Mutual Funds: Dealing with Market Downturns




Investors who ignore history are doomed to repeat it.

Lessons of a
Bear Market


THE RECENT BEAR MARKET CAN TEACH SOME VALUABLE lessons to CPA/financial planners and their clients. The first sustained market decline in recent memory was a test of CPAs’ investment and client management skills.

BAD MARKETS OFFER A CHANCE TO RETHINK AN EXISTING investment strategy. CPAs can use it to reexamine a client’s original asset allocations and make sure the portfolio is properly diversified.

THE VALUE OF DIVERSIFICATION BECOMES PARTICULARLY obvious when markets drop. This is especially true for executives who own stock in the companies they work for, much of it acquired through stock options. These clients also need help to determine if it is wise to exercise additional options.

IN A BEAR MARKET, THE PERSONAL ASPECT of investment advisory work plays an important role. CPAs may find themselves doing a lot of handholding and may find it advisable to call the client before the client contacts them.

CLIENT EXPECTATIONS ARE AN IMPORTANT CONCERN in a declining market. Clients need to understand that it’s too late to sell in the down market. The only money they have invested now is long term.

MAUREEN NEVIN DUFFY is an independent journalist based in New Jersey. The founding editor of the Journal of Performance Measurement, her articles have appeared in Institutional Investor, Money and The American Banker .

o prepare for the inevitable rainy day, most CPA/financial planners advise clients to diversify their portfolios, cautioning them that markets can go down just as easily as they go up. But some clients, for various reasons, don’t always follow that advice. What do you tell a client who has lost $5 million in a bear market? What of the widow watching her life savings disappear who asks, “When is it going to stop going down?” CPAs must reassure these clients and do their best to manage investment portfolios that have been mauled by a large bear. The onslaught of the 2000 bear market presented some financial planners with their first opportunity to test their skills—both investment and client management. Whether they are new to the game or seasoned pros, their experiences offer some valuable lessons.

Ups and Downs

On March 24, 2000, the S&P 500 Index closed at 1527.460 . By March 22, 2001, it had dropped more than 400 points, or nearly 27% to 1117.580 . As of June 26, 2001, the S&P 500 stands at 1216.760 , a roughly 9% increase since March.

Source: Standard & Poor, .


Most planners we spoke with said bad markets present an opportunity to revisit an investment strategy. From a big-picture perspective, financial planners basically make assumptions and decisions based on estimates, says Bart Francis, CPA, CFP, CIMA, a planner in Boca Raton, Florida. In a bear market, he says, “we not only have the significant repricing to consider, but also changes in expectations. Aha, the new economy turns out to be the old economy—with a few extra wrinkles. We then have the opportunity to take another look at clients’ goals and assess the reasonableness of the assumptions we initially used in their planning based on new, reduced stock prices.”

Angelo Ciullo, a CPA who is series 7 and series 66 securities licensed, helped his firm, Trien Rosenberg Weinberg Ciullo & Fazzari, LLC, in Morristown, New Jersey, launch its financial advisory service in the fall of 1999. Ciullo and his partners analyze their clients’ needs and design investment strategies accordingly. They began investing for clients between November 1999 and March 2000, the same month the market began to drop, and soon found themselves rebalancing their original allocations.

“If the recommended asset allocation is, say, 60/40” stocks to bonds, says Ciullo, “and stock values slide to 40% of portfolio value, you’ve got to rebalance the bonds,” to maintain the ratio. Ciullo sold bonds to buy lower priced stocks. When the stock market started to rise, the bonds declined in value, “averaging everything out,” he says.

Ciullo’s example highlights another reason to review strategy—diversification tactics may have lost their effectiveness. “The correlations get thrown out,” agrees Barbara Raasch, CPA, a partner of Ernst & Young in New York City. For example, if the strategy is to divide the client’s stock portfolio among 10 different asset classes, and one of the classes, say large cap stocks, loses 20% of its value, the investor won’t own enough of the S&P 500 (the benchmark) to stay within his or her investment policy or test for exposure. Risk assessments and other forecasts won’t be true.

