Back in 2006, before the current financial crisis became visible, CNBC carried an on-air showdown between market commentators Peter Schiff and Mark Haines. During the debate, Mr. Haines uttered what may stand alone as the definitive statement of the era:
"Bear markets the size of 2002 are usually once-in-a-lifetime events, and you're suggesting that less than 10 years later we're going to have another one?" Market bubbles, Mr. Haines suggested to his later embarrassment, have a timing to them.
Mr. Haines was not alone in being deeply wrong. How did so many intelligent brokers and advisors get blindsided by the crisis of 2008? In this article we suggest seven mistakes made by investment advisors. Disconcertingly, we don't believe that the industry has absorbed the lessons of 2008. As a result, your retirement plans may depend upon your ability to avoid these mistakes—in yourself and in your advisor.
Mistake #1. Thinking you can predict the timing of market downturns. Advisors love historical patterns. They use historical patterns constantly to plan your asset allocation and to choose the investments that sit inside your allocation. By and large, this is a good thing. However, advisors sometimes forget that in capital markets, patterns are made to be broken—usually at great cost to your wallet.
Good advisors note historical patterns—yet also use hedging (options, market neutral positions, cash and short hedges) to safeguard your portfolio from unexpected breaks in the patterns. Good advisors know that rare events, while unlikely, can be very damaging.
An un-hedged portfolio is always susceptible to an unforeseen event.
Mistake #2. Thinking the severity of a crash is predictable. Possibly the most painful thing to watch last year was the stream of newsletters coming out of investment advisors with the following kind of logic: "The average market downturn in modern financial history is a 20-percent loss. Since the market is currently down 18 percent, we don't expect the crisis to get much worse." This line of thinking, which is clearly absurd when divorced from the financial jargon that normally accompanies it, was ubiquitous.
Quarterly report after quarterly report over the past 24 months has used this bruised thinking to pacify investors, all the while leaving them largely un-hedged and unprotected from a further decline.
Mistake #3. Assuming the market will always bounce back within a year or two. In our current crisis, there are two possible outcomes. The economy and market may be "fixed" by early next year, or we may be amid a long de-leveraging process that will fundamentally alter the American lifestyle for years to come. There are smart thinkers on both sides of this debate. While it's too early to know who's right, it's inexcusable to ignore the possibility of either.
Unfortunately, many advisors simply assume that the market always corrects itself quickly. They present you with data to support this conclusion, though they oftentimes have not seriously looked for countervailing evidence. The danger of this assumption is serious: After all, the length of a downturn is one of the biggest variables in your ability to retire on time.
Even today, it is highly unlikely that your advisor has modeled in the possibility of a 15-year period from here where equities have a 0-percent growth rate—or worse. In fact, your retirement plan, designed in 2007 or before, may hinge on the assumption of a "safe" 5-percent growth rate of your capital invested in equities. What if the 15-year return is 2 percent? Or -4 percent? Or worse? Is there any riskier assumption one can make with the retirement capital of one's client?
Mistake #4. Thinking diversification among long-only investments would work in a crash. Diversification is a necessary part of investing. It's based on ideas about statistical correlation: the idea that when small cap value stocks are underperforming, large cap growth stocks may be outperforming—and vice versa. The assumption, of course, is that diversifying your investments protects you by not putting all your eggs in one basket. This is true—so long as a large anvil does not fall onto all of your baskets at once, crushing your eggs.
In 2008, practically all un-hedged investments crashed. Investments which previously had shown very little correlation to each other suddenly saw their correlations skyrocket.
Few advisors realized the connections between all these investments that were supposedly uncorrelated. Many investments had exposure to real estate in unpredictable ways. Many had exposure to liquidity risk. Most eerily, many investments lost value simply because they were owned by investors who were forced to sell them (to cover margin calls on other, unrelated investments).
When the market falls, even diversified portfolios, if unhedged against market collapse, are far more vulnerable than anyone thought.
