We have enjoyed a very long bull market. Many clients have short memories. Based on the analogy “A rising tide lifts all boats” they sometimes get euphoric and want to take themselves far out on the risk curve in the hope of getting a big return. As their advisor, you need to remind them risk free investments don’t exist. Put another way, all investments come with a degree of risk.
Risk or “What Could Possibly Go Wrong?”
Here are several things that could cause a client’s investment in a “sure thing” to sour.
1. Bank deposits and inflation. In this example, savings accounts or a money market fund at a bank are a good example. The most conservative client knows their account is insured within limits by the FDIC.
They can lose because: Bank accounts often pay a rate of interest below the rate of inflation. In addition, the interest earned is taxable, unless it’s in a retirement account. They are losing in terms of purchasing power.
2. Buying real estate. Everyone has heard the expression “Safe as houses.” Then came the 2007 Financial Crisis. People who assumed they could buy, then flip discovered they couldn’t, as more and more inventory came onto the market. That’s only one scenario.
They can lose because: Real estate had bubbles before. A real estate agent (at the gym) explained people are offering $ 50-75,000 over asking price to get the house in multiple bidder situations. The market is inflating. When more inventory and new construction comes onto the market, prices should come back into line. It might be a decade before prices rise back to the level they paid.
3. Rental property. It makes sense. If people are priced out as home buyers, the rent instead. The returns look good. Rents can be increased in line with inflation.
They can lose because: It all depends on the tenant. If you have a tenant who stops paying rent, you still need to make your tax, insurance and mortgage payments. Even with the best tenants, periodic maintenance is required.
4. Stocks. Long term returns require a long term holding period. You’ve seen the mountain chart, how equities have outperformed almost everything else for decades. Unfortunately it doesn’t happen in a straight line.
They can lose because: If they need money, they might be selling at a bad time in the market. Many investors might not need the money but still act emotionally, selling at the bottom and buying at tops.
5. Corporate bonds. They are guaranteed by the issuer, but the company can get into financial problems and default on their debts.
They can lose because: There are many reasons besides default. The client sells before the maturity date, which is a problem in a rising interest rate environment. They get a great interest rate, but the bond offers little call protection. The company refinances at a lower interest rate, paying off their high coupon bond.
6. Sovereign debt. As Americans, we know the United States is creditworthy. Sometimes people assume bonds issued by governments in other parts of the world are equally secure. They are not.
They can lose because: The issuer might default on their bonds. The country might run into problems and seek to renegotiate payment to bondholders at less than face value. Even if the issuer is solvents, there is currency conversion risk, unless the bond id denominated in US dollars.
7. Overseas bank accounts. Many people assume “a bank is a bank.” If they carry FDIC insurance in the US, there must be equivalent protection in foreign countries, especially sunny islands. Wrong.
They can lose because: Depositor insurance at overseas banks may not exist. The bank might not exist and it’s a fraud. There might be a run on the bank. There’s a reason they offered high interest rates.
8. Buying gold and precious metals. It makes sense. Gold has traditionally been considered a hedge against inflation. It has industrial uses too.
They can lose because: Lets assume you prefer the metal, not a security. You are prepared to hold it a long time. Gold pays no dividends. There are storage costs incurred between the time you buy and the time you sell.
There are many different areas clients might consider investments. Everything carries a degree of risk. Part of the value the financial advisor brings to the relationship is helping clients make decisions with their eyes open.