Most clients are oblivious to such concerns, says Stuart Zimmerman, CPA/PFS, a principal in the St. Louis-based Buckingham Asset Management and a member of BAM Advisor Services, created in 1997. Clients are more likely to ask, “Can I afford to retire now?” Or, “Can I buy that place in Florida?” he says.

Many clients see a bear market as a reason to cash out, says Francis. Because of his long-term investment philosophy he typically views this as a mistake. Other clients see it as an opportunity to buy, “a kind of Kmart BlueLight special. But many companies are still overpriced based upon their price-to-earnings ratio,” he said this spring, “but when viewed in comparison to the past few years, they’re much better than they were.”


Another positive of a down market is that clients who have nonqualified employee stock options can exercise them with less compensatory income. This typically requires a buy-and-hold philosophy rather than an approach that involves simply trying to cash out of in-the-money options. For holders of incentive stock options, exercising when the price is low will reduce the clients’ exposure to the alternative minimum tax. (A client who exercises incentive stock options when the stock value is low reduces the amount of tax preference adjustment items included in income for AMT purposes.) But Francis cautions the right strategy depends on the specific situation.

Francis’ clients also seek his advice about when to exercise options based on their future with the company. A number of his clients received blocks of stock options that are now “under water” because the companies’ stock prices still aren’t doing well. Consequently, the client may feel there is not adequate incentive to stay with the company, let alone exercise the options.

When clients have too much wealth tied up in a company, such as the one they work for, Francis generally advises them to diversify, but this isn’t always simple. “There are challenges to selling stock if the client is a key employee. They need to be aware of the message they are they sending to Wall Street.” Key employees may have to put the company’s welfare ahead of their own.


All of the planners we spoke to typically spend many hours talking with new clients to assess their risk tolerance and investment horizons—in other words when they expect to need to draw from their portfolios. Raasch tried her best in January 2000 to rein in one client, an adventurous young entrepreneur with a high-flying high-tech company. He had an aggressive portfolio, invested entirely in high-tech companies that yielded no annual cash flow from interest or dividends. The client had made a lot of money on the sale of his technology business two years before, and was staying on as an executive with the company. Frequent bonuses and compensation from that position allowed him to spend lavishly. Raasch had a tough time convincing him to invest in more conservative investments, such as bonds, because the 40-year old was certain his $100 million portfolio ensured he had more assets than he needed to live on, even though his portfolio was concentrated in only one industry.

Even after the value of his portfolio dropped in April 2000, Raasch says he was reluctant to invest in anything other than his technology holdings because he was sure the correction was over. She did calculations based on his age, spending and appropriate return assumptions to illustrate his portfolio’s risk and return potential, as well as that of her recommended plan. “This showed him,” Raasch says, “that by selling half of his $100 million portfolio and investing in a diversified portfolio he could achieve both his short and long-term objectives with greater probability than if he continued to hold his current portfolio.” After six months of coaxing, the client sold half his tech holdings in June 2000 and reinvested the aftertax proceeds in bonds, real estate investment trusts and value-oriented and international stocks. Raasch says the international stocks have fallen a little since then but all of the other new investments have performed exceptionally well.

By the beginning of 2001, Raasch says the remaining $50 million of the client’s tech holdings had dropped by 70% to $15 million. “His compensation was dropping and his company was teetering on failure.” He had to withdraw cash from the portfolio to live on because he wasn’t going to get the bonus he counted on. So Raasch recommended withdrawing interest and dividends rather than reinvesting them. “This kept him from selling off stock at a loss,” says Raasch. She points out that in a bear market, if investors sell stocks to buy bonds (because they’re generally safer) they are selling into a falling market. If clients need portfolio returns for income, Raasch recommends taking the greater proportion of the cash from the bond interest and the lesser amount from stock dividends (see the sidebar below).

Drawing Income from a Portfolio

A ssume there are two assets in a client’s portfolio: a bond returning 5% interest with zero percent growth expectation and a stock yielding 1% in dividends. The stock has a 9% average annual growth expectation, so the rate of return on the stock portion of the portfolio is twice that of the bond side.

