Investing in an Unpredictable Market | March 2002 Cover Story

Cover Story: Investing in an Unpredictable Market

Back \| E-mail to a Friend \| Print

By Janet C. Arrowood

Getting back to the basics, constant communication and clearly articulated goals are more essential than ever.

I went to a local independent bookseller the other day and spent a few minutes browsing the investment self-help book and magazine sections. What I saw was very interesting; what I didn't see was revealing.There are plenty of books that assure readers that they can invest pennies a day and retire rich, or that the author will reveal stock tips and investment strategies guaranteed to make anyone rich. The magazine articles take a similar tack.

Titles might include "Twenty Fail-Safe Ways to Make Money in Any Market," "10 Guaranteed Ways to Make 10% Right Now" and "Why You Should Only Invest in CDs." The people who write these books and articles are generally not securities licensed; as a result, they can say anything they want to say. I didn't see any books or magazines that explored the issue of what to do in a market that has declined as steeply as our major indices have over the past two years.

It is only in the equity markets that long-term investors have the possibility of getting ahead in real terms.

Advisors, on the other hand, have many limitations and requirements imposed on them. There are rules about what they can and cannot say, about what caveats they must mention, about what they can send to clients and who has to bless the materials, about what records they must keep, about determining client suitability, about disclosure and so forth. When you first passed your securities licensing exam, your broker-dealer probably told you that there were certain words and phrases that are taboo, like "guarantee," "sure-fire," "can't miss" and "going to the moon." You probably also learned very quickly that you must tell your clients that past performance is no guarantee of future returns, and that markets can, and do, go down.

In this current volatile investment climate, the advice of an informed, experienced financial advisor is more important than ever. This is a good time to revisit the basics of being a financial advisor and come up with a plan to support your current clients and develop new ones, while instilling realistic expectations. In the "go-go" markets of the second half of the 1990s, it seemed that anyone could make money, and even grandmothers on fixed pensions were investing in extremely aggressive mutual funds. In retrospect, there are many things that advisors could have done differently, and many changes that you may want to consider going forward.

Reasons for the downturn

Let's briefly review some of the factors that may have contributed to the current downturn in the equity markets.

Over-priced stocks.

During the run-up to Y2K, anything high-tech or ending in "dotcom" seemed to be on a one-way trip to earning record returns. Once Y2K became a non-issue and these stocks still weren't showing much -- if any -- profit, the bottom started falling out. Many so-called experts believe that the high flyers of the 1990s are still overpriced.

High interest rates/inflation fears.

At the same time the price earnings ratios on many stocks reached unsustainable levels, the Federal Reserve Board started raising interest rates. This may have kept inflation in check, but it also made the cost of borrowing prohibitive for many companies.

End of Y2K spending.

Once Y2K spending ended, a major source of revenue dried up for many companies, especially those that paid incredible hourly wages to programmers, analysts and consultants; as a result, jobs started disappearing. The job market for low-paying service industry positions remained fairly strong, but the high-paying tech jobs started vanishing. That reduced the number of workers with disposable income to invest.

Poor or negative earnings.

Many companies, especially those that had experienced geometric or exponential growth in per-share prices, continued to lose money. That gave them an effective price to earnings (P/E) ratio that was undefined.

Unrealistic expectations.

Part of your annual meeting with your client should involve rebalancing the assets in his portfolio.

Many investors entered the market for the first time in the early to mid-1990s, according to David Wickersham, president and CEO of The Leaders Group, Inc., Littleton, Colo. They had no experience with down markets and had every reason to expect continued double-digit returns. Wickersham also pointed out that 401(k) and other retirement plans proliferated in the 1980s and 1990s at a time when almost no individuals owned mutual funds. The result was a large number of "virgin" investors who think equity markets always go up. As Jim Barnash, regional CEO for Lincoln Financial Advisors, Chicago, mentioned, it seems to be the investors with three or fewer years who are most likely to take their money out of the market lately.

Minimizing risk

What can you do in a bear market to minimize risk? The following suggestions might help.

