Prepare clients for the terror of falling markets

It’s witching season and while our costumed children invade our neighborhoods for candies and treats, almost no-one considers the “trick” part of the equation anymore. It’s much the same way for investors today; it’s been nothing but treats and no bad scares for years now.

At the turn of the century, we suffered two big bear markets in the first 10 years, but since then we have experienced historically low volatility. Since 2010, investors in all assets have benefited from a flood of capital and low interest rates provided by the ever-supportive Federal Reserve.

Assets across the globe, from investments like stocks and bonds to less liquid assets like homes and fine art, have all appreciated measurably for years. More importantly, this has happened with some of the lowest levels of volatility we have ever witnessed.

It’s more fun to talk about the good stuff, but the scare is worse when you don’t expect it. Here are four ways to discuss the increasing risk implied by ever growing valuations:

BEWARE THE HYPE

At one point internet stocks were considered a surefire money maker. Five years later, real estate became the guaranteed winner. After two dreadful bear markets, stocks were shunned . None of it turned out to be true. In investing, the more people believe any one thing, the more the opposite viewpoint turns out to be correct.

The crowd is seldom right when they all agree. Asset prices become expensive when investors are too optimistic, and cheap when they are too pessimistic. We are at an increasingly optimistic time in the market right now, and as such, investments are becoming historically expensive.

That’s not a reason to sell, but it is a great time to discuss market risks and assess whether your clients are taking more risk than they need in their portfolio.

ANTICIPATION BEATS REACTION

Timing is not worth trying. It’s important for any investor to be able to withstand meaningful declines with their current investment allocation and be mentally prepared for what it will feel like when the portfolio loses value. We like to suggest investors imagine their portfolio declining 25% and then calculate what that would mean in dollars.

Even though the math is the same, many folks can imagine withstanding a larger percentage decline than they can withstand a loss in actual dollars. If they aren’t sure they could sit tight, then they should adjust their portfolio risk to ensure they can stay with it.

TIME HEALS ALL WOUNDS

The Dow Jones Industrial Average was at roughly 11,000 at the beginning of the century. By 2010 it was priced at 10,067. Investors suffered two bear markets over the 10-year period, one of 40% and one exceeding 50%. Even after receiving dividends, investors had not really grown their value over 10 years. However if they held on, seven years later the index has more than doubled to over 23,000. That doesn’t include the dividends along the way.

While history has shown that time is your client’s greatest ally if they do not sell when markets decline, they won’t feel that way when they are scared. Ensuring nervous clients have several years of savings not subject to the whims of the market may allow them to ride out the decline and participate in the following recovery.

REALISTIC EXPECTATIONS

For the past seven years, we have seen the market more than double with almost no meaningful declines along the way. That’s not normal. While it might feel great, it will make the inevitable decline more painful. More importantly, the higher valuations, the lower future expected returns should be, and the higher the expected volatility.

Re-run your clients’ financial plans with lower returns to show them how their plan is impacted by a less-than-stellar market. It will help them prepare for a more tepid market should it happen. If the markets perform better than what you illustrated, they will be overfunded and over-prepared. That’s not a bad place to be.

I always loved walking my three young daughters to particularly scary houses on Halloween. I loved the feeling of their little hands squeezing mine a little harder as they battled their fear and we walked past the fog and the skeletons and the witch cackles to get to the candy waiting for them at the front door. Our clients all want the candy, our job is to help them make it to the front door.

Joe Duran is chief executive of United Capital. Follow him @DuranMoney.