Hurley and Fuller, December 2001
The phone rang in Kathy
Boyle's office one Friday evening in September. The voice on the
other end was familiar. But it was not friendly: "I pay you
to give me advice. Now give me some advice."
Frantic and panicked
after the worst week in Wall Street history, the voice needed
more than an eager ear to shout at. It demanded action. After
30 minutes, the client, an unemployed owner of a house in the
Hamptons and a penthouse in New York City still trying to finance
helicopter lessons from last summer, instructed Boyle to sell
a substantial portion of her client's portfolio.
"I think the layoffs
are starting to hit a little closer to home," said Boyle,
president of Boston-based Chapin Hill Advisors. "Stores are
closed. The market has now been bad for a year and a half and
it's just starting to get uglier. Some clients are paralyzed.
They're refusing to invest. They have a lack of reality."
The example is an extreme
case of a client stretched too thin by unrealistic expectations
and unfortunate circumstance. But most advisors have clients in
similar situations as a result of the market meltdown. In the
18 months ended August 31, 2001, the Nasdaq was down 61.1 percent,
the EAFE (Europe, Australia, Far East) 27.1 percent, the Russell
2000 17.3 percent and the S&P 500 15.5 percent. Then September
2001 was even worse. Unemployment is up. Consumer confidence is
down. And more clients are seriously struggling to resist the
urge to go to cash.
In early 2000, Professor
Robert Shiller of Yale University published Irrational
Exuberance, a book that speculated that a fall in the market
was imminent. Valuations were crazy. Fundamentals were ignored.
Stocks had to come down in a big way, he said - and they subsequently
did. As we near the end of 2001, the pendulum has swung to the
use the term "saliency" to refer to how the human brain
reacts to extremely traumatic events. The more traumatic and more
recent the event, the greater the human brain assumes its probability
of recurring, regardless of the actual probability of a similar
event. The brain simply chooses to ignore other factors that might
affect a particular event or circumstance.
From a financial markets
perspective, saliency is one of the core sources of value investing.
Companies that have exceptionally poor results for a long period
of time are often mentally written off by investors. They even
ignore potential positive signals - such as improving fundamentals
or even senior management increasing their personal holdings of
company stock - and artificially depress the company's stock price.
Famous investors such as Michael Price and Warren Buffett seek
out these companies that other investors give up on prematurely.
Saliency is not limited
only to individual stocks. The prolonged trauma of a market meltdown
over the last 19 months has caused many investors to give up on
the stock market in general, placing all of their investable assets
Clearly the events
of September 11 have traumatized the nation and have had extremely
negative effects on the financial markets. And no one can say
with any certainty what the financial markets will do over the
next 12 to 18 months.
However, similar moments
of crisis in the past have provided lucrative opportunities. As
seen in Table 1, the market has bounced back strongly after several
previous crises - and there is reason to believe this crisis period
offers similar potential. The Federal Reserve is currently flooding
the economy. Liquidity and interest rates are at a 29-year low.
And the government is preparing to launch a massive fiscal stimulus
to jump-start the economy.
challenge for advisors is to convince investors to ignore instinct
and remain rational after 19 months of financial trauma.
"My clients are
concerned," said Kelly Auslander, president of American Financial
Advisors in New York. "I think this is going to be a painful
rise upward. I'm personally not expecting anything to happen until
2002. But when you see an opportunity that stock prices are extremely
low, that is the time to get in the market."
While no one can precisely
predict when the market will bottom out, one thing is certain
- attempting to time the market can be disastrous. Missing only
a few days in any market rally can cost investors a substantial
part of their potential return. From May 1992 to April 1993, shortly
after the conclusion of the Gulf War, the Dow Jones was up 5 percent,
but if you missed the best five days, the return was - 10 percent.
Similarly, the year after the Korean War, the market was up 10
percent, but if you missed the five best days, the return was
Facts like these, combined
with the historical market performance in post-crisis periods,
help advisors educate their clients. But they don't convince all
clients to stick to the plan. Some are taking extreme steps to
avoid having their portfolios depleted. They are fearful that
they won't have enough money to retire, fearful that they won't
be able to maintain their current lifestyle or pay for their children's
education. And they are forcing their advisors to put their portfolios
completely in cash.
Auslander has two such
clients. So does Jayne Byrne of Wayne Warner & Associates
in California. In fact, one of Byrne's clients, after acquiring
new cash as a result of a recent real estate sale, called on four
consecutive late September days to ensure that the money hadn't
yet been invested.
This potentially irrational
pessimism in effect is a greater challenge to advisory businesses
than irrational exuberance. It is a far easier proposition to
convince an investor in a booming market to reduce some risk in
exchange for less upside than to convince traumatized investors
to go against their instincts and remain in the markets - that
is, continue to risk already depleted capital in exchange for
potential upside. But if they don't, the client may miss most
of the upside and will likely have a horrible return that could
lead to the advisor being fired.
"You have to take
certain levels of risk to meet long-term investment objectives,"
said Chris Wilkinson, the chief operating officer of Miller/Russell
& Associates in Phoenix, Arizona. "But the last few years
(before the downturn) the market was so strong that people really
didn't understand the inherent risk. Our discussions in meetings
are now much more honest in terms of risk. But (with less risk
taken) it may be hard to accomplish all the goals of a client,
whether it be a second cabin or retirement or whatever."
That said, Wilkinson
and his firm, as well as the majority of advisory firms throughout
the country, are trying to make sure their clients stay invested
in equities, so they don't miss the turn. The scattered extreme
examples notwithstanding, most clients aren't complaining too
loudly. They are sticking to the plan.
Hurley is president and CEO of Undiscovered Managers, LLC, based
in Dallas, Texas.
Tom Fuller is director of research in the Investor Services Group
for Undiscovered Managers, LLC.