The COVID-19 pandemic has created unparalleled challenges for investors. With a recession officially underway, unemployment surging, and unknowns looming regarding the impact of a potential second wave of the virus, the markets have embarked on an unpredictable — and at times, baffling — track. This has left many retirement savers anxious about how their income plans will fare and contemplating whether or not changes are prudent to better meet their needs in the future.
Gauging and managing risk is a North Star of successful financial planning. However, advisors also know that it’s nearly impossible to plan for retirement without riding the rollercoaster of market volatility along the way. Navigating clients’ behaviors and fears is no easy task, and it’s more important than ever for advisors to be able to distinguish between a true, needed change in risk tolerance and common anxiety as they guide their clients through challenging times that are very likely to occur at least once before retirement. Here’s what advisors need to know as they prepare their clients to take the ride.
Higher risk aversion may lead to higher risk for losses.
In order to help clients, face their fears, advisors first must understand where they often come from. As clients run through the natural ups and downs that come with the markets, many are bound to be prone to loss aversion, one of the building blocks of behavioral economics.
(Related: Structured Annuities Soften Downturns)
First identified by Nobel Prize winners Amos Tversky and Daniel Kahneman, loss aversion causes the psychological pain from losing to feel about twice as powerful as the pleasure of gaining. For investors, this often plays out as more openness to abandoning carefully crafted financial plans in a downturn than sticking around for a market rebound; the threat of sustained damage to their financial security may be smaller compared to the upside potential that could be had, but this smaller possibility of damage is far more compelling to act upon. Even before the pandemic started, this phenomenon was prominent — in 2018, nearly 75% of investors would rather have portfolio protection than portfolio performance.
This is why it’s so important for advisors to lean into their roles as counselors — students of human behavior — and not just financial experts. By understanding the psychology behind drops in risk tolerance, advisors can then help clients navigate these emotions that come in situations that are stressful and complex.
Probe the plan to keep eyes on the prize
It’s crucial for advisors not to pontificate, but to educate — to help teach clients how to identify and sort through their own feelings. The best way to start is to take a step back and ask them to describe their values and concerns. What are they trying to achieve through their financial planning efforts? Where do these fall in terms of priorities? What are they most nervous about, and why?