A recent news report stated that this year has been the worst start for U.S. stocks in history. The media’s use of terms such as “crisis” and “collapse” has contributed to an increase in investor anxiety, opening the door for emotionally driven decisions.
What can advisors do to help clients avoid the mistakes often made during times like these? If we have a good understanding of the situation and communicate this to our clients, it should provide perspective and reduce irrational decisions. In this post, we will review the purpose of the financial markets; examine the causes of financial disruptions, and discuss what an advisor can do to help clients.
The Purpose of the Capital Markets
The recent selloff is certainly nothing new. It has happened before and will repeat itself many times in the future. To have the proper perspective, one must understand the purpose and function of the capital (i.e., financial) markets. The capital markets are the intermediary between investor and recipient. The recipients include businesses and governments around the globe. These entities require capital to operate and investors seek a profit. The financial markets are the vehicle that transports money from investor to recipient. Academically speaking, this process should follow a relatively smooth path with minimal disruption. In reality, however, disruptions are a common occurrence. Let’s look at the catalysts behind these disruptions.
The Causes of Financial Market Disruptions
Two primary issues cause a market disruption. They are macroeconomic policy and market excesses. Most disruptions stem from a combination of both and the current global selloff is no exception.
Here is a good example to explain how macroeconomic policies can cause a market excess and subsequent disruption.
After hitting bottom in March 2009, stock prices rose at a much greater rate than GDP. Although there are many factors that influence stocks, prices cannot continue to rise faster than the underlying economy in perpetuity. Productivity and improvements in efficiency can only take you so far. Why did stocks continue to rise despite a weak U.S. economy? There are two reasons. First, the Fed used financial repression to push investors into risk assets, hoping that the capital flowing into stocks would create economic growth. It might have worked, if not for a massive amount of new regulations. To be specific, Obamacare has been a significant impediment to new business generation and economic growth. In short, Fed policy (i.e., macroeconomic policy) contributed to a bull market that endured well beyond the average (i.e., market excess) and Obamacare has been a significant headwind to private sector expansion. The result is a significant market disruption.
There are other examples, including the Fed’s easy money policy leading up to the Tech Bubble and the federal governments’ sub-prime lending push that contributed to the housing bubble.
Steps for the Advisor
It is important to communicate with your clients. To provide balance to the media’s message of impending doom, last Friday I sent an email to all clients. It included a link to a Forbes article I wrote the day before, entitled, The Top 8 Risks of the Financial Markets in 2016. I received several emails from clients thanking me for the information with phrases like, “I was worried. Thanks for looking out for us.” and “Thank you for the information.” Clients appreciated the article and were relieved knowing what I had done and plan to do if necessary.
According to Rob Arnott of Research Affiliates, “The costliest errors in investment management are firmly rooted in human nature.” Therefore, when clients realize that you understand the situation and are looking out for them, they can relax, enjoy life and avoid the temptation to make an erroneous financial decision. In the final analysis, we are all in the business of providing peace of mind.
Until next time, thanks for reading and have a great week!