Preventive medicine: protecting client portfolios from market crashes

In the 1980s, we financial planners called ourselves ‘investment advisers’, which described our primary function at the time.

In the early 1990s, the term ‘financial planners’ was adopted, in recognition of the many other functions we performed beyond solely investment advice. Virtually all planners today offer a broad range of services.

However, we must never forget that sound investment advice is an essential component of our service to clients. If our clients lose a substantial portion of their net worth in a downturn, it can nullify all the value we have provided in structuring, estate planning, and so on.

Unfortunately, this is the position of many planners and their clients today. This can be blamed on markets, and in one sense this is true. Nonetheless, the portfolios we recommend determine our clients’ exposure to various markets, and therefore we materially contribute to clients’ experience.

Many planners had never been through a cyclical downturn and this inexperience made it almost inevitable that they would underestimate the reality of serious declines.

However, how do we explain the industry-wide (with limited pockets of exception) failure to become risk averse as markets became excessively overvalued?

This is a repeat of the failure at the last market peak, in the madness.com era.

At that time, the proportion of funds flow into international equity funds, and the exposure to international shares in balanced and growth funds, reached unprecedented levels. Several subsequent years of material wealth destruction revealed the absurdity of this. Yet all the pertinent facts — that technology businesses with little history of earnings were trading at amazing prices — were known at the time. How was the risk missed?

Today, everyone looks back at the latest boom, characterised by excessive leverage, overdone financial engineering, and the self-destructive lending by American banks to many thousands of people who could never repay their debt, and recognises the seeds of destruction. Again, none of this was hidden at the time.

Blindness to risk also marked earlier cycles — for example, the run up to the crash of 1987.

We can, therefore, assume this is an enduring characteristic of markets — indeed, it must be, as there could never be market bubbles if most participants weren’t caught up in them.

This behaviour will never change, so the important challenge for us, as individuals, is to learn to recognise bubbles to avoid being caught next time.

The first step in this is to never forget how essential it is to avoid significant losses for clients in a downturn.

One major setback can wipe out a significant proportion of all the wealth accumulated from positive investment returns over many years. If a portfolio is geared, it can wipe out all the wealth accumulated.

We need to realise that several forces can also be relied on to reassure us that the market is not overpriced, even at its absolute peak. Most industry participants offer this reassurance. A study of their history demonstrates that consensus forecasts never predict a heavy fall.

Few equity managers or brokers ever express views that could lead planners to reduce their exposure to markets. Like many planners, they really want conditions to be healthy, and have a financial interest in conditions being healthy, and this seems to cloud their judgment. (However, there will always be foresighted individuals with the character to hold to a minority view, such as Anton Tagliaferro and Kerr Neilson proved to be in recent years — not for the first time — resulting in superior returns during the slump.)

Efficient market theory will also always give reassurance that markets are fairly priced, as the essence of this theory is that markets are all-wise and efficiently process all known facts into the most rational price at every moment of every day, even on the most overpriced day.

Another factor that will characterise periods of excessive risk is that many planners will somehow determine that the majority of their clients’ risk profiles are fairly aggressive. Paul Resnik aptly described this as “the projection of the financial planner’s risk tolerance onto their clients”.

It is ironic that proponents of non-subjective risk profiling (by ‘subjective’ I mean self-assessment by clients or subjective assessment of clients by their advisers), and critics of risk profiling, always find themselves allied in a downturn. Both deplore the tendency to forget that almost everyone hates losing a lot of money. Anything that blinds us to this is dangerous.

Critics of profiling suggest a better approach is to simply assume that people dislike losses and advise accordingly, which is my view.

Advocates of non-subjective profiling point out that there is little evidence in the lives of most people to indicate that they are great risk-takers.

While disagreeing in theory, both sides align in practice in cautioning against aggressive portfolio creation when the animal spirits are running wild.

Fortunately, there is one strong antidote to being caught up in a market mania: an understanding of market valuation research.

Every indicator of market value that you hear or read about has been researched academically and commercially, and its reliability measured. In other words, the strength of the relationship between the purported indicator of market value, and subsequent returns, has been analysed.

There is no justification for guesswork, or belief in unreliable methods, when all have been thoroughly tested. If someone says falling interest rates are healthy for stock markets, is this consistent with history or not? Surely the speaker should know if they are going to state it, and you should know before paying any attention to it.

Take the example of market PE using last year’s actual or next year’s forecast earnings. This has been tested many times and proved of little use in valuing markets (ie, there is no material relationship between this PE and future returns over any timeframe). Yet it remains the most widely quoted measure.

As one example of the aberrant results this measure

produces, the American market PE at the market peak, using consensus E forecasts, was in the mid to high teens, yet in January 2009 it was around 20. Unless you believe the market has become more overvalued as it fell, you must recognise that this indicator is a waste of time.

Incidentally, using forecast E is even worse than actual E, due to the chronic over-optimism of consensus estimates. Clearly these folks aren’t paid to talk the market down.

On the other hand, PE using trend earnings over a very long-term period, at least 50 years, does have a useful correlation with real, medium to long-term returns. It is a useful, though not perfect, predictive tool. You can verify this for the American market either by reading the material freely available on the Internet, or testing it yourself in a spreadsheet (most of the data you need is available on Robert Shiller’s website).

Tobin’s Q, developed by Nobel laureate James Tobin, is an even more reliable indicator for the US.

If you find yourself in the next cycle, at a point where both of these tools are warning you of over-valuation, but the mood of the day is optimistic, ask yourself which was the better guide in the current cycle.

In my view, the greatest value planners can provide in the investment arena is to protect their clients from substantial losses during major market declines.

Ironically, it is also the easiest benefit to provide, as long as you have robust market valuation tools and are willing to materially alter asset allocation at periods of high risk. Market extremes are not difficult to measure if you use robust tools.

The investment strategy I am arguing for adopts conventional views of long-term portfolios at most stages in the cycle — for example, equities should be the largest asset class, the majority of portfolios in growth assets, and so on. However, it materially lowers these exposures when markets are excessively valued. Invariably this is well before the peak, and results in short-term underperformance rewarded by longer-term superior returns.

The essence of this approach is a preparedness to materially change asset allocation.

One of my doubts about risk profiling is that it implies asset mixes should not change as long as the client’s profile does not. But why should clients invest in a market that offers a poor risk/return trade-off at some point in time, irrespective of their willingness to take sensible risks?

The graph represents the actual returns achieved from a strategy that has been followed by a large group of clients since 1991, compared to various Morningstar indices. It has never contained gearing and has been almost exclusively invested in equity, listed property and interest bearing assets (generally using managed funds). In other words, it has required no exotica. However, it adjusts exposure to growth assets based on their market valuation. As you can see, it has comfortably outperformed conventional growth, balanced and capital stable styles.

The majority, but not all, of the outperformance arose during the bursting of the bubbles at the start of this decade and over the past year and a half. In each case, the portfolios were moved to around 50 per cent in mainstream interest bearing securities at the peak.

The situation is that too large a portion of the financial services industry, richly populated with investment professionals though it is, substantially failed to add much value during the two great bubbles in the past dozen years.

As a consequence, much of our industry is in a parlous state, along with many of its clients.

Robert Keavney is an independent spirit, of no fixed industry address, who believes financial planning is an honourable profession.