Five Years Later, Lessons Learned
Five years have passed since the fall of 2008, the most acute phase of the 2007-09 financial crisis. While periods of business and economic stress routinely occur, the cascading and widening series of crises, the resulting deep bear market, and the extraordinary government intervention that unfolded from late-2007 through early-2009 was truly unprecedented for both our clients and for Aspiriant.
Looking back today, with domestic equity markets achieving new highs and the global economy on the mend (albeit painfully slowly at times), it’s easy to forget the intensity of the financial panic and the visceral reaction to the rapid market decline five years ago. Painful as it was, that period reinforced many lessons for our clients as long-term investors and for us as financial advisors, so the five-year anniversary seems like a good time to remind ourselves of those lessons learned and re-learned.
The popular press has also recognized this anniversary and has published many articles about what banks, regulators, policy-makers and others have (or should have) learned over the last five years. Rather than focus on the larger economic and policy questions… many of which are still evolving… this article focuses instead on a silver lining from the financial crisis: how it has helped make all of us – investors and advisors – a little wiser, even if a little grayer.
Lend Me an Ear
Financial advisors often comment among ourselves that one of our biggest value-adds is not counseling clients when times are good, when the investor’s job is easier, but rather during the scariest, most stressful times, when clients’ emotional reactions and behavioral biases can create the very real risk of turning temporary volatility of investment values into a permanent, devastating capital loss.
The period from August, 2008 through March, 2009 was, for virtually all, the scariest, most uncertain time in memory to be an investor. With each passing week, alarming and increasingly dire headlines multiplied, volatility measures shot through the roof, stock prices plummeted, and investors’ collective anxiety hit a fever pitch. While many investors knew intellectually that they should ignore the short-term noise and that the lessons of history and a dispassionate assessment of probabilities supported a focus on their long-term investment strategy, from an emotional standpoint, such restraint and discipline bordered on impossible. “This time it’s different” is a common refrain in all bear markets, but this time it really did feel different to all of us.
Faced with pervasive and profound uncertainty and fear, clients frequently turned to us for guidance. Somewhat to our surprise, though, the actual content of many of these conversations did not matter; we often did little talking. In most cases our clients knew the right decision before picking up the phone, and did not expect Aspiriant to offer any groundbreaking insights; rather, clients were looking for support, reassurance, an assessment of the impact of the crisis on their financial plan, and, most of all, someone to listen and empathize.
Mark The financial crisis did a good job of stripping away the theory and revealing investors’ true risk tolerance […] we’ve enhanced our process for assessing the likely impact of market volatility on a portfolio’s value, before it occurs.
We also recognized the need to anticipate and respond to client questions, so we designed a pro-active communication campaign that ranged from client-wide conference calls with our investment team, stepped-up email commentary, and more frequent telephone calls to clients to address specific concerns and to empathize with their emotional reaction to the world around them.
While Aspiriant has always been guided by our core value of “providing clarity and peace of mind for clients,” the financial crisis etched in stone an even deeper appreciation of the importance of timely communication during times of crisis.
Re-defining Risk and “Right-Risking” the Portfolio
Making sure that each client’s investment strategy reflects their tolerance for volatility is a cornerstone of Aspiriant’s investment planning process. Simply stated, we try to assist our clients in determining:
- How much return do they need, and how much risk must they accept, to achieve their goals?
- What’s the consequence of coming up short or exceeding the target return?
- How much volatility can they stomach before deciding to abandon the investment strategy for the sidelines?
Our biggest take-away from the financial crisis was the realization that many clients had previously professed an appetite for investment return that was quite a bit greater than their tolerance for the associated risk. The financial crisis did a good job of stripping away the theory and revealing investors’ true risk tolerance. During this period we had conversations with some understandably distressed clients who were considering liquidating portfolios and going to the sidelines, at least until the markets were “safer,” i.e., higher.
As noted earlier, while clients intellectually understood that remaining committed to a sound long-term investment plan during difficult periods was the best approach, many were stunned by the sharp drop in asset prices and just couldn’t bear the thought of things getting worse. Fortunately, after much communication and consultation, the vast majority of our clients remained committed to their investment plans. They’ve since been rewarded for this commitment with five years of strong investment performance and a return to pre-crisis values (and then some). Needless to say, though, we are continuing to have conversations with clients… particularly those who were most concerned during the last bear market… about their risk exposure in preparation for the next bear market.
Unfortunately, a handful of clients were not able to hang on. Our focus on these clients has been, “what could we as advisors have done differently?”
Not surprisingly, we observed that clients’ professed risk tolerance is highest when things are going well and lowest when things are at their worst. And while clients intellectually agree, during good times, that the time horizon for assessing their investment plan’s success is 10 or more years, for some the time horizon shrinks dramatically during difficult periods. This contrast is understandable, of course, as it’s impossible to replicate during good times the visceral reaction one feels when an investment portfolio, which represents a lifetime of work, plunges.
To address this conundrum, we’ve enhanced our process for assessing the likely impact of market volatility on a portfolio’s value, before it occurs. In addition to discussing the expected, long-term percentage ranges of portfolio returns (e.g., “over 5 years the portfolio has a 90% probability of returning between -3%/yr and 10%/yr”), we now emphasize to clients the potential for shorter-term losses (a peak to trough decline, known as a drawdown), and how losses translate into absolute dollar terms. Honing in on the “expected dollar drawdown” for the portfolio, and putting that result into the context of the actual decline experienced during the 2007-2009 crisis period, has proven to be a very good gut-check for clients making decisions in the post-crisis environment (see below for a brief thought experiment that we use).
