The dangers of American exceptionalism in today's markets

A recent conversation with a friend while visiting Europe underscored the dangers of American exceptionalism as it relates to investing. While waiting at a crosswalk signal in Vienna, my friend expressed frustration with European regulations that made it difficult to take his kids out of school to visit family back in the States. "The rules are for everyone here," he said.

This is in sharp contrast to the American attitude I often encounter: a belief that the rules apply to others but don't apply to us. We are exceptional. Right? 

American exceptionalism, a philosophy with deep roots in our history and national psyche, can be a double-edged sword. In the U.S., our culture of confidence (if not overconfidence) can be a beautiful trait that fuels entrepreneurial spirit and innovation, driving U.S. economic leadership.

But when confidence veers into exceptionalism to the point where we believe the rules do not apply to us, it becomes problematic. As financial services professionals, when we lose sight of the temporary nature of being on top we can become complacent and develop a disregard for risk. Nvidia, anyone? We forget that trends, like going bankrupt, move slowly, then quickly.

READ MORE: Adjusting course in the wake of the Fed's rate pivot

The indexing … trend?

When it comes to markets, it is easy to see why we might dive into the fantasy of exceptionalism. After the last global financial crisis the S&P 500 emerged as the clear market leader. We bounced back from the COVID-19 hangover faster than most countries, and currently have an all-around prosperous economy. This has led some to believe U.S. markets are uniquely resilient.

So, what's the problem? Massive financial corporations with endless marketing budgets and media pundits often promote a simplistic approach: Buy low-cost index funds and hold them indefinitely. The market goes up 70% of the time, right? 

But this strategy ignores historical downturns and the human cost of potential losses. To measure only upside performance is to ignore history and to fail to prepare for what may happen when the debt and tech booms that have fueled our recent exceptionalist mindset explode.

This indexing trend — yes, I called it a trend — has been on the rise for the last 30 years (trends don't have to be fast), during which we have gone from approximately 2% of all mutual funds and ETFs in index products to 50% today. This has led to an overemphasis on return-based investing: maximizing return while minimizing risk takes a back seat.

Risk tolerance gut check

The return-based advisor does not ignore risk but puts more emphasis on supersizing upside. This is an easier strategy because one can hitch their wagon to the S&P and just let it ride, warning clients that there will be times when it will be hard to stay in their seat. 

Risk-based investors do not ignore upside, but the philosophy emphasizes the existential crisis that people endure when they see their assets cut in half. If your response to this last sentence is, "Yeah, but that won't happen again," you may want to check yourself for exceptionalism, or, at the very least, overconfidence. 

Our research shows a significant disconnect between advisors' perceptions and investors' actual risk tolerance. Investors often express greater anxiety than they let on. In many cases, advisors think their clients are more confident, happy and content than they actually are. As fiduciaries, advisors have a duty to consider clients' emotional and mental well-being alongside their financial goals. 

READ MORE: ​​Helping clients cut through the noise of recurrent crises

Start by asking clients what it would mean if the portfolios that you create were based on risk tolerance rather than return. Would you be giving up a significant return over the long run? 

Next, ask which clients you think may not have as much tolerance for pain as you previously thought.

Lastly, ask what would happen to you, your practice and your clients if the S&P were cut in half, as it was in the dot-com bust and financial crisis of 2007-2009. 

The nature of exceptionalism is a lack of perspective on oneself, history, the moment and human nature. If asking yourself these questions does not add items to your to-do list, perhaps you truly are exceptional, and the rules don't apply to you.