Editorial

Time is now to prepare clients for a stock market correction

All advisers should be taking steps to prepare clients for the reality of a correction

Jun 10, 2017 @ 6:00 am

An ounce of prevention is worth a pound of cure, the old adage goes, and now is the time for advisers to be taking steps to prevent client angst or panic when the market correction comes.

No one can time the next market correction, but many experts believe that after an eight-year bull market, it can't be too far away, especially with productivity growth low, economic growth slow and the U.S. stock market sitting at a high price-to-earnings multiple.

Actions by the Trump administration and Congress to cut taxes and reduce regulation have been slow in coming and seem unlikely to prolong the bull market too far into the future. At 98 months, the current market rally is the second longest since World War II, and it could be vulnerable to external shocks.

All advisers should be taking steps to prepare clients for the reality of a correction. Even though they may realize the market is flying high, many clients will still be dismayed by a correction — whether it be 10% or 20% — and will be tempted to pull out of stocks after the market has already fallen significantly. In fact, many clients have become used to the stock market moving mostly upward and will be reluctant to accept the loss of even a fraction of the gains they have experienced.

risk tolerances

First, advisers should be reviewing their clients' risk tolerance with them. Previous bear markets have shown that clients' risk tolerances are far higher when the market is rising than when it suddenly turns down. That is, clients often overestimate their risk tolerance in rising markets.

The task of reviewing risk tolerances will be easier for advisers whose clients were with them during the 2007-2008 bear market. They can discuss with those clients how they reacted to that decline and adjust the asset allocation, if necessary, to bring it in line with the true risk tolerance demonstrated in that period. Both advisers and clients should recognize that the risk tolerance displayed during the bull market may no longer accurately reflect clients' current risk tolerance. Clients are almost 10 years older — closer to the goals they are investing for — and they most likely have more assets at stake.

(More: Market gains concentrated in biggest stocks)

Advisers who do not have that history with clients should be discussing risk tolerance with them by seeking their reactions to potential losses of 10% or 20% of their assets, given it is impossible to know in advance how long it will take to recover those losses.

Clients who have long investment horizons should be better prepared to handle a correction, even one that takes six years for the major indexes to get back to even — as was the case in the most recent bear market — than those with shorter horizons.

After reviewing risk tolerances and the appropriate asset allocation, and perhaps taking some of the gains off the table to serve as buying reserves if the market corrects, advisers should try to prepare clients for the frightening headlines they're likely to see in the newspapers, on television, and on various websites. One of the scariest sights will be the asset declines shown on their quarterly account statements.

(More: Investments that advisers should look at in an overheated market)

Advisers should be reminding clients that the S&P 500 and the Dow Jones Industrial Average do not represent their portfolios, which, if advisers have been doing their jobs, are diversified enough to soften the blow of any correction.

Advisers should identify the clients most likely to overreact to a correction and focus much of their attention on these clients. They should also train their staff so that all are prepared to handle calls from concerned clients and provide reassurance that the financial world is not ending. Even firms offering robo-adviser programs should be preparing staff for the inevitable hand-holding that's likely to be necessary. They should also be stress-testing those programs, examining how they will advise clients in market correction conditions.

Clients might think it odd to be talking about a market correction now, but they will thank advisers who prepare them if and when a correction comes. Little is lost by being mentally and financially prepared.

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