Gird­ing for the Next Cri­sis

Pre­pare your­self for the next big mar­ket down­turn, which may be ex­ac­er­bated by highly lev­er­aged de­riv­a­tives.

Financial Planning - - Contents - BY BOB VERES

Pre­pare your­self for the next big mar­ket down­turn, which may be ex­ac­er­bated by highly lev­er­aged de­riv­a­tives.

I think most of us re­al­ize that the cur­rent bull mar­ket will not last for­ever. I’m es­pe­cially wor­ried that by adding tax stim­u­lus to an over­heated econ­omy, not to men­tion in­creas­ing short-term in­ter­est rates and start­ing a global trade war, there is at least the pos­si­bil­ity that in­vestors ev­ery­where will sud­denly de­cide it’s time to book their gains and re­treat in a heated rush to the side­lines.

I also worry that in the ab­sence of mean­ing­ful reg­u­la­tion, bro­ker­age firms are qui­etly build­ing a new death bomb for the global econ­omy, in­volv­ing highly lev­er­aged de­riv­a­tives where the wire­houses are bet­ting far more than their to­tal net worth on bond rate move­ments.

My pre­dic­tion is that the mar­kets are go­ing to drop — pos­si­bly sharply — and that will pose a prob­lem for many fi­nan­cial plan­ning firms.

Why? The first and most ba­sic rea­son is that most plan­ning firms are still, ac­cord­ing to my lat­est fee sur­vey, fol­low­ing an AUM rev­enue model.

In do­ing so, they have made them­selves quite un­usual in the mar­ket­place. In most cases, when there’s a down­turn, a nor­mal com­pany ex­pe­ri­ences lower rev­enue and can cut back on staffing and ca­pac­ity to ride out the storm.

But a plan­ning firm ex­pe­ri­ences that drop in rev­enue just when all hands need to be on deck, man­ning the phones and at­tend­ing meet­ings with anx­ious clients who are un­der­stand­ably con­cerned that their net worth has dropped 30% over the pre­vi­ous eight days. Should they stock up on cat food? What are you do­ing about this? When will the mar­kets go back up again?

You could ar­gue that plan­ning firms need more ca­pac­ity dur­ing a sig­nif­i­cant drop in their rev­enue, which can put a squeeze on mar­gins.

None of us knows when the mar­kets will drop and there­fore we should al­ways be ex­pect­ing those un­happy days.

We’ve been through this be­fore, back in fall 2008 through early spring 2009, and I think we might want to re­learn some of the lessons from that trau­matic pe­riod.

Back then, I be­gan writ­ing weekly mes­sages to my In­side In­for­ma­tion read­ers, ask­ing them to share what they were do­ing with client in­vest­ment port­fo­lios, what mes­sages they were send­ing to clients in the mid­dle of the fi­nan­cial hur­ri­cane, and also what they were do­ing ad­min­is­tra­tively to stay afloat.

It was a way for all of us to pool our col­lec­tive wis­dom and stay sane while the world seemed to have lost its mind. I also wrote columns for Fi­nan­cial Plan­ning, fo­cused on what ad­vi­sors could do then to pre­pare for, well, right now.

The most im­por­tant thing I learned from this ex­er­cise 10 years ago is that fi­nan­cial plan­ners are not im­mune to herd men­tal­ity. A very few of my read­ers said that they were hav­ing fun buy­ing stocks at ab­surdly low prices. The ma­jor­ity of them said they were grit­ting their teeth and rid­ing it out with­out sell­ing their clients’ stock po­si­tions. Upon fur­ther prob­ing, more than a few ad­mit­ted that they had

The most im­por­tant les­son I learned from the trau­matic pe­riod 10 years ago is that fi­nan­cial plan­ners are not im­mune to herd men­tal­ity.

stopped re­bal­anc­ing to their ini­tial al­lo­ca­tions, and thus were build­ing up cash po­si­tions at a time when stocks were on a fire sale. In do­ing so, they were al­low­ing their eq­uity ex­po­sure to drift lower as the port­fo­lios lost value.

The fol­low­ing year, in a fol­low-up sur­vey, many ad­vi­sors re­gret­ted this ap­proach. In ret­ro­spect, they had a tremen­dous op­por­tu­nity to build some ex­tra re­turn into their clients’ fi­nan­cial lives by sim­ply fol­low­ing their nor­mal re­bal­anc­ing pro­cesses.

