Content provided by Rusty Vanneman, CFA, CMT, Chief Investment Officer

At a recent panel, an advisor asked our portfolio managers what they believed to be the biggest risk in the markets today. As usual, I was proud of every response from our portfolio managers on the panel. We sounded smart, disciplined, and experienced. We should sound that way, because we are.

As I’ve written in the past, I believe risk is best defined as the element that will destabilize investors and shake them out of their investment plans and portfolios. That catalyst is usually volatility, which is defined as the magnitude with which prices move around.

I identified the biggest risk to investors these days — what will likely cause the most significant damage to well-laid plans — as not the market moving lower, which most investors and advisors seem to be relatively prepared for, but the market moving higher.

Ten years ago, investors were not like they are today. There was a very clear and powerful optimism — even in the face of well-known structural and economic issues. I talked to many individual investors, including my clients, and my biggest problem every day was managing their expectations and keeping their portfolios at appropriate risk levels. I was often called too conservative, even by my own sales team, although we hadn’t fundamentally changed the way we managed portfolios. Some clients even left for what they felt were “greener pastures.” Greed dominated, and investors didn’t want to miss out on the returns they were seeing and hearing about in the media and at cocktail parties. That definitely doesn’t describe the environment we are in now.

The late 1990s were even worse for gung-ho greed and complacency. Appropriate and reasonable portfolios bit the dust even harder than they did 10 years ago. Sure, we have FANG stocks and bitcoin now, but the current environment is nothing like it was nearly 20 years ago.

Personally, I would not be surprised if the market gained another 30% to 50% from current levels in the months ahead — and did so in almost parabolic (i.e., pace of accelerated sharply increasing) fashion. Now, that’s not my “most-likely” call, nor the CLS house call (see page 50 of the CLS Reference Guide for that), but it’s definitely possible. And if it happens, it will hit like a hurricane on appropriately built, balanced portfolios.

The CLS Reference Guide (page 12 in the latest version) includes a “Cycle of Investor Emotions.” If I had to assess where I think we are based on my conversations with advisors and investors, I would say we are at the Optimism level — and more likely closer to Relief than Excitement.

Ever wonder why Dalbar’s study is so powerful, or the behavior gap exists, or so many studies show investors trail market benchmarks? Most think it’s because investors get scared out of investments when prices are down, and that is indeed a large part of the problem. But an equally significant problem is their tendency to chase higher prices and assume far more risk than they should. This is especially problematic when they do so during the late stages of a bull market — when euphoria has taken over.

We are most likely not at the late stages of the bull market. Many of the classic signs, at least in terms of investor sentiment, are not in place yet. I talk to a lot of advisors and investors, and not one has told me I am being too conservative. Not one. Instead, they ask about corrections and bear markets.

But what if we do experience a bear market soon? While, admittedly, they’re not great for paychecks — thankfully, they are typically short-lived — there are positives about bear markets. These are the times quality investment managers and counselors shine. In our roles, we preach, teach, and educate investors about the markets and why they should stay the course and invest for the long-term. If we do our job, they do well. When the markets are down, it’s our calling to help investors stick to their financial plans and stay on track to reaching their investment goals. And as investment managers, stocks are on sale! It’s a great time.

However, during a parabolic, melt-up market, many investment professionals sort of lose their cool. Everybody is making money — it’s a win-win-win for all. But the problem is market cycles haven’t broken. Trees still won’t grow to the sky. As counselors, we need to tamp down enthusiasm and teach market history just as we’ve done in bear markets. We might be called killjoys, and may even lose some clients to investment firms that have more “juice,” but we will be acting as we should.

As money managers, it will be time to take some chips off the table (at least as much as we can with Risk Budgeted portfolios). We might lag the go-go firms at this point. As the market runs higher, and before it peaks, we won’t be making as much money for ourselves and our clients, but when the market cracks after an epic melt-up (which it always has and always will), our disciplined money management and counseling will serve our clients well.

3023-CLS-10/02/2017