If a client needs to pull 4% from the portfolio every year, the best way to do this is to take two-thirds from the stock side and one-third from the bond side. Even though the bond produces sufficient cash flow to meet the 4% withdrawal, the client should still take the greater share from the stock side, selling pieces of the stock portfolio as needed to meet his or her cash flow needs.

That’s how it should be done under normal circumstances. But the recent bear market has been anything but normal.

At a time when portfolio values are beginning to fall, following that program would mean selling into a loss. Studies have proven that when stock prices are falling and are expected to continue to do so, a better approach is to take only the dividends from the stock side of the portfolio and withdraw the remaining cash flow needed from the bond side. Then, every quarter consider rebalancing the portfolio (by buying or selling stocks) to maintain the desired asset allocation. This allows you to keep the portfolio in balance.


Karen Goodfriend, a partner in Goldstein Enright Financial Advisors/Goldstein Enright Accountancy Corp., in Menlo Park, California, the heart of Silicon Valley, found herself smack in the middle of the high-tech meltdown. Goodfriend’s clients had come to the firm with portfolios heavily weighted in tech stocks, “because that’s what they knew,” she says, paraphrasing Warren Buffett.

A former chairperson of the California Society of CPAs PFP committee, Goodfriend says most of the firm’s new financial advisory clients had been tax clients managing their own portfolios, made up mainly of stock options. The value of diversification became painfully obvious as the market dropped. “Many had less confidence about investing on their own than before the market drop,” she says. While clients had previously come to her for help in managing their sudden wealth, now they needed help maintaining it.

Similarly, Buckingham’s Zimmerman has found the bear market good for business. “We have a financial and tax planning client who managed his own money. After the bear market reduced his wealth, he told me he’d fired himself.”

Certainly, the personal aspect of investment advisory work plays a more important role in a bear market. “There’s a lot of handholding at this time,” notes Lyle Benson, CPA/PFS, president of L.K. Benson, a CPA/financial planning firm in Baltimore. “We have to determine whether their concerns are real or emotional. We’ve been proactive in contacting them, before they call us.” When making these calls, Benson says the key is to “listen to the clients and their concerns and help them put things in proper historical perspective.”

One issue for his clients was taxes. Those invested in mutual funds were getting hit with high capital gains, passed on to them by funds that divested lots of holdings when the market started heading south. “It’s a disadvantage of owning mutual funds,” says Benson, “great for diversification, but this is the downside.”

At Berkowitz Dick Pollack & Brant CPA LLP, in Miami, Randi Grant, CPA/PFS, CFP, a director of her firm and a member of the AICPA PFP executive committee, says, “We tell clients the only money they have invested now is long-term money.” In other words, it’s too late to sell in the down market. To avoid the compulsion to sell, she says, “don’t watch CNBC and don’t open your brokerage statement—there’s no point in it.”

Grant’s clients did reasonably well with basically flat returns last year, due to the firm’s aversion to technology stocks and its conservative investment approach. “We were lagging the big 30% returns of the technology portfolios,” says Grant. “But our clients are thrilled. They love us now!”

Suggested Reading List

Against the Gods: The Remarkable Story of Risk, by Peter L. Bernstein, 1st edition, John Wiley & Sons, New York City, October 1996.

Stocks for the Long Run, by Jeremy J. Siegel, McGraw-Hill, New York City, 1997.

The Only Guide to a Winning Investment Strategy You’ll Ever Need: Beyond Index Mutual Funds—The Way Smart Money Invests Today, by Larry E. Swedroe, NAL, May 1998.

What Wall Street Doesn’t Want You to Know: How You Can Build Real Wealth Investing in Index Funds, by Larry E. Swedroe, St. Martin’s Press, New York City, January 2001.

Winning the Loser’s Game: Timeless Strategies for Successful Investing, by Charles D. Ellis, 3rd edition, McGraw-Hill Professional Book Group, New York City, February 1998.

