Help­ing Ner­vous Clients

Some in­vestors may fear de­ploy­ing cash into stocks be­cause they sense the mar­ket will tank sooner rather than later.

Financial Planning - - Contents - BY CRAIG L. ISRAELSEN

Some in­vestors may fear de­ploy­ing cash into stocks be­cause they sense the mar­ket will tank sooner than later.

Per­haps you have some clients who have kept a high per­cent­age of their port­fo­lios in cash for sev­eral years, or newer clients who have been hes­i­tant to fully de­ploy the eq­uity por­tion of their port­fo­lio. They fear another steep de­cline like the one we saw in 2008.

These fears are un­der­stand­able. As shown in the chart “Past Decade for U.S. Eq­uity,” large-cap U.S. stocks have pro­duced noth­ing but pos­i­tive an­nual re­turns since 2009.

For a broader per­spec­tive, since 1970, the batting av­er­age of large-cap U.S. stock has been 81%. In the past decade, the S&P 500 has pro­duced pos­i­tive re­turns in nine of the 10 years.

So we’re in a pos­i­tive streak that is above the 48-year av­er­age.

Small-cap stock U.S. stocks have pro­duced pos­i­tive an­nual re­turns 71% of the time go­ing back to 1970. Over the past 10 years, small-cap U.S. stocks (as mea­sured by the S&P Small­cap 600 In­dex) have pro­duced pos­i­tive an­nual re­turns in 80% of the years — also higher than the his­tor­i­cal norm.

Mid-cap U.S. stocks do not have a per­for­mance his­tory go­ing back to 1970, but since 1992 they have pro­duced pos­i­tive an­nual re­turns 77% of the time. In the past 10 years, mid-cap stocks have gen­er­ated pos­i­tive an­nual re­turns 70% of the time — so a bit un­der its longer-term av­er­age. How­ever, two of those re­turns (a loss of 1.73% in 2011 and a loss of 2.18% in 2015) were triv­ial.

Clients can­not stay hun­kered down in cash for­ever, un­less they are in their 80s and have lots of money.

Clients may be afraid to start in­vest­ing now be­cause they think the stock mar­ket will tank sooner rather than later, and they want to avoid that bad-tim­ing ex­pe­ri­ence.

But clients can­not stay on the side­lines hun­kered down in cash for­ever, un­less they have a ton of money and are well into their 80s. Ev­ery­one else needs to pru­dently in­vest for the fu­ture and think about the long term.


This is, of course, eas­ier said than done when hu­man emo­tions are in­volved.

One way to counter the fear of bad in­vest­ment tim­ing is to help clients find an ap­proach that is less sen­si­tive to tim­ing. This ap­proach has two di­men­sions: What they in­vest in and how they in­vest.

Let’s talk first about what

to in­vest in. To dra­mat­i­cally sim­plify this dis­cus­sion, I have cho­sen two dif­fer­ent types of mu­tual funds (both hap­pen to be Van­guard funds).

One fund rep­re­sents the mar­ket as many in­vestors re­fer to it (although it is not ac­tu­ally a rep­re­sen­ta­tion of the broad mar­ket) — that is, a fund that mim­ics the S&P 500.

In this case, I am us­ing the Van­guard 500 In­dex Fund (VFINX). This fund has 100% ex­po­sure to large-cap U.S. stocks and uses a mar­ket cap­i­tal­iza­tion weighted ap­proach.

The other fund I have cho­sen is a fund of funds, specif­i­cally the Van­guard STAR Fund (VGSTX). This par­tic­u­lar fund in­vests in 11 other Van­guard funds and is di­ver­si­fied across sev­eral as­set classes.

Specif­i­cally, VGSTX has an al­lo­ca­tion of roughly 40% to U.S. eq­uity (with ap­prox­i­mately 80% al­lo­cated to large-cap U.S. stocks and the bal­ance al­lo­cated to mid-cap and small-cap U.S. stocks), 20% to non-u.s. stocks and 35% to bonds, as well as a small per­cent­age in cash. In gen­eral terms, it em­ploys a di­ver­si­fied 60% stock/40% fixed-in­come ap­proach.

A 60/40 fund and a highly ag­gres­sive large-cap stock fund have sim­i­lar re­turns but very dif­fer­ent mea­sures of volatil­ity.

As shown in the chart “Two Funds, Two Ap­proaches,” the out­comes for these two funds over the past 25 years are sur­pris­ingly sim­i­lar. The 25-year av­er­age an­nu­al­ized re­turn for VGSTX is 8.72%, and VFINX has a 9.58% re­turn.

How­ever, the path to those out­comes was very dif­fer­ent, with VFINX be­ing far more volatile (as noted by the stan­dard de­vi­a­tion fig­ures), with sig­nif­i­cant losses ex­pe­ri­enced in 2000, 2001, 2002 and 2008.

It is pre­cisely this type of volatil­ity that may have caused your client to pull out of eq­uity in­vest­ments in the first place — and hav­ing pulled out dur­ing pe­ri­ods of tur­bu­lence, they would prob­a­bly have failed to achieve ei­ther the 8.72% or the 9.58% re­turn.

