Why Severe Market Drops Are Fool’s Mate for Individual Investors
Fool’s mate happens in chess when a player, often a novice, is boxed into a position where any action leads to defeat.
That’s the case for individual investors today as evidenced by the record 1,089 point drop in the Dow-Jones Industrial Index in first few minutes of trading on August 24, 2015. After about one hour into trading, the Dow had recovered (it was down 302) points to trade at 16,157.
This was a huge drop in the market, but it was not the largest.*
Still, the huge decline in the stock market today translates into a decline in wealth for millions of retirees and investors accompanied by justified concerns about where to invest, what can be done to preserve wealth and what actions, if any, individual investors should take to protect themselves.
These are normal concerns. And given the huge financial and emotional swings, professional financial advisors have an arsenal of responses for nervous investors.
The big problem is that the advice is old. Any investor who has been through a crash or correction has heard it all before.
The other problem is that the financial services industry always wins in advancing and declining markets. The reason: fees are always collected. In the 401(k) industry alone, some $164 million in fees are collected daily, in bull and bear markets, even when investment managers don’t do anything except watch their screens. In the field, advisors commonly avoid investors not to panic. And while the advice is often true, it is also blatantly self-serving to the investment industry.
In the 401(k) industry alone, some $164 million in fees are collected daily, in bull and bear markets.
But from the investor’s perspective, what’s missing is a different perspective. Investors should realize that in the new retirement world, they are assuming 100% of the financial risk, while their investment firm and planner, however well-meaning and concerned, and are just along for the ride. They make money if you lose it (in the form of fees) and this is just part of the system.
It’s also important to realize that retirement security is now bound to the new global financial system. This means that macro-global risk management, which is essential to any portfolio, is more difficult than ever. Yes, it is possible to hedge via ETFs and short-selling, but this is outside the expertise of most individuals. Even most planners will not raise this alternative since it requires significant oversight, expertise and trading that most planners don’t know how to execute.
Shorting and buying specialized inverse ETFs is also not part of the corporate financial planning advisory culture at the largest national firms. This means that even for the most risk tolerant investors, if they have accounts at big-name firms, they will not ever hear about any alternatives for even a small part of their portfolios.
The bottom line is there are more global variables than ever that are outside the control of any individual or institution. The only investment variable individuals can control is fees and expenses.
The way load mutual funds operate, by the time the average investor writes their check to fund a $10,000 investment, only $9,450 will be invested in the market before they even leave the advisor’s office. The other $550 gets eaten up by commissions and sales charges, which go to the selling broker-dealer and the fund distributor. In addition, another $50 typically is paid as an underwriting commission to the fund distributor.
That’s just for starters. Every year, the shareholder pays about 25 basis points (bps), or one-quarter of 1%, in 12b-1 fees, a management fee of about 90 bps, plus a $20 administrative fee to the fund distributor.
Many mutual funds are so laden with special charges that the DOL has identified 17 distinct fees which can be paid by shareholders. While some costs are well-known (administrative fees, for example), there also are hidden costs, such as trading expenses, which can add up to 50% to shareholders’ costs. While this may sound inconsequential, the fees can be devastating. Finance Professor Burton Malkiel estimates that over time, fees of just 3% can devour up to 50% of investment returns.
For a more detailed explanation of how fees impact investors, see the book “How 401(k) Fees Destroy Wealth.”
For most investors, the only risk-free part of their retirement planning is Social Security and Medicare, but that could change if a Republican president is elected who wants to privatize both or push for vouchers. (Vouchers are just another way of privatization.)
In the upcoming presidential year, there are no real answers that don’t involve a political-economic solution, and that discussion will never be brought up by an advisor, who is trained to avoid serious political discussions with clients.
The Financial Advisor’s Standard Playbook for Severe Market Declines
So when there is a market drop, financial advisors have some standard responses they are prepared to tell investors.
Here are the most common:
–There is a price for expected higher returns. The expectation of higher long-term returns on stocks compared to less-risky assets, such as than on cash and bonds, exists because equities have greater volatility. This is standard investment theory, but it does not come close to explaining previous recessions.
–Market timing does not work. True. When the market changes direction, is does so very quickly , so most amateurs miss out on the biggest moves that happen in a matter of days.
–Portfolio diversification works. Unquestionably corerct advice as evidenced by classic financial books, but when the market drops today, there are few safe havens or hedging opportunities for individuals, nor can they get into them fast enough.
–Big market drops happen. Yes, life is unpredictable. Some advisors even call a market decline “long-term noise” that “should have no major import on their life plans.” Others even call it the proverbial “buying opportunity,” but this assumes average investors have uninvested cash and even more faith in buying than they do in keeping the money for another rainy day. Buying on drops is a luxury for the vast majority of investors. This is a throw-away line best aimed at institutional investors.
Client Relationship Advice 101
Then, there is Client Relationship 101 Advice centered on “active listening.” This essentially means don’t doodle while your client is telling you their concerns. Another is telling clients: “Please do not hesitate to contact your advisor if you have any questions or concerns.”
Still another common recommendation is that advisors and planners “should put themselves in their clients’ shoes” after markets plummet. One advisor recommends the line: “I understand you’re frightened.”
Data driven advisors also can rely on market history, which has validity. Since 1900, there have been 35 declines of 10% or more in the S&P 500, according to Azzad Asset Management of Falls Church, Va. “Of those 35 ‘corrections,’ the index fully recovered its value after an average of about 10 months,” the firm wrote in a client memo.
In the field, advisors commonly advise investors not to panic. And while the advice is often true, it is also blatantly self-serving to the investment industry
So What Should Average Investors Do?
There is some authentic truth behind the standard industry advice. Market timing is dangerous, long-term investors have to ride the roller-coaster, diversification is essential. But investors also have to ask more questions about the important things they can control: fees and expenses.
Saving money on these essentials can mean a lot more money in an investor’s pocket over time. And since the financial services industry is not forthcoming about fees and expenses, investors have to push hard for answers, protect their own interests and then do what is right for their own portfolios.
*The biggest single-day point decline for the Dow was 777 points, during the financial crisis in September 2008, caused by systemic mortgage fraud among the largest major banks and mortgage companies in the U.S. Today’s drop was the biggest for the Dow since Aug. 8, 2011, when it fell 634.76 points.
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