Actuaries have long considered the concept of mean reversion in their actuarial models. Mean reversion, which is the tendency of alternating periods of above-average returns with periods of below-average returns, exists in many different forms within investment markets. However, none of these forms is necessarily inconsistent with efficient markets. Mean reversion does not indicate that there is a true average for any economic index, such as interest rates. Instead, it explains that, in a model, it is mean reverting if the asset prices tend to fall after reaching a maximum or tend to rise after hitting a minimum. It is simply taking a longer-tem perspective.
This simple concept is very applicable for financial planners after the financial crisis wiped out significant fund balances for customers. Representatives from the Casualty Actuarial Society, Canadian Institute of Actuaries, Society of Actuaries' (SOA) Joint Risk Management and Investment Sections, International Network of Actuarial Risk Managers (INARM) and Enterprise Risk Management Institute International coordinated a call for essays on "Risk Management: The Current Financial Crisis, Lessons Learned and Future Implications." This call for short essays attracted a great deal of interest from actuaries and non-actuaries alike. Much of the focus was on risk management for insurance companies, but many of the points are equally applicable for individuals. The complete set of essays is instructive for any financial planner and can be downloaded for free from the SOA Web site at http://www.soa.org/library/essays/rm-essay-2008-toc.aspx
Here are excerpts from just a few of the essays and the impact that they may have with individuals:
1. Sam Gutterman, FSA, is director and consulting actuary at Pricewaterhouse Coopers. In his essay, "A Tale of Improperly Placed Incentives," Sam writes, "Two further contributing factors need to be highlighted: (1) an overemphasis on short-term thinking and (2) the typical human tendency to assume the current trends will continue. These factors have been at the route source of most housing bubbles, as they also have been a factor for most underwriting cycles in insurance."
You need to be prepared with facts when you meet clients who think this way. The worst year in the history of the S&P 500 index was 1931, with a 43 percent drop. However, the subsequent five-year annualized return after 1931 was a 23 percent gain. More recently, we saw a 22 percent drop in 2002, but the subsequent five-year annualized return was 13 percent. It is important that you give these facts to customers who want to move all of their money when they have equity losses. At the same time, a few years ago when customers were getting used to double-digit positive returns in the stock market, this was also unusual, and not to be anticipated year after year. Many people became used to double-digit returns, making the pain caused by recent events more excruciating. It is important to set realistic expectations, as it is not normal for stocks to consistently rise 20 percent per year.
Another area impacted by flawed thinking is the topic of rebalancing the portfolio. For example, a client with a 60 percent stock and 40 percent bond mix at the start of 2008 likely ended up with a 60 percent bond and a 40 percent stock mix at the end of the year. Very few clients wanted to rebalance to move funds back to the stock market after they suffered 40 percent losses in 2008 when they only consider the short term. However, since 1926, the annual return for a 60-40 mix in stocks was 8.5 percent versus an 8.1 percent return if the mix was an equal 50-50 split. The difference of 0.4 percent does not sound like very much until you consider the power of compound interest. For a portfolio with $500,000 today held for 20 years, that results in an extra $182,000. Pointing out that scale of impact to your customers can get them to consider the value of rebalancing their portfolios.
2. David Ingram, FSA, is senior vice president at Willis Re. David wrote an essay titled, "Your Mother Should Know," in which he writes, "Well, there are two different approaches to risk that firms in the risk-taking business use. One approach is to assume that they can and will always be able to trade away risks at will. The other approach is to assume that any risks will be held by the firm to maturity ... So the conclusion here is that at some level, every entity that handles risks should be assessing what would happen if they ended up owning the risk that they thought they would only have temporarily."
You see this every day with potential customers. They often assume that they will be insurable in the future at the same rating basis as today. They do not think that any illness will prevent them from getting a preferred rate in the future. Are they prepared if they are uninsurable in the future?
The cost of guarantees has risen dramatically for companies, and many are passing along rate increases to their customers. Auto and homeowners policies are expected to climb three to four percent this year. In the term insurance market, Banner, ING and Prudential have already passed along rate increases, and other companies are in the process of raising their premiums. This is reversing a long trend of falling prices. It is now imperative to explain that there can be a real cost to waiting to make the insurance purchase, even in the event that customers are still healthy.
3. Max Rudolph, FSA, owner of Rudolph Financial Consulting wrote an essay entitled, "Should you have a Chief Skeptical Officer." In it he concludes, "When a business line brings a new idea to the CEO, he should be able to ask, `Have you run this past the Chief Skeptical Officer and does she concur with this proposal?' The CSO (who could also be referred to as the Common Sense Officer) might not always be popular, but the improved decisions made will allow the CEO to more confidently execute the company's strategic plans."
As a financial planner, you essentially are the Chief Skeptical Officer. With unemployment nearing double digits, many customers have not invested enough in their long-term investment portfolio, and some do not have enough for an emergency fund. Bring the "what if" risks to your clients' attention. What if the portfolio does not recoup its losses for another four years? What if it takes six more years for their home value to recover? What if their jobs were lost next month? It is the big picture, long-term perspective that is needed most, just as noted in the above actuarial essays. By documenting the responses to these scenarios, you will be able to understand the need, and respond with the right financial possibilities for clients.