Every time the market drops, we hear from our nervous clients, and it's a challenge to come up with a different way of explaining the same answer.
Many years ago, long before I entered the investment business, I attended a luncheon sponsored by a local stock broker, Bob. He asked the audience why a person's investment portfolio performed better over the long term if they used a broker, rather than investing on their own. The audience responses included "because the broker knew more about the stock market," "because the broker's company had access to different types of investments," and so forth. Bob listened carefully to all the answers. Then he shook his head and said, "No. The reason is that when the client calls in a panic and wants to sell out, the broker doesn't let him."
And that, in a nutshell, is the most important role that investment advisors have--to help their clients stick to their investment plans.
We all know the truth of this, but as we enter the fourth year of this recession and "recovery" period, and the extreme market volatility that has accompanied it, it gets harder and harder to persuade some of our clients to stay in the game. Fortunately, most accumulators are comfortable with the volatility, even if they don't like it. Our biggest issue is with clients who are living off of their portfolios and, for us, it is the single women who are retired, widowed, or divorced who struggle the most. They experience a strong fear reaction when the portfolio declines, and even a few days of negative returns are enough to remind them of the extreme panic they felt in early 2009.
Understanding the Triggers
What do you say when your client pleads, "I just can't take it any longer. I want to get out of the market!"? We know she is having a strong, emotional reaction to something--panic at the decline in the value of her portfolio, fearful anticipation of negative news she heard on TV, or some other trigger. It is no longer enough to say, "Don't worry. It's fine." To calm her, you need to spend the time to explore her fears and remind her why she is in the market in the first place.
One really common misperception among our clients is when they hear that the Dow Jones has declined by 10%, they think that their entire portfolio is down by 10%. Our bellwether client, who calls every time there is a multi-day drop in the Dow, has to be reminded that her portfolio has only 30% invested in equities, with the balance in fixed income. In addition, her equities consist of broadly diversified asset classes, not just large U.S. companies. In any event, if you can explain that a 10% overall decline in equities represents only a 3% decline in her entire portfolio, it goes a long way to calming her fears.
Some Basic Storylines
Depending on what you hear from the client, you can tailor your discussion. Some possible talking points are:
• No one knows when a recovery will occur. If you bail out now, how will you know when to get back in? By the time you hear in the media that the recession or bear market is over, stock prices will have already recovered and you'll miss some of the market's best returns. Just look at the second half of 2009.
• You have an appropriate allocation in your portfolio to fixed income, which will cover your withdrawal needs for several years. You need to keep some equities to provide long-term growth to cover the inflationary rise of your withdrawals over time.
• Entirely converting your portfolio to cash or fixed income now will guarantee you a low rate of return on your investments, due to the low interest rates. Since the interest is not enough to cover your withdrawals, you will experience a decline in your portfolio without any potential for future growth.
• Investment decisions should be made rationally, and not controlled by emotions. If your long-term goals and plans have not changed, then there is no reason to change your investment strategy now.
• During a period of volatility, it is helpful to minimize the withdrawals from your portfolio. Let's get together to review your situation to see if you can reduce your expenses, defer discretionary spending, or increase your income.
Is There a Way to Control the Emotional Reactions?
The Center for Behavioral Finance of Allianz Global Investors published a white paper entitled "Behavioral Finance in Action." One of the sections discusses the lack of investor discipline and introduces the concept of the "Ulysses Strategy." Remember that Ulysses had himself bound to his ship's mast to prevent him from succumbing to the sirens' song. In investing, this strategy asks clients to pre-commit to a rational investment strategy that describes what they will allow themselves to do when they experience an emotional reaction to the markets, either fear or greed. The strategy involves three steps:
1. Help clients understand the sometimes impulsive nature of investment behavior.
2. Discuss and agree upon what action will be taken when, for example, the markets move 25% up or down.
3. Draw up a commitment memorandum, signed by both the client and the advisor.
The whitepaper includes a sample "Commitment Memorandum," which explains the behavioral reactions that can affect investment decision-making, and lays out a method of dealing with the client's response. After reading through it, I often wished that we had such an agreement with our bellwether client when she calls.
On a Lighter Note
Another solution for the client who constantly questions her investment decisions is suggested by Michelle Matson in a blog posting, "Saying 'I Do' to Your Financial Future." She compares making a lifetime commitment to your financial future to getting married. The difference is that it is a commitment to yourself and the life you want rather than to another person. She points out many parallels, including that both situations have ups and downs, and neither your spouse nor your portfolio will always behave the way you wish. And if you bail out early, you won't get the long-term result you were seeking.
The investment portfolio must be designed to meet the client's long-term needs, including being broadly diversified and appropriately allocated, and must take into account the client's willingness and ability to tolerate risk. Once the portfolio is in place, Michelle says it's time to take the vows:
"Do you (client name) take this globally diversified portfolio,
to buy and hold from this day forward,
for richer and poorer,
in good markets and in bad,
forsaking stock picking and market timing,
from this day forward until my time horizon has been fulfilled?"
"I now pronounce you Investor and Portfolio."
We can't wait to get our clients in here to take their vows. Champagne anyone?
This article was co-authored by Sandra L. Atkins, CPA/PFS.