Your Financial Future / Stock Market Considerations

 

By Roxanne E. Fleszar

The eleven per cent decline in the stock market in three days in August caught investors’ attention. In addition to a few clients’ emails, I received an unexpected phone call from my college roommate. She said her husband was not willing to go through a significant stock market correction again. Did I recommend that they move the investments in their retirement accounts out of the stock market and into fixed annuities?

The Standard & Poor’s 500 index has almost tripled since March 2009 without much volatility; many investors became complacent. Consumers of investment advice have noted that passive, buy and hold strategies have outperformed most active strategies over this time period, giving some the false impression that ‘risk management,’ in the context of tactically changing portfolio asset allocation to defend against bear markets, is a fools game.

We shouldn’t be surprised; as we have written in the past, managing risk is a thankless task when viewed in the rearview mirror. All that you can see looking backwards in time is the certainty of what has been. Any tactic employed to defend against potential bear market scenarios in the past looks silly when viewed from the perspective of a new market high in the present.

This phenomenon is called “hindsight bias,” and it occurs whenever we think we should or could have predicted something that occurred in the past. The fact is, we have remarkable clarity of vision about variable outcomes… once the present obliterates the probability of the negative consequences we faced in the past.

The recent bull market provides a good example. The market has steamed ahead to record highs, so does it matter that…

  • Banks don’t have to mark their securities to market.
  • Derivatives are still a huge part of the economic landscape.
  • Europe’s experiment with the euro is tenuous at best.
  • Central Bankers create trillions in liquidity with the push of a button.
  • Global debt levels will be reduced at a cost of lower growth.

Perhaps these things will matter in the future, but we can acknowledge with the help of our rearview mirror that they didn’t matter in the past six years.

Modern finance gives us “alpha,” a way of measuring how well we do in managing risk relative to the returns we earn. Alpha risk-adjusts returns so we can compare them to a benchmark; in our case, our portfolios earned positive alpha over the past six years, a statistic that gets lost when focusing on returns.

Today our analysts are sweating over a landscape of risks. This has been a long bull market by any standard, and the gains are already above average. Until very recently, volatility has been low. Our historically low interest rates will start to rise, likely sooner than later. Meanwhile, geopolitical risks abound. Investors must ask themselves if it’s less important to manage risk after a six-year bull market run than it was after a disastrous market decline. Put another way, is now the time to chase investment strategies that did well for the past six years, or is it time to look ahead?

There will always be investors who get swept away by the moment, and our advice to them remains the same: evaluate your portfolio returns in the context of a full market cycle, when fear becomes just as important as greed. Don’t make rash decisions, such as selling out of the stock market. Instead, evaluate your long-term goals in context to the amount of risk and return you want to assume in your portfolio going forward.

Hindsight is a lousy method for identifying winning strategies in a risk-filled future.

Roxanne E. Fleszar, CFP, ChFC and Ken Solow, CFP, ChFC of Financial Resources Management Corp. and Pinnacle Advisory Group, Fee-only Registered Investment Advisors in Key West & Naples, FL, Boston, MA and Columbia, MD.

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