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Why advisors continue to favor risk-managed strategies

by Sep 14, 2022UpClose

Why advisors continue to favor risk-managed strategies

by Sep 14, 2022UpClose

Advisors are increasingly turning to risk-managed portfolio strategies that seek less-volatile growth through full market cycles.​

A​ recent article in Proactive Advisor Magazine explored the growing trend among financial advisors toward the inclusion of risk-managed strategies in client investment allocations.

This trend accelerated in late 2020 and early 2021—largely based on the investment performance witnessed in 2020 and how these strategies, in the words of one advisor, “did almost exactly what they were supposed to do.” The feedback we have received in 2022 has been similar, as advisors guided clients through a challenging first half of the year.

We reviewed, from the financial advisor’s perspective, many of the benefits of risk-managed strategies—in good times and bad.

This week, we take that discussion a little further, focusing on four important reasons “why risk management matters.”

This was prompted by the following statement from a recent article by an investment firm that specializes in tactical and risk-managed portfolio strategies: “History teaches us that one way to beat the market is simply not to lose what the market loses when the market inevitably declines.”

It is hard to disagree with that thought. “Not losing” is generally always a good thing.

But for investors, what are some of the principal impacts of “losing less” (hopefully significantly less) than the major market benchmarks during periods of market stress?

This is particularly relevant at this time, as equity markets have recently experienced either a strong, yet volatile, bear market rally that has merely served to raise false hopes or the early stages of another run toward new market highs into year-end.

Bear market mathematics

Put simply, bear market math is daunting. It takes longer than most investors think to recover from severe bear market drawdowns—a gain of 50% is needed to overcome a 33% portfolio loss. And it takes a gain of 100% to recover from a 50% loss—which investors have seen twice this century.

For some investors, it takes years to recover from such declines in a buy-and-hold portfolio. And, even after years of recovery, they have merely achieved breakeven. Wealth-management expert and author Kenneth Solow sums it up in his book “Buy and Hold is Still Dead (Again)”: “Patiently waiting for stocks to deliver historical average returns does not rise to the level of an investment strategy.”

As risk-managed strategies seek to mitigate the impact of bear market portfolio drawdowns, investors are, in effect, better positioned to recover and then profit from the next bull market period.

A financial advisor we interviewed for Proactive Advisor Magazine describes it this way in his discussions with clients:

“I think of investing like a staircase. What I have found over the years is that when risk is on, when the market is strong, investors are climbing the staircase. They’re going up, up, up. They’re happy as they get to the top of the staircase. But, the market inevitably pulls back. There is a correction, and instead of falling down a step or two or three, they go all the way back down to the landing. 

“With a portfolio that has a strong risk-management orientation, I can’t say that they’re never going to fall down some steps. But I want them to be able to get off the staircase just having fallen two or three steps at a time. Then, when the market gives a signal to go back on offense, hopefully clients are starting from a higher stair level rather than the landing again.”

The power of compounding

Many of us were probably exposed to the idea of compounding with our first savings account, perhaps as a young child. But few of us understand just how powerful compounding can really be.

Another financial advisor we have interviewed for Proactive Advisor Magazine shares an interesting real-life story with his clients to illustrate points on saving, putting money to work, and the power of compounding. He called this story “The $197,000 Cell Phone Switch” in a blog post. Here is a shortened version of his story:

“Just a few weeks ago, I decided to change cell phone providers. The base plan saved me $110 per month, plus they’d pay for my Netflix subscription and they take off another $15 per month for setting up auto pay. The total savings was $140 per month.

“As a financial advisor, I’m always looking for ways to make saving (and investing) extra money easier for my clients. My favorite strategy is to use impending events, such as a pay raise, a bonus, or simply having a major bill paid off. This cell phone switch was such an event. So I ran some numbers. I’m saving $140 per month, which is $1,680 per year. If I invest this money and it makes 8% per year, after ten years I have $25,220. After 20, $79,665. After 30, $197,207!”

I think it is important to note that his “passive” investment results are theoretical and not always as consistent as they sound.

Notably, this advisor also says, “I am a proponent of incorporating risk-managed strategies in clients’ investment plans … seeking to capture a large portion of gains in bull markets and mitigate losses in poor market environments.”

Technical analyst, author, and strategist Greg Morris distinguishes between “negative” and “positive” compounding. In a recent article for Proactive Advisor Magazine, he speaks about a variety of “market myths” that can severely impact an investor’s long-term retirement goals. One of these “myths” is, “Compounding is the eighth wonder of the world.”

Mr. Morris points out,

“In the stock market, there are many years when prices go down, and those down years can destroy an investor’s wealth quickly. Negative compounding requires exceptional returns over the following years just to recover. … A better and more accurate statement would be: Positive compounding is the eighth wonder of the world. …

“One should adopt an investment philosophy that realizes the market has its good periods and its bad periods, and the philosophy adjusts to them as needed. A technical approach that follows the intermediate trends of the market with strong risk management offers a peace-of-mind dividend.”

Sequence-of-returns risk

For retirees or those approaching retirement, the “sequence of returns” dilemma can have a devastating effect on future income needs. Over the history of the U.S. stock market, given a long enough period, equity investors have been rewarded with growth in their portfolios. However, they have faced periods of extreme volatility and steep drawdowns for those same portfolios.

When those losses occur for any given investor is really at the heart of the theory of sequence-of-returns risk. Twenty-five-year-olds, who have 35–40 years of earning and saving in front of them (the argument goes), can afford to “ride out” stock bear markets. This assumes they never sell out at or near the bottom, as so many people do.

However, for someone about to enter retirement and begin the distribution phase of their nest egg, as opposed to accumulation, a 30%–50% hit to their retirement funds early on will wreak havoc on their planned withdrawal rates. There is a good chance their funds will no longer last throughout a lengthy retirement. (You can read more about the topic in this article.)

A portfolio including dynamic risk-managed strategies offers a prudent path for retirees seeking to achieve the twin goals of asset preservation and compounded capital growth.

‘Behavioral adherence’ to an investment plan

Behavioral finance studies have documented the tendencies of investors to operate on the destructive principles of “fear and greed.” Of course, financial advisors play a critical role in ensuring this does not happen for clients.

One financial advisor authored an article on this topic for Proactive Advisor Magazine a few years ago. He wrote, in part,

“I believe ‘behavioral adherence’ is critical for clients to invest successfully over the full market cycle. One of our most important responsibilities as financial advisors and proactive portfolio managers is to help our clients optimize behavioral adherence.

“All that is guaranteed in the world of investing is risk. Therefore, it’s imperative that we design portfolios and investment policy by considering not only the minimum annualized rate of return our clients need to achieve their stated financial objectives in mind, but also their ability to stick with the portfolio, and adhere to the investment policy, over the full market cycle.

“To this point, it is my belief and experience that clients are far more willing to stick with an investment plan if a significant percentage of their portfolio incorporates active, or tactical, risk-managed strategies.”

This last thought is one that financial advisors—and their investor clients—may want to consider carefully as financial markets continue to face many diverse headwinds in 2022 and beyond.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.

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David Wismer is editor of Proactive Advisor Magazine. Mr. Wismer has deep experience in the communications field and content/editorial development. He has worked across many financial-services categories, including asset management, banking, insurance, financial media, exchange-traded products, and wealth management.

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