And, of course, a hand­ful of ad­vi­sors shared their process for strate­gi­cally “har­vest­ing tax losses” (sell­ing out of eq­ui­ties) as the mar­kets de­clined, and I never did hear their strat­egy for strate­gi­cally buy­ing back in again. In fact, I never heard from them again, at all.

The mes­sages that ad­vi­sors were send­ing to their clients were in­ter­est­ing. Some of them went back into his­tory, not­ing that down­turns were a nor­mal part of mar­ket be­hav­ior.

They re­minded clients that his­tory sug­gests that this one would be fol­lowed by an­other long and only fit­fully in­ter­rupted bull run. There would be a re­turn to a time when all the ideas we have held dear — diver­sify, buy-and-hold, etc. — would once again work mar­velously in client port­fo­lios.

Oth­ers ad­dressed the val­u­a­tion is­sue, say­ing that stocks were on sale, and you would only think that com­pa­nies were less valu­able now than they were six months ago if you truly be­lieved that, dur­ing all that time, all the work­ers go­ing to work ev­ery morn­ing in all those com­pa­nies, day af­ter day, were some­how pro­duc­ing neg­a­tive value for their cor­po­ra­tions.

Oth­ers in­vited their clients to come into the of­fice and, if they were think­ing about aban­don­ing their stock po­si­tions, asked them to re­visit their goals and mar­ket ex­pec­ta­tions.

I was told that these meet­ings tended to end with clients say­ing that they re­ally didn’t want to change their long-term ex­pec­ta­tions, and there­fore they were now will­ing to ride out the storm.

Some of the best let­ters shared the ad­vi­sor’s own trauma with the sit­u­a­tion: that the fa­tigue as­so­ci­ated with these un­usual mar­ket con­di­tions was not un­like pass­ing the 23rd mile marker in a marathon, when run­ners some­times feel like they can’t force them­selves to muster the stamina to go on.

Shar­ing vul­ner­a­bil­ity — and the pain that clients were ex­pe­ri­enc­ing — turned out to be a very ef­fec­tive way to keep clients calm.

I’m shar­ing this so that when the Big One hits, you’ll have some tips on how to pre­pare.

But what about pre­par­ing your prac­tice? A few ad­vi­sors, back then, opined that they wished they had shifted out of the AUM rev­enue model — but of course it was too late now. Oth­ers wished that more of their staff salaries were vari­able — such as an­nual bonuses that were tied to the prof­itabil­ity of the firm.

More than a few founders of smaller ad­vi­sory firms stopped tak­ing per­sonal com­pen­sa­tion and put the money into a money mar­ket fund to en­sure that they would be able to pay staff salaries as the down­turn con­tin­ued in­ter­minably. Of course, they also re­gret­ted not hav­ing set aside more cash re­serves be­fore Lehman went down.

Pro­fes­sional in­vestors al­ways live in a zone of un­cer­tainty; none of us knows when the mar­kets will drop, and there­fore we should al­ways be ex­pect­ing those un­happy days.

My best ad­vice, to­day, is to think about pre­par­ing your clients for the worst. What would they do (you can ask them now) if the mar­kets were to fall 30% or 40% over a rel­a­tively short time pe­riod? It’s hap­pened be­fore, and it may well hap­pen again in their life­time, per­haps in the near fu­ture.

You can­not guar­an­tee that the mar­kets will re­cover quickly; all you know for sure is the di­rec­tion of the next 100% move­ment. That is, the mar­kets will dou­ble their cur­rent level at some point, but they’ll never fall to zero.

Per­haps, for some who are at that del­i­cate stage just be­fore or right af­ter re­tire­ment, some re­tire­ment as­sets could be moved to an in­ex­pen­sive de­ferred an­nu­ity.

Oth­ers, if the thought of a down­turn makes them skit­tish, might want to re­think their goals and port­fo­lio al­lo­ca­tions.

Ad­vi­sory firms, mean­while, should stock­pile cash and see how much of their fixed-cost struc­ture can be made vari­able. And they should start com­pos­ing re­as­sur­ing mes­sages that say a mar­ket down­turn is not the end of the world. The pos­i­tive will, in the end, out­weigh the neg­a­tive: You’ll be able to buy stocks on the cheap, your com­mu­ni­ca­tions and shared pain will deepen your re­la­tion­ships with clients, and maybe (fin­gers crossed) the next round of wire­house malfea­sances might see some ex­ec­u­tives fi­nally get to know the in­side of a prison cell.

Newspapers in English

Newspapers from USA

© PressReader. All rights reserved.