China’s soaring stock market crashed in June 2015. Two months later the country followed up with disappointing economic data. The reverberations of these two events were felt worldwide, shaking U.S. stocks and factory orders. Between June 23 and August 25 of 2015, the S&P 500 fell 12%.

While many were caught flat-footed, the warning signs were there to be seen for those looking in the right place. Investors count on their financial advisors to be that proverbial canary in the coal mine.

From a macro perspective, warning signs include soaring debt that a government acknowledges as worrisome; poor economic indicators such as weak manufacturing, sales or labor figures; securities prices plunging due to these factors.

“Financial advisors need to remind clients not to get emotional about their money,” says Phil Blancato, New York-based Ladenburg Thalmann Asset Management’s chief executive. “It’s the number one mistake every investor makes, whether professional managers or retail clients. Your money doesn’t love you and you should not love it in a way that compromises your portfolio.”

With this philosophy in mind, his team searches for opportunities to reallocate ahead of rough waters, even when it requires addressing clients’ sentimental attachment to long-held investments. Blancato says if such conditions arose, he might point to runaway inflation and rapidly rising rates as signs of such rough waters for skeptical clients.

Steve Kaplan, head of portfolio insights for J.P. Morgan Asset Management, says advisors can back up these client conversations with hard data that make concentration risk and market-exposure risk very apparent. For example, if 35% of a client’s portfolio is stock in one U.S. company, that shows a major bias to the U.S. and likely a specific sector.

“When is the right time to reallocate, and once those events do or do not transpire, when is the right time to reposition again?”
Peter Murphy
Founders Financial

For some clients, the difficult part is accepting it’s time to make a change on a previously successful investment.

Peter Murphy, chief investment officer of Maryland RIA and independent broker-dealer Founders Financial, warns that advisors must be cautious in such situations. “Any time you’re having a conversation with a client about reallocating in response to risk events, you introduce an element of timing,” he says. “That raises several potential issues. When is the right time to reallocate, and once those events do or do not transpire, when is the right time to reposition again?”

This is why advisors typically advocate staying the course, says Murphy. However, he acknowledges, economic imbalances in a major economy such as China or the U.S., which have historically triggered significant equity market declines, may warrant stronger consideration for reallocation.

Rick Kent, head of Merit Financial Advisors in Alpharetta, Ga., an FT 300 Top RIA, recalls saving a client from a similar situation in the lead-up to the 2008 financial crisis.

His client and the client’s brother had each received $1 million in bank stock from their deceased mother. Kent advised his client that such a strong concentration in a single company was risky in general, but especially during that economic climate. His client diversified, but the client’s brother did not and subsequently saw the stock lose half its value during the 2008 crash.

“I often share that story with clients who seem sentimental about a certain investment,” Kent says. “No matter how well a stock performs for some period of time, that success does not last forever. Some people are inclined to hold a stock just because their coworker or family members are holding it, too. I explain how that’s not an investment strategy. That’s luck.”

Erik Davidson, Wells Fargo Private Bank’s chief investment officer, says advisors may have to overcome a client’s belief that since a certain stock is closely linked to the source of the family’s wealth, selling it — even partially — is unthinkable.

That’s when advisors should acknowledge the client’s sentimental attachment, and then remind the client that lowering concentration risk is not an all-or-nothing proposition, he says. For instance, if a client has 25% of the portfolio in a single domestic technology or financial stock, or even in a China-specific fund, first persuade the client to reduce to 20%, and a bit later on try persuading the client to reduce to 15%, according to Davidson.

“People change incrementally,” he says. “It’s sort of like running a marathon. Think of it as going one mile at a time instead of the entire 26.2 miles.”

Portfolio Trends

“Advisors should identify major outliers or risk exposures in their portfolios and adjust accordingly. Understanding exposures such as overweights to one region or sector, as well as what is contributing to risk and returns should identify opportunities to reallocate a portfolio as necessary. For example if one stock represents 35% of a portfolio it will likely create a significant overweight to a single sector and be a large driver of risk and return.”

-- Steve Kaplan, Head of Portfolio Strategies, J.P. Morgan Asset Management

J.P. Morgan Asset Management and Financial Advisor IQ are not affiliated. All trademarks appearing herein are owned by their respective organizations. JPMorgan Distribution Services, Inc. is a member of FINRA.