The following was published in www.seekingalpha.com by our very own John Whaley, CFA.
- Historic market valuations accompanied by historically low volatility create a type of euphoria risk dangerous to clients.
- Strategic asset allocations should not be changed due to market results.
- Advisors and clients alike need to be aware of the dangers of a mismatched risk profile driven by extreme market circumstances.
The stock market’s climb to nosebleed valuation levels has been accompanied by the type of consistent positive gains that leave many of us wondering why we should ever mention risk again. Through November 2017, Morningstar’s Moderately Aggressive Target Risk Index has shown positive gains in all but one of the last twenty-two months. The one-year standard deviation of this index is calculated at 2.25%, a sliver of the 11.56% fifteen-year measure.
The third quarter of 2011 was the last time this measure of 80% market risk fell by more than 10% in a calendar quarter. From that point, we have witnessed fourteen quarters of positive gains and only four quarters of negative returns. Those negative returns averaged a paltry 3.4%.
Advisors and clients alike need to be aware of a little-discussed definition of risk:
The risk that unusual or unforeseen portfolio developments in Period 0 lead to a sub-optimal portfolio decision in Periods 1 and beyond.
That includes “euphoria risk”. When every portfolio makes money, it is easy to forget about the consequences of assuming a risk profile too aggressive for client circumstances.
We are witnessing two phenomena in this environment. First, new client risk profiles are, on balance, more aggressive than we experienced in 2008 and 2009. Second, existing clients are increasingly questioning their original profile and are worried that they may be invested too conservatively.
The consequences of ignoring risk are significant. Declines in the S&P 500 ending in late 2002 wiped out total returns dating back to June 1997. The collapse which began in late 2007 and ended in the first quarter of 2009 took us all the way back to the June 1997 starting point.
In the perfect world, advisors and clients have jointly reviewed their Investment Policy Statement and the annual updates to that document. A proper risk profile should have generated an appropriate long-term strategic asset allocation. We all need to remember that the strategic allocation should not be subject to change because of market circumstances.
– John Whaley, CFA
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.