Having filled out several risk profiles over the years, I've found they share one characteristic in common: They really don't measure how I feel about losing money on my investments.
I understand why advisers must quantify an investor's appetite for risk — an indirect way of getting at how much volatility an investor can stomach. Covering one's legal and compliance bases, even if not the primary reason, is certainly a prime motivator. The core reason, however, is the need to accurately assess how much of a roller-coaster ride an investor can tolerate before an adviser creates an investment plan and starts building a portfolio. But using conventional risk-tolerance questions to measure how much volatility an investor can live with, seems to me like measuring weight with a thermometer. It's just not the right tool.
In fact, I'm not even sure an accurate tool can be developed because as every adviser knows from experience, people say one thing about their willingness to assume risk (and how they answer multiple-choice questions about risk-tolerance) and then usually do something completely different when reality hits them in the face. As a result, when the market starts dropping, a good many investors decide the risk is too much to bear and bail out in order to stop the pain.
Of course, buying high and selling low doesn't make sense, and is contrary to what investors know they should be doing. But running away from pain is consistent with findings of research by behavioral economists, which has shown that losses are felt far more strongly than gains. So despite what clients may say or what their risk-tolerance profiles may indicate, it's safe to assume that each downswing in the market will be greeted with fear and negativity (to use an oxymoronic turn of phrase) far greater in magnitude than the joy and euphoria that accompany any sudden upswing.
Preparing clients for what is essentially market volatility's net negative impact, therefore, requires a measure of rational discussion, and something else.
The rational part involves repeated discussions about the need to diversify. Yes, equity investments tend to outperform fixed-income investments, but not all the time, and not without losses along the way — which is why advisers must keep reiterating the need to balance portfolios and possibly even add alternative assets to the mix, such as real estate, to diversify.
Part of that diversification effort should also include keeping some investment assets in cash. Advisers must explain (over and over again) why cash is a cushion against downturns, even if it doesn't provide great returns itself. Cash also provides the liquidity to take advantage of buying opportunities when other investors are fleeing the market and selling assets at distressed prices.
Discussions about rebalancing also are important to reinforce the discipline and benefits of having a long-term approach to asset allocation that tends to dampen booms and busts.
framing, mental accounting
That's the rational part. For the “something else,” advisers should use tactics that rely on behavioral finance insights to nudge investors into better behaviors. Using two principles — framing and mental accounting — can be particularly effective in getting investors to think and act more wisely about market volatility.
Framing involves how an investment topic is positioned and explained. Instead of positioning volatility as a negative event looming in the future, consider positioning it as a fait accompli. When talking to clients, explain that you want to do an exercise in which they, and you, assume their portfolio falls by 10% today. In addition to allowing the idea of a “new” lower balance sink in, it encourages a discussion of how client saving may have to change to meet financial goals and how their time horizons might change.
Tying the mental accounting principle to framing can be the next step. Mental accounting describes how people think about money being in certain buckets, not in one fungible pool. If they think about spending a certain amount on restaurant dining each month, for example, and then don't spend the money from that mental bucket, they tend to feel they have saved money, even if they've overspent on sporting event tickets, for example. While money is fungible, people usually don't think of it that way. So if an adviser were to take cash or liquid assets equivalent to the amount that would be lost in a 10% correction and put it into a notional or real “reserve for bear market losses account,” clients could better compartmentalize and prepare for a real loss because emotionally they have already put that money in a “lost” bucket.
Finally, there is herd behavior, or our tendency to go along with the group because we figure that if so many people are doing something, it must be right. The more advisers start talking about creating a “bear market loss account,” the more investors will “open” them, and the more other investors are likely to want to do it too.
Other behavioral finance principles can be explored and adapted as well, because preparing clients for market volatility and sudden downturns takes more than just warning them that bad days — like those scary ones at the end of 2018 — are bound to come again.
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