Confidence Bands

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Confidence bands are a way of explaining risk in terms of what a “bad” situation or “good” situation might look like, with the focus usually being on the former. They are generally a statistical measure that uses the volatility of a portfolio to calculate a certain probability of a particular loss. The most popular version is the “95% confidence” band. For example: “There is a 95% probability that you would not lose more than 17% in any given year.”

The #1 Good:

By framing the discussion in terms of "likely maximum loss," clients can start to get a better sense of what a bad loss might look like for them, which is an important step on the path to understanding risk. It can also help mentally prepare the client for such a loss if it did occur. This might help them not to think that the market is "broken" and panic. Additionally, this loss can be translated from percent-loss to a dollar value loss if you know the starting size of the portfolio. Everyone understands dollars and cents.

The #1 Bad:

Some people might point out that the confidence bands are predicated on returns being normal, which they aren't. But, I think a bigger problem is that the 95% confidence loss is generally calculated based on historical volatility. The higher the historical volatility, the higher the loss estimate. Unfortunately, historical volatility tends to increase in periods of rapid market decline or dislocation. This has the potential to INCREASE the loss estimate as the market DECREASES rapidly, which is not particularly helpful from almost any viewpoint.

You can read the full article on Advisor Perspectives:

#financialadvisors #rias #wealthmanagement #wealthtech #fintech #investments

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