The most interesting emails I get after some of these Financial Advisor columns come after I have written about how we discuss various issues with clients. Readers have a lot of great ideas. So to start the year off right with an inbox of interesting interactions, I am going to share a few talking points I have used with clients and prospects regarding a few investment issues that keep coming up. If you are into market timing or tell clients you will get them market-beating returns, this will be a good column to skip.
With the market at all-time highs, I am worried about a big drop.
There is nothing funny about market declines, but I admit I often find the reaction to declines a bit comical. If you let the headlines lead your thinking, you might get the idea that declines are in some way odd, even rare occurrences. They are not.
Even a cursory review of market history shows declines of some significance come often. Yet, some financial planners go right along with the premise that a decline is a horrific event rather than the natural result of free markets.
According to Yardeni Research, since 1928 the S&P 500 index has experienced 46 corrections, defined as a decline of 10 percent or more. That’s more frequent than once every other year. In 20 of those cases, more than once every five years on average, the decline was over 20 percent. The longest stretch between corrections was just eight years. In 34 of the 35 years since 1980, the S&P 500 has dropped at least 5 percent at least once during the year.
Corrections and “bear markets” are so common, that experiencing them should be expected as a normal part of being a long-term investor, not something to hope will not happen. So, my first suggestion is to develop a plan to make sure your clients understand this and the typical media reaction to it.
Second, if your client’s life will be devastated by a correction, you have a lousy plan. A portfolio should be designed with the client’s goals and time horizon in mind. A correction should be inconsequential and a bear market should be something you can weather. If that is not the case, the goals may not be realistic.
Last thing to note is that the record shows corrections are not more likely at market highs. The frequency of declines in the U.S. stock market after the market reaches an all-time high is virtually identical to the frequency of declines after any other period.
This does not mean a correction will not occur. As I mentioned, they occur often and for all sorts of reasons, but the existence of an all-time high in and of itself is not the trigger.
So and so says the market is overvalued. Should we get out?
Gauging whether the market is under or overvalued is almost an obsession with some of the financial press. It is completely understandable to me that people might get the impression that high valuations portend market doom. Ah, if only it were that simple.
Valuation is not a good timing tool. Turns out, there really isn’t any good timing indicator when we apply statistical rigor to the data.
Vanguard did a study in 2012, “Forecasting stock returns: what signals matter and what do they say now,” that examined a variety of market valuation measures and found all them to be almost entirely useless in predicting market returns in the coming year. Some, like trailing 12 months P/E ratios or Shiller’s CAPE, gave some clue as to returns 10 years out, but they explained only about 40 percent of the returns of the following 10 years.
A couple of years ago, I heard a speaker at a conference cite the Shiller CAPE ratio and declare the markets 20 percent undervalued. The next day, I heard another economist cite the exact same statistic and declare the market 30 percent overvalued. Difference of opinion is normal and this is a significant reason why trying to time markets is folly. You can't be a buyer unless you find a seller and you can't be a seller unless you find a buyer.
What about the times when markets are “clearly” over or undervalued?
Even points of valuation extremes are not particularly useful as timing mechanisms. By most measures, stocks had become expensive on a historical basis in early 1996. If you took that as a sell signal, you would have missed out on the four most profitable consecutive years in the history of the U.S. markets. Since the crisis of 2008, many people have pointed to the historically high prices of U.S. government securities and recommended abandoning these holdings.
Rather than viewing valuation as a timing tool, I think looking at valuation and adjusting expectations for the next decade can be a useful exercise. Historically, when market valuation was high, future returns were below average more often than not and when valuations were low, future returns were better than average more often than not.
The market has been on a tear. Shouldn’t I own more stocks and less bonds?
The extra expected return from increasing an allocation to stocks doesn’t come free. The ride is wilder and more uncertain. Recall the classic efficient frontier. The curve flattens. To get a little more return, one must take on a lot more uncertainty.
Financial planning involves working toward goals of a more practical nature, like not running out of money. Seeking extra returns is not usually the answer.
Take a look at just about any study on sustainable withdrawal rates or run a Monte Carlo simulation and you often see that increasing the allocation to stocks increases the average return but decreases the success rate.
The purpose of having bonds in the portfolio is to add stability. They won't grow a lot, but they won't collapse at the drop of a hat either like stocks are known to do.
Having no bonds in a downturn makes the math work against you when you are pulling money out of a portfolio. If you are too heavy in stocks, you must sell at the lower prices to meet your withdrawal needs. If you own bonds, you can choose to cash some of those out to meet your withdrawals, thus buying the stocks a little more time to recover.
Which brings me to another reason most people should temper their enthusiasm for stocks. If they hold too much, they can become powerless.
The next time the market takes a real tumble, if you have some money in bonds, you could look to buy more stock at the lower prices. If you are overallocated to stock, you have less ability to do this. If you are all stock, you can do almost nothing but sit and wait. Powerless. You might do some tax loss harvesting. You would also naturally have the option to panic and bail out but that's not advisable.
Of course all this assumes you are not in speculative bonds or too far out on the yield curve but that’s another story.
My portfolio hasn’t kept up with the S&P 500. What gives?
If a client’s portfolio is well diversified, this should be expected from time to time. The more conservative the portfolio, the more often this will be true simply by virtue of not having all the money in stocks.
Looking just at the equity portion of a portfolio, unless you have a working crystal ball, it is highly unlikely that moving significant chunks of money between asset classes in an effort to be in the best-performing class will add any value over time after costs. Avoiding this losing game is one of the very reasons to diversify in the first place.
One benefit to diversifying is a less volatile investment experience. They will never be entirely in the worst performing asset class. One price clients pay for this smoother ride is they never get to be in the best performing class.
Perception Vs. Reality
These four sentiments present a great opportunity to discuss your client’s perception of how they are doing. I’ll bet few, if any, were concerned that their portfolio didn’t keep up with the Russell 2000 in 2013 (+38.82 percent). Their frame of reference is on the headlines, not their goals or what they can control. That’s usually dangerous. Good thing you can help them refocus on what matters.
Dan Moisand, CFP, has been featured as one of the America’s top independent financial advisors by Financial Planning, Financial Advisor, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager, and Worth magazines. He practices in Melbourne, Fla. You can reach him at [email protected]