I write this as we enter the fifteenth month of the bear market, when keeping our clients calm and focused on their financial planning goals and priorities is becoming, if anything, even more challenging.
Recognizing the four emotional and psychological stages our clients go through during a market downturn can help us understand how to cope with market volatility and avoid some common pitfalls. This can help manage expectations through turbulent markets, resulting in a better planner-client relationship as well as improved investment results.
Downturn Stage One: Surprise
The first emotional stage that a client experiences in a market downturn is surprise. During a bullish phase for equities, such as the most recent one lasting from early 2003 and ending in October 2007, investors become accustomed to account statement balances either staying flat or increasing almost every month. When a bear market hits and clients see a sudden drop in account balances lasting more than a few months, they react at first like this: “My accounts didn’t go up this quarter again?” The key point here is to do a better job educating your client on the subject of market volatility and market pullbacks using actual dollar scenarios. People relate to dollars; speaking or displaying fluctuation using percentages creates a disconnect from volatility in their particular portfolio. The surprise stage can be minimized by doing a better job identifying a client’s true risk tolerance and having the investor in a portfolio that accurately reflects their risk tolerance.
Downturn Stage Two: Denial
The second stage is denial. Investors grow increasingly agitated, prompted by the fear-mongering of the popular media which, when combined with actually decreasing asset values leads them to slip into denial, since acknowledging the truth would be too painful. For the segment of the investor population at or close to retirement, worries that they may no longer be able to maintain their lifestyle drives them to deny the reality of the current market situation. They begin to “hope” that market conditions will turn around, leading them to maintain the spending habits to which they are accustomed. The denial stage causes the investor to freeze and become reluctant to take any change in their investment allocation.
Downturn Stage Three: Fear
The third emotional stage clients face in a prolonged downturn is fear. Basic behavioral psychology teaches us that people are driven by the two forces of fear and greed. As investors get beyond the denial stage, acknowledging the markets are rapidly declining and it’s affecting them, they face what they think could be the new dark reality with a genuine sense of fear. My experience has taught me that when people become gripped by either fear or greed, they tend to overreact to the extreme.
As investment advisors, we need to help control the fear and lead them to make the right choices; for example, not letting an investor get too far out on a limb with margin in search of large gains or overextending their portfolio if the choice of securities or the markets work against them. Another more widespread example would be investors in the real estate bubble that formed in 2002 and lasted through 2007. In many of the sunshine states, speculators purchased multiple homes with the expectation that they would always increase in value, allowing them to “flip” the properties and get rich quick, even though the prices they paid made no economic sense. These are examples of the pendulum swinging in the direction of greed; when it swings in the other direction toward fear, it often travels just as far. Investors who are properly diversified begin to have an exaggerated fear that everything they have in their savings and retirement portfolios will evaporate with the drop in the equity markets. Unfortunately this fear causes the investor to make the wrong moves at the wrong time. They sell at the bottom of the market only to find themselves struggling when conditions improve to buy back into the market but at a much higher point than where they sold.