of), was recently in Sydney for a speaking engagement. We took the opportunity to record a series of conversations on the future. Here is our conversation on the future of money.

The key points we make are:
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The state of expert networks and the rising role of LinkedIn

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It is some years now since ‘expert networks’ have become a significant force, linking subject matter experts in science, technology, and business to clients, largely in funds management and finance, usually at very healthy hourly rates. Clients such as hedge funds that are investing in particular sectors or companies want to know more about issues such as the viability of drug development processes, or when they can, about internal issues like staff turnover. A survey showed that over 40% of institutional investors found that expert networks were an “extremely” or “very important” aspect of their company research.

Clearly there is the potential for insider information to be made available if people are currently, or even possibly recently, employed by the company in question. The expert networks, most notably Gerson Lehrman Group, which is reported to control two-thirds of the market, have strict clauses in their agreements about what can be discussed by experts. But sometimes things go too far. An FBI probe into a consultant working through Gerson Lehrman Group was launched in December. The New York Times recently reported that after their success convicting Raj Rajaratnam of Galleon of insider trading, federal authorities are turning their attention to expert networks.
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SEC opens the gates to crowdfunding and a new structure of capitalism

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This is significant. While talk doesn’t necessarily lead to action, a significant shift in capitalism could be coming.

On Wednesday US SEC Chairman Mary Shapiro sent a letter to Rep. Darrell Issa, chair of the House Oversight Committee. The letter is embedded at the bottom of this post.

Many have focused on the potential from the current SEC review to relax limits on shareholders for private companies, notably the rule that if a private company has 500 investors or more it has to disclose its finances. Changes to this and related rules could have a significant impact on capital raising for private companies.

Few seem to have focused on what I think is potentially a bigger issue from the SEC moves: opening up crowdfunding as a mechanism for equity investment. The Wall Street Journal has an interesting piece called SEC Boots Up for the Internet Age. The article begins:
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Conversation with Tom Stewart: intellectual capital, new reporting, finance and strategy

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I first met Tom Stewart in 1998 when I was involved in bringing him to Australia to speak about intellectual capital to the local business and finance community. We became friends and we kept in touch while he moved on from his role at Fortune magazine to become editor-in-chief of Harvard Business Review, and then to become Chief Marketing and Knowledge Officer at Booz & Co.

Tom came to Sydney a few weeks ago to do the keynote at the CPA Congress, and I was asked by the CPA Australia magazine In the Black to speak to Tom for the magazine. Here is the article.

In Conversation: Value Judgement

Tom Stewart discusses the new imperatives in corporate finance with Ross Dawson

Tom Stewart, keynote speaker at CPA Australia’s Congress in October, has a challenge for financial executives. “You are the executive in charge of knowing value,” he says. However, as he rightly points out, only part of an organisation’s value is captured in financial accounting.

The field of ‘intellectual capital’ proclaims that for many companies the most valuable productive assets are intangibles such as knowledge and business processes, and these need to be measured and managed better. The idea is far from new. Indeed, Tom Stewart was there from the outset, when his 1991 ‘Brain Power’ cover story for Fortune magazine first introduced the issue to a broad business audience.

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Seven trends driving the future of financial advice

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The main reason I haven’t been able to blog or Twitter much over the last week is that I am currently on a national speaking roadshow for a major financial services firm, hitting five cities in six business days, ending today. The firm is building relationships with its key financial advisors, hosting dinners in the best restaurants in each city, preceded by presentations from a prominent industry figure on the role of regulation and from myself on the big-picture future.

While I work across many industries, my background in financial services means I am often drawn back into the space. Some of my reflections on financial services trends are captured in posts I’ve written after keynotes I’ve delivered on the role of the reputation economy for professionals and financial advisors and the future of global financial services.

The future of financial advice is a massively important issue, not just due to the size of the sector, but also because quality advice is critical for many people in supporting their financial well-being. I will spend some more time delving into this issue, but for now here are seven key trends and issues that I see are driving the future of financial advice.

1. Transparency is making commissions more visible.

Transparency is an inexorable trend across industries, not least in financial services. Visibility of what are sometimes massive advisor commissions on financial product is shaping attitudes to what is fair and appropriate.

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How IT analyst firms can learn from investment bank research pricing models

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Gideon Gartner has just posted a great article titled Advisory Industry, a future redesign: the “Payment” Model, in which he draws on investment banking research pricing as a model for IT analysts and their clients. Gideon writes:

So in the Wall Street model The buy-side “analysts” will work closely with their most helpful and favorite sell side analysts, and buy-side “portfolio managers” will work with sell-side salespeople who funnel ideas and information from their research departments to the buy-side clients. During the year, when investment issues arise (many dozens of times each day), the BofA money managers and staff analysts will call several(!) appropriate sell-side analysts, and may even effectively triangulate among them until a level of understanding an issue, or a decision to buy or sell stocks or other investing instruments with traders, can be reached.

Not until the end of the year do the buy side money managers and analysts “vote” for those individual sell-side analysts and salespeople who were most helpful and influential during the past twelve months; and when this process is completed and the numbers added up, the decision is made as to the percentage of trading volume (e.g. money) to be generated for each of the brokerage ?rms for the next year! Thus the compensation will vary somewhat each year based upon trading volumes and perceived relative performance. Most important perhaps, new sell-side firms and analysts are added to the list since innovative and effective research and interactions will be recognized! (the sell-side firm will have sent all its research, and its analysts will accept phone calls hoping or expecting that content and interactions will be recognized and therefore compensated for their value).

He wraps up:

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Will there be capital markets for equity in people?

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I recently read the entertaining science fiction novel The Unincorporated Man by brothers Dani and Eytan Kollin. The premise is that several hundred years in the future everyone is incorporated at birth, with the government owning 5% and parents 20%. People trade equity in themselves for their education and development, then spend their life trying to earn back majority ownership so they can control their lives. Into this world an entrepreneur of today who underwent cryogenic freezing is revived, and refuses to cede ownership of himself.

This is not a new idea. In 1995 aspiring British actress Caroline Ilana, trying to fund her attendance at acting school, established a corporation with herself as the sole asset, giving shareholders 10% of her earnings. Andrew Lloyd Webber, Ben Elton, Julie Christie and many other celebrities she approached bought shares.

In their 1998 book Blur, Stan Davis and Chris Meyer wrote about the blurring line between being a laborer and a capitalist, resulting in the securitization of individuals.

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How reputation measurement will transform professional services

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Earlier this week I did the opening keynote at the AMP Hillross annual convention, with the title of Embracing the Future. Hillross, one of the most upmarket of the wealth management networks, is seeking to lead the rest of the market by shifting to a pure fee-for-advice model, and rapidly developing a true professional culture. My keynote was designed to bring home the necessity of individual and firm leadership at this key juncture in industry structure.

One of the central themes of my talk was the increasing importance of reputation for professionals. Clearly reputation has always been critical for any professional, and there are some parts of professional services markets where reputation is already highly visible, such as prominent M&A lawyers, who are identified by numerous client surveys. While clients of other professional services (for example audit or management consulting) tend to be more focused on engaging firms rather than individuals, there is a fundamental shift from corporate to individual reputation under way.

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