We’ve all heard the cliché “all good things must come to an end,” which has been bandied about with slight variations since Chaucer penned the “Canterbury Tales.” Although many investors may not want to believe it, it is very possible that we’re approaching that point with the current bull market.
As we approach 2018, there are a number of factors that have the potential to derail the bull case — Federal Reserve tightening and balance sheet normalization, interest rate action from the Bank of Japan and European Central Bank, potential Trump administration policy missteps, the risk of open conflict with North Korea, high equity valuations and low bond spreads. The market has mostly shrugged off such concerns over the last several years, and it’s certainly possible that it will continue to do so.
However, judging from market history, there is a high likelihood that the lack of volatility in the equity markets will prove temporary and that measures will revert toward historical averages. Consider also that it usually isn’t the widely known and publicized risks that have the biggest market impact, but the ones that no one anticipated. As the old boxing aphorism goes, “It’s the punch you don’t see coming that knocks you out.”
FOMO (fear of missing out) is the predominant sentiment today, and our clients have certainly not been immune. No one wants to see clients walk away from potential returns, but we believe part of an advisor’s fiduciary duty is to also hold a healthy fear of permanent losses and unachieved goals, which are ultimately much more painful for clients than missed gains.
Imagine a football team that has a three-touchdown lead going into the fourth quarter. After such a streak of “unrealized gains,” most seasoned coaches would choose to concentrate on their team’s ground game and not making mistakes, rather than continuing a more exciting but considerably riskier aerial attack. It may mean missing out on additional points, but it also increases the odds of the team accomplishing its goal — winning the game.
Likewise, a financial advisor’s job isn’t to maximize returns for his clients at any cost, but to help them achieve their financial goals, and to do so without taking on more risk than they can afford. After a 5-year streak of equity market returns averaging over 14%, we think there is value as an advisor in focusing on “winning the game” for your clients rather than keeping up with the S&P 500.
What does that look like? For starters, focus on investment products that have performed well on a risk-adjusted basis and over complete market cycles. Statistics like Sharpe ratio, which measures returns above the risk-free rate per unit of risk (volatility), and active share, which scores portfolios based on how much a manager’s portfolio selection differs from the benchmark index, can be helpful differentiators and give investors insight into managers who are adding value rather than just mimicking or levering up the performance of an index.
Remember, the time to discuss risk with your client is when you’re both able to reason clearly and rationally, not when the alarms are ringing and panic sets in. A willingness to sacrifice additional points on the board now could offer significant protection when the bull market inevitably comes to a halt.