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Five Answers to Calm the Scared Voices in Your Clients’ Heads

When market fluctuations are paired with rumors of hydrogen bomb testing in North Korea, the recent acts of domestic terrorism and a long-in-the-tooth bull market, it can all be a little frightening and overwhelming.

It’s at a time like this that it’s best to temper the catastrophic voices in our head with some research-based truths about how financial markets work.

For each of the rash, fear-induced common thoughts clients may have (below in bold), advisers can offer a counter argument fueled with a dose of realism:

“It’s been a good run, but it’s time to get out.”
From 1926 to 1997, the worst market outcome at any one year was pretty scary, -43.3 percent; but consider how time changes the equation—the worst return of any 25-year period was 5.9 percent annualized. Take it from the Rolling Stones: “Time is on my side, yes it is.”

“I can’t just stand here!”
In his book, What Investors Really Want, behavioral economist Meir Statman cites research from Sweden showing that the heaviest traders lose 4 percent of their account value each year. Across 19 major stock exchanges, investors who made frequent changes trailed buy-and-hold investors by 1.5 percent a year. Your New Year’s resolution may be to be more active in 2016, but that shouldn’t apply to the market.

“If I time this just right…”
As Ben Carlson relates in A Wealth of Common Sense, “A study performed by the Federal Reserve…looked at mutual fund inflows and outflows over nearly 30 years from 1984 to 2012. Predictably, they found that most investors poured money into the markets after large gains and pulled money out after sustaining losses—a buy high, sell low debacle of a strategy.” Everyone knows to buy low and sell high, but very few put it into practice. Will you?

“I don’t want to bother my adviser.”
Vanguard’s Advisor’s Alpha study did an excellent job of quantifying the value added (in basis points) of many of the common activities performed by an adviser, and the results may surprise you. They found that the greatest value provided by an adviser was behavioral coaching, which added 150 bps per year, far greater than any other activity. At times like this is why investors have advisers so don’t be afraid to call them for advice and support.

“THIS IS THE END OF THE WORLD!”
Since 1928, the U.S. economy has been in recession about 20% of the time and has still managed to compound wealth at a dramatic clip. What’s more, we have never gone more than ten years at any time without at least one recession. Now, we are not currently in a recession, but you could expect between 10 and 15 in your lifetime. The sooner you can reconcile yourself to the inevitability of volatility, the faster you will be able to take advantage of all the good that markets do.

This post originally appeared in the Brinker Capital blog. It is intended for informational purposes only. The views expressed are those of Dr. Daniel Crosby and are not intended as investment advice or a recommendation. The Center for Outcomes is a subsidiary of Brinker Capital. Brinker Capital and Nocturne Capital are not affiliated. You can find more of Crosby’s work on remaining calm in scary times here. 

Daniel CrosbyDaniel Crosby
Executive Vice President, The Center for Outcomes
President, Nocturne Capital
Atlanta, Ga.

 

Editor’s Note: Dr. Daniel Crosby will be leading a session on behavioral finance at this year’s FPA Retreat at the Wigwam Resort in Phoenix, Ariz. His session will take place at 9:55 a.m., Thursday April 28. To register for FPA Retreat, click here.

You may also be interested in the following related FPA content: 


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Advising Clients During Turbulent Markets

The old Wall Street saying “financial markets are driven by two powerful emotions—greed and fear” is particularly relevant during turbulent times. Many individual investors are full of greed during up markets but fearful during down markets. However, as Warren Buffet acknowledges, overcoming fear is easier said than done. “There is no comparison between fear and greed. Fear is instant, pervasive and intense. Greed is slower. Fear hits,” Buffet has said. He’s also offered such sage advice as “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”

Unfortunately, following this advice is difficult for many investors because it seems counterintuitive. This is where financial professionals enter the picture.

Financial planners and advisers face an especially challenging task in working with clients whose emotions and cognitive biases influence their behavior when faced with extended periods of boom or gloom. Investors often act irrationally during periods of stress that can lead them down the wrong path. For example, investors may fall victim to the disposition effect in which they tend to sell their winners too early, and hold on to their losers too long. However, financial professionals can play an important role in providing both financial and behavioral guidance in navigating within increasingly complex financial marketplace and helping investors from self-destructing if left to their own devices.

Some other behavioral biases, clients may suffer from are the following:

Loss aversion: Individuals tend to focus on downside risk when they invest in stocks. This feeling of loss can remain for an extended period. Many people who realize major losses during a market decline tend to avoid stocks and remain in cash because they perceive this is a safer strategy.

Anchoring: Clients often cling to a specific piece of information, which serves as a reference point that affects their future decisions. When clients anchor on a bad investment decision, they can be very risk and loss averse. Anchoring can result in both higher levels of worry and risk perception as well as lower risk tolerance, leading them to underinvest in stocks and overweight cash in their portfolios.

Negative affect: Research evidence shows a link between seasonal depression disorder and stock investing. When people become depressed during the winter months, they demonstrate a predisposition to have higher levels of risk aversion, which leads them to own fewer stocks and allocate more money to cash.

Financial planners often work with individual clients to develop an investment policy statement (IPS) that defines general investment goals and objectives and describes the strategies that will be used to meet these objectives. Thus, an IPS outlines general rules to be followed in managing the portfolio. However, the stress associated with volatile markets can result in irrational reactions by clients to change the asset allocations in their portfolios. For example, a client may want to reduce the allocation in stocks and increase the allocation in debt instruments or cash during a market downturn. Investors often suffer from short-term bias in which they emphasize short-term financial results.

Some clients have difficulty staying disciplined and following the agreed upon rules or guidelines in the IPS. Rarely does such market volatility merit a knee-jerk reaction. Here is where good advisers can add substantial value to their client relationships. When faced with periods of market turbulence, they need to advise their clients to stay true to their plans and to focus on long-term goals, not market timing. The value proposition of such advisers centers on client outcomes, not uncertain markets. In short, advisers need to remain disciplined even though their clients are not. By doing so, advisers can help their clients maintain a long-term focus instead of succumbing to short-term greed and fear.

This blog draws upon some concepts and strategies in the authors’ book Investor Behavior—The Psychology of Financial Planning and Investing (John Wiley & Sons, Inc., 2015) and their article “Understanding Behavioral Aspects of Financial Planning and Investing” published in the March 2015 issue of the Journal of Financial Planning, available here.

HKentBakerKent Baker
Professor of Finance
American University
Bryn Mawr, Pa.

 

Victor RicciardiVictor Ricciardi
Assistant Professor of Financial Management
Goucher College
Baltimore, Md.