Which is heavier – a pound of feathers or a pound of bricks?
Answer these two questions:
- You have a $5 million investment portfolio. How big a decline are you comfortable with?
- You have a $5 million investment portfolio. How big a decline are you comfortable with?
Think about it for a second and you quickly realize that your answers should match. But in reality people will very often pick a higher (in some cases much higher) number for question 1 than for question 2. What gives? A loss expressed in dollars is far easier to translate into something that’s relevant (“It took me x years to earn $1 million and I lost that in 3 months?” or “Imagine all of the vacations I could have taken for the $1 million I just lost!”). By estimating loss potential in terms of dollars as well as percentages, we attempt to get a better take on the emotional reaction of losing money during a bear market.
Re-Run Your Numbers
When watching cable news or reading the headlines it’s easy to get a distorted and exaggerated sense of what’s going on in the world. That was particularly true during the financial crisis, when there was no shortage of talking heads claiming that the world was coming to an end. Setting aside that level of hyperbole, though, it was understandably easy for clients to look at a 25% decline in their investment portfolios and translate that into the conclusion that, “I’ll never be able to retire” or, “I have to severely reduce my living expenses.”
Developing custom long-term financial projections to create clarity and context for our clients’ financial decisions, a process we call Wealth Allocation™, is at the heart of what we do at Aspiriant. The exercise provides an excellent framework and decision-making environment for addressing an array of financial decisions, including, “Can I afford to retire at 55,” “How much can I afford to give to my children or to charity,” and “How much return does the portfolio need to earn for me to reach my goals.”
This process also puts a steep downturn in context… and in most cases when we “ran the numbers” clients discovered that the downturn, while uncomfortable, was not devastating. Even with depressed values, they were still able to achieve their primary goals, perhaps with some lower-priority, secondary goals put at risk. In other situations, clients needed to make some adjustments to their primary goals (e.g., work a couple more years, plan to reduce their spending many years later), but these adjustments were generally fairly modest, a testament to the reasonable return expectations and other conservative elements we try to weave into our planning. And, of course, for those who were skating close to the edge even before the crisis, the downturn resulted in the need to make some significant changes… in response, we worked closely with these clients to help develop an action plan for dealing with the situation in a manner that allowed them to sleep better at night.
The downturn also reminded us of a key weakness of long-range financial planning: it provides an estimate at a single point in time, and that estimate can vary widely depending on market conditions. The projections that we prepared in 2008-09 indicating some need to cut back would, if re-run even a year after the bottom, have shown a much better result. This highlights the importance of not extrapolating any result (positive or negative) indefinitely into the future; rather, the process is necessarily iterative, dynamic, and evolutionary, and requires flexibility in one’s expectations.
Quotation Mark If there’s one fundamental truth to investment it’s that investors earn a return for bearing risk.
Find the Silver Lining
Despite the pervasive gloom during the financial crisis, with an eye focused on the future we recognized that dislocations created by the crisis environment presented a number of very attractive planning opportunities for clients. For example, extremely low interest rates and deeply depressed asset values combined to create unprecedented opportunities for:
- estate tax reduction, by allowing clients to transfer assets to their heirs at very low cost.
- income tax reduction, through Roth IRA conversions and tax loss harvesting, and
- for the risk tolerant, enhanced long-term investment results by investing cash that had been on the sidelines and, for a very brave few, amplification of those results through the use of portfolio leverage.
The Path Ahead
While navigating the rocky waters of the financial crisis presented unique emotional and intellectual challenges, we believe we have emerged as wiser investors and more effective advisors. The crisis confirmed that our basic investment principles and philosophies are sound; however, we’ve also received the message from clients… loud and clear… that they are looking to us to develop and offer additional tools for managing risk. So to that end, Aspiriant has:
- hired a director of risk management, making us one of very few independent investment advisory firm to have resources dedicated to managing risk.
- working with leading third-party investment firms, we have developed a strategy for cost-effectively hedging severe downside risk in public equities.
- re-examined all of the underlying managers in clients’ portfolios to better understand how they performed during the downturn, how they interacted with each other, and how we might better offset some of that risk in the future by making changes at the manager level.
To be sure, we have not seen the last of investment volatility. If there’s one fundamental truth to investment it’s that investors earn a return for bearing risk. All that you and we, as investors and advisors, can do is control and understand how much risk we take, the consequences of taking that risk, and the behavioral responses required to remain disciplined when that risk expresses itself in unpleasant ways. These lessons will be tested and reinforced again and again over time. As a result, we move forward as partners with our clients, with the increased clarity and confidence that only actual experience can provide.
1Bureau of Labor Statistics, Change in Total Nonfarm Payroll Employment (June 2014).
Important disclosures: Past performance is no guarantee of future performance. All investments can lose value. Indices are unmanaged and you cannot invest directly in an index.
S&P 500 is a market-capitalization weighted index that includes the 500 most widely held companies chosen with respect to market size, liquidity, and industry. The volatility of an index may be materially different than that of a model. You cannot invest directly in an index. Index returns assume the reinvestment of dividends and capital gains. The MSCI ACWI All Cap Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. It is not possible to invest directly in an index. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.
S&P GSCI: The S&P GSCI© is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment.
Wilshire Global RESI: Is a broad measure of the performance of publicly traded global real estate securities, such as Real Estate Investment Trusts (REITs) and Real Estate Operating Companies (REOCs). The index is capitalization-weighted.