“It’s all about managing expectations,” says E&Y’s Raasch. “If I’d told my client in January 2000 that I expected a correction instead of showing him what could happen to his income, net worth and ability to maintain his financial independence in the event of a technology industry decline, he wouldn’t have been prepared for the slump.” She addressed the client’s most immediate concerns by pointing out that he could meet his cash flow needs by withdrawing the interest and dividends the portfolio generated. The key, Raasch says, is to “reassess the client’s risk tolerance level and be sure of it. Clients with high risk tolerance often have no stomach for pain in a down market.”

Even Raasch’s entrepreneur spoke with her several times about selling all of his stocks when their value dropped by more than $35 million. But with the risk management strageties Raasch put in place, she was able to convince him to “hold tight” because, even with this loss in value, he would still incur capital gains taxes and transaction costs if he sold. “Why pay income taxes to sit in cash?” At last word, her client was still hanging on.


At the time of this writing, in June 2001, the worst of the bear market may be over. But even if this is true, the long period of annual double-digit stock returns may have come to an end. Markets are likely to return to a more normal cycle, one that includes occasional declines. The more CPA/financial planners learn the lessons of the 2000 to 2001 downturn, the better prepared they will be to manage their client’s investments—and expectations—in the future.

Mutual Funds: Dealing with Market Downturns

During the past 12 to 18 months, the stock market has for the most part resembled a down escalator. While experienced investors remember the market decline in 1973 to 1974, and more recently in 1987, many of today’s mutual fund investors took their first plunge into the market in the last 12 to 15 years. This means these clients are inexperienced in weathering a down market, creating trying times for some CPA/financial planners.

The Facts of Life

Many mutual fund investors first entered the market as 401(k) plan participants. Since 1985, the number of 401(k) plan participants has more than doubled, from 10 million workers to 25 million in 1997. The growth in 401(k) plans coupled with the roaring bull market means stocks now represent a tremendous share of personal wealth. Although clients have more money than ever before, they have less investing experience than any previous group of investors. As a result, many have developed unrealistic expectations. According to one survey conducted by Montgomery Asset Management just before the October 1997 market correction, investors expected a 34% average annual return on their mutual fund investments over the next 10 years.

As every financial planner knows, past performance is no guarantee of future success. Double-digit returns do not endure and market declines are simply a fact of life. Data from Ibbotson Associates in Chicago show that during the 75-year period from 1925 to 2000 large company stocks posted annual declines more than 20 times—approximately 1 year of decline for every 31/2 years of positive returns. A look at the entire 75-year period suggests a brighter view. The average annual return on stocks—as measured by the Standard & Poor’s 500 Index—was over 10%. Stocks outpaced both long-term U.S. government bonds and U.S. Treasury bills.

Still other data support stocks as long-term investments. In evaluating nearly two centuries of stock returns (1802–1992), University of Pennsylvania professor Jeremy J. Siegel found that for nearly all of the rolling 30-year periods from 1882 to 1992, stocks provided returns at least 5% higher than inflation and higher than cash or bonds. In his book, Stocks for the Long Run: A Guide to Selecting Markets for Long-term Growth (McGraw-Hill, 1998), Siegel concluded that, “Although stocks are certainly riskier than bonds in the short run, over the long run the returns on stocks are so stable that stocks are actually safer then either government bonds or Treasury bills.”

While Siegel’s time horizons may seem extreme, his data show that the benefits of stocks also apply to shorter time periods. He contends that for periods of 10 to 12 years there is little risk in stocks compared with bonds or cash. For periods of 20 years or more, Siegel believes cash and bonds carry more risk than stocks.

The year 2000 brought the most extraordinary stock valuations in modern times. Siegel points out that it is important to remember that before the historic 1999 to 2000 surge in the NASDAQ, tech companies were viewed primarily as cyclical stocks with some potential for long-term growth. The price/earnings (P/E) ratio for the 82 companies in the S&P 500 technology sector was only slightly above the average for the other 418 stocks in the index. But when tech stocks soared in 2000, they reached prices 75 times earnings and more than three times the P/E levels of non-tech companies. Their subsequent collapse occurred when earnings growth faltered. Will these companies lead the new economy or revert to their historical pattern—rapid growth followed by sharp contradictions in demand? Siegel cautions investors to approach this sector with the “utmost caution” in view of its history.

