Practice Wise: Market Turmoil Is an Opportunity ... to Assess Your Own Practice

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

This article was originally published in Morningstar Office.

The stock market's plunge on the coronavirus scare is an opportunity for advisors.

Not in the traditional way of "buy when there is blood in the streets." (Though that could still be useful.)

Instead, it's an opportunity to test your ability as an advisor to assess your clients' risk tolerances, and whether their risk profiles and investment strategies are aligned to meet their goals. In fact, it's a good time to revisit the question of how we as advisors determine how much risk a client can, and should, be taking.

It's also a time to assess how effective your client communications and coaching has been. How are your clients responding to the market turmoil? If your phones are lighting up and your email inbox is clogged, you may want to ask some questions about your process.

That's because managing portfolios for clients is not simply a calculation exercise. It involves working with clients through the market's ups and downs--coaching, communicating, reassuring. To properly invest on behalf of clients, we advisors must consider a variety of factors in addition to the client's personal feelings on risk.

And there's nothing like a double-digit plunge in stocks to reveal if you have overestimated how strong a stomach a client has.

The More Sophisticated Approach to Risk Tolerance This question starts at the beginning, when a client first comes on board.

For the most part, advisors will assign a risk-tolerance questionnaire to new clients prior to investing. The risk-tolerance questionnaire will generate a score, and then the score is matched to an appropriate corresponding portfolio allocation. This methodology is simple and easily documented for compliance purposes, but it is only one piece of the puzzle. A more sophisticated approach allows advisors to look at how a client's risk-tolerance questionnaire relates to his or her capacity to take on risk, and how that capacity informs long-term goals.

That's because no matter how risk tolerant the client is, consideration must be given to the capacity to take on risk from the perspective of the client's ability to reach goals notwithstanding market volatility.

For example, an extremely wealthy client will likely have more risk capacity than a working couple whose only investments are their 401(k)s. Indicators of greater risk capacity include stable employment, outside investments (like real estate), younger age, good health, potential inheritances, and so on. Indicators of lower risk capacity include unstable employment history, no outside investments, older age, poor health, dependent parents, and so on.

I remember a new client who wanted me to invest his savings of several million dollars. Eric was retired but received $1 million to $2 million a year from royalties. He lived a simple life and didn't want to take on any risk at all. Eric wanted to keep his money in certificates of deposit and U.S. government bonds. In addition to his aversion for risk, Eric didn't need significant returns to maintain his lifestyle. It would have been easy to construct a portfolio of CDs and government bonds, knowing that it would be appropriate based on Eric's risk tolerance and return needs. However, he had capacity for additional risk. I pointed out to him that a somewhat more aggressive portfolio would enable him to give more to charity without jeopardizing his own cash flow needs. Showing him that taking on a small downside risk could provide significant funds for worthwhile organizations gave Eric a new perspective and created more meaning in his life.

Coaching and Communication A more sophisticated approach to risk tolerance also requires advisors to be pre-emptive when an actual or potential market event could cause clients emotional distress. As we are seeing now, anxiety as the coronavirus continues to spread is causing many investors to panic.

When you truly understand every facet of your client's risk tolerance, goals, and investment strategy, it is easy to reach out pre-emptively to prevent emotional decisions and reinforce the "stay the course" approach.

Both downside and upside risk can be big emotional triggers for clients. When it comes to their life savings, people are understandably nervous and upset when their portfolio shows losses or doesn't reflect the amount of growth they think it should.

I sometimes say that my greatest value to clients is keeping them from making these kinds of emotional decisions that will hamper their ability to meet their goals. This means I need to continually coach and reinforce the "stay the course" mantra.

Since each client is different--and can react differently depending on the situation--I recommend ongoing, multifaceted communication. In my firm, we educate clients beginning with the introductory meeting and every annual review. We offer webinars, present seminars, send newsletters, include information in quarterly letters, and send timely emails during periods of market shifts.

Being proactive is extremely important in helping clients stay the course.

This time around, even before things got really ugly in the markets, we sent an email to clients on Feb. 20, 2020, with the subject being "The Coronavirus & Your Portfolio."

This is how we started the email: "As I write this, the market is at an all-time high. Although this is good news, it always prompts the question: When will everything drop?"

Of course, we didn't really know what was about to happen! But we walked clients through previous episodes of epidemics and their market impacts. The goal was to show our clients that we were paying attention and we have done the work to back up our recommendations.

When you reach out early and often, keeping clients informed and reminding them why their investment strategy works, they are much less likely to panic and let their emotions take charge.

We followed up with an email on Feb. 27 with the subject line "The Sky is Falling! (Stay the Course, Version XXXIII)."

Throughout this coronavirus market decline, we have had only three clients reaching out with concerns. We were able to talk to each of them and provide reassurance. And the other 250-plus clients? We didn't hear from 90% of them. The remaining 10% responded by thanking us for watching out for them.

Control What You Can A market drop like the one we are experiencing now can be a great opportunity for an advisor to remind clients of the work you are doing behind the scenes. That's because staying the course does not mean "do nothing." It means rebalance as needed and harvest tax losses. During the 2008 drop, my firm was able to harvest losses equal to 3 times the amount of portfolio declines.

And when you make lemonade out of lemons, let your clients know! They will remember the next time and will panic less.

Conclusion The market is unpredictable. There is no way to know what it will do in the future or to control it. Our clients know this, even if their emotions sometimes get the best of them.

As advisors, it is our job to take all of this into consideration when initially creating an investment strategy. However, at least as important is the client's ability to stick with the strategy through the ups and downs of the market. So, it is equally important to continually assess risk tolerance through coaching and frequent communication.

Sheryl Rowling, CPA, is head of rebalancing solutions with Morningstar and principal of Rowling & Associates, an investment advisory firm. She is a part-time columnist and consultant on advisor-focused products for Morningstar, and she continues to actively run her advisory business, from which Morningstar acquired the Total Rebalance Expert software platform in 2015. The opinions expressed in her work are her own and do not necessarily reflect the views of Morningstar.