with Their Long-Term Goals
Sponsored Content – American Century Investments
The financial crisis sparked widespread flight from risk. Although the crisis is over and equity prices have rebounded, many investors have not yet returned to the capital markets. For them, the safe-haven appeal of money market funds remains strong. However, the fear of losses may be blinding them to another danger: the risk their investment returns will fall short of their future needs. In other words, by trying to eliminate risk, investors may have misaligned their portfolios with their long-term financial goals. Financial advisors—who know there is a correlation between risk and reward—want to get their clients off the sidelines, out of cash alternatives, and back on track.
American Century Investments® proposes a strategy of “smart risk taking,” an active asset management approach that seeks to identify, understand, manage, and be consistently rewarded for risk. Smart risk taking focuses on investment vehicles that offer higher potential return, lower volatility, and better downside protection—all of which are vital to building wealth over time.
Investors are at a crossroads. In the shadow of the financial crisis and worried about future uncertainties, they must choose: Move forward toward their financial goals or remain on the sidelines. Many have opted to linger in low-yielding investments, such as money markets funds, rather than assume investment risk.
What explains this persistent risk aversion? The painful losses of the financial crisis, in part. Between October 9, 2007, and the market bottom in March 2009, the S&P 500 Index (representing the broad stock market) fell 57%.1 These shocks also capped a dismal decade. According to Standard & Poor’s, the 2000s was “the first 10-year span in 90 years that ended in the red.”2
Source: Morningstar
That stormy decade may have been something of a surprise to investors. Remember, many people were introduced to investing in the 1980s and 1990s when stock prices (as represented by the S&P 500 Index) posted nearly 20% annualized total returns— the best back-to-back decades in its history. At the time, investors seemed to be rewarded by whatever security they bought.
Then came the bursting of the dot-com bubble and the market dislocations following 9/11. In both cases, investors returned to the financial markets relatively quickly. The financial crisis, however, was apparently a bridge too far. Consider the “fear gauge”—the VIX or volatility index. It spiked to 80 in late 2008, well above its historical average of about 20. To further complicate the situation, Americans also saw a significant amount of wealth evaporate as the housing bubble deflated. Combined, the declines in the financial and housing markets led to a 29% decline in American households’ net worth. From a peak of $65 trillion in 2007, household net worth fell to $50 trillion in 2009.3
Furthermore, there is now growing awareness that large market declines were more common than previously recognized. In the 64 years since the end of World War II, the S&P 500 Index has experienced 32 downturns of 10% or greater. That means on average, investors in the broad equity market have endured one market correction every two years.4
Uncertainty About the Future
Investors are also grappling with considerable uncertainty. A number of issues and concerns cloud the investment horizon.
- The Great Recession was deeper and longer than most previous recessions. At -4.1%, it was the worst contraction since World War II.5 Renewed economic growth has also been painfully slow.
- Unemployment has remained high. People are out of work for longer periods of time, and finding a new job takes twice as long on average as it once did.
- Home prices, which fell 21% between 2006 and the end of 2010, continue to slip in many regional markets.
- Many corporations have successfully repaired their balance sheets and have taken advantage of low interest rates to reduce their cost of borrowing. Although they hold large amounts in cash alternatives, they have not yet deployed it to create new jobs or expand their operations.
- The impact on investors of the federal government’s fiscal, monetary, and tax policies is unclear. Tough financial challenges lie ahead, including the growing deficit, the solvency of Social Security, and the implementation of new health care regulations.
Fearful of Losses
Caught between the specters of the past and growing clouds of uncertainty, investors seem more worried about potential losses than about the gains they need to reach their financial goals. Significant assets remain on the sidelines with more than $2.6 trillion in money market funds.6 Add bank accounts and certificates of deposit and the amount of money in low-risk investments approaches $9 trillion.7 Furthermore, and in spite of the stock market rally, investors have shown a distinct preference for fixed income over equities.
In this environment, many investors have been reluctant to re-engage with the financial markets. In certain respects, this behavior makes sense. According to “prospect theory,” proposed by Nobel laureate and behavioral psychologist Daniel Kahneman, people weigh gains and losses differently. In other words, an individual tends to be more distressed by a prospective loss than happy about the possibility of an equivalent gain. He gets more upset, for example, when he loses $20 than he gets excited about finding $20. The reason: “loss aversion.” People seem to be willing to take on more risk to avoid losses than to try and realize gains.
As financial advisors know, a client may think he is avoiding risk by leaving his money in a money market fund—he has certainly reduced the risk to his principal—but he has effectively traded one type of risk for another. One is the loss of purchasing power. Cash alternatives provide limited protection against inflation, and with yields at about 1%, money market investments cannot keep pace. Although inflation fell -0.04% during 2009, it was up 1.6% in 2010.8 Annuities and certificates of deposit, which do not offer substantially higher yields, have similar risk.
