After experiencing years of strong investment returns, your clients may be getting too comfortable.
After more than a decade of generally favorable conditions in stock and bond markets, financial advisors' clients may be feeling a bit complacent and acting, well, a little spoiled.
If an advisor is not careful, clients can go from being grounded, with realistic expectations, to being overconfident. Most important, their hubris can make them more vulnerable the next time the markets start to turn against them. That can put their advisor, whose job it is to keep them out of hot water, in the hot seat.
To keep clients within the guardrails of their own emotions, financial advisors should be upfront about the realities of investing. Any investment can appreciate in price at any time. What differs from one investment to another is the risk of major loss they carry at that point.
For instance, the S&P 500 and Nasdaq have had historic runs recently, and they could continue ticking upward for years. Conversely, they could roll over and crash. Or they could spend years flopping up and down. Anything is possible. But when clients have only experienced rallies and successful buy-the-dip recoveries, they may not recognize that reality.
You are paid to know market history and put the current environment in context. Your clients hire you for that knowledge and experience. And it's important for them to understand this common investing warning: Past performance doesn't guarantee future results.
Here are a few current market realities to explain to your clients, depending on what they own now.
Investing for Yield Doesn't Guarantee Stable Stock Prices
Clients may feel pretty safe when investing in dividend stocks. After all, these stocks have an extra level of credibility since they pay cash from their profits every quarter.
But that relative stability in the business is of no concern to the stock market when it decides that some bigger, macroeconomic issue should take all stock prices down by 50% or more.
Don't let clients get too complacent. It doesn't matter what the company does or how cheap some analyst thinks it is. All stocks are vulnerable when the market mood turns.
In fact, March 2020 was the most recent example of this reality, when a coronavirus-spooked market dipped suddenly, and the Dow Jones Industrial Average lost nearly 13% in a single day.
Wall Street pros talk about "90% down days" when nine of every 10 stocks drop in price. But major market drops don't have to be single-day events. They can be a longer-term condition as part of the market cycle. In investing, nothing is more frustrating than realizing too late that something was not what it appeared to be.
Before market volatility produces an erratic reaction from clients, make sure you are blunt and equipped with some historical perspective, preferably in a visual format.
If you work for a big firm, it likely has materials for you. If you are a boutique operator, you might need to be more resourceful. While fund companies can supply historical analysis of the range of returns one can expect in the public markets, make sure that you are presenting not just their messaging, but yours as well.
If all their material ends with "just hang in there," and you do not endorse that view, create your own analysis. Particularly when it comes to the topic of preserving capital amid rough markets, you want the message to be in your voice, not parroting some third party.
Junk Bonds Don't Provide Return Without Extra Risk
While the serene times can continue, investors can't count on highly leveraged businesses collectively staying intact and avoiding default when that financial support is eventually pulled away.
Investors should understand that bonds rated BB or lower are called high-yield bonds because they pay a higher yield for the increased risk that they will not make their interest payments as contracted.
They were dubbed "junk" bonds back in the 1980s, before they crashed in price due to excessive leverage, and after investors lowered the bar on the level of company quality level they would invest in. If you think that sounds like what's going on in today's markets, your suspicion is correct. But this time, it is the Federal Reserve itself that is backstopping junk issues.
That could be a shock to clients who do not understand how much risk comes with the reward they have been getting. They see a nice sticker price in the form of yield to maturity on these bonds and assume they're getting a good deal without really grasping the risk-reward trade-off.
Investors have seen several episodes of massive "yield reaching," when investors seek higher yields on their investments, over the past two decades. Particularly when counseling clients in or near retirement, advisors should help warn them of the risks before the bottom falls out.
Owning Bond Funds Isn't Like Owning Bonds
Investors have been confusing this for decades and conflating bond funds with stand-alone bonds.
The advisor might hear a client make an argument for a bond fund that the client understands as yielding 6%. In reality, that fund might yield closer to 1% or 2%. But the dive in bond prices over the past several years pumped up the total return and slashed the yield.
Financial advisors should take care to illustrate this point to clients, given the massive flows of investor assets into bond funds over the past few years.
That's even as interest rates fell to near-record lows. Bond prices rose as yields fell, so novice investors could be excused for assuming that the past performance of the bond fund (looking at total return) implied that they could make higher yields than they can today.
Financial advisors can explain to clients that some of their sky-high past returns will be nearly impossible to repeat going forward.
That conversational kickoff could lead into a valuable discussion about how you can adjust their portfolios to rely less on traditional bond and cash investments. After all, there will come a time when clients notice their bond yield and total return falling below the amount they pay you as an annual percentage fee. Advisors, take note: You will need to have a good explanation for that.
Investors like good news when it comes to their money. And most investors have had a ton of happy updates over the past decade, even after being hit with a pandemic. But don't let those good times inspire complacency.
By stepping in, you will remind your clients why they hired you in the first place. Results are the end goal, but getting there with clarity is a better way to travel.