Fortunate is the financial advisor bullish on US stocks in recent years. But more fortunate will be those who prepare clients for the inevitable market downturn. This is one of the most important things an advisor can do, says Glenn Dial, and now is the time.
When the bull market ends
It’s been a spectacular summer so far for stocks. In July, the S&P 500 Index and Dow hit new highs in a bull market still going strong eight years on, the second longest bull market on record. Retirement investors with an overweight to US stocks in recent years have been richly rewarded. But whether this performance can continue through the rest of the summer and beyond is anyone’s guess. The only thing certain is that every bull market eventually ends, and the sooner financial advisors prepare for this inevitability, the better.
At this stage in the bull market, valuations rising to all-time highs are just one part of the story. Another part is that volatility, as measured by the CBOE Volatility Index (VIX), also known as the “fear index,” has fallen to near all-time lows. This curious combination of high valuations and low volatility is a sign that investors have perhaps become too complacent. Sudden reversals in both have a tendency to catch investors by surprise, and too often without a plan for action. This is particularly true for 401(k) investors that have been defaulted into a Target Date Fund (QDIA investors), many of whom don’t actively monitor their investments or market exposures.
A curious combination of high valuations and low volatility is a signal that investors have become too complacent
To see how shocking a reversal could be for retirement investors, think back to 2007 when rumblings in the US mortgage market transformed into a full-blown global financial crisis and the S&P 500 Index went on to fall 56% from peak to trough. This precipitous drop was particularly difficult on investors nearing retirement as 401(k) account balances plummeted. The result was soon-to-be retirees with a much more uncertain future than they envisioned a mere few months ago. And if that wasn’t bad enough, many prospective retirees couldn’t retire at the designated date after all.
In the last bear market during 2007-2009, the S&P 500 Index plummeted 56% from peak to trough
Preparing your practice
Before you set about preparing your clients for the inevitable market downturn, good form requires that you first prepare your practice. Begin by reviewing your book of business to see who’s overexposed to overvalued areas of the market. The strong run-up in stock prices during this eight-year run have skewed allocations towards equities, either because rebalancing hasn’t been disciplined enough, or the portfolio purposely set out to participate more fully in market gains. Either way, these clients could be much more exposed to risk than they realize.
It’s here where the investment policy statement (IPS) comes into play as a guide to allocations, time horizons and risk levels. But just as important, the IPS should also serve as a guide in a market downturn, stating what asset classes, allocation ranges and risk profiles are acceptable. The IPS should also set the stage for a portfolio stress test through various market scenarios—what would a 20, 30 or even 50% decline in the S&P 500 mean for the portfolio? The answers could come as a shock, but it’s better to talk about it now than after stocks begin a long fall from their peak.
An IPS should serve as a guide in a market downturn, stating what asset classes, allocation ranges and risk profiles are acceptable