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Commentary by: Fran Kinniry, Head of Investment Advisory Research Center, Colleen Jconetti, Senior Manager, Investment Advisory Research Center and Chris Tidmore, Senior Manager, Investment Advisory Research Center
This month marked the three-year anniversary of a major shift in the world which impacted many of our lives—both personally and professionally—due to the coronavirus (COVID-19) pandemic. Not only was this an event that will define a generation, but it also contributed to a generation’s worth of capital market events. During times of stress, many clients look to their financial advisors, as the stewards of their financial well-being and caretakers of their emotional well-being. As we have “coined” before, periods of uncertainty and capital losses, are the “moments that matter” and “Advisor’s Alpha weather.” These are the times where you, acting as a behavioral coach, have saved your clients hundreds of thousands or even millions of dollars, potentially offsetting years or even a lifetime of fees.
As these types of “moments that matter” become more frequent, they begin to take a toll on the stress levels and anxiety of the advisory community. Over the last three plus years, advisors, and their clients, have experienced the initial stages of COVID-19, followed by: mandatory lockdowns around the world, a fast and deep bear market, followed by a strong and steady bull market, eventually leading to historic increases in inflation and interest rates, along with negative returns for both broad market equities and fixed income. There was hope that the first quarter of 2023 would bring an end to some of this anxiety for advisors. But in mid-March the markets were confronted with bank stress and failures, triggering an immediate “code red” once again for the advisory community.
Figure 1 provides a glimpse of what advisors, and their clients, have been experiencing over the last three years by looking at the increase in volatility of a typical 60% equity and 40% fixed income portfolio (60/40). In the seven years leading up to 2020, there were only five days (on average, less than one day per year) where a 60/40 portfolio was up or down more than 2%; in contrast, over the last three-plus years we have seen an astonishing 33 days (on average, more than 10 days per year) where a 60/40 portfolio has been up or down 2% or more.
Figure 1: Significant increase in price volatility of a 60/40 portfolio during the last 3 years
Source: Vanguard Investment Advisory Research Center calculations using data from Factset, Inc.
Notes: Daily 60/40 portfolio returns are from January 3, 2000, thru March 21, 2023, calculated as 60% U.S. equity market using daily returns of the Wilshire 5000 Total Equity Market from January 3, 2000, thru April 30, 2004, and Dow Jones U.S. Total Market thereafter and 40% fixed income using daily returns of the Bloomberg U.S. Aggregate Bond Index. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
We have experienced trying markets before; however, what is not as common, are periods of poor performance in the equity markets coinciding with poor performance in the fixed income markets. Figure 2 illustrates this by analyzing the percentage of days in drawdown of 10% or more for equities and 5% or more for fixed income over three-year windows from 2000 through early 2020. As you can see, for most of the last 20 or so years, when equities are in a drawdown, fixed income is performing well and vice versa. The clear outlier is the last three-plus years where both equities and fixed income are in drawdown—not giving even the most conservative investors a place to hide. This is unusual, and a critical stressor for investors and advisors, as most have balanced portfolios of equity and fixed income.
Figure 2: Percentage of days in drawdowns of 5% for bonds and 10% for stocks over rolling 3-year windows
Source: Vanguard Investment Advisory Research Center calculations using data from FactSet, Inc.
Notes: U.S. equity market returns calculated using daily returns of the Wilshire 5000 Total Equity Market from January 3, 2000, thru April 30, 2004, and Dow Jones U.S. Total Market thereafter and U.S. bond market returns using daily returns of the Bloomberg U.S. Aggregate Bond Index. For each rolling three-year window starting January 2, 2000, through January 31, 2020, the percentage of days that equities were down 10% from the start of the three-year window and separately the percentage of days that bonds were down 5% were calculated. Additionally, the same calculations were done for the time period from February 1, 2020, thru March 21, 2023. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Why this matters and three Bs that might help
Research has shown that some level of anxiety, stress, and/or uncertainty can help propel things forward in the short term; however, the longer-term effects can be detrimental. A well-known researcher, author, and former options trader, Nassim Nicholas Taleb, found that individuals have “the ability to improve function or capability in the face of adversity—stressors, shocks, volatility, noise, mistakes, faults, attacks or failures.” In other words, something or someone can actually become stronger or better when exposed to short-term periods of stress; he coined this phenomenon “anti-fragile.”
While episodic stress can be beneficial, repetitive or prolonged stress can have the opposite effect, often resulting in very negative health consequences and/or emotional challenges. Ongoing exposure to high levels of stress has been shown to harm our health, performance, happiness, effectiveness, relationships, and practice. But you do have a choice, there are things you can do to reduce stress levels and to squelch the swirl.
