As with most financial advisors, our investment performance in the third quarter was poor in absolute terms and, in our case, relative to the benchmarks we use. Worse, the subsequent losses in the first part of October made the third-quarter decline look tame. When we exceeded the 12-month loss targets set for each asset allocation strategy by quarter-end, only to face an additional 20% decline in stocks in the first eight trading days of the new quarter, many clients were shell-shocked and uncomfortable with risk of any kind. This makes our current round of client calls and meetings as important as any we've ever done.

Many advisors are facing a similarly difficult situation. The magnitude of this market decline exceeds the frame of reference of nearly every advisor in business today, and most of their clients. It's no surprise that many of our AdvisorIntelligence subscribers are looking for guidance on what to say to their clients. This article roughly lays out the approach we're taking with our clients. It's presented in the same sequence as an actual client discussion, and each broad topic is followed by supporting bullet points and then further detail.

Give Them the Facts

First, we let them know what caused the massive declines in the markets:

• Credit markets froze, stifling business activity and stoking fears of major failures throughout the financial system. The credit freeze that chilled the financial markets in early and mid-September was more alarming than anything we've experienced in our lengthy investment careers. The credit (lending) markets were dysfunctional for months, but the risks to the broader economy significantly increased in September as credit markets came close to a standstill. Businesses couldn't access the short-term capital they've relied on for decades to fund normal business operations, which threatened severe damage to the economy. In October, fear intensified as investors began to realize how negatively deleveraging (reducing debt) would affect economic and corporate earnings growth, even if they could avoid collapse of large portions of the global financial system. This led to a massive selloff in every asset perceived to have any risk.
• We are in the midst of massive deleveraging as businesses and individuals reduce debt. This is damaging the economy. Over the past years, the amount of debt has grown unchecked relative to the size of the overall economy, infecting the global financial system. Financial institutions, hedge funds and households must reduce debt at the same time, forcing sales of investment assets and shrinking the amount of capital to the credit markets. Governments worldwide have taken action to restore confidence in the credit markets. But the problems won't be fixed quickly, and investor confidence is likely to return only gradually.

Don't Sugarcoat

Next, we acknowledge that our performance was bad, with no sugarcoating:

• We recognized—but gave a low weight to—the possibility of a very negative market scenario. A small handful of investors warned about the risks that have triggered the current credit crisis and bear market. But the major deleveraging environment we are in now is outside the experience of most investment professionals. We were in the process of understanding the risks as the year progressed, but we believed that the very negative scenario that is playing out now was not very likely to happen.
• There was no place to hide in this selloff. In contrast to previous bear markets, our portfolios performed poorly throughout this environment, seemingly hit by a perfect storm. First, as the crisis became more acute, our tactical allocation to emerging-markets local-currency bonds underperformed the domestic investment-grade bond exposure we would have otherwise held. Second, our tactical allocation to large-cap stocks hurt us as small-cap stocks outperformed in this market decline (which is historically unusual). Third, a number of our equity managers were late to grasp the severe ripple effects of the credit crisis and largely underperformed their benchmarks.

   

  There is also growing evidence that huge deleveraging by hedge funds triggered selling that caused many stocks and bonds to perform out of line with their fundamentals. That could explain the underperformance of many of our managers (and suggests it could reverse).

  Finally, the extreme demand for the safety of U.S. Treasury securities meant investment-grade corporate bonds had their worst month ever in September, and worst quarter ever. We believe this damage is mostly temporary and has resulted in corporate bonds now offering compelling yields.

• We're disappointed in our risk management. In the last bear market, we outperformed by a large amount, and prior to this period we'd exceeded our risk threshold only once in our 21-year history. But after September, our portfolios significantly surpassed their risk thresholds over the last 12 months.
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