By lingering in these investments, which have historically provided lower long-term returns than stocks and longer duration bonds, a client is also taking on shortfall risk— the risk he will not have saved enough for his future needs, including retirement. The Center for Retirement Research at Boston College calculates the gap between the pensions and retirement savings that American households actually have and that they should have at $6.6 trillion.9
The cruel math of market downturns teaches that it takes significant gains to recover from large losses. If a client’s portfolio dropped 50% in value from $800,000 to $400,000, it would take nearly 12 years at an annualized return of 6% to regain the lost ground. However, if the same client had de-risked the portfolio (that is, dramatically reduced its risk) and it earned an annual return of just 3%, it would take 24 years— nearly a generation—to break even. This significantly reduces the time the client can compound wealth, which also reduces probability he will be able to fund his long-term liabilities.
Source: Retirement USA
What Should Clients Do?
Given the painful experiences of the past, your clients may be struggling to decide on a course of action—one with the potential to get them back on track toward their financial goals. Should they:
Save More? Although Americans are saving more (the savings rate has increased to 6%), most of it is going into money market funds and short-duration bond funds. This may make sense for clients with a short time horizon, but for baby boomers who have 10 years or more to retirement, this kind of investing may increase shortfall risk.
Double Down? Some investors are putting money into volatile segments like emerging markets and commodities. Others are investing in funds that seek to time the market or have unconstrained, untested investment processes. Will these high-risk approaches generate strong long-term returns? Only time will tell. However, if these tactics fail, investors could suffer significant losses and dramatically compound their shortfall problem.
Diversify? Some investors are skeptical of diversification. During the financial crisis, everything seemed to lose money. The passive indexes of all asset classes had a correlation of nearly 1, meaning they were all moving the same direction at the same time.
None of these options seem very promising. American Century Investments proposes an alternative: smart risk taking. We believe smart risk taking can help your clients realign their portfolios with their financial objectives
Our Smart Risk-Taking Solution
Risk is real. It is unavoidable, it is necessary, and ultimately the way you manage it can determine investment success or failure. At American Century Investments, we believe that investors should be rewarded for the risk they take, and that principle is the central tenet of our smart risk-taking solution.
What is smart risk taking?
In our opinion, smart risk takers look for the performance characteristics that provide a better probability of building wealth, including:
- Higher returns
- Lower volatility
- Better downside protection
To reach these goals, smart risk takers seek active asset managers who can:
- Identify and fully understand risk
- Manage risk consistently with proven long-term, diversified strategies
- Reward investors for the risks they assume
Start by Redefining Clients’ Relationship with Risk
Before financial advisors can help clients become smart risk takers, it’s important to recognize that those clients likely have a different definition of risk. For most investors, risk is the chance they will lose money and be unable to reach their financial goals. This is absolute risk. Financial advisors have been trained to think about risk in terms of volatility (the potential changes in the value of an investment relative to benchmark). In this relative risk framework, taking risk is the opportunity to generate alpha (the value that an active manager adds or subtracts from portfolio returns). Absolute risk and relative risk have one thing in common: the desire to be compensated for the risk taken.
This shared view can provide the basis for frank, open conversations about risk and how to manage it. Most clients know it is difficult to avoid risk entirely and that they need some level of risk to reach their financial objectives; many understand that de-risking has introduced its own set of risks. The most critical question for you and your client to ask: If I’m going to take a risk, is it worth taking?
Build Diversified Portfolios Using Risk-Smart Managers
Investors should begin with a well-diversified portfolio using asset managers who are focused on delivering superior, long-term risk-adjusted performance. Active risk management should be at the core of these managers’ investment culture. They should also have a track record of managing to the characteristics of their specified benchmark indices. This can help maintain low correlations between portfolio components. We respectfully suggest that investors might have experienced better returns between 1999 and 2009 if more investment managers had stressed active risk management and had faithfully managed to their benchmarks. Further, we believe broad diversification would not have failed as it did in 2008.
In selecting risk-smart investment managers, look for:
- Reasonable return expectations—fund returns are consistent with an asset class or benchmark index
- Disciplined process—the fund uses controlled investment strategies to keep managers “in their lane”
- Articulated, documented controls for risk—the pursuit of opportunities, tempered by prudence.
Know Which Measures to Look for in a Manager
- Address your clients’ anxiety about absolute risk by looking at the manager’s Sharpe Ratio. Because the Sharpe Ratio does not refer to an index and instead expresses the potential excess return of a portfolio relative to a risk-free investment such as Treasury bills, it is well-aligned with your clients’ view of risk.
