Toward the end of each year, Wall Street erupts into a speculative frenzy about what may occur next year. We could join the mob and predict markets will be volatile as the Federal Reserve normalizes interest rates, and even offer some investment ideas, but it is better to focus on nascent forces that are increasingly impacting financial advisors even though many are unaware of the risk.
After a major financial crisis, the bursting of several bubbles, and extraordinary market volatility that emerged in October, non-financial people now have enough experience to measure what they are told by so-called financial experts against their own realities. This creates simmering tension in many advisory relationships, and sharp risks in others.
As clients become more experienced, they become less trusting, and advisors are stuck in the credibility gap that Wall Street faces on Main Street. The gap, which threatens the stability and growth of investors with financial institutions and representatives, can be narrowed by educating people about issues that historically have been the domain of institutional investors. This involves topics such as volatility, diversification effectiveness, single-stock risk, and even how to handle market corrections. Many investors want to better understand the market’s forces and obstacles so that they can make better decisions, and this creates opportunities for evolved advisors.
To be sure, the popularity of the Cboe Volatility Index, or VIX, has weaponized J.P. Morgan’s dictum that the stock market will fluctuate. Most portfolios move in the opposite direction of VIX. This has prompted discussions about the appropriate portfolio allocation to volatility. A standard has not emerged, though advisors need not wait to analyze portfolios for volatility exposure or to educate clients about equity risk so there are no panic attacks when VIX spikes, and net worth declines.
The basic underpinning of investor stability is challenged. Most portfolios are divided between 60 percent stocks and 40 percent bonds. Yet, the allocation often behaves similarly to pure-stock portfolios. This is widely known, and many firms are increasing litigation reserves in anticipation of legal troubles as the market evolves away from the Fed’s easy-money policies. And even as firms prepare for trouble, advisors will be stuck dealing with the fall out. Some privately complain that compliance departments force them to into traditional bond and stock allocations for their clients, which only amplifies the trouble. Demographic patterns guarantee these issues will become more pernicious, and that advisors will increasingly have to analyze and explain portfolio risks so investors know what to expect.
Each day, 10,000 Americans turn 65. This is evolving the dialogue between investors and advisors away from expected returns to what they can earn with less friction. Many people need the reduced risk of bonds, and yet they must invest in stocks because they are not prepared for retirement. Meanwhile, their children are watching. This puts advisors and Wall Street on trial in the court of public opinion at a time when technology has changed everyone’s expectations about information, and how they interact with the world.
These themes are coalescing and creating profound challenges for advisors who will increasingly be held responsible for the risks, not just the rewards, faced by clients. How can advisors balance those polarities? By becoming risk managers and financial educators.
Steven M. Sears is chief market strategist at www.StratiFi.com.