Estimated reading time: 3 minutes, 14 seconds

While market bulls are understandably cheering the ongoing equity rally off of 2009 lows, the recent climb of the Dow Jones Industrial Average to record highs is creating a quandary for advisors.

 

On one hand, some clients may look at market performance over the past few years and unrealistically conclude that the rally shows that equities are likely to continue to provide stellar returns with minimal volatility. On the other hand, some risk-averse clients may use the rally to justify avoiding equities. Buying equities now, with markets at record high levels, they may argue, is simply entering the market at a peak, which is a classic mistake that can result in negative returns, at least over the short term.

The negative consequences of either school of thought can be considerable. Investors who jump into markets with optimism based on past performance rather than having long-term strategic goals are susceptible to panic selling during market turmoil. In doing so, they are likely to realize considerable losses.

Meanwhile, investors dominated by pessimism regarding the markets’ future may fail to reach their long-term savings goals by investing primarily in less aggressive assets that are less likely to generate attractive long-term gains.

Yet, investors’ reactions to new market highs are providing an opportunity for advisors to deliver value to clients by encouraging investors to take a long-term strategy approach to equities rather than make emotionally-driven and counterproductive decisions. For both optimistic and pessimistic investors, advisors should focus on the long-term track record of equities. More specifically, advisors should make sure that overly optimistic clients understand they will need to ride out market volatility. The goal is to make sure that clients understand the need to tolerate market volatility without causing clients to become overly fearful of market declines.

When meeting with overly optimistic clients, advisors should use graphs that illustrate long-term market performance. In the process, they should show clients that even during prolonged bull markets, equities have experienced substantial declines.

Rather than limiting the discussion to vague terms, however, advisors should quantify the impact of past market declines in dollar values based on the amount of a client’s investable assets and show how declines in portfolio values during prior market dips would have been determined, in part, by an investor’s asset allocation.

As an example, an advisor may want to estimate the dollar value of declines of a $100,000 equity portfolio from recent market dips. At the same time, the advisor should show how the impact of the market decline would be muted by including bonds, international equities and alternative investments in a portfolio.

The presentations, of course, should illustrate the benefits of riding out market declines by showing how equities, over the long term, have outperformed other asset classes. Advisors can also illustrate the impact of panic selling during market declines by citing Dalbar research that claims excessive trading by mutual fund shareholders resulted in the average retail investor underperforming the S&P 500 by 7.85% in 2011.

For risk-averse investors, advisors need to take a similar long-term approach when discussing equity performance. In the process, advisors should acknowledge that equities may be more likely to decline after markets have hit new highs than during more normal periods.

Yet, the impact of those declines can be mitigated by riding out market declines. Advisors should also provide illustrations that show that investing during prior market peaks and maintaining a long term perspective by riding out subsequent market declines has frequently resulted in equities outperforming other asset classes once bull markets return.

Advisors can also provide projections of the growth of clients’ savings based on different asset allocations. Advisors may also want to encourage their clients to use dollar cost averaging, which entails spreading purchases of equities over time, rather than making a lump sum purchase. While dollar cost averaging can hurt performance when markets rally, it can help lessen the impact of market declines.

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Last modified on Sunday, 19 May 2013
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