Three Bs, if understood, could help combat repetitive stress: Business model, biology, behaviors
1) Business model—The incentive-based, revenue model used by most in the financial media, is primarily centered on grabbing your attention, promoting noise, fueling drama, and encouraging trading; their incentives are most often NOT aligned with the long-term best interest for your clients’ investment success. Just as one would be extra aware of the diet and food they consume, and hopefully not live off junk food, one should be equally aware and attuned to what they are feeding their brains. Most financial media is “junk food” for the brain. Carefully curating your sources of information, news feeds, readings, attention, and time is critical for long-term reduction in your anxiety and stress as well as achieving long-term investment success. Helping the clients you serve, with this same message, will likely also reduce their stress, improve your relationship with them, their investment success, and the success of your advisory practice. Turn off the “junk news”!
2) Biology—With deep awareness of the business model incentives above, one must also understand that fear, stress, and pain have been proven to shrink time horizons. Our biological systems, both physical and emotional, are programmed to escape danger, pain, and fear. When invoked, our longer-term systems are shut down and all our energy is re-directed to our short-term survival systems. After all, when you are being chased by a grizzly bear, your body and attention is 100% focused on the next second or maybe 30 seconds, but certainly not your plans for 10 years from now! Understanding that anxiety, fear, and pain shorten decision horizons not only increases the motivation to better curate your news feeds and turn off “junk news,” but it also increases your awareness to hit pause when considering significant decisions. Hitting pause allows you to evaluate whether the motivation for the decision is truly the right decision for the long run rather than a decision to alleviate short-term pain resulting from acute stress or fear.
3) Behaviors—It is critical to understand how the above two factors influence behavior, especially in reacting to the noise and news cycle, as well as shortened time horizons during periods of stress. Being acutely aware of the first two Bs, and their influence on the third B (behavior), is often the primary difference between investors reaching or failing to reach their goals. This is where advisors act as emotional circuit breakers for their clients and coach them through the volatility of markets, loss aversion, etc., thus, putting their clients in the best position to meet their long-term financial goals.
An example of all three Bs can be seen in Figure 3 below which shows the cumulative value of three separate potential portfolio scenarios. The x axis shows years from the beginning of 2020 through March 24, 2023. The y axis shows portfolio values. The teal line represents a 60% stock/40% bond, broadly diversified allocation, which declines sharply through the COVID-19 pandemic, but recovers fast and strong in the spring of 2020 through 2021, only to enter another bear market in 2022.
A very wild ride that would test the nerves of investors and the advisors who serve them, the 60/40 allocation had an overall gain of 11% through the period ending March 24, 2023. The yellow and dark green lines, begin on March 23, 2020, and represent the many investors who moved out of stocks and their balanced allocations and into more risk-off investments, bonds (dark green line), or money markets (yellow line). An investor who bailed to 100% bonds at the market bottom would have ended up with a total return of –25% as opposed to the stay-the-course investor who achieved 11%. An investor who bailed to 100% cash at the market bottom would have ended up with a total return of –18% for the full period. The chart reinforces the power of staying the course, and how critical the role advisors as behavioral coaches can be, as demonstrated in, The evolution of Advisor’s Alpha®: People with portfolios.
Figure 3: Value of an advisor keeping their clients invested through turbulent times
Source: Vanguard Investment Advisory Research Center calculations using data from FactSet, as of March 23, 2023.
Notes: The 60/40 stock/bond portfolio is split between U.S. and non-U.S. allocations. The equity portion of the portfolio consists of 60% CRSP US Total Market Index and 40% FTSE Global All Cap ex US Index. The bond portion consists of 70% Bloomberg U.S. Aggregate Float Adjusted Bond Index and 30% Bloomberg Global Aggregate ex-USD Float Adjusted RIC Capped Hedged Index. Cash represented by the FTSE 3 Month US Treasury Bill Index. 100% bonds represented by 70% Bloomberg U.S. Aggregate Float Adjusted Bond Index and 30% Bloomberg Global Aggregate ex-USD Float Adjusted RIC Capped Hedged Index. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
While this is a hypothetical example, in our decades of analyzing risk appetite and investor cash flows through Vanguard’s Risk Speedometers, we have seen the moments that matter—times of market distress and contagion—coincide with de-risking of higher risk assets into lower risk assets. When viewing market stress with an awareness of the three Bs, these are the moments when advisors can make all the difference in their clients' long-term investment success. We believe that the potential value advisors can add is priceless!
Vanguard Financial Advisor Services™ is here to help
Ultimately, extended periods of Advisor’s Alpha weather can take its toll on an advisor and their practice, but Vanguard’s Financial Advisor Services is here for you—every step of the way. Today our offer includes custom, portfolio analysis and consultations; low-cost, high-quality funds; access to product specialists; turnkey model portfolio solutions; personalized indexing; and, most recently, investment research from our Investment Advisory Research Center.
While we know the last three-plus years have been extremely challenging, and we do not know what the future holds, please know we are here to help you and your practice navigate what may come. What we do know is that the three Bs are unlikely to change. Having an awareness of each and understanding how they can help or harm your anxiety levels, your practice, and the success rates of the investors you serve, is a critical differentiator, especially in moments that matter.
All investing is subject to risk, including the possible loss of the money you invest.
Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Past performance is not a guarantee of future results.
Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.