In last quarter’s Investment Committee Briefing, I encouraged investors not to be frightened or react when the stock market reaches new all-time highs. Although the financial press may say stock markets are overvalued and are possibly trading at “precarious levels,” our research found that historically, if you look at the average gains in the stock market one year after the market hits new record highs, and you compare that average to any randomly selected one-year period in stock market history, the gains following a record high are pretty much the same as at any other time. The market in the year following a record high neither outperforms nor underperforms the long-run market average return for a single year. Simply put, all-time record highs make no difference.
Even though current stock market all-time highs are not a reliable signal of a type of market pullback to follow, we should assume the high level of risk that is always present in markets, and the potential for volatility that history indicates are hallmarks of investing in the stock market. I encourage investors and advisors not to slip into complacency and forget about risk and volatility when markets are on the rise.
Risk and volatility are part and parcel of investing; they are healthy, consistent components to making markets work. And if you think about it, risk and volatility are present even in “up” times. Though domestic stock markets, value and small-cap premiums have been strong lately, it is important to remember the following:
- International stock markets and value and small cap premiums have not performed as well as their U.S. counterparts recently
- Domestic bond markets, especially long-term, low-quality bonds, have been under pressure of the Fed’s publicly-stated commitment to a string of increases in short-term interest rates
- About a year ago, the stock market was falling because of concerns that global oil prices had fallen sharply
- Last June, we saw Britain vote to pull out of the European Union, which put a scare into global stock markets
- Last quarter, the U.S. had an historic presidential election, which brought with it uncertainty about the markets
I believe that it is our job to remind our clients not to get complacent during what feels like good times in their portfolios or statements — and to remind them that investing always brings risk and carries volatility. The most important decisions we all make in the management of risk and return are around how we:
- Understand and measure our clients’ risk tolerance
- Match their risk tolerances or risk profile to how they are invested
- Continually talk to our clients about changes in their lives or goals, and monitor this process
Times of strong market returns may lull investors into feeling that their current risk profile or portfolio is “holding them back.” New investors in particular might be attracted to a higher risk profile or portfolio than is warranted for them because good times can mistakenly lead them to believe that they may be able to handle more risk than they really can or should.
Whether markets are up or down, we encourage advisors to share their market experience and expertise by doing the following:
- Meet with clients in person and discuss any changes to their current situation or to their goals
- Talk with clients about what has been happening in the short term and balance the recent strength with the realities of what should be expected on a long-term investing journey: risk and volatility
- Review their current risk profile and check for continued alignment to their current risk exposures through their portfolios. Proper risk taking may be key to weathering volatility necessary for long-term returns
- Rebalance, or re-optimize, portfolios as necessary
- Remind clients who might be tempted to take on more stock exposure or risk (just because markets are up) that markets can and will fluctuate. Any unnecessary or uncompensated risk taking when things look good only gets in the way of all the long-haul reasons why their current risk profile and portfolio were selected in the first place
At Loring Ward, we believe that it’s always a great time to review risk and volatility with clients! It’s especially a great time now, when things seem to be generally rising strongly, to put the short-term recent market conditions in perspective with what really matters to long-term investors: their long-term goals and investing game plan.
1 The U.S. Value Premium is the difference between the total return of an index of US value stocks, such as the Russell 1000 Value, minus the total return of an index of US growth stocks, such as the Russell 1000 Growth.
2The U.S. Small Cap Premium is the difference between the total return of an index of U.S. small capitalization stocks, such as the Russell 2000, minus the total return of an index of U.S. large capitalization stocks, such as the Russell 1000.
3During 2016 on a monthly basis, the U.S. Value Premium as defined above was positive in 9 of the 12 months of the year, for a cumulative 2016 level of 10.25%. During 2016 on a monthly basis, the U.S. Small Cap Premium as defined above was positive in 9 of the 12 months of the year, for a cumulative 2016 level of 9.26%.