Let’s face facts. While clients may hire financial advisors for a number of reasons, perhaps the most common reason is that they want to make sure that their financial future will be secure: that they will be able to afford certain personal goals like sending their kids to college and still have enough stashed away to retire comfortably. So when they sit down with their advisors, they do not want to hear about the vagaries of the market and how they are outperforming this quarter and underperforming next quarter and they certainly don’t want to feel like their life savings is on some sort of roller coaster. No. All they really want to hear is that they are making steady and uneventful progress towards meeting their financial plan … that they will be okay.
So what is required of financial advisors to meet that expectation? Well, they need to produce consistent investment returns that meet financial plan assumptions and they need to do so with as little volatility as possible. After all, most of us taught our clients that the goal was to steadily compound returns over time much as their parents taught them when opening their first bank savings account as a child.
During the secular bull market of the 1980s and 1990s, this was easy. Markets dutifully marched higher without much volatility. Indeed, professionals and clients alike understood volatility as little more than a brief pullback to opportunistically be purchased.
All that changed at the turn of the millennium as the secular bull market transitioned to a secular bear market. Equities, which had hitherto promised excess returns over the long-term, have generated scratch after more than a decade of patience. In some more unfortunate cases, clients experienced a loss of principal and, as we know, losing a client’s hard earned and saved money is far more painful than giving back profits. The compounding machine that promised to meet planning assumptions has slowed if not ceased and instead been replaced by consistent and exacerbated volatility. And this transformation could not happen at a more inopportune time as our clients are suffering more uncertainty and fear than ever before in their daily lives, and, for the baby boomers in particular, their time horizon is beginning to run short. They cannot afford any additional uncertainty in their safety net.
Consider this: studies have shown that the emotional impact of pain is at least twice as great as that of pleasure. So when investors experience the historical +10% annual return in equities, because the number of plus days barely exceeds the number of minus days, investors feel enormous stress (pain of loss) even when markets behave as promised.[i] Now imagine the emotional impact that the financial crisis had on clients: balanced funds fell 25%, anecdotal reports tell us that advisors at some TAMPs suffered losses closer to 30-40%, and we have certainly reviewed advisor portfolios that incurred losses of 50-60%. And let’s keep in mind, to recover from a 50% loss, a “double” is required and they do not come along very often. Instead, those losses more often expend valuable client time horizon to recover. Regardless of whether those advisors were able to lean into the recovery and reduce those losses in 2009/2010, that type of emotional stress was the last thing clients needed to feel as so many faced layoffs.
What’s more, given today’s markets, a more appropriate question is whether the markets will continue to snap back from future declines so readily. Indeed, the markets have experienced two major declines and yet there remains greater uncertainty about the future today than before. Concern is growing that governments around the world are running out of bullets and may not be able to “bail out” the markets and the economy from future shocks. With client time horizons wasting away, can advisors afford the risk that the next major decline may not be followed by a recovery leaving clients with a broken financial plan? How many of you are prepared to tell your clients that they did everything right, but they ran out of time horizon and they will not be okay after all?
Advisors must therefore manage risk more effectively. They must pursue an investment strategy that allows clients to participate in rising markets and reduce losses in declining markets. So doing restores the compounding process and in such a way as to reduce the emotional tax on clients who want some peace of mind about their future when their present feels as though it is falling apart.
We came to this conclusion about the turn of the millennium at Pinnacle Advisory Group. Accordingly, we began a nearly decade long process of building a more risk-managed tactical investment process to support the financial plans of our own clients. We have been fortunate to have been successful in our endeavor so far. Our investment program has proven to exceed benchmarks with less volatility for nearly a decade.
[i] Fooled by Randomness by Nassim Taleb Copyright 2001.
