Monday, Aug. 24, 2015, will be remembered as the day that the Dow dropped more than 1,000 points and the Standard and Poor’s index closed in a correction. Stock markets rallied early Tuesday only to disappoint in the final hour.
On volatile days like these, the temptation to throw in the towel is very real. Experienced advisors have been here before. Talking panicked clients off the ledge is part of the job description. The key for experienced and young advisors alike is to avoid panic in the first place. My job as an expert in risk tolerance and strategist for FinaMetrica is to explain how.
Here are the 3 things advisors can do to help clients avoid panic:
1. Know Your Clients. Risk tolerance dictates an investor’s willingness to take risk. Subsequently, it also helps determine the level of losses that they can conceivably suffer without panicking. People are different, and some are better equipped to cope with their emotions than others. A psychometric risk tolerance test will enable you to assess and scientifically quantify your clients’ risk tolerance, giving you the ability to see how your clients compare. But it can’t stop there. You have to be able to talk to your clients about risk. A well-constructed risk profile report will facilitate the conversation in a thoughtful and consistent manner. Learning and talking about what keeps your clients up at night are keys to strong, enduring and fruitful relationships.
2. Construct Portfolios for Good Times and Bad. Once you have gained a better understanding of your clients’ risk tolerance, construct portfolios that they can emotionally stomach under duress. The ability of your clients to take risk is determined by their financial circumstances: the expected returns required to achieve their goals in combination with their risk capacity. However, do not lose sight of their emotions. A suitable asset allocation is one that also considers risk tolerance. Your clients have to be emotionally and financially committed to the plan in order to get where they want to go. Appropriate tools will provide the methodology to help balance those considerations and enable you to communicate the trade-offs.
3. Manage Expectations. Everyone enjoys rewards, but financial losses can be emotionally devastating. Prepare your clients for market turmoil and make certain that they understand the risks involved. Historical risk and return data provides a good frame of reference. By educating clients about worst case scenarios you can help set expectations from the get-go and better prepare them to weather the storm. Of course, projecting future returns from past performance is a dangerous game, so the point is to use historical data as a point of discussion – not as an investment strategy.
Following this advice will help you fulfill your compliance obligations and lower your potential legal liabilities. After all, the majority of complaints filed by investors relate to unsuitable investment advice. “Taking too much risk” is an often cited as a leading cause. More importantly, adhering to these principles will help you guide your clients through the market’s ups and downs. Keeping your clients focused on the long term will enable them to achieve their financial and life goals. As investment professionals, isn’t that what our jobs are really about.