Why Advisors Should Prepare for a Downturn Now

The current bull market is the longest in history. So too, is the U.S. economic expansion. As those record-breaking streaks continue, it is hard for investors to remember that big losses can — and do — happen. It’s even harder to convince investors to prepare for them in advance.

Advisors face an uphill battle fighting investor complacency in the current market climate. Outsized gains, and our temporal distance from the financial crisis, have tempted many clients to keep riding the current bull market out, waiting for more evidence of a downturn before investing in risk-mitigating strategies that would defend against it. But markets remain impossible to time.

It is paramount that advisors convince clients to prepare for the downturn now, not wait for definitive evidence it is coming. That evidence always arrives too late. With that in mind, we share a few stats and charts to help advisors get their clients to prepare for a downturn now:

For starters, investors need to know why defending against a big loss is so important. Put simply, the bigger the loss, the deeper the hole to crawl out from. For context, a 10% loss requires an 11% gain to recover. But a 50% loss requires a 100% gain to get back to the pre-crash starting point. As markets fall further, the math just gets more daunting – a 60% loss requires a 150% gain just to get back to even.

The Gains Required to Recover from a Loss

The Importance of Limiting Investment Losses

Given the severe impacts of steep losses, investors need a permanent allocation to risk-mitigating strategies. The next chart puts this into perspective, showing the lower return required for the long/short index to recover from previous bear markets, compared to a traditional 60/40 stock and bond portfolio.

Long Short Equity Drawdown ChartFinally, it’s important to remind investors that it’s not just the sheer return numbers that are required to recover from a big loss, but the time. Too many investors fail to realize just how long it takes a portfolio to get back to where it was before an equity bear market. The next chart provides perspective on this timing. And it’s worth mentioning, the chart was only looking at a 20% loss, the bare minimum of a bear market definition.

A $500,000 Portfolio’s Recovery From a 20% Decline

A Risk to Retirement

The Time is Now

While we don’t know when the next bear market will come, advisors should be assessing the risks in their clients’ portfolios now, before it hits. The right preparation will vary based on the individual client and the advisor’s concern. If the concern is equity market volatility, then long/short equity should be considered.

If rising default rates in the bond market are worrisome, consider long-short credit strategies. If you are searching for a source of returns that has a low correlation to traditional assets, consider managed futures funds and market neutral strategies.

Whatever strategy advisors deem appropriate, the bottom line is the same: protection from adverse market events needs to be in place prior to the occurrence of those events in order to be effective.

Read our recent blog post, Where to turn for Low Correlation and Downside Protection? >