by Jack Waymire
The bear markets of 2000/2001 and 2007/2009 left investors bruised and battered but not out for the count, assuming they resisted the urge to sell their stocks during these downturns and held on until the market resumed its upward trajectory. At the same time, the precipitous nature of these declines demonstrated the significant damage that a bear market can do to an investor’s portfolio.
With stock markets around the world turning in solid gains, for the most part, ever since the U.S. market begin recovering from its low point in 2009 (and with the more broadly-based Standard and Poor’s 500 up 106% from what some cite as the start of the crisis on August 9th, 2007), the question on many investors’ minds these days is whether another market crash is looming on the horizon. The market’s powerful advance in 2017 (capped by its surge to all-time highs above the 22,000 level in August) has caused a number of prominent market pundits, including famed bond manager Jeff Gundlach, Seth Klarman, manager of one of the largest hedge funds in the U.S., and former Reagan budget director David Stockman, to issue warnings that the stock market could be poised for a significant decline.
It is true that, as the saying goes, nobody has a crystal ball. Nevertheless, it’s understandable that investors concerned about a repeat of the market downturns of the 2000s might want to contact their advisors to see if they are taking steps to protect their portfolios if such an event were to occur. While there is no one right answer to the question of how to protect your portfolio from a crash, in the current circumstances it is certainly a relevant question to ask.
If a crash does happen, it is much better if you and your advisor are on the same page ahead of time, after all it is a key role of the financial advisor. Working out a strategy to deal with a crash after it has occurred is like locking the barn door after the horse has escaped; a sub-optimal approach to the situation. If you manage your money yourself, the decision as to what actions, if any, to take to protect your portfolio in case of a crash are yours alone to make. If you have hired an advisor to make such decisions, however, this by no means implies that you shouldn’t learn more about the logic behind their approach.
Investment Management Approaches
The reason there is no single answer to the question of how to prepare for, or protect against, a dramatic market downturn is that the answer is likely to depend on the investing philosophy you and your advisor are following. To generalize, there are three major approaches used by advisors when managing investor portfolios:
- Passive asset allocation: This approach generally doesn’t take into account current market conditions. It relies on analyzing past long-term returns of different asset classes to determine how an investor with a given age/risk classification should allocate their investments. It is often used by robo advisor services where a computer decides your asset allocation based on predetermined criteria.
- Active asset allocation: This approach also uses an investor’s age and risk classification to determine how their portfolio should be allocated, but it allows for active management of the portfolio by de-emphasizing an asset class or stock if it doesn’t appear to have acceptable risk/reward potential, and emphasizing those investments that do appear to have such potential.
- Absolute return or total return based asset allocation: This approach differs from active asset allocation mainly in that it allows the portfolio manager to short the market or sell all account assets and go to cash when doing so appears to offer better risk/return potential than investing in the market via stocks, mutual funds, and other equity investments.
These three approaches will generally involve different methods of dealing with the potential of a market crash. As mentioned above, none of these approaches is right or wrong in and of itself – each method has benefits and drawbacks. The important thing is that you understand what approach your financial advisor is using to manage your investments and that you are comfortable with it.
How the Different Investment Management Methods Deal with a Potential Market Crash
Passive asset allocation relies on long-term investment returns, rather than changing an investor’s investment allocation in response to current market conditions. Given that large market advances can happen quickly, this helps sidestep the risk of missing out on market gains by being out of the market during a market advance. A drawback of this approach is that if the market does decline substantially, it can take many years for your portfolio value to recover.
Because of this, such strategies generally adjust for an investor’s age: because you have less time to wait for your portfolio to recover as you enter or get closer to retirement, your allocation to equity investments is generally reduced as you get older in favor of more conservative investments such as bonds. This approach typically does not involve taking any action in the short run to ward against a market crash.
Active asset allocation takes current market conditions into account, meaning that if the market seems overvalued and potentially near a market top, your advisor can reduce your market exposure accordingly. However, in many cases this approach doesn’t involve drastic changes in allocation. For instance, your advisor might reduce your market exposure from 40 percent to 30 percent if the market appeared overvalued, rather than eliminating market exposure altogether. The degree to which advisors using this approach will change your allocation in response to expected market conditions varies greatly – if your advisor takes this approach you should ask them what steps, if any, they plan to take if they believe the market to be overvalued.
Absolute return investing typically involves more aggressive changes to portfolio allocation when a potential market crash is feared. Such a strategy could even involve shorting the market via an ETF or individual stocks in an attempt to capitalize on an expected market downturn. This is the most aggressive of the three approaches, and thus has the highest risk/reward characteristics. If your advisor is correct in predicting a crash your portfolio can benefit greatly from avoiding it and/or shorting the market when it happens; on the other hand, if he or she is wrong you risk missing out on a market advance and/or losing money from going short the market.
Ask Your Advisor About Their Investment Management Approach
With a different investment guru proclaiming on what seems like a daily basis that the market has peaked or is close to peaking, if you haven’t closely questioned your advisor previously about their approach to portfolio management, it makes sense to do so now. While all the approaches listed above have advantages and disadvantages, knowing which one of them your advisor utilizes is important to managing your expectations about the performance of your portfolio.
For instance, if you are worried about a potential market crash but your advisor recommends a passive asset allocation strategy, you may want to consider whether that is in fact the strategy you want to pursue. If you decide it isn’t, and your advisor doesn’t work with any other strategies, it may be a sign that you will be better off working with an advisor whose investment philosophy more closely matches your own.
Another issue to consider is how successful your advisor has been in dealing with past crashes. If they provide performance data, instead of just looking at their average performance overall, examine how they did during market downturns. This will provide concrete examples of how their management approach does during a bear market.
Don’t Forget That It’s Your Money
If you feel concerned enough about a potential market crash to want to take defensive measures in your portfolio you have the right to do so, even if your advisor doesn’t agree. Whether you should do so is, of course, a complex question, and one you and your financial advisor should discuss in relation to the investment strategy the two of you have agreed upon. That being said, any strategy can be adjusted if you feel strongly enough about it. If there comes a time when market conditions concern you enough to make you want to take steps to protect your investments from a potential market crash, there is nothing stopping you from telling your advisor to take such steps. It’s your money, after all.
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