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Expert's Corner: Stage Fright

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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.

Observing fear and greed in human nature has led me to realize that, in the long run, investments perform better than investors. The popularity of the financial news channels and hundreds of available Web sites has considerable influence over clients’ emotions. Too often in a bear market they are drawn to dire predictions of doom and gloom, leading to a short-term mind set.

With the major implementation of 24-hour online account access over the past ten years in conjunction with the 24/7 news channels, investors are constantly checking their account balances not just daily, but multiple times during the day, adding to their fear and anxiety during turbulent markets. This causes the investor to be tortured by day-to-day fluctuations, in turn losing sight of their original long-term objectives.

Downturn Stage Four: Acceptance

As time passes and the bear market gets long in the tooth, experience has shown me that the investor mindset changes as they enter the fourth and final stage: acceptance. This stage occurs when investors are over their surprise, clearly out of denial, have come to grips with their fear and are now accepting that there may have to be changes to their lifestyle, spending plans, or retirement time horizons. Signs of this mindset are clients making comments like, “I don’t even look at my statement anymore,” or “I haven’t checked my account online in months.” These investors have accepted the fact that their accounts are down and they don’t need to be reminded of it.

There are many factors that will determine how the investor comes out of the bear market, including the severity of the downturn itself and the financial condition of the investor. Hopefully, throwing in the towel doesn’t cause the investor to cash out and get out of the equity market at the bottom as many want to do, losing faith that the market will ever recover and fearing it will continue to decline. As I mentioned earlier, investments do better than investors because investors frequently behave irrationally. If a client is working with an advisor who keeps him well diversified, well informed, and has reduced market exposure prior to or through the major declines, crying “Uncle!” means the client has accepted the bear market and will be patient for the inevitable turnaround. The client will be well positioned and mentally ready to take advantage when the upswing arrives.

The Lessons of History

Interestingly enough, the Acceptance stage and the end of a bear market often coincide. Historically, bear markets don’t end with equity markets selling off harshly in capitulation, but rather gradually wind down as selling volume drives up the final batch of sellers willing to throw in the towel.

Following this fizzling, there is a flat period when the markets thrash back and forth, due to the lack of buying conviction of soured investors and the buying public.This trickles through large institutions with heavy influence on the markets’ direction. This flat line historically lasts between six and twelve months. During the last nasty bear market of March 2000 through October 2002, the markets bounced back and forth and started a new powerful advance in the middle of March 2003. This began the next upward phase of a new bull market that lasted almost five years. Investors who stayed with the long view and did not sell out at the bottom in late 2002 took advantage of the upswing.

You might want to suggest to your clients that having patience through the Acceptance stage has paid off in the past, and is likely to do so this time as well.

Nick Giacoumakis is founder and president of New England Investment & Retirement Group, in North Andover, Massachusetts, which provides investment management and wealth management to clients, and is affiliated with Commonwealth Financial Network. He can be reached at [email protected].


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