ELITE ADVISOR BEST PRACTICES

Faith in Equity

And how does it compare to faith in fixed income?

By Glenn S. Freed

Key Takeaways:

  • While fund flows and investor sentiment suggest that faith in equity has been gravely ill, the returns of equity have been quite robust.
  • Investors have been warming up to stocks in the past few months while becoming more wary of bonds—but neither is a complete solution.
  • Both stocks and bonds belong in a client’s portfolio, and elite advisors should work with their clients to determine their true risk tolerance and thus appropriate allocations for each asset class.


While many measures of the stock market are at or near their all-time highs, faith in equity as a whole has taken a hit over the past few years. While stocks have enjoyed a very nice annual real return of 6.6 percent over the past century, returns can lag for extended periods. Skeptics argue that some unique circumstances have led to these high, very long-run returns and that future returns will not be so lofty. However, with yields near historic lows, the same can be said for bonds.

So, is faith in equity dying or perhaps even dead? Until recently, equity funds had suffered a continuous stream of outflows, which the Investment Company Institute (ICI) pegged at $150 billion a year since the financial crisis and market meltdown of 2009. Such behavior helps confirm anecdotal evidence from many advisors about their clients’ distrust of stocks. Faith in equity has been on its sickbed for quite a while now.

Distinguishing faith from reality

Ironically, while faith in equity has been gravely ill, the returns of equity have been quite robust. As mentioned earlier, the stock market has rallied remarkably from its lows of early 2009, and the S&P 500 has just hit an all-time high. Investors have noticed, and flows into equity funds have turned positive this year. Meanwhile, wariness of fixed income has increased, with Morningstar reporting average inflows into core bond funds falling by 71 percent over the past three months.

So should we be proclaiming the revival of faith in equity and the demise of faith in fixed income? We hope not—neither is deserving of absolute faithfulness on its own. Stocks do provide a means to participate in economic growth, for which the investor can expect to be rewarded. However, stocks can and do suffer periods of severe losses. Investors experienced this truth very painfully in 2008 and when the technology bubble burst between 2000 and 2002.

Such poor equity returns were not without historical precedent, as periods such as the Great Depression of the 1930s and the economic malaise of the early 1970s also saw dramatic equity losses. Constant, year-after-year positive stock returns are not a guarantee—that is the “risk” in the equity risk premium. Over time, however, equity should outperform fixed income, but an important role for elite advisors is to work with their clients and understand how much of that downside risk their clients can tolerate financially and emotionally.

Right role for bonds

Fixed income has enjoyed a historic run of exceptional performance and demand, but it is not worthy of complete faith either. Past success has driven yields to historic lows, such that the high returns of recent decades will be extremely difficult to repeat. Bonds also fulfill a variety of roles in the portfolio, such as preservation of capital, income provision, diversification and reduction of overall volatility. These roles can become more difficult in a low-yield environment. Income is harder to find, and a rise in rates back to historical norms can produce an unwelcome surprise in return patterns. Bonds also offer no guarantees, but they do tend to be less volatile and provide a shock absorber in periods when stocks fall. Again, a critical role for elite advisors is determining the appropriate exposure to fixed income for their clients.

Conclusion

In the end, the one aspect of investments deserving of supreme faith is diversification, at least for those of us without perfect foresight. Nothing is certain, and even someone with exceptional insight can be hit by surprises. Both stocks and bonds have their place in a portfolio, but neither is worthy of blind faith. Elite advisors understand their clients and work with them to provide the appropriate mix of a variety of assets.


About the Author

Vericimetry is an academically based, quantitatively structured investment adviser providing capacity-constrained asset class strategies to an exclusive group of elite financial advisors. Website: www.vericimetry.com.

Glenn S. Freed, PhD, CPA, PFS, is a leading investment and tax expert in the investment management industry. Dr. Freed is the Chief Executive Officer of Vericimetry Advisors LLC, which intends to make necessary filings to become an investment advisor registered with the Securities and Exchange Commission during 2011. Dr. Freed has 25 combined years of experience in investment management, tax and accounting research, education, and tax advising. He received a PhD from the Graduate School of Business at the University of Southern California and a BS in accounting from the University of Florida.

Phone: (818) 813-1351