We might wish our clients’ investment journeys will invariably be beautiful experiences but we know that things will turn ugly from time to time. How do we prepare our clients for the ugly times? What do they need to know?
It seems to me that what we need to do is give them a feel for the likely pattern of the experience that lies ahead. We can do this through stochastic modelling but the technicalities are likely to be overwhelming and the results’ lack of concreteness mitigates against the learning experience.
Accordingly, our explanation of risk and return should include lessons from history. We can look at what would have happened in markets past with the portfolio we are now recommending.
Perhaps the place to start is with how often the value of the portfolio would have been falling, recovering and rising: falling from a previous high, recovering from a previous low, rising from a previous high.
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For example, let’s look at the monthly historical performance over the past 40 years of a 70% stocks portfolio, where each of the months is categorized as falling, recovering or rising (see note below for more details on the portfolio’s composition).
What we see is that the portfolio was falling 33% of the time, recovering 41% of the time (recoveries tend to take longer than falls) and rising 26% of the time. So our client should be aware that when they look at the value of their portfolio, it is likely to be falling a third of the time.
But what if our client has a more conservative portfolio, say, a 30% stocks portfolio? Perhaps somewhat surprisingly, the pattern is very similar: still roughly ,/,/. The difference is that with the more conservative portfolio the size of both the rises and falls is smaller than with the more aggressive portfolio. (The size and duration of rises and falls will keep for my next blog.)
So far we have been looking at monthly data, i.e. what a client will see if they look at the value of their portfolio every month. However, if the client looks less frequently, the pattern changes dramatically. With our 70% stocks portfolio, the pattern is: