In today’s volatile global financial markets, headlines of doom often dominate our morning reading. Many times, no investment action is needed, but how do you know when you should act? When is it time to make adjustments in your portfolio? This article will provide an answer to the question, “How do I know my investments are ok?”
An interesting thing has happened in 2017. Our clients have become increasingly nervous and concerned about high market valuations and downside risk at the same time that market volatility is hovering near all-time lows. When we ask clients why they are worried about risk and volatility right now, the answer usually comes down to uncertainty. At this time, especially here in the United States, there is a great deal of uncertainty about proposed domestic initiatives such as tax restructuring or infrastructure spending in addition to global concerns around a looming trade war with China or a potential conflict with North Korea. For clients who are feeling concerned and nervous about macro issues like these, questioning the safety of their portfolios is only natural.
This is the way uncertainty works in the market, too. If investors are confident in the direction of the global economy, they tend to accept a slightly higher price for growth. If investors are uncertain about the direction of the global economy, they tend to value security over growth. In other words, I might pay $100 for a shirt from a brand I love and know it will fit me perfectly, but I might only pay $50 for the same shirt from an unknown brand simply because I’m less certain it will fit me well. It’s the same phenomenon with stocks: clients and investors who are feeling more uncertain naturally put a higher premium on safer assets.
Our job as an advisor to our clients means we need to help them control their “animal spirits.” Keynes noted years ago that individuals are often driven to take actions based on their emotions rather than logic. Hence, we, as advisors, first try to listen and understand what is driving our clients’ concerns? Once they put a voice to the real fears they have, we try to offer mitigating factors or play devil’s advocate. If the client is concerned about a trade war with China, we would discuss all the reasons a trade war would be bad for both sides. Often times, clients will have read or listened to a convincing thesis that argues for an extreme outcome. That may be what eventually happens, but it is often unlikely. Sure, some people correctly foresaw the debt crisis, but some people also incorrectly foresaw the demise of the dollar and made claims that oil production had peaked. All of these forecasts are worth understanding, but we need to look at both sides of the argument. We also remind clients that their portfolios are often structured to provide downside protection in a market downturn. We show them that their conservative portfolio assets likely won’t reprice materially if equities fall.
At this point, hopefully some of the fear and urgency will have been removed from the discussion, allowing us to reach a critical point in managing a long-term portfolio: deciding how much risk to take. While allocators often speak about ability to tolerate risk, we also think about a client’s willingness to accept risk. Investors in aggressive portfolios in 2008 did just fine if they remained invested and stayed aggressive through the downturn and in the following years. Passive portfolios did just fine if they remained passive and did very well if they took a more aggressive stance during the downturn. The investors who suffered material losses were those who were aggressively invested heading into the crisis but then became nervous and turned conservative (i.e., they sold assets at the trough) instead of staying the course and participating when markets recovered. Hence, we test our clients at this point as to how they would react to the market’s being down 30-40%. If they indicate they’d be inclined to sell and de-risk the portfolio, then they are probably too aggressively positioned for their real risk tolerance, and the portfolio needs to be adjusted.
However, if their risk tolerance is appropriate for the portfolio risk level, then the best strategy is simply to prepare for the downturn emotionally. Expect that it will come; eventually there will be a time when there is extreme uncertainty producing mispriced assets. As our CIO says, you want to be the guy walking into the burning building with a wad of cash to buy it on the cheap. Right now, we’re testing our clients’ risk tolerances, de-risking portfolios as needed and warning our clients they may be asked to walk straight into that burning building sometime in the next 2-3 years.
Managing Partner, Delegate Advisors