How to manage your clients’ emotions when market volatility spikes

The market volatility we’ve seen at the start of 2015, due in part to falling energy prices and fresh uncertainty in the eurozone, has many investors exercising caution when including equities in their portfolios. Based on our quarterly Fidelity Advisor Investment Pulse survey, managing volatility was one of the top concerns among advisers in 2014.

Equities are a vital tool in helping drive retirement readiness. Without the appropriate level of equity exposure, clients could compromise their retirement dreams and may not have the income needed to cover health care and other expenses. Here are a few things to consider when speaking with clients about their asset allocation in times of market volatility:

1. Know your clients’ risk tolerance: Research by Amos Tversky and Daniel Kahneman has demonstrated that the pain of loss is twice as powerful as the pleasure of gain. That loss aversion is most relevant to clients with low risk tolerances. Studies show that frequent portfolio evaluation prompts risk-averse behavior. For example, those that reviewed their portfolios on a monthly basis had an average of 59% of their portfolios in bonds and 41% in stocks. Conversely, those that reviewed their portfolios on a yearly basis had an average of 30% of their portfolio in bonds and 70% in stocks.

For those clients with low risk tolerance levels, consider explaining to them the importance of staying fully invested — many of the best periods to invest in stocks have been environments that were among the most unnerving. Looking back at the performance of the S&P 500 since 1980 through Sept. 30, 2014, an investor who missed out on only the five best-performing days in the market would have ended up with a portfolio worth roughly 35% less than one that had been fully invested throughout the period. And missing out on the 30 best-performing days for the market since 1980 would have reduced the value of a portfolio by about 81%. Appealing to clients’ sense of loss aversion with these statistics may help them be more comfortable with their current portfolio allocation.
(Market insight: Mohamed El-Erian: Market volatility means buying opportunities)
If clients continue to express concerns around the ups and downs of the market, advisers may want to discuss adding more core fixed income, which has low correlation to the markets, to their portfolios.

2. Consider your client’s age: Gen X and Gen Y have been particularly reluctant to invest in equities. This wariness is understandable considering their recent experiences with the markets — a series of record highs followed by major corrections. However, our research suggests that during the accumulation phase of retirement saving – age 25 to mid-40s – an allocation of 90% to equities is ideal.

The first step to addressing their concerns about stocks is to talk to them about their time horizons. With most likely decades from retirement, these investors have time to ride out market highs and lows. Then, reconfirm their investment objectives and goals and set up a regular investment plan, investing a specific amount of money at the same time each month or quarter, and periodically reviewing the overall portfolio.

3. Know your clients’ concerns: Some investors may be worried that now isn’t the right time to invest in stocks, or that stocks are too expensive or that equities may not perform well if interest rates spike. Market fluctuations occur more often than clients may realize. Providing them with the historical context can help.

• It’s not unusual to have more than one correction in the course of a bull market. Elevated stock market volatility is not necessarily synonymous with declines, and although unnerving at the time, history has shown that some of the worst short-term losses in the stock market were often followed by rebounds.
• Since 1969, stocks have experienced bull markets, corrections, bear markets and crashes. Yet through all the ups and downs, the stock market has trended higher.
• Historically, equities have continued to rise even after an initial interest rate hike. Research shows the S&P 500 has posted positive returns 69% of the time after a first rate increase.

Staying fully invested can give investors an opportunity to fully participate in the market’s long-term upward trend.

Taking the time to look at an individual client’s portfolio goals, time horizon and tolerance for volatility can help advisers respond in a way that will foster a stronger relationship. Now is not only a good time for investors to take advantage of the markets, it’s an opportunity for financial advisers to strengthen their business.

Scott E. Couto, CFA, is president of Fidelity Financial Advisor Solutions.