- Use a fund’s information ratio10 to understand its alpha per unit of active risk. If two investment managers provide the same alpha at different levels of active risk, smart risk takers favor the lower-risk manager.
Invest in the Smart Risk Zone
For your clients to be smart risk takers, they should focus on investment vehicles offering the highest potential return with lower volatility, better downside protection, and consistent compensation for risk. These risks must be measurable and manageable.
In our opinion, these investment vehicles can be found in the “Smart Risk Zone.” If the investment vehicle lies within the Smart Risk Zone, it is consistently taking less risk (volatility of returns) and getting more reward than its peers among Morningstar categories.
Approximately 38% of assets in long-term, open-ended mutual funds are held within Morningstar’s Large Cap Value, Large Cap Core, Large Cap Growth and Intermediate- Term Bond fund categories.11 Since smart risks should always be taken at the core of a portfolio—where a financial advisor can have the greatest impact on a client’s ability to create wealth—we believe these foundational investments offer significant opportunities. Within these categories, your clients can assume risk incrementally based on their financial objectives, time horizon, and risk tolerance.
The Smart Risk Zone is determined simply by plotting a fund’s total return and standard deviation versus its benchmark or peer average. The northwest quadrant is the Smart Risk Zone.
Strategies for Smart Risk Takers
Opportunities in Large Value
In the large value universe, we believe a smart risk-taking approach should focus on valuation, quality, and income.
- Investing in high-quality companies with low-risk business models
- Buying stocks that pay a dividend
- Purchasing stocks at a discount to their fair value
- Incorporating risk-adjusted investments (e.g., convertible securities)
We believe this approach can provide the foundation for building and protecting wealth over time through higher returns, lower volatility, and better downside protection.
Opportunities in Large Growth
We think that seeking long-term sustainable growth without unnecessary risk is one way to be a smart risk taker in the large growth universe.
- Investing in large companies with compelling potential
- Purchasing the stocks of companies experiencing sustainable business improvement
- Seeking to understand and quantify all portfolio risks
- Adding value through security selection
- Seeking to neutralize exposure to systemic and sector-level risks
In our view, this approach can increase the chances of outperforming large growth benchmarks and peers while maintaining a consistent risk/return profile.
Opportunities in Intermediate-Term Bonds
A smart risk-taking approach in the intermediate-term bond universe should focus on delivering consistent levels of return, ongoing income, and reduced volatility.
- Investing in a diversified mix of core bond investments
- Seeking sub-sector opportunities across fixed income sub-sectors, issuers, and securities
- Exploiting inefficiencies through risk analysis and budgeting
- Conducting ongoing risk monitoring and credit monitoring
We believe this approach can provide the bond-like attributes and characteristics investors expect as well as the consistent total returns they need.
A Final Word
Risk is real. So are investors’ long-term liabilities. Your clients need your help to realign their portfolios with their financial goals. Smart risk taking offers advisors a strategy to help clients obtain better risk adjusted returns, returns that are consistent with a specified asset class or benchmark. It can also enhance portfolio diversification—deep, broad diversification among investment vehicles with low correlations. Combined with a disciplined investment process and well-documented risk controls, a smart risk strategy can make more likely a positive financial outcome.
For more information contact your wholesaler at 1-800-345-6488 or visit us at americancentury.com/ipro.
1 Source: Standard & Poor’s. “Saying Goodbye to a Dismal Decade?” (January 2010). The S&P 500 Index is a capitalization-weighted index of 500 widely traded stocks. Created by Standard & Poor’s, it is considered to represent the performance of the stock market in general. It is not an investment product available for purchase.
2 Source: Standard & Poor’s. “Saying Goodbye to a Dismal Decade?” (January 2010).
3 Source: Federal Reserve System. Includes Non-Profit Organizations.
4 Source: Crandell, Pierce.
5 Source: Commerce Department, National Bureau of Economic Research.
6 Source: Morningstar.
7 Source: Federal Reserve Bank of St. Louis.
8 Source: Bureau of Labor Statistics.
9 Source: Retirement USA.
10 The information ratio is a ratio of portfolio returns above the returns of a benchmark (usually an index) to the volatility of those returns. It measures a portfolio manager’s ability to generate excess returns relative to a benchmark, but also attempts to identify the consistency of the investor.
11 Source: Morningstar, as of 12/31/2010.
The opinions expressed are those of the fund manager and are no guarantee of the future performance of any American Century Investments portfolio.
This information is for educational purposes and is not intended as investment advice. Diversification does not assure a profit or protect against a loss in a declining market.
Investments are subject to market risk.