First -- and most important -- get back to the basics!

Always keep in touch with your clients when their investments are doing poorly, not just when they are doing well. All the brokers and managers I spoke with reiterated this; yet, it is tempting to hide when the equity indices seem to go nowhere but down. Send holiday or other cards and end-of-year account summaries, schedule annual meetings and mail information about 529 college savings plans.
Keep good records of telephone calls. Send copies of emails to your compliance office, and make sure you get proper approval for all client materials and correspondence.
Carry good errors and omissions (E&O) insurance.
Join professional associations, work on industry designations and keep up with your continuing education.
Always perform a complete factfinder and risk-tolerance assessment in writing. If you don't have one on file for a client, make an appointment and do it now. Update these documents at least annually. Make sure you ask questions about things such as disability income insurance and long-term care insurance, as well as estate planning and other "noninvestment" items.
Always hold an annual review, either by telephone or in person, with every client. Update the factfinder and risk-tolerance assessment.
Each client needs a written financial plan and goals. Reevaluate these items at the annual meeting.

Talk to your clients.

Many investors panicked in the days following the Sept. 11 disaster and as soon as the markets reopened, they took all their money out. Since the various indices all hit 2001 low points about 10 days later, these clients succeeded in locking in losses. Yet, before the year was out, all the indices were well ahead of these lows and were generally above the Sept. 11 levels.

If you and your clients have clearly written plans and goals for the long term, and these plans and goals haven't changed, then an annual review is a good way to refocus you and your clients so that both of you can stay on track.

Put it in writing.

Avoid confusion later by keeping good written records of what did or did not happen. People have selective hearing, but a written record often solves that problem.

I am a big fan of email, which ensures there is always a record of who, what, when, where and so forth. Just remember to "cc" your broker-dealer, compliance department or registered principal. Don't cross the line into advertising and get advance approval of emails if required. Keep telephone logs and records of all written correspondence such as plans, factfinders, risk-tolerance assessments, new account forms, applications and so on.

Explain investment risk factors.

We owe it to our clients to make sure that goals are set, that they are realistic and that they are suitable.

Explain the risk factors to your client (market, interest rate, political and currency). You should seriously consider using a written, scorable risk survey to do this. As James Haass, vice president and branch manager for the AG Edwards office in Denver, Colo., says, the client should be able to invest in instruments that are in keeping with his or her risk tolerance score. Investing more conservatively is acceptable, but investing in a riskier mix of investments requires serious reevaluation and written justification.

We often do a good job of explaining market risk to clients but tend to forget interest rate, currency and political risks. Lately, however, it looks as if these three factors are driving market volatility.

Encourage clients to diversify.

If you've done the factfinder and risk-tolerance assessment, you should already have a plan for diversifying a client's assets. If your client decided (against your better judgment and advice, I hope) to put all of his or investments in the aggressive growth basket, you need to go back to basics and build a financial plan. As Haass said, when his brokers looked at clients' investments after Sept. 11, if they were allocated in accordance with the risk-tolerance assessment and long-term financial goals and rebalanced regularly to maintain the desired allocations, the clients were encouraged to stay the course. If the clients insisted on reallocation, the brokers worked to partially reallocate funds, keeping the clients' financial plans and long-term goals in mind.

Regularly Rebalance accounts and use asset allocation.

Part of your annual meeting with your client should involve rebalancing the assets in his portfolio. If your client's original risk-tolerance assessment indicated that 50 percent of the investments should be in growth, and this was done in 1997, by the end of 1999, the client might have had 85 percent to 90 percent of his or her assets in growth. Had the assets been rebalanced to the original 50 percent allocation to growth stocks, only half of the client's portfolio would have been exposed to the worst of the volatility of the past three years, rather than exposing 85 percent to 90 percent. This would almost certainly have greatly reduced the client's losses in 2000.

