Investors' Biggest Risk: Themselves

We recently surveyed a few financial professionals to hear their thoughts on managing risk (and their clients' risk tolerance) in today's environment. Frank Armstrong III is the president and founder of Investor Solutions, a registered investment advisor based in Coconut Grove, Fla., and he answered our questions on what risks are underdiscussed and/or underrecognized today, concerns about the risks of a rising-rate environment, and protection against macroeconomic risks. He also addressed the key lessons learned from the bear market of 2008-09 and the risk of higher taxes in the near future.

What risks do investors face that you think are underdiscussed and/or underrecognized?
The biggest risk many investors face is their own behavior. Far too many practice reverse-market timing, repeating the endless cycle of buy high, sell low, and wonder why they are not profiting in the world's capital markets. While not all investors fit this pattern, we know from watching cash flows into and out of mutual funds that after the market has gone up substantially, investors pile on. And after a dip in market prices they head for the doors. All of our past experience indicates that having an appropriate asset-allocation plan and sticking to it through thick and thin is the best predictor of investment success.

Underinvestment is another huge risk. The hardest-hit members of the retirement or about-to-retire cadres are the ones that didn't save enough in the first place or who invested too conservatively during their entire careers. Facing retirement with insufficient funds, they are poorly positioned to ride out the inevitable market dips. A society that had a net-zero savings rate shouldn't be surprised that retirement poses a challenge. At the risk of sounding like your mother, if you don't save, the world's best investment advisor can't help you.

Are you concerned about the risks of a rising-interest-rate environment? If not, why? If so, would you take any steps to hedge client portfolios?
I'm very concerned. The math is straightforward. If interest rates rise, bond values fall, and the longer the maturity of the bond portfolio, the greater erosion of capital value. Lower-quality bonds will be proportionally more disadvantaged. Investors ignore this at their peril.

For almost 40 years, we have had a slow ratcheting down of interest rates. This has greatly distorted the return and risk data that we see looking back at various time periods. So all data streams looking at one, three, five, 10, 20, 25, and 30 years will be inflated. Hardly anyone remembers the horrible devastation in bond portfolios during the 1960s and 1970s. It's off the radar screen for most investors.

Clearly interest rates can't fall much further than they already have. Zero is a reasonable assumption for the lower boundary of interest rates. We are in the middle of an unprecedented massive global intervention in credit markets. Sooner or later the vast sums injected into the world's credit markets must be scaled back which inevitably will increase interest rates. No one knows when this might happen, but you can be sure that the central bankers will not telegraph their intentions.

So, what should fixed-income investors do? Unless they have strong reason to dismiss the possibility of rising interest rates, they should diversify their portfolio widely, keep the quality high (B or better), and have a duration toward the short end (five years or less).

 

To what extent do you alter client portfolios to protect against big macroeconomic risks--that is, to what extent would you use tactical allocation in client portfolios? Do you get pressure from clients to employ more of a tactical approach?
We never make predictions. We never make tactical decisions. Absent super-human powers, which we freely admit we do not have, attempting to forecast future events is a losing game. Markets react to news, and news is by its very nature unpredictable and random. There is precious little evidence that tactical moves do anything but increase risk and cost while reliably reducing long-term returns.

Our clients understand this philosophy up front, so we face little pressure from them. On the other hand, our approach isn't sexy, so we encounter a marketing challenge because many potential investors feel that advisors should protect them from market fluctuations. We don't encourage them to believe this can be done consistently, so they end up some place willing to accommodate their delusional beliefs.

During the bear market of 2008 through early 2009, the correlations of many different asset classes converged at once. What are the key lessons you learned from that experience? Have they influenced how you manage portfolios today?
We have taken diversification about as far as it can go using only assets that are marked to market daily, liquid, transparent, and provide full disclosure. But at the end of the diversification process, market risk still remains. By definition, market risk cannot be diversified away. And market risk appeared with a vengeance 2007-08. In a panic, correlations move toward one.

The key takeaway is to invest no more than you are financially and emotionally able to bear; keep plenty of short-term fixed income available to ride out the inevitable market declines. We suggest that your portfolio contain enough fixed income to support any projected withdrawals for the next seven to 10 years, plus an emergency fund. We don't pretend that you will enjoy the next market decline, but if you have sufficient reserves and fortitude, you should prevail with minimum stress.

Are you concerned about the risk of higher taxes? What steps can you take to insulate client portfolios?
Taxes are the biggest expense that investors endure, and tax policy is beyond our control. Few investors would argue that taxes will stay at their current low level.

But there are lots of things that can be done to minimize the impact. For instance:

• Passive investment strategies to limit portfolio turnover
• Regular tax-loss harvesting. Booking or realizing a loss allows you to offset other gains in the portfolio or elsewhere.
• Asset-location strategies. Placing assets that generate lots of taxable distribution inside qualified plans reduces the impact of those distributions.
• Tax-efficient accounting strategies. Identification of tax lots allows for selective sales later to minimize taxable gains.
• Tax-efficient portfolios. Many fund families incorporate tax-favored practices for taxable accounts and ignore tax implications in institutional accounts.
• Municipal bonds for fixed income. Where clients are in high tax brackets (federal and/or state) municipal bonds may be appropriate.
• Maximize the use of qualified plans. Many investors fail to defer taxes in available pension plans.

Any good investment advisor will routinely incorporate these strategies into your investment policy. Keep in mind that tax avoidance is not the goal; aftertax total return is the appropriate objective. The tax tail should never wag the dog.

More on What Financial Advisors Are Saying About Risk

• Ross Levin of Accredited Investors
• Sue Stevens of Stevens Wealth Management
• Mark Balasa of Balasa Dinverno & Foltz

For more on Morningstar Risk-Control Week, click here.