VGSTX gen­er­ated 91% of the re­turn of the large-cap U.S. eq­uity mar­ket with only 64% of the volatil­ity. For skit­tish in­vestors, that is re­ally an

ex­cel­lent trade-off.

The re­sults in this chart as­sume a lump-sum in­vest­ment at the start of 1993. This is the as­sump­tion be­hind all re­ported per­for­mance data.

What if your client chooses to get off the side­line and back into the stock mar­ket grad­u­ally by in­vest­ing money sys­tem­at­i­cally over time, rather than all at once? This tech­nique can re­duce risk, specif­i­cally what we might re­fer to as in­vest­ment-tim­ing risk, which is prob­a­bly the con­cern that is keep­ing your client on the side­lines.

The no­tion of bad tim­ing gen­er­ally doesn’t ap­ply to clients who in­vest reg­u­larly and stay in­vested for at least 10 years.

Rather than re-en­ter­ing the mar­ket all at once, your client can make reg­u­lar con­tri­bu­tions (an­nu­ally,

quar­terly, monthly, weekly) over a pe­riod of time. In fact, this is how most of us ac­tu­ally in­vest, whether it be in 401(k)s, IRAS or other ac­counts.

Shown in the last row of “Two Funds, Two Ap­proaches” is the in­ter­nal rate of re­turn when mak­ing an­nual in­vest­ments into both funds over the past 25 years — 8.6% for Van­guard STAR and 9.48% for Van­guard 500 In­dex. These are very sim­i­lar to the 25-year lump-sum re­turns. We now have our bench­mark re­turns for both of these funds based on two meth­ods of in­vest­ing: lump sum or sys­tem­at­i­cally over time.

Let’s now eval­u­ate a bad-tim­ing sce­nario in which an in­vest­ment was made on Jan. 1, 2000 — just be­fore the U.S. large-cap eq­uity mar­ket tanked for three con­sec­u­tive years.

This is a the­o­ret­i­cal sim­u­la­tion of what could hap­pen to a client who comes out of cash and re-en­ters the stock mar­ket now in 2018, if the mar­ket were to sub­se­quently go into de­cline for sev­eral years.

We find in “Bad Start” the re­sults of

this sort of bad in­vest­ment tim­ing from a his­tor­i­cal per­spec­tive. How­ever, that ap­plies only to VFINX, which ex­pe­ri­enced losses of 9.06%, 12.02% and 22.15%. Van­guard STAR had pos­i­tive re­turns in 2000 and 2001 and a loss of just un­der 10% in 2002.

Thus, it clearly mat­ters what we in­vest in. For ner­vous clients, the best ad­vice is to di­ver­sify, di­ver­sify, di­ver­sify.

In the 18-year pe­riod from 2000 to 2017, a lump-sum in­vest­ment ex­pe­ri­enced the brunt of bad tim­ing and fin­ished with an 18-year an­nu­al­ized re­turn of 5.29%. Van­guard STAR fared bet­ter, with a re­turn of 6.96%.

In­ter­est­ingly, if a client chose to in­vest money each year (say, $3,000) into each fund, the in­ter­nal rate of re­turn for both funds was im­pres­sive: 8.41% for Van­guard STAR and 9.78% for Van­guard 500 In­dex.

The no­tion of “bad tim­ing” gen­er­ally doesn’t ap­ply to clients who in­vest sys­tem­at­i­cally and plan to stay in­vested for at least 10 to 15 years.

Mo­ral of the story: Sys­tem­atic in­vest­ing markedly re­duces tim­ing risk, whereas lump-sum in­vestors are fully ex­posed to tim­ing risk — at least dur­ing the first sev­eral years.

Iron­i­cally, sys­tem­atic in­vestors can feel good whether they start in­vest­ing in stocks when mar­kets are drop­ping or ris­ing.

Clients who get back into the mar­kets by mak­ing reg­u­lar con­tri­bu­tions may ac­tu­ally ben­e­fit if they de­cline dur­ing the first few years.

And if mar­kets don’t de­cline ini­tially, that’s OK, too.

Very sim­ply, lump-sum in­vestors can feel good ini­tially only if their in­vest­ments have pos­i­tive re­turns.

Sys­tem­atic in­vestors can feel good ei­ther way — if per­for­mance is ini­tially bad, they are ac­cu­mu­lat­ing more shares with their sub­se­quent in­vest­ments. If per­for­mance is good, well, they can live with that.

If you have clients who are ner­vous about re-en­ter­ing eq­uity in­vest­ments, you might sug­gest they do so grad­u­ally. As the say­ing goes — this is a marathon, not a sprint.

Craig L. Israelsen, PH.D., a Fi­nan­cial Plan­ning con­tribut­ing writer in Springville, Utah, is an ex­ec­u­tive in res­i­dence in the per­sonal fi­nan­cial plan­ning pro­gram at the Wood­bury School of Busi­ness at Utah Val­ley Univer­sity. He is also the de­vel­oper of the 7Twelve port­fo­lio.

The re­turns of Van­guard’s 500 In­dex and STAR funds are sim­i­lar when com­pared very long term (25 years).

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