Fear ruled the day in 2012 as investors spent much of the year fleeing equities in favor of fixed income. This has created an opportunity for financial advisors to help clients understand the need for investing in stocks for long-term capital appreciation while managing risk with asset diversification.
During the first 11 months of 2012, investors redeemed nearly $115 billion from actively managed stock mutual funds, exceeding the $108 billion in outflows during 2008, according to Morningstar. In comparison, bond funds are expected to exceed $350 billion in inflows when all the figures are tabulated.
Unfortunately, the outflows mean many investors are missing considerable equity gains, with the S&P 500 Index having climbed 15% during the first 11 months of 2012. From a longer term perspective, bond funds – especially portfolios of short-term U.S. Treasuries currently being favored by investors – are unlikely to generate sufficient returns needed for many investors to reach their long-term saving goals. Furthermore, in many instances the funds may have negative returns after factoring in inflation.
Investors, of course, have good reason to be concerned about the near-term outlook for equities. Ongoing tumult in Congressional over fiscal policy, the euro-zone debt crisis, and the subprime mortgage crisis is still fresh in investors' minds. Yet, over the long-term, equities have outperformed other assets classes, which underscores a need for advisers to educate investors on the need of equity investing. In presenting the merits of equity investing to clients, advisors should provide illustrations that show how equities have outperformed other asset classes. Advisors, however, should also consider using the following approaches to help investors embrace equities.
Advisors should illustrate how diversification can reduce risk, or volatility. Illustrations should focus on how diversification of assets can dampen the impact upon portfolios of market downturns, thereby improving the risk/return profile of an investment program. In addition to including traditional assets – such as various categories of equities and bonds – advisors should also illustrate the benefits of including international securities and alternative investments in model portfolios.
Equities' Long-term Track Record
Showing how equity values eventually recovery from past market declines through illustrations may also be helpful. For example, they can show how long it took for $1,000 invested at various market peaks to recover following subsequent bear markets.
Advisors should emphasize that the illustrations depict the worst case scenario—that is investing shortly before a bear market. Investors that committed assets to equities substantially before bear markets and thereby benefit from market gains before a correction, therefore, will have a short-time period to reach a break-even point.
Advisors can also illustrate how dollar cost averaging, or allocating a portion of portfolio assets to equities over a specified schedule, can help reduce the risk of investing shortly before a bear market.
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It's not uncommon for novice investors to comment that they have friends who "lost everything in the stock market." By using the illustrations described above, however, advisors can show that “losing everything” is virtually unheard of. In the process, advisors can explain that most investors who have experienced substantial losses typically have engaged in panic selling during market downturns or have experienced exaggerated losses by having over-leveraged their portfolios.
The Wall of Worry
Explaining that equities climb a wall of worry may also be an effective strategy. Indeed, equities, over the long haul, have outperformed other asset classes despite an ongoing stream of global crisis, including fears of nuclear war during the Cuban Missile Crisis and the Cold War; the rise of communism; conflicts in Europe, Latin American and the Middle East; two attacks on the World Trade Center; Y2K hysteria; large scale natural disasters, including the Japanese earthquake, tsunami and nuclear reactor explosions; hurricanes such as Sandy and Katrina; and the sub-prime mortgage conflict and other tragedies.