When clients come to us for financial planning advice, they often share their concerns about the stock market. The most common questions we hear include: Has the market peaked yet? Is another decline on the way?
Given the market turmoil in recent years, we certainly empathize with feelings of uncertainty. Even though market conditions may shift dramatically from year to year, the answers to either of these questions tend to be consistent. Here’s why.
Financial Strategies: Take With a Grain of Salt?
It’s probably not news to you that the media’s portrayal of market health doesn’t always correlate with actual, on-the-ground market conditions, but you may not be aware of the extent of this disconnect.
Remember that the media’s goal is to garner attention – in the form of viewers, "clicks", and ratings – in any way possible; dramatic content offers an effective way to keep people tuned in. Despite the fact that the stock market has gone up and down it has historically experienced periods of growth over 80% of the time. Let’s take a look at the years from 2003 through 2012.
The news from this period did not make it “feel” like it was a good time to invest, but it is hard to come to the same conclusion when we look at the actual numbers.
Let’s face it; overall, the media does not make money by reporting on good news. They get viewers by reporting on events that are shocking even if it is fabricated. News about a relatively stable trading day just isn’t that interesting, especially when compared to hysterical reports about potentially steep declines.
While it’s true that short-term declines can certainly hurt, accurately predicting long-term rebounds is virtually impossible. And again, while it may be more balanced and realistic, the fact that markets are expected to go up and down does not make for a thrilling news report.
Unfortunately, this massive volume of bad “news” actually leads many investors to question whether it is ever a good time to participate in the market. And when enough investors' attitudes are effected, the media’s practice of negative news can actually effect the markets themselves.
However, and in general, any market effect should be considered to be short-term because in the long run it will be a companies’ financial performance and market participants’ evaluations that will ultimately determine stock prices. This is because the market is “forward-looking,” or structured to anticipate what’s to come, rather than what’s already occurred. Which means that market prices also takes investor expectations such as optimism, pessimism or uncertainty into account.
Investment Risk: How Does it Fit Into Your Comprehensive Financial Plan?
Regardless how well the markets are performing, as investors, we need to balance our desire for growth with the wide variety of investment risks that are always present.
There are many types of investment risks including the following:
exchange rate risk
interest rate risk
purchasing power risk
reinvestment rate risk
Many successful portfolio managers focus on the last two forms of risk. Unsystemic risk – or the diversifiable portion of total risk -- can be eliminated by simply increasing the number of securities in a portfolio. In contrast, systemic risk is the non-diversifiable portion of total risk. It represents the risk inherent to the entire stock market and is driven by macroeconomic forces, such as recession, interest rates, inflation or the money supply.
Reducing Risk as a Wealth Managment Solution
Unsystemic risk is eliminated through broad diversification and the use of structured asset-class portfolios that represent a broad cross-section of industries and companies. Effective wealth advisors focus on including market components that result in compensated risk, such as:
Stock of established companies in emerging economies
Systemic risk can’t be eliminated, but it can be offset; successful advisors know that balancing risky assets with conservative, high-quality, short-term fixed investments helps reduce overall portfolio volatility. In addition, maintaining a comfortable cash reserve along with a fixed component helps investors get through tumultuous market periods, especially if they withdraw from their portfolio systemically.
Over the past 25 years, we’ve found that client perception of market conditions actually presents a more significant risk than short-term market declines. When clients react to short-term declines by choosing to liquidate their portfolios, they essentially lock in their losses. Over time, this decision can be very costly to a long-term portfolio. Remember, the media wants people to pay attention -- and dramatic, negative reporting tends to draw more viewers. In the reality of historical context, the stock market may rise and fall, but it has also grown over 80% of the time.
That’s why we generally tell our clients that it’s best to stay the course and give their portfolios time to recover (unless there’s a pressing short-term need for funds, of course). The decision to sell is often a choice, rather than a need, and investors can choose to sell low – and lock in unnecessary losses – or hang in there and sell at a later date when prices are much better.