RISK #2: Missing out on upside growth. The risk of losing wealth is accompanied by the risk of missing investment gains during up markets by investing too conservatively or being out of the markets entirely. That means risk mitigation must strike the right balance between growth and protection.
Missing up markets can seriously hamper wealth creation. Consider Exhibit 2. It shows that the top 25% of quarters for the S&P 500 in terms of performance returned 14.2%, on average, since 1928. In contrast, the remaining 75% of the quarters saw a negative average return of -0.8%.
Exhibit 2: Average Quarterly Performance of S&P 500—Top 25% of Quarters Versus Bottom 75% of Quarters (1928 – Q4 2017)
Source: Source: S&P 500 TR using data from SBBI Ibbotson, calculations by Horizon Investments.
Clients who miss some or all of the best quarters’ returns might see very little asset growth—a potentially major problem for investors who still require more wealth to achieve their goals. Such underfunded clients must continue to build wealth even as they take new steps to shield wealth they have created.
Lack of adequate growth could also spell trouble for you, as unhappy clients potentially begin to doubt the value you bring to them and look elsewhere for guidance.
RISK #3: Making bad, emotion-driven investment decisions. Risk management strategies do little good if they don’t prevent investors (and advisors) from making emotional investment decisions during extreme market conditions, when fear and greed can override clear-headed thinking.
Behavioral finance tells us that emotional reactions to market conditions consistently lead to bad behaviors—such as buying stocks at their peak prices, then selling them after they’ve fallen and turning a paper loss into a realized one. Likewise, investors often are slow to get back into the markets after they suffer a painful loss– causing them to remain overly conservative and potentially miss out on gains when markets recover.
It’s no wonder investors earn significantly lower returns over time than their actual investments generate (see Exhibit 3).
Exhibit 3: Performance of markets vs average mutual fund investors January 1, 1984 to December 31, 2015
Source: Quantitative Analysis of Investor Behavior (QAIB), 2016, DALBAR, Inc. www.dalbarinc.com. Average equity fund investor and average bond fund investor performance results are based on the DALBAR 2016 QAIB Study. DALBAR is an independent, Boston-based financial research firm. Using monthly fund data supplied by the Investment Company Institute, QAIB calculates investor returns as the change in assets after excluding sales, redemptions and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After calculating investor returns in dollar terms, two percentages are calculated for the period examined: Total investor return rate and annualized investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net of the sales, redemptions and exchanges for the period. Returns are for the period ending December 31, 2015.
The message is clear: Any risk mitigation strategy must be systematic and disciplined–and applied consistently—to head off costly, irrational decisions. It also helps if the risk reduction strategy is clear and understandable to clients. If a plan makes sense to them, they’ll likely stick to it even on dark days.
Take stock of your risk reduction methods
During the next few weeks, we’ll examine some of the most common strategies for reducing clients’ risk–and how those methods stack up in terms of addressing these three major “protect-phase” risks. While many of these approaches have merit, they typically come with trade-offs that are far from ideal. In addition, we’ll explore some of the key traits of the most effective types of risk mitigation strategies and show how they can maximize clients’ ability to protect wealth, grow wealth and remain disciplined during difficult markets.