October 19, 1987

Twenty five years ago, this 19th day of October, the stock market experienced the worst one-day decline in its history. The Dow Jones Average fell an excruciating 23% on what would become known as Black Monday. As a broker and branch manager with only five years’ experience, I remember that day as if it were yesterday. Stalwarts of my clients’ portfolios like Procter & Gamble, Eastman Kodak, and AT&T had lost half of their value in a day or two. Even the bluest of blue chips like Coca Cola, Philip Morris, Merck and McDonalds were down between 20 and 30%. Brokers and clients alike were asking me for answers I didn’t have. The best we could offer was to not panic, to stay the course – surely the world was not coming to an end. I was scared to death for my clients and I was scared to death for my family.

The huge drop was later blamed on a combination of program (computer) trading, significant over-valuation, and illiquidity as Fed Chair Paul Volker had for months been sopping up excess dollars in his successful bid to end double-digit inflation. Whatever the primary cause, the drop drove many people out of stocks for good and planted seeds of distrust that flourish today.

Since the 2008 financial crisis that sent stocks down nearly 40% and the one-day ‘Flash Crash’ on May 6, 2010 which drove averages down 9% in a matter of hours,  investors have taken some $440 billion from equity mutual funds, according to data from Bloomberg and Investment Company Institute. People are scared of market volatility and many believe the markets are rigged against them by the big Wall Street banks and hedge funds who use sophisticated computer programs to squeeze profits from the capital markets, at their expense. Far too many have remained in cash since 2008, missing the 103% rally in stocks (Total US Stock Market as measured by VTI) that began in March of 2009.

But the real tragedy for those chased out of stocks for a time or forever is not as easily measured, however, it is just as real and ever more costly. Their losses are in nothing less than their lifestyles; they will be forced to make compromises they may not now envision because their savings will be insuficient to withstand relentless inflation and lengthening lifetimes.

An almost universal characteristic we find among our new clients is that they were encouraged by their advisers to take more risk than was necessary to meet their important lifetime financial goals. Think about that for a moment. If you are taking more risk (translated – investing more heavily in stocks) than is required by your plan, you are more exposed to severe market storms that inevitably will visit from time to time. The cost may seem sublime before the storm, but it becomes painfully real amidst the tempest. Your precious, hard-earned assets disappear in large chunks in short violent turns.

Another huge, but subtle risk is that the timing of your cash flows, whether you are accumulating wealth or distributing it, will badly align with market volatility. As you build unnecessary volatility into your portfolio through excessive stocks or active managent focused on high returns, it becomes more likely that your planned cash flows will hit when markets are not friendly, which translates into lower confidence that your wealth will be sufficient to meet or exceed your goals.

The chart below represents our most aggressive model portfolio. It is invested 85% in domestic stocks, 15% in international and .5% in cash. As you can see, the model (in blue) closely tracks the most widely followed US index, the S&P 500 (in green). The lines are very irratic or volatile.

Beacon Aggressive Growth Model

If you experienced a portfolio like the one above, your plans of 2007 likely dramatically changed in 2008. In fact I had numerous conversations with other advisers whose clients were getting out of the market, some for good. Notice that the lines on the right of the chart, five years later are only just now approaching the 100% levels where they were in October of 2007. People spending money who had portfolios like these in 2008 remember well the anguish they felt pulling funds from their investments.

October 19, 1987 and the NASDAQ crash of 2000 are seered into my memory as experiences never to be forgotten. While it took both experiences, I did learn from them, making changes that would serve our clients far better than if we had continued the blind chase for returns.

Our client experience in 2008 was remarkable, not for the reasons of the first two historic crashes, but for the lack of them. Our phones were not ringing off the hook. Clients were not calling in a panic. And not one them asked us to sell any portion of their stock position in a panic.

Why? Because they were not worried for their financial future. We communicated frequently that their plans maintained sufficient confidence to exceed their goals and assured them that we would contact them with new advice should that change. Only 15% of our plans became underfunded during the crunch of 2008, requiring adjustments to risk  or other less important goals they were willing to compromise (perhaps only for a time) in order to get their plans back on track.

Pictures are worth thousands of words, so here’s the rest of the story.

We continually stress test our clients’ plans measuring their uncertainty enabling us to ensure that they do not take more risk than is absolutely necessary to meet or exceed their goals. The vast majority of our clients (75%) were in portfolios like the two on the right above ranging from 60% stocks (middle chart) to 30% stocks (right chart). Notice how much smoother the blue lines lines on the right are compared to the green lines (S&P 500) and to the blue line on the left (our near-100% stock model).

Clients were not afraid (perhaps they were for our country, but not for themselves) because they were not losing money like their neighbors. Our 60% stock model lost 10.3% in 2008, (including a 1% fee) compared to the 100% model’s 36.5% and the S&P’s 38%. Our 30% model lost only 2%.  Our clients were not as worried because they had little financial reason to be. What’s more, the model hypothetically shows that clients in  the most conservative model accumulated 34% more wealth than their 100% stock friends over the period from October 2007 until September 30, 2012.

Planning and investing for lifetime goals is serious business and should not be subjected to emotional swings. If you take more risk than you need to, odds go up substantially that you will make mistakes along the way that will force compromises to your life – no matter how much money you have. By controlling what can be controlled in the investment process and planning for what cannot, we can help you live a better life.