Preparing for the Next Bear Market: Why Market Timing Destroys Client Portfolios
Some people would suggest that the single most important service a financial advisor can provide is preventing their clients from market timing. Every year, we see the same pattern: retail investors significantly underperform benchmarks. They sell into the trough and buy back into the peak. The buy high/sell low trap, aka market timing, is the number one killer of performance.
Virtually every client onboarding process includes a conversation about risk tolerance. That is a good thing, of course, and it’s fundamental to financial planning and vital to asset allocation. It’s also where things tend to go terribly wrong if the advisor and the client aren’t speaking the same language. This happens far too often, as clients are asked to check a box if they are “aggressive,” or “conservative,” or somewhere in between.
How Miscommunication About Risk Tolerance Leads to Avoidable Investment Losses
The big problem is that there is no precise definition of what those terms mean. There may be a financial advisor out there somewhere who actually knows what “moderately aggressive” means, but if there is, we’ve never met them. The really big problem is that the client won’t discover what moderately aggressive means until their account is down 40% and panic sets in.
We know a lot about how the public stock and bond markets in America work. We have a robust and reliable database of securities prices going back almost 100 years. Even the most cursory look at a graph of the S&P 500 and its antecedents will show that the market has ups and downs but, over a long period, trends upward.
There have been 13 bear markets in the S&P 500 in the past 100 years. Most of them have occurred since 1950. A bear market is generally thought to be a drop of 20% or more. Among those bears have been four truly rough spots, and two of those have happened in this century. “Truly rough” is defined as a peak-to-trough loss of over 50%.
One hundred years is a long time, for sure, but two truly rough bears in less than 25 years are enough to destroy the financial plans of millions of investors. Keep in mind that those two bears were just 7 years apart.
The Financial Advisor’s Role: Educating Clients on Risk, Return, and Market Volatility
To our knowledge, nothing has changed that would cause stock prices to behave differently going forward. Our sense is that only a change to humanity could do that. Behaviors that led to the rise of the human race also cause problems for investors. These are things like the fight or flight instinct, herding, FOMO, regret, recency bias, and loss aversion. Advisors simply must accept that their clients are susceptible to these destructive behaviors.
Instead of asking, “Are you aggressive?” advisors should ask, “Can you handle a 50% loss on your stocks?” And, instead of asking nothing at all about bonds, advisors should ask if their client can handle a 10% loss on their diversified, investment-grade fixed income. There would be ample historical evidence to suggest losses of that magnitude are not only possible but, over the long haul, inevitable.
Explaining how the losses work would be a big improvement over using amorphous terms like “moderately conservative,” but it would only be a halfway measure. If an advisor truly wanted to educate their client about how markets actually work, they would explain that risk and return are related—that it’s the taking of risk that leads to the accumulation of wealth.
Realistic Financial Planning: How to Align Client Expectations with Market Realities
Domestic large caps have produced a roughly 10% average annual return for the past 100 years and have never experienced a negative return over any 20-year period. For wealth accumulation, and in the context of a diversified portfolio, the stock market has been where it’s at. Hedge funds and private equity and real estate, as asset classes, have underperformed stocks over time. Cash is almost always a wasting asset, and bonds have produced a small real return.
Most families need the exposure to stocks to achieve retirement security. A portfolio growing at 10% per year will double every 7.2 years, but a portfolio growing at 7.2% will take 10 years to double. The Rule of 72 is an ingenious piece of math. You can divide an interest rate into 72 to see how long a double takes. Or, you can divide 72 by a desired rate of return to learn how long a double takes. A 6% return would take 12 years; a 4% return would take 18. If you need to double every six years, you need a 12% average annual return, a number very few (if any) advisors would say is reasonable.
You must also remember that inflation is a silent killer. It’s the purchasing power you seek to acquire, not the absolute dollars. For example, $1 million in 1955 would be the same as $11.8 million today. While the stock market has produced about a 10% return over many years, in real terms, the number is somewhere near 7%. So, a doubling in real terms looks like a 10-year timeframe. If you’re 50 now, you have two doubles to go before you’re 70.
Now, we confront what “realism” actually means. It means none of us get out of this life alive. It means we have to deal with what’s actually obtainable. There’s an old phrase in money management, but it’s actually profound: you get rich by concentrating, but you stay rich by diversifying. Some families must take risk to build enough wealth, while others can protect their wealth by reducing risk. You signed up to be an advisor: this is the job.
Using language arts in an effort to ease the pain of conversations about reality, or to get the damn paperwork done, or to not scare the horses, is a career mistake for advisors. What the advisor seeking lifetime satisfying relationships should do is provide education about the efficient frontier, the simple truth that risk and return are related. Try to imagine a family office not having that conversation.
Some advisors want to avoid conversations about risk because they believe it will kill their sales. Our view is that sometime in this 21st Century, those dinosaurs will die off. In fact, the utility of sales skills may fall to zero before 2050. Your doctor, your lawyer, your yoga instructor, your therapist: do any of those professionals rely on salesmanship? Why in the world would your financial advisor?
At Financial Gravity, we saw this situation as an opportunity—as a weakness in our competitors and a benefit for our clients. We developed the Risk Meter™ to help advisors teach their clients about the realities of investing and to win and retain new clients. It’s an interactive tool that will animate financial planning conversations and get clients intimately involved in their own success.
For many advisors, the market is a ticking time bomb. We can’t know when the next bear will come, but we strongly suggest you spend time with every client to find that specific point, measured as a percentage, of downturn they can handle. This isn’t an “if” thing; it’s a “when” thing.
