One of the more difficult lessons we learn as financial advisors is that our clients tend to forget the level of anxiety, and in some cases, absolute terror, that accompany bear markets. This bout of forgetfulness typically accompanies bull markets, or in the recent case, very long bull markets. Those advisors who guided clients through the bear markets of 2000 – 2001, or 2007 – 2009, remember the stomach churning levels of fear that accompanied the market’s daily grind to seemingly endless new lows. As risk markets make new highs and the current bull market extends its history-making advance, those advisors who are good storytellers should take liberal license in spinning tales of “the bad old days,” reminding clients who are focusing on greed that fear is the other side of that old coin. For those who prefer a more academic approach to client education, they might share the overwhelming data showing that long-term stock market returns are significantly lower than their historic averages, and volatility is significantly higher, following periods of high market valuations such as we currently experiencing. Don’t be surprised to find that clients forget the data but remember the stories, especially when the market news turns sour.
Another way to prepare your clients for bear markets is to translate percentage market declines into absolute dollar portfolio declines. Many clients will bravely state that they can wait their way through a 25% eighteen-month stock market decline. But they get more thoughtful when contemplating a $140,000 decline in their $1 million portfolio. Clients typically put dollar declines into the familiar context of losing current income or spending while percentages simply don’t have the same emotional connection. Try this, “Remember what it felt like to open your portfolio statement to see that the value of your portfolio was down $15,000 that month? How did that make you feel when you remembered that your portfolio declined by $7,000 the month before?” (I know that opening portfolio statements doesn’t often happen in a world where our clients go online to see portfolio stats… but go with me here.) And yes, clients often forget these forward looking “fire drill” conversation in the middle of the extreme decision regret that comes with every bear market, but it certainly helps to gingerly refer to these conversations when your client is asking you to change to a more conservative portfolio policy at or near a market bottom.
The question of how to best manage portfolios through bear markets begs the question of whether financial planners should “manage” client portfolios during different parts of a market cycle at all. After all, if you believe that a properly diversified portfolio sitting nicely on the efficient frontier represents all that can reasonably be done to mitigate risk in a bear market, and that rebalancing to a fixed mix portfolio policy represents advanced active portfolio management, then you and your clients are doomed (if you are a believer, the better word is “prepared”) to collect 100% of whatever market volatility comes your way, including those unfortunate peaks in correlation, and corresponding plunges in portfolio value, that occur with pesky regularity during steep market declines. For those advisors who refuse to incorporate more active strategies for managing risk, it is imperative that they educate clients about “worst case” historical portfolio declines. The message here is patience, patience, patience. As long as the client is willing to accept the implied short-term and long-term volatility of their investment policy derived on a needs basis through the lens of a well-crafted financial plan, then all should be well.
For those clients who prefer an additional level of downside risk management in dangerous markets, Pinnacle provides several options that fit the bill. Unfortunately, risk management connotes the frightening (for some) or enlightening (for believers) specter of market timing. Interestingly, managing client expectations is just important for active managers as it is for passive strategies. Clients should be willing to accept the implied volatility of their portfolio policy even though they’ve employed the services of an active manager that claims to employ a variety of methods to sell risk assets prior to a market decline. This client message makes sense when you consider that both quantitative and qualitative methods for managing risk have a disturbing tendency to “work until they don’t work.” In many cases, when managing downside risk the problem here equates to the “opportunity cost” of being out of the market in a stock market rally. Client education must include a discussion about the difference between opportunity costs to the upside versus collecting 100% of market volatility to the downside. For your risk averse clients, they will be eager to agree that opportunity risk is a risk that they are willing to take.
In Pinnacle’s case we have been managing risk since 2002, which leads me to my last observation. Beware of manager-driven, or quantitatively driven, strategies built on only one factor. It could be momentum, or value, or interest rates, or something else, but choose a strategy based on an underlying philosophy that more is better when making portfolio decisions. We call these factors “building blocks” to our investment view. Our conviction in the message from each block allows us to build our portfolio construction from the bottom up, and allows us to properly manage the perceived risks of making an investment mistake. Which raises the question, is buying, holding, and rebalancing, after a ten-year bull market, the biggest investment mistake of all?