Market insights and analysis

How dynamic, risk-managed investment solutions are performing in the current market environment

2nd Quarter | 2022

Market insights and analysis

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Updates on how dynamic, risk-managed investment solutions are performing in the current market environment.

By David Wismer

I shared some thoughts recently related to Jerry Wagner’s overview of the 2022 first-half performance of Flexible Plan Investments’ (FPI’s) turnkey multi-strategy portfolios.

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

Today, I want to take that discussion a little further, focusing on four important reasons for “why risk management matters.”

This was prompted by a statement in Mr. Wagner’s article last week that said, “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?

I think this is particularly relevant at this time, as equity markets are seeing either a strong bear-market rally that merely serves to raise false hopes or the true beginning of another run toward new market highs.

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: “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 adviser we interviewed for Proactive Advisor Magazine (PAM) 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

I think 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. (A lesson I am still trying to impart to my two adult children!)

Another financial adviser we have interviewed for PAM 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 in a blog post, “The $197,000 Cell Phone Switch.” 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!” 

This adviser 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.”

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

Technical analyst, author, and strategist Greg Morris distinguishes between “negative” and “positive” compounding. In an upcoming article for PAM, 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 it, 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.

Investment plan “behavioral adherence”

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

One financial adviser authored an article on this topic for PAM 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.”

I think this last thought is one that both FPI, and those advisers and investor clients who work with the firm, would heartily endorse.



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