ELITE ADVISOR BEST PRACTICES

What the Frack?

How to use the 2014 bear market in oil to educate your clients

By Glenn Freed

Key Takeaways:

  • We tend to think we see meaningful “patterns” in all the news and data we receive to forecast markets accurately—most of the time we can’t.
  • Use the bear market in crude oil to reinforce the importance of diversifying and taking a long-term view.
  • We all have behavioral biases. It’s crucial to insulate your clients from their misperceptions—and yours.


More often than not, forecasting markets can make investors look foolish. But that does not stop investors (and their advisors) from trying to make forecasts. Our behavioral biases and other shortcomings rear their ugly heads, and we start thinking we can forecast markets. We think we see meaningful patterns in the data, and all of a sudden, we think we can accurately forecast the future prices of stocks, bonds, commodities, interest rates, real estate and other asset classes.

The elite financial advisor must slap the forecasting delusion out of clients’ minds. We know where forecasting follies can make us end up—buying high and selling low—the cardinal sin of investing. The elite advisor takes short-term forecasting out of his or her clients’ investment experience.

Living with oil prices

For some reason, the media has made the price of a gallon of gasoline a newsworthy item. Somehow we’re led to believe the cost of a barrel of “light sweet crude oil” is vitally important in our daily lives. Just go to the Yahoo Finance website. Right below the daily returns of the S&P 500, Dow and Nasdaq indices is the closing price for crude oil and its daily return. Your client has to dig a little deeper to see that the so-called crude oil price is really the price of a futures contract for a barrel of oil with the shortest time to maturity. Forget about the details of the crude oil price—the media is getting your client hooked on the cost of a barrel!

Crude oil prices

The year 2014 made crude oil prices quite newsworthy. The price started the year at $89.91 per barrel. The price reached its high of $99.53 on June 25 and ended the year at $54.26, its lowest level for the year. From a bear market perspective, you look to the high price for the year ($99.53), and when it has dropped at least 20 percent from that high, you’re officially in bear market territory. The tipping point occurred on October 15, when the crude oil price closed at $79.21.

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Forecasting the bear market

We should have seen the bear market in oil coming. The media has been playing up the new oil extraction technology, hydraulic fracturing (aka “fracking”) for quite some time, particularly its ability to unlock massive stores of oil in the shale formations of North Dakota and Texas. Even better, from consumer and political perspectives, fracking was reducing the United States’ dependence on foreign oil imports. But where was the connection to crude oil prices?

The media was also reporting about all the geopolitical problems in Africa, the Middle East and Russia/Ukraine, which supposedly impacted the supply of oil. The media was reporting that China had an insatiable thirst for oil. Was forecasting crude oil prices really that easy?

Having an honest dialogue with your client about what everyone was thinking about the future of crude oil prices will hopefully wean you and your clients from the habit of trying to forecast the future prices of stocks, bonds, commodities and real estate.

Educating your clients

Elite advisors use the crude oil bear market to reinforce one of the most important investment concepts for a long-term investor—diversification. You can look no further than at the 2014 SPDR S&P 500 ETF return of 13.46 percent compared to the 2014 Energy Select Sector SPDR return of -8.70 percent. Striving to beat the market by investing in temporarily mispriced securities or by trying to gaze into the future is hazardous and often yields suboptimal returns. Instead, one can benefit from other investors’ market speculations by investing patiently in a wide and well-diversified portfolio. It is no secret that in order to outperform the market averages over long periods of time, one must thoughtfully assume more risk and carefully calculate the costs of doing so.

Conclusion

We all like paying less to fill our cars up at the pump—provided we don’t have to drive far out of our way and the gas is the same quality octane we always get. The elite advisor needs to reinforce to clients that forecasting is not critical to having a successful long-term investment experience. An advisor must keep clients disciplined and protect clients from their behavioral biases that can cause them to jump into the next “hot thing” or be fooled by the media into irrational fear or greed.


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