Mistake #5. Measuring risk incorrectly to begin with. Advisors are fairly uniform in the measurements they use to gauge the risk of your investments, whether they are stocks or mutual funds. The language used in these measurements sounds fancy—terms like Sharpe Ratio, Sortino Ratio, Information Ratio and Morningstar Risk—but the mathematics behind the calculations your advisor uses all share one common attribute:
They use the past-price volatility to project the future risk of you losing money. This is fundamentally wrong. Historical volatility does not equate to future risk of crash. There are many examples of investments with low historical volatility that crash unpredictably.
Past volatility is not future risk, and using volatility to measure risk is like using inches to measure temperature.
To understand this point, suppose you are looking for a new mutual fund investment.
You identify two managers who produced 9-percent returns over a six-year period. Fund manager A was un-hedged and put a large percentage of your capital at risk (but did not get burned). Fund manager B was 50-percent hedged the whole time against a market collapse. Which manager performed better in terms of risk-adjusted returns? Of course, fund manager B. Yet fund manager A could easily show up as "less risky" if you (or your advisor) use things like Morningstar, Sharpe, Sortino, etc. They privilege the measurement of volatility over the measurement of how much you could have lost.
Mistake #6. Overconfidence caused by expertise. Expertise can be dangerous if it breeds overconfidence. Lawrence Gonzales is an author who studies life disasters (such as boat wrecks and hiking disasters) and the people who survive them. His work has ramifications for both investors and financial advisors.
One of his findings is that those who initially appear most likely to survive (the most experienced) are actually more likely to die first in a disaster. Small children and less-experienced outdoorsmen are more cautious and less confident of their ability to survive, and consequently their caution often translates into survival. In an interview with CNN, Mr. Gonzales said, "Humility can keep you out of trouble. If you go busting into the wilderness with the attitude that you know what's going on, you're liable to miss important cues."
The same applies to financial experts. The greatest long-term investing skill is the humility to accept that events you can't see coming can wipe you out. If you are un-hedged, you are vulnerable. In capital markets, charging into the wilderness without a safety mechanism can lead to dangerous results.
Mistake #7. Allowing optimism to cloud judgment. Advisors often skew toward optimism—even more so when addressing their clients. Just as patients avoid doctors when they can expect bad news, advisors sometimes avoid clients when there are potentially negative prognoses about the market. Hope creates rose-tinted glasses. No advisor wants to believe that a difficult market time—where they are certain to lose revenue and likely to lose clients—is right around the corner.
Leaning toward optimism may keep a client temporarily happy, but it is not going to protect a portfolio when a bubble bursts.
Aside from simply avoiding the above mistakes, there are ways to proactively reduce your likelihood of making them. First, seek out advisors and investment managers who hedge their portfolios at all times against unforeseen events. Diversification alone is not enough—seek advisors and managers who use options, short positions, market neutral trades and other measures—and make sure they are using them to decrease the risk from unforeseen events. Ask to keep a certain percentage of your portfolio in investments that are always hedged against a market collapse but simultaneously can outperform the market over time. Be cautious of investments that rely on heavy borrowing to be successful. Seek advisors who invest significantly in the same items they recommend to you. Seek advisors who accept no compensation from the investments they recommend. Seek advisors who freely admit that there are limits to their knowledge.
Often, advisors get lucky and are right: The downturn doesn't come, or it's shallow or the market bounces back quickly. Yet there will be times when events occur that no one could have predicted. In those times, a large gap grows between those who are always prepared and those who try to time such things. Those who assume nothing and hedge portfolios against severe market downturns rest easy; those who make the mistakes above feel the anxiety of a retirement plan threatened. 2009 is an excellent year to review your own portfolio—and your own advisors and managers—to see just how ready you are.
Mr. Abernathy is a principal and portfolio manager and Mr. Scarfo is director of communications and investor relations at The Abernathy Group, an asset-management firm dedicated to serving medical professionals. Contact them at 1 (800) 342-0956, email@example.com or visit abernathyfinancial.com.