A while back, during the late, great bull market, I penned a piece titled, “When the Risk Chickens Come Home to Roost.” In it, I noted the irony that investors virtually ignore risk when the market is at its peak, focusing on it only after the worst has happened.
Now that the risks I noted then have been realized in the market — and in people's investment portfolios — it's a good time for advisors to revisit this subject.
Risk, by definition, is a potentiality. The problem for most is that the mere possibility that something bad may or may not happen is simply too intangible to fully grasp. While we may understand a specific risk on an intellectual level, taking it down to the personal level is far more difficult, and often doesn't occur until it's too late. Unfortunately, by then, the proverbial “risk chickens” have come home to roost.
How to live with risk? Market technicians say that a fairly reliable indicator has been the percentage of investors who are bullish on the market versus those who are bearish. The greater the percentage of those who expect stocks to rise, the greater likelihood that stocks will decline, and vice versa. Yes, you read that right: Consensus sentiment is a contrary indicator. Why?
One reason is the previously mentioned propensity to extrapolate, to anticipate that events will continue indefinitely along their current path. The longer the bull market lasts, the greater the number of investors climbing on the bandwagon. “Heck, Lucent (Microsoft, Cisco, WorldCom … fill in the blank with your former favorite) has been going up for years; why shouldn't it continue to? Everyone I know has made money on this stock; it's time that I did too.”
Another reason is that short-term liquidity drives the market. If a sizable portion of that liquidity is already tied up in stocks — or real estate or gold or whatever the current mania happens to be — that doesn't leave a whole lot of new money available to buy into that asset class to continue driving it higher.
So what can you do to mitigate potential losses? Follow these 10 Commandments.
Recognize risk. Everyone knows the aphorism that the first step toward dealing with a problem is recognizing it.
Be sure your client truly understands the level of risk undertaken.
Investments should be consistent with your client's goals and objectives, not those of their neighbors or colleagues. You're not out to beat the S&P 500; you're generally trying to prepare for a client's comfortable retirement.
Help your clients get a handle on their true comfort level when investing in potentially volatile investments such as stocks — and don't exceed it.
Diversify prudently. In 2000, a lot of people lost a lot of money because they were overconcentrated in certain industries or certain kinds of stocks.
Realize that good companies can still be bad investments if you pay the wrong price.
Don't be a sucker for the “relative value” argument. Simply because a stock may be less overvalued than its peers doesn't make it a good investment.
Don't get greedy. Over the long run, stock returns have averaged about 10 percent a year. Those shooting for 15 percent or 20 percent ended up missing that mark by a wide margin.
Don't feel compelled to be 100 percent invested in stocks all the time. There's nothing wrong with bonds or even a little cash as part of your investment portfolio.
Don't lose sight of the long term. The stock market will always be volatile over the short run, but this should have little relevance to a long-term investor.
If you stick by these rules, it is far less likely that your client — or your business — could suffer irreparable damage in a bear market. Remember, a 10 percent decline requires just over an 11 percent gain to get back to even, but a 50 percent loss requires a 100 percent gain — that's 10 percent a year compounded for seven years just to break-even.
The first rule of making money is always to keep what you've got.
David Harris is a senior vice president at Salomon Smith Barney.