Clients may forget lessons of 2000 too soon

(November 25, 2003) As the markets continue to climb and investor confidence slowly returns, financial advisors can expect to face some clients who are dismissive of the very notion of risk.

Never mind that the tech-sector bubble popped just under four years ago, wiping out untold fortunes on paper. The anxiety caused by those losses has led clients to feel they need to catch up — which they might, but they might also make the same mistakes that wiped out their investments in the first place.

“There was a one-way definition of risk which basically was almost non-existent,” says Michael Newton, investment advisor and vice-president at CIBC Wood Gundy. “Everybody was looking for upside and weren’t really cognizant of what effects a minus 10% year would have on a long-term financial plan. The last three years have been very sobering for people.”

He sees investors following the same track they did in 1998 and 1999, as they will look at a portfolio offering 11% rate of return, but which also warns of a 25% loss every 25 years and think they are comfortable with that level of risk.

“People looked at the minus 25% as something that wouldn’t occur in their time horizon. They regarded it as something that happened a long time ago, in another generation,” says Newton. “The focus on a televised event called ‘the S&P 500 index and the NASDAQ’ became more important than what I define risk as — the ability to fund your retirement.”

Traditionally, investors think of risk as the loss of capital and risk becomes evident at this point of loss — a fairly easy connection to make. But Newton says one way to recognize excessive risk is through the over-performance of a portfolio.

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“The definition of risk changed, not only on how much downside could exist, but also the risk of going outside of our targeted rate of return,” he explains. “A plus 25% gain is great, but when you’re only trying to get a 7% rate of return, you’re probably sitting with 18% too much return. The corollary of that is the downside.”

Newton demonstrates to clients that a portfolio earning a 10% return for three years, then posting a loss of 10%, leaves the investor with an annualized rate of return of around 5%. Compounded over the long term, this can leave an enormous dent in the client’s retirement savings.

“To get back to 10% in the fifth year, you have to get something like a 46% or 47% rate of return,” he says. “It’s a real shocker to people. That’s why people have had to redefine risk the hard way, through a very sobering three years.”

It may have become a bit of a truism, but proper retirement investing is a marathon, not a sprint.

“I would prefer to have a high probability of getting 7% consistently for the next 25 years as opposed to getting 11% inconsistently for the next 25 years,” Newton says. “I tell clients that we need to look for money managers or investment vehicles and asset allocation that are geared toward the minimization of risk,” Newton says.

Retirement is far more expensive than many clients realize and with a distant time horizon, it can become rather abstract. And thanks to inflation, the further off the client’s retirement, the more it will cost. They might need to be reminded of the less obvious assets they hold, such as real estate and human capital.

“Instead of just showing them their bottom-line performance, I’m showing them their net worth statement on an annual basis,” he says. “I’m showing retirement as a liability and I’m putting it in at about $1.6 million. I’m showing them whether they’re close to or further from breaking even on this goal. It’s been really well-received.”

Clients who can make the connection between risk and not only large losses, but also high returns will be more comfortable with a more realistic annual goal. If the clients are comfortable with an agreed-upon goal of 7%, for example, then it will be easier for the advisor to deliver on these goals and keep the client satisfied.

“I have to mitigate the volatility, which in turn mitigates the knee-jerk reaction to a bad statement, which in turn mitigates them getting completely out,” Newton says. “The redefinition of risk is going to be a huge advantage in constructing portfolios going forward. I think this lesson is going to be remembered for a long time.”

The trouble starts when clients forget the lessons the market taught in the spring of 2000.

“You’re going to have a new generation of investors that are trying to make up for lost time,” he says. “I myself am starting to get the calls saying ‘hey, can’t we do better?’ It’s kind of frustrating.”

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Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(11/25/03)

Steven Lamb