The 38.5% drop in the S&P 500 during 2008 and the further drop of 25% by March 9, 2009 have tested the tolerance for risk of individual and institutional investors alike. This has been the worst stock market decline of our generation.
It has been a terrifying ride for clients as well as for investment managers. Although the investment professionals at BWFA foresaw an economic downturn, we did not plan for a disaster. However, “bear markets” do not last forever. After the markets bounced 35% off the bottom this spring, one of the sharpest rebounds on record, we sat down to discuss what we learned from the experiences of the last year.
Here are some of our observations. We learned that for some of our clients, risk tolerance was biased by many years of excellent market returns. Their actual tolerance for risk was considerably lower. When the markets fell deeply, we encountered a few panic attacks.
Clients who experienced the tech bubble burst of 2000-2002 tended to weather this crisis better than newcomers to the equity markets. Clients with larger portfolios generally had fewer concerns than clients with smaller portfolios. Age also played a role, which is understandable. Clients in retirement and drawing on their portfolios were very concerned about the ability of their portfolios to support their lifestyles throughout their retirement years.
It was good to see that many clients who are living off their portfolios (in the “distribution” phase) were flexible enough to reduce monthly distributions and cut their living expenses somewhat so their portfolios had time to recover. We were also pleased that some of our clients had the foresight to continue adding funds to their portfolios at the market’s bottom.
Unfortunately, some clients panicked at the bottom. We were able to dissuade most, but not all, clients from selling in a bear market. So, we have reclassified many of those clients (and even some who did not panic) into lower-risk portfolio models that are more suitable for them. Most of those clients have been quick to concur; hopefully, they sleep better these days.
We found that clients who were utilizing financial plans that BWFA had prepared were generally better able to keep their portfolio risk in perspective as stock prices were pounded lower. Their portfolio allocation was based on the degree of risk necessary to accomplish their long-term financial goals, rather than to maximize returns. BWFA’s plans assumed that markets would be volatile, so these clients were more willing to view the markets from a longer-term perspective. We did learn, however, that we should do a better job of addressing clients’ emotional needs as well as financial needs.
One lesson we won’t forget is the ease with which clients who managed their own 401(k) investments could move their entire 401(k) plans to cash with the click of a mouse. This is a form of market timing—that is, trying to perfectly “time” your entry and exit from market sectors. But market timing is extraordinarily difficult, since you not only have to time the sale correctly, but you also have to get back in at the right time. When the markets snapped back recently, these portfolios were sitting in cash.
Investors need to be well-disciplined; investors can’t allow their emotions to control decision-making. One of the reasons BWFA is hired is to take the emotion out of those decisions. We create an asset allocation that matches a client’s goals, and then we help the client stick with it.
Also, we thought that most people learned their lesson about missing opportunities to exercise stock options back when billions of dollars of stock options at dot-com companies and Enron became worthless almost overnight. Yet, it has happened again. Most stock options that were not exercised are now under water again. Is this a case of tax considerations wagging the tail of making investment decisions? We recommend a disciplined approach of exercising options systematically over time. Those who did not exercise any of their options over the last few years of record stock performance wished they had today.
Two final thoughts: Emergency funds should not reside in one’s investment portfolio, and bear markets are always followed by bull markets. However, no one rings a bell to tell you when one market ends and the other begins.