The conversations we have been having with advisors this year have distinctly changed. During the bull market our conversations were focused on either building a practice or planning for retirement. Now the conversations have shifted towards risk management and preparing clients for the next market downturn. There is growing angst that clients expect advisors to proactively protect them against market downturns – they are anticipating the question “isn’t that what we pay for?” Advisors fear that if they fail in the next bear market, clients will leave.
Why worry now?
We are in the second longest running bull market in history, but it feels like it may be nearing an end. Advisors and clients alike would be hard pressed not to agree that the probability is greater that there will be a market downturn in the next five years than a continued bull market. And of course, the markets have been volatile and range-bound this year. Pinnacle’s Chief Investment Officer Rick Vollaro notes in his recent Market Review that global markets have softened and have broken lower. In a global market, markets tend to move together which means either the US market will pull global markets higher or global markets will pull the US lower.
What is the nature of the worry?
The severity of the last bear market has not been forgotten. The S&P 500 fell by more than 50% and it took more than five years to recover. The decline cost clients dearly not only in terms of asset value but in terms of time horizon to build (or re-build) wealth. It is not surprising that Pinnacle and many of the advisors with whom we speak are seeing growing interest among clients in investment solutions that participate in rising markets, but more importantly protect in declining markets. Current trends indicate capital preservation trumps capital accumulation.
Based on our conversations, the angst is greatest among those who employ more traditional passive investment strategies. These strategies rely on diversification and rebalancing for risk management. As markets have become more global, correlations have narrowed. Worse, correlations may race towards 1.0 in down markets indicating diversification is just not as effective as it once was. A growing number of advisors with whom we have spoken over the last year believe that risk management may better satisfy the expectations of clients in the next downturn than diversification and rebalancing alone.
Pinnacle faced this same existential angst following the Tech Bust. For many years, we employed a passive strategic asset allocation strategy too and our clients still lost money. We decided diversification and rebalancing alone was insufficient and additional risk management was needed. Today we offer clients the choice of four investment strategies that offer successively greater amounts of risk management. By adding risk management, our portfolio volatility declined, and risk-adjusted returns increased.
What is the solution?
“Preparing for the Next Downturn” was the theme of our annual Strategic Partners Forum this year with the 18 independent wealth management firms with whom we work. Our recommendation is proactive communication with clients. Now is the time to remind clients about the success in building wealth together over the last nine years and to begin preparing expectations for the next market decline. Now is the time to discuss whether it is time to bank those gains and shift to a more risk managed investment solution that is designed to defend against increased volatility and a potential market decline. Granted clients are loathe to pay taxes but that is a rich man’s problem. Better to pay Uncle Sam some than Mr. Market everything. Strong communication and the right investment strategy will go a long way towards addressing client expectations. Show your clients how an actively managed portfolio can help defend against both volatility and downside risk, and give them a head start on recovering their nest egg when the bull returns.