You've probably heard the term, "irrational exuberance." That's how former Federal Reserve Board Chairman Alan Greenspan described the market mania leading to the stock market crash of March 2000. A blind herd of investors bidding a market up with no regard for company valuations – or even profits. One lemming following another straight over the cliff.
Today, the same phenomenon is known as a "market melt-up," and that warning phrase has been heard more and more in recent months. Are we setting up a stock market that rises to a dangerous peak, only to crash over the cliff?
Nick Phelps, a fee-only financial planner in State College, Pa., is having that talk with his clients.
"I am proactively discussing the possibility of a melt-up, in order to draw attention to the chance that 'irrational exuberance' will return along with bubbles in asset classes," Phelps says. "In particular, I remind clients that we do not want to chase returns; and that investing defensively when there are relatively few pockets of value is the better long-term strategy for most investors.
"In most cases, investors should feel very happy with the returns in equity markets recently, and by not participating fully in a melt-up they will also avoid the full force of a corresponding melt-down. It is OK to take some profits to the sidelines."
Chris Chen, a wealth strategist based in Waltham, Mass., says many times clients struggle to perceive market risk objectively.
"In my experience, a market 'melt-up' is often irresistible to a consumer," Chen says. "In finance 'risk' really refers to the statistical concept of variance. At the risk of being over-simplistic, it means that 'risk' happens when the market goes up and 'risk' happens when the market goes down.
"However, in the consumer view, a market that goes up is not 'risky;' it just behaves as hoped for. On the other hand, a market that goes down is very risky, as it takes away hard-earned wealth. Yet 'up' and 'down' together constitute variance -- and risk."
Helping clients to perceive risk in both market directions is a constant challenge for advisers.
"I reference the financial crisis and the returns in 2008 often, as an example of a possible worst-case scenario," Phelps says. "While it will be different next time, 2008 is still an excellent recent example to use in determining risk tolerance."
Phelps uses software simulations to demonstrate the likely range of returns for a given asset mix, and then asks his clients: How would you feel if your investment suffered this performance? Would it change your lifestyle or standard of living? "These questions address the potential real-world ramifications of a given level of risk-taking," he adds.
Both advisers remind clients to assign investments to particular goals and then invest in a manner appropriate to achieve each goal.
"Say the money in question is intended for a down payment on a house in five years," Chen says. "That money should definitely be kept in a safer instrument than the stock market. The consequences of being too greedy are to get caught on the wrong side of a meltdown. It could mean postponing that home purchase for several years."
Clients are prone to "let their winners run" when markets are rising. That's when rebalancing becomes extremely important.
"Given that stocks have risen so rapidly, I am focusing on long-term asset allocation recommendations," Phelps says. "It can be difficult to take money away from asset classes that are performing well and invest in areas that are not currently 'exciting.' The primary factor that I emphasize with clients is value (buy low): Chasing returns and following momentum can work for a while, but the risk is substantial. Once we have a discussion/reminder about long-term investing principles, most of my clients are open to reducing their risk exposure by avoiding overvalued investments (to avoid buying high), rather than trying to gain every bit of a bull market."
Chen adds that clients can be guided to rational behavior with effective coaching.
"The near-future is unpredictable, and for most clients the thrills of 'melt-up' markets are not outweighed by the sorrows of a 'melt-down' market," he says.
Hal M. Bundrick is a Certified Financial Planner™ and former financial advisor and senior investment specialist for Wall Street firms. He writes about retirement accounts and personal finance for NerdWallet. Follow him on Twitter: @HalMBundrick
Photo courtesy of iStock photo.