Market Corrections Necessitate Asset Management Best Practices
Stock market corrections are healthy. They perform an important function as a counterweight to unsustainable rallies, poor investment decisions and by piercing market bubbles. Once high or unsustainable valuations are brought back into line, market expansion can begin anew. As corrections run their inevitable course it is essential that investment advisors remain realistic yet constructive on the markets. Assuming each client’s risk tolerance remains acceptable and appropriate, a commitment to the strategy allocation should remain.
The 2016 Legg Mason Global Investment Survey of investors found that respondents would capitulate (or liquidate their core equity holdings) after a 23 percent market decline. Investor psychology, especially during market corrections, is clearly of critical importance. Similarly, a 2014 Vanguard study “Putting Value on your value: Quantifying Vanguard Advisor’s Alpha,” found the single largest contribution to “Advisor’s Alpha” was behavioral coaching which could add up to 150 basis points annually (or around half the overall value-add potential accorded to advisors by their study).
What does the poor market performance of 2015 and early 2016 and the ongoing unwind of QE hold for future investment returns? What does the worldwide credit/commodity recession mean for the U.S. economy and future stock returns? Only time will tell but eight years into the bull market we can anticipate a continued narrowing of stock market leadership and a slowdown in corporate earnings growth. Pressure on earnings growth along with growing market volatility will continue to frustrate investors and may ultimately lead to heightened anxiety, occasional panic attacks and the especially harmful behavioral psychology gaffes.
Within this more challenging environment, the use of large-cap stocks in a buy and hold portfolio may soften the market setbacks and the emotional client reaction that can result. According to Vanguard, cost effective portfolio implementation (minimizing management fees, trading costs and taxes) can add up to 45 basis points per year. Maintaining a long term, balanced portfolio with a thoughtfully designed asset allocation should lower volatility and ease investor anxiety. Avoiding the siren call of market timing during corrections is essential. Rebalancing only when necessary in taxable accounts is the best tax-aware strategy and can add value over and above the 35 basis points Vanguard assigns it.
Challenging markets require improved lines of client communication. Better communication (more of it, more often) should lead to a shared understanding of market fundamentals and help advisors to anticipate changes in a client’s tolerance for risk. Exercising proper manager selection and due diligence, with an emphasis on less active, more defensive managers and avoidance of passive index-like strategies (or market beta) can support improved client confidence and patience. Helping clients remain calm and stay the course during protracted market declines is one of the most important value-adds an advisor can provide. Discipline, behavioral coaching and a modicum of guile will prove useful in overcoming the episodic emotional over-reaction investors are prone to during market corrections.
Steve Riley, CFA, CFP, and Rick Furmanski, CFA, CFP, are tax-aware portfolio managers at Clearview Wealth Solutions.