Whenever markets decline significantly, much of the focus leans toward the issue of whether people should flee to cash. The financial planning community rises up to remind clients that this is usually not a good move. Experienced planners know there are plenty of other mistakes clients can make now besides moving to the sidelines.

I’ve been through more than a few bad markets and each time a steady drumbeat of negativity makes some clients and prospective clients consider investments that they would not consider otherwise. This is fertile ground for scams, but there is a subtler way to hinder a client than an outright fraud. Bear markets are good conditions for inducing clients to buy an inferior product and rationalize the buy as a sensible “adjustment.” Planners beware: the pitches for bad products are coming.

Based on past market malaise, here are some products planners should be prepared to address.

Alternative Investments

Alternative investments get a lot of play during a bear market. The press loves to profile people who called the top or profited from the decline.

It all sounds so good. Hire the grand wizard that will zig when the market zags. There is a certain cachet to that.

Even advisors can succumb to the cachet. Some want to bring an air of sophistication to their offering or think talking about something new will give their clients the impression they are working harder for them. In some cases, advisors put clients in these because their employer is emphasizing the products.

If you want higher costs, greater risks, greater dependency on management’s crystal ball, less transparency, low tax efficiency and limited or no access to the funds, alternatives are worth considering. Fortunately, most clients find these qualities unattractive. Add to that the inability of most clients to understand how the products work, and these pitches are among the easier to reject. Other than cachet and commissions (I do not work on commission), I can’t see why an advisor would be interested in exposing their clients’ futures to so many unknowns. 

Yes, ‘40 Act products help with access, but the rest of the negatives typically remain. And, yes, I know endowment funds and the uber-wealthy tend to own alts but my clients aren’t endowment funds and are not uber-wealthy. The markets are risky enough for my clients and my clients can only spend cash, not cachet.

Gold

With the recent drama in Washington, the idea of holding something that could benefit from a dysfunctional government has appeal. With many people on both ends of the political spectrum concerned, gold will get a lot of touting as a smart play for safety.

You probably won’t get very far by pointing out that gold has no projected earnings stream, does not, and never will, produce anything. Afterall, that’s true of commodities generally and many rational portfolios have some exposure to commodities nonetheless. The fact that gold has been far more volatile than mainstream financial products probably won’t influence a fearful client that is sure economic disaster is imminent either.

What has helped clients take pause is a direct common-sense rebuttal of the main pitch. Gold is pitched as a "diversifier"—some form of protection against economic harm. Specifically, it is lauded as a hedge against inflation and currency devaluation. After all, gold has been used on and off as money through history.

If you have a client that is sure the folks in DC will turn the national debt into a dollar collapse or lays out a similar argument of doom, be sure to ask them how confident they are this will happen and when it will happen. The gold salespeople are telling them it is inevitable and imminent, so they should buy NOW. If they repeat that urgency ask, “If the dollar is so bad and the collapse is both probable and imminent, why would the gold firm trade their great gold for your lousy dollars?”

If that doesn’t slow them down, they may be too wound up to accept objective advice.

Deferred Annuities

When markets decline, any pitch with the word, "guarantee” can get a client’s attention. It is hard to find an annuity that doesn’t tout a guarantee.

In the consumer press, the discussion about annuities usually revolves around high cost products and shady sales techniques. Guaranteed income or withdrawal riders and equity indexed annuities do indeed tend to have high costs. Many agents do pitch annuities improperly. A thorough exam of the products typically results in guarantees that are less enticing than those presented.

Those criticisms are valid but I’m not going to rehash all that. There are low priced annuity products and ethical agents out there. The problem I have with annuities is that most clients end up creating more issues for themselves by buying any deferred annuity. Buying a bad one just makes things worse. Before deciding if a particular product is any good, the wisdom of using an annuity at all should be evaluated.

With IRAs and retirement accounts, the tax deferral element of an annuity is moot. By using these contracts in these accounts, you greatly restrict what clients can be invested in and add in a layer of complexity that is unnecessary and often problematic.

For products with surrender fees, those fees must be navigated. The products typically have provisions to keep required minimum distributions from triggering surrender fees but even when surrender fees are not incurred, withdrawals can adversely affect the performance of the product or undermine the very guarantees that were touted to make the sale. We have not found clients that need these extra hoops. The retirement withdrawal puzzle is complicated enough as it is.

With non-qualified money, the same issues with investment flexibility and added complexity is there too. However, in many cases, the annuity also serves to create something clients don’t need or want any more of—deferred income.

Many clients are converting money to Roth IRAs or taking retirement account distributions to reduce future taxation. Building an additional pool of deferred income makes little sense for these clients or others in modest tax brackets.

Even high-income clients can be bit by the tax bug if they aren’t careful. When they take money out, the deferred income comes out first and is taxable at ordinary income rates.

The deferred income in non-qualified annuities is income in respect of a decedent (IRD) and does not get a step up in basis at death. Someone will pay taxes on the earnings. In many cases, the net to surviving spouses or other heirs is hampered because the inheritor is in a higher tax bracket, or the IRD puts them in a higher bracket.

Options Strategies

Owning something that will increase in value precisely at the time the market dives sounds awesome, doesn’t it?  Options contracts can do just that. They really are fascinating instruments. Options are the most direct and precise way to counter downside in the stock market of all the things I have written about today.

They are not, however, free. Unfortunately, to use them to great effect, you have to be right about which way the market is going to go, how far it will move and the time frame in which the move occurs. That is asking a lot. If the market goes the wrong way or not far enough or not in the right time frame, the options don’t help. In taxable accounts, it can be even harder to net a big enough profit because short-term gains and ordinary income is the usual result of a position that pays.

Options and the use of the other items I have mentioned all suffer from the same basic problem. The focus has turned away from a sound long-term plan and toward trying to lessen the effect of a market downturn as though downturns are something to fear rather than something to expect.

The whole exercise of finding “where to invest now” suggests market timing but some clients won’t see it that way. They aren’t bailing out to sit in cash. They are just adjusting. They don’t see the bet on market behavior their change implies.

Back in late February of 2009, I got an email from a client about an “adjustment” with this sentence in it: “I know none of us can predict the future but depression or not, the stocks will continue to go down in the next few months.” (emphasis added) Classic. He says no one can predict, then he makes a short-term prediction as though it were a sure thing.

As I write this, the S&P 500 is flirting with the traditional bear market threshold of down 20 percent. If the market continues down another 20 percent, mainstream media will cover the markets a lot more and not in a positive way. This will induce some otherwise calm clients to worry and some may get uncomfortable enough that they may forget the tenets of prudent investing. They’ll do much better if you can guide them back to prudence.

Dan Moisand, CFP, has been featured as one of 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].