I always chuckle when I read articles with titles like "How to Position Your Portfolio for the Great Bear Market to Come." First, they are almost always written by someone who is selling an investment product designed to protect you in a down market. Second, they never tell you when the Great Bear Market is coming.
It’s actually pretty easy to position your portfolio for a bear market if you know when it’s coming. About a week or so before it starts, you just call the guy who is selling the investment product designed to protect you in a down market and you buy it from him. Or you can simply pull your money out of the market and hold it in cash until just before the bear markets ends.
The real problem is that no one knows when the next bear market is coming. That doesn’t stop people from guessing, though. Market timing is a tried and true industry tradition. It just isn’t a very good investment strategy.
Investment managers who try to time the market have a poor history of success. Sure, they get it right once in a while, and sometimes their wins are spectacular. But the sad truth is that markets are notoriously hard to predict. There is a good reason why they say that the market-timers hall of fame is an empty room.
A quick check of the Morningstar database confirms that there will be no inductees into the hall of fame any time soon. For the five years ending June 30, 2017, the average tactical manager fell 900 basis points short of beating the S&P 500 Index, and fell more than 400 basis points short of a simple 60 percent S&P 500/40 percent Barclays US Aggregate benchmark. Yes, you are correct in saying that the past five years hasn’t exactly been ideal conditions for market timers—they need volatility in order to weave their magic. What about the last 10 years?
For the 10 years ending June 30, 2017, the average tactical manager fell over 300 basis points short of beating the S&P 500 and almost 300 basis points short of beating the 60/40 benchmark. No tactical manager beat the S&P 500 Index over either the five- or 10-year period, nor did any beat the 60/40 benchmark for the 10-year period. Only four out of 66 tactical managers beat the 60/40 benchmark for the five-year period, but none by more than 100 basis points.
These facts suggest that you are probably not going to invest your way around a bear market. But in case you are still not convinced, consider this. From 1965 through 2016, Warren Buffett, one of the greatest investors of all time, returned 20.8 percent for Berkshire Hathaway investors. That’s more than double the return of the S&P 500 over the same period. Yet Berkshire underperformed the S&P 500 in over half the calendar years during that period, and experienced drawdowns of 37 percent in 1987, 37 percent from 1989 to 1990, 49 percent from 1998 to 2000, and 51 percent from 2007 to 2009. Buffett didn’t even try to avoid the bears, so why should you?
The problem is more difficult than simply avoiding bear markets. On average, they only come along every three and a half years or so. But we get noticeable downdrafts almost every single calendar year. Turns out the road to riches is a very bumpy one.
Ben Carlson of Ritholz Wealth Management identified the largest downdraft in every calendar year from 1950 through 2016. He found the average drawdown was -13.5 percent, and the median drawdown was -10.5 percent. There were double-digit drawdowns in more than half of these years, and one out of every six years saw a drawdown of 20 percent or more. A grim picture, right?
Not really. During this same period the S&P 500 was up over 11 percent per year. Returns were positive in 79 percent of all calendar years. They were up by double digits roughly 60 percent of the time, and finished up by 15 percent or more almost 50 percent of the time. The overall results were excellent, but patience and fortitude were required in order to reap the benefit.
That’s where you come in.
Getting a client from point A to point B is not simply a matter of building the perfect portfolio. In fact, there is no such thing, so you can stop trying. Bears, bumps and downdrafts are an unavoidable part of investing. In fact, we should all be grateful, because without them there would be no risk and, therefore, no risk premium. As investors, we get paid to take risk.
But most clients are not wired to remain calm in the midst of volatile markets. We didn’t need the academics who have studied behavioral finance to tell us that. They have simply confirmed what we already knew from experience and have given wonderful names like loss aversion, hindsight bias and mental accounting to our clients’ behavioral anomalies.
In the face of these anomalies we need to do two things. We need to assess the client and we need to educate the client. Yes, first we need to go through the planning process to identify the client’s goals, and then we need to identify a portfolio (or series of them) that will maximize the likelihood of achieving those goals with the least risk. But that’s only half the battle.
We also need to know if the client can live with the portfolio that is best suited to get them to their goals. Advisors make this kind of assessment using various methods ranging from a gut-feeling, seat-of-the-pants approach to the use of risk-tolerance questionnaires that purport to precisely measure the client’s ability to stomach risk. All of them have their weaknesses.
The good news is that new tools are emerging that have more scientific underpinnings than most of the existing options. More good news is that client-assessment tools are still only truly useful in the hands of skilled advisors. There is still no such thing as a standalone profiling tool that can, by itself, assess a client’s ability to weather stormy markets.
Advisors must also have a strategy to deal with clients who are constitutionally unable to live with the portfolio that is best suited to help them reach their goals. One such strategy is education. That is, teaching the client to live with the volatility that is going to be necessary if they are to reach their goals. If soldiers can be trained to function effectively on a battlefield with bullets whizzing overhead, and baseball players can learn to stand in against a 100-mph fastball, clients can increase their tolerance for volatility. But not without your help.
Unfortunately, this is another area where good tools seem to be lacking. But this presents advisors who are enterprising enough with an opportunity to differentiate themselves by developing an ongoing program of client education as part of their service offering. Showing a client an Ibbotson chart during the onboarding process and telling them to stay the course once the turbulence hits won’t cut it. You don’t start a soldier’s training on the battlefield, nor do you wait for the game to start to teach a ball player the finer points of hitting a fastball.
You are your client’s best resource for dealing with the difficulties inherent in long-term investing. Make sure your toolbox is full and includes a reliable way of profiling your clients and understanding how they make decisions and deal with risk. Also, make sure you have a program to help them behave in a way that maximizes their chances of successfully getting from point A to point B in the face of the headwinds they will inevitably encounter.
Scott MacKillop is CEO of First Ascent Asset Management, a Denver-based firm that provides investment management services to financial advisors and their clients. He is a 40-year veteran of the financial services industry. He can be reached at [email protected].