Some investors and planners have also been agonizing over the choice between growth and value mutual funds. History provides some peace of mind. In the late 1990s, growth funds were the way to go. For example, if you invested $10,000 in an average mid-cap growth fund in January 1998, that investment would have been worth $24,000 in February 2000. In contrast, a $10,000 investment in an average mid-cap value fund over the same period would have been worth only about $11,000.

Recently the tide has turned in value’s favor. A March 2000 investment of $10,000 in a mid-cap growth fund would be worth only about $7,000 in April 2001. However, a similar investment in a mid-cap value fund would be worth about $13,000. Over the long term, according to Morningstar data, either style does the trick. The 10-year average annual return for large-cap growth vs. large-cap value was 13.7% vs. 13.6%; mid-cap growth vs. value was 14% vs. 14.4% and small-cap growth vs. value is 13.4% vs. 13.3%.

Dealing with Down Markets

While it may be natural for the market to decline periodically, it is never easy to help clients stay calm. Here are a few successful strategies CPAs can recommend that may help mutual fund investors weather the storm.

Help clients develop realistic return expectations. Although investors were thrilled when annual returns on the S&P 500 Index topped 35%, most investors should expect less than 10% returns from the U.S. stock market in the next 40 to 50 years. History is the best indicator of what the market may do in the future. It’s the CPA’s job to use past experience to manage client expectations.

Recommend that clients diversify their portfolios. As one of the most venerable portfolio strategies, diversification can reduce overall volatility. It has long been understood that different asset classes react differently to changes in the economy and the financial markets. A portfolio composed solely of small-company mutual funds may not perform in the same way during a market downturn as a portfolio of small-, mid- and large-capitalization companies. By suggesting consistent investment in mutual funds that concentrate on various areas of the market or that have different investment philosophies (such as growth or value funds), CPAs may be able to help clients build a portfolio that reduces volatility while maintaining appreciation potential.

Look for investment potential overseas. Overseas investments can help defend a portfolio against domestic down markets. Economies around the world may perform differently from the U.S. market and can even outperform it. The recent stellar performance of the U.S. market has masked the long-term trend: U.S. markets’ best years have had an average return in the range of 30% to 40%, compared with 116% for the United Kingdom, 126% for Japan and 136% for Germany.

Consider some actively managed funds over all passive funds. In recent years, passively managed mutual funds (also known as index funds) have become popular. In downturns, these funds mirror the market and move where the market moves. Actively managed mutual funds may be able to find more attractive and promising investment opportunities and take defensive action, shielding against the downturn. Active managers can move from one asset class to another based on their perceptions of the markets as a way to preserve capital and provide consistent portfolio growth.

Encourage clients to add to their portfolios using dollar cost averaging. This strategy takes the guesswork out of when to buy because it is impossible to know where prices are headed daily.

Encourage clients to stick with their investment plans. When clients’ portfolios are tailored to their goals, risk tolerance and time horizons, they probably don’t need to make drastic changes. A key job for their financial advisers is to review these factors with them. Explain how their risk tolerance affects volatility, which in turn affects market returns. Once clients understand this, they often are better able to make informed portfolio decisions that reflect their goals rather than their fears.

Beyond Performance

CPAs can play a key role in helping clients to analyze opportunities objectively, rather than make decisions solely on the basis of performance. A key step is to underscore history’s lesson about stock market returns: Over the long-term, equity investments provide strong returns and outperform inflation and many other asset classes. Perhaps the best way to help clients prepare for an uncertain future is to do two things: encourage them to keep a long-term focus and help them make sure their portfolios are adequately diversified and fit their risk tolerance.

—Phyllis Bernstein

Phyllis Bernstein, CPA/PFS, is president of Phyllis Bernstein Consulting, Inc., in New York City. She was previously director of the AICPA personal financial planning division. She can be reached at .


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