How to Prep Clients for Market Stress When They Don't Understand Risk

One of the lessons that can be learned from the current COVID-19 pandemic is that market stress is inevitable, so advisors need to always prepare their clients for that reality, according to Katherine Nixon, a chartered financial analyst who is executive vice president and chief investment officer of wealth management at Northern Trust.

“We know that asset allocation is the single most important decision that we will make with our clients,” she said Wednesday during the online CFA Institute Virtual Conference. After all, “it will absolutely define their investment experience,” she said.

“Particularly given the environment that we’re in, it’s worth exploring perhaps a little bit more deeply than normal,” she said, during a session called “Asset Allocation for Private Clients: Lessons Learned Amid Stressed Markets.”

Discussions about asset allocation usually start with risk and how much risk tolerance a client can afford to take, she noted. So, advisors tend to ask a lot of questions and use the data to establish where clients fit on the risk spectrum in comparison to other clients. Using that data, the advisor comes up with a suitable mix of assets for each client.

One “problem” for advisors, however, is that “most clients don’t understand standard deviations, so if standard deviation is the measure of risk and if risk is the key input that we use to determine a client’s position on that efficient frontier, and clients don’t understand it, there may be sort of a foundational problem at hand,” Nixon said.

Answers that clients tend to give about their risk tolerance are also often problematic because they tend to be “variable” and dependent on multiple factors that may change from day to day, she noted. Responses that she has heard from clients have run the gamut from: “Low”; “I’ll know it when I see it”; “What day is it?”; “What did the market do yesterday?”; “I have a high risk tolerance but I don’t want to lose any money”; and “then there’s the ever-popular ‘not low but not not low,’” she said.

Another key issue: “The portfolio that you build is probably a lot more risky than you think it is,” she said. One reason is that “high volatility” events tend to “happen with more regularity than the models would tell you,” she noted.

That ends up “opening the door to behavioral biases, which tend to characterize the way clients behave and, in some ways, how advisors can behave in times of market stress,” she pointed out. Those biases “can be actually really detrimental to your client’s portfolio and their investment experience because they do tend to manifest at [the] perfect wrong time and create really bad decision-making,” which is “another impediment to success,” she said.