Executive Summary
The prevailing wisdom in financial planning is that clients should stay the course... always. It's "never" appropriate for clients to get out of stocks (even a little bit), and the eternal chiding to any so-called market timer is that even if you can figure out when to get out, you'll never figure out when to get back in again, and you'll miss any rally that might follow a market decline. But does this miss the point? If you actually sell BEFORE a severe market decline (as opposed to after), you don't even NEED to get back in until the market recovers anyway!
The inspiration for today's blog post is a series of email and in-person conversations I've had lately with several planners, who in today's nervous economic environment have been very critical of other financial planners who have gotten defensive with their client portfolios. In the typical fashion, they have criticized that if the client has reduced equity exposure now, even if the planner is "right" and a market decline comes, the planner will lose money in the form of foregone growth for the client by being unable to time when to get back into the market. But I think we're missing the point.
Certainly, we can (almost?) all agree that if a client has a $1,000,000 life savings invested in equities, and the market crashes down 40%, taking the portfolio to $600,000, then it's probably not a great time to get out of equities. The market is likely priced for a bounce or rally, and the client may very well miss an ensuing price increase that could recover most or all of the losses. Of course, that's not guaranteed, and the markets could always go lower - as the client fears when he/she sells out "at the bottom" - but to say the least, the odds of a rally would appear to be much higher after a market crash, if only to recover the losses that just occurred.
But this is very different than the client who sells out BEFORE the crash in fear of a potential market decline. When the decline comes and the index crashes downwards, the client is already safely in cash, earning a modest cash/bond/fixed return on that $1,000,000. Which means even if the market rallies sharply after the crash... IT DOESN'T MATTER. A client who has a 40% crash followed by a 50% rally watches their $1,000,000 rubber band down to $600,000 and back up to $900,000. The client who sits in cash simply goes from $1,000,000 to $1,010,000 to $1,021,000 as they earn their meager 1%/year short-term fixed return. Which means the client who misses the crash, and the recovery, still has more money (not to mention achieving it with no downside volatility!)! In fact, if the client simply says "I won't buy back into the markets until their reach their old highs" - then nothing is lost! The hypothetical stock index goes from 1,000 to 600 and back to 1,000; the client's cash portfolio grows slightly; ironically, the client who is out actually has MORE to reinvest back into the markets when they recover to 1,000, because the client can reinvest not only 100% of his/her principal, but also a few years' worth of fixed returns, too. Or put more simply, if you miss the crash, you actually don't need to participate in the recovery, either! The recovery is only "needed" if you failed to get out of the way in the first place.
Instead, the "risk" of getting out not at the bottom when times are bad, but at a perceived/potential top when times are still good, is the risk that the market won't crash at all. If it does, the client has already won, even if the client doesn't re-enter the market until the entire recovery occurs. If there is no crash, and the market just keeps going up, the client won't participate of course. But is this always bad?
We often treat markets as if they're always the same, and the upside is always better (or at least equal) to the downside, but that doesn't seem realistic. Sometimes the risk proposition of the markets is more asymmetric, where the upside benefits are limited, but the downside risks are increased. In such environments, is it really, truly, always necessary to force clients to shoot for a tiny bit of additional upside, with a huge downside risk on the table? If we say as financial planners that we're about managing risk, in addition to trying to earn returns, why can't there be some environments where the "manage the risk" part actually trumps the "earn more returns" part?
So simply put, why is it ALWAYS so universally bad to talk about getting clients out of risky markets? Does every client really have to get every tiny bit of market upside, even when faced with the risk of a financial crisis if things go the other way? Even when it's true that if the client actually gets out BEFORE the crash, the client doesn't have to get back in at any point until the market returns to its old highs anyway?
Some of you might be saying "yes, but no one can predict these things" - yet that doesn't appear to be entirely true, either. For instance, Financial Advisor magazine did an article two years ago highlighting several planners who saw something bad coming in 2008 before it happened - including noted retirement researcher Bill Bengen. Wouldn't our time be better served by asking them how they did it, and trying to learn from them and what they saw, rather than casting stones at them for breaking with conventional wisdom?
So what do you think? Is there really a difference between the client who gets out before the crash - at the top - rather than the one who more clearly damages themselves by getting out after the crash at the market bottom? Is there EVER a time when the risk of the markets could overwhelm their upside potential? Can we learn something from planners who actually have made the calls effectively?