Asset allocation, in accordance with a written financial plan and risk-tolerance assessment, can be a way to take some risk out of a volatile market. Haass recommends to his brokers that they have an opinion about how to allocate investments and be able to articulate why this is a viable approach, keeping in mind the risk-tolerance assessment of the client. As he and Barnash point out, clients are paying for your advice; as a result, you need to be able to communicate with them so that their long-term goals are understood and followed. You and your client have to have a written plan.

Take what the so-called media experts say with a teaspoon of salt.

As I mentioned earlier, many investment experts are not securities licensed. They are not registered investment advisors and are not held to the same standards as advisors are. If their methods are so fail-safe, everyone would be following their advice.

When I worked as a stockbroker, I read Money Magazine just to see what novice investors were reading. My partner and I quickly realized that there was money to be made from buying the stock picks in it, provided we could get the magazine as quickly as possible. So, we used to race out to the airport, pick up a copy fresh off the plane and start calling our clients from a pay phone. This usually gave us just enough of a jump to get in before the prices rose. Of course, this was before this information was available online!

Don't chase returns.

The biggest mistake many investors made was to assume that a 40 percent to 80 percent return on high-tech and other aggressive stocks was normal. So they moved money into stocks or funds that had already been growing at astronomical rates for a year or two or more. They read one of the popular magazines or books and followed its advice, basing investment decisions on the previous year's returns. As Wickersham mentions, the investments that were up last year are probably not going to be the best performers this year and what works in a down market rarely works in a rising one. Barnash points out that just a few years ago, small and mid-cap growth funds were being closed to new investors; now, it is the small and mid-cap value funds. Does that mean a turnaround is on the horizon and advisors should be recommending a return to small and mid-cap growth funds?

Dollar-cost average.

If you take the optimist's point of view, many equities are on sale right now. If you liked it at $50 per share, you should love it at $25, provided it meets your needs and long-term goals. With dollar-cost averaging, clients get more shares with the same regularly invested dollar amount. As the market turns around, they have more shares to participate in the market recovery. This is a great time to get current and new clients to think about dividing $100 or more into several mutual funds each pay period. If they don't put the money in, they will probably spend it; even if it loses value, they should still have something left in an investment.

Plan to be in the market for the long haul.

Every advisor and CEO I spoke with agreed with the fact that equity investments are long-term investments. You have to be in the market for the long term. All the assessments and factfinders you do with clients need to emphasize that equity-based investments are long-term investments. Long term means at least five years during which the original investment will not be touched and all dividends and gains will be reinvested.

What the future holds

What happens next? Let me take out my crystal ball. ...

Since about 1926, markets have risen fairly steadily, but there have been periods of one or two (or even more) down years in a row for one or more indices. Nonetheless, for long-term investors, nothing so far has ever beaten the historical returns of the major market indices. Depending on the particular bond index you consider, the rate of return has been so low that investors do well to break even after taxes and inflation, and many times they lose money in real terms. It is only in the equity markets that long-term investors have the possibility of getting ahead in real terms.

If the original plan you developed still makes sense, review it with the client, get his or her affirmation, and stay the course. If the plan does not meet the client's needs anymore, overhaul it, get the client's concurrence and reallocate the investments. If you and your client don't have a written plan, do a full factfinder and a complete risk assessment and conduct a goal-setting session. Then put everything in writing and get the client's written agreement.

Clients who hear regularly from their financial advisors are, in my experience, far more likely to stay fully and suitably invested, provide good referrals and look to the advisors for other financial needs. Without regular correspondence and communication, you can't possibly know what matters to your clients.

In a volatile market, constant communication, clearly articulated goals and written documentation are more essential than ever. We owe it to ourselves and we owe it to our clients to make sure that goals are set, that they are realistic and that they are suitable.

Janet Arrowood is an Evergreen Colo.-based writer and trainer as well as a registered representative with The Leaders Group, Inc. You can reach her at jc_arrow@hotmail.com.

Top | Back | E-mail to a Friend | Print

If you are not receiving your magazine or need to change your address,
please contact membersupport@naifa.org.

For comments on articles on this website contact mleyes@naifa.org.