As a financial professional, you respond effectively to volatile markets. You know that your success will be built on your ability to think rationally and act knowledgeably on behalf of your clients. That is what it means to be a professional.
But market volatility isn't your only challenge. You also must deal with the emotional volatility of clients.
Even small fluctuations in the markets can generate intense emotional reactions. Behavioral finance has shown that all investors, even those who try to maintain a dispassionate, rational perspective, are affected by markets because of common, hard-wired vulnerabilities.
Over time, it is likely that you will experience more volatility from your clients than you will from their portfolios. Fortunately, even when clients become emotional, you can still engage them as a professional, provided you know what their behavior means and how to respond effectively.
The last time a conversation with a client heated up, did you find yourself surprised, defensive and off-balance? Did you ask yourself, “What's going on here?”
In the same way that it is helpful to understand the mechanisms behind market behavior in order to respond knowledgeably, it is important to understand the mental mechanisms that cause clients to become volatile.
Volatility activates the fight-or-flight instinct in investors.
Of course, not all volatility is negative. Clients love to watch their investments increase in value.
But when a portfolio trends downward, several mechanisms get activated within the client's brain. Even small losses feel painful (researchers call this “loss aversion”), and it feels as if downward trends will continue forever (known as “inappropriate extrapolation”).
Once the client expects that there will be more painful losses, fear kicks in and sparks an impulse to flee.
This is an important insight. It isn't the pain of realized losses that stimulates impulsiveness; it is the fear of additional losses.
The human mind doesn't become anxious about past events. One may feel sad, angry, guilty or regretful (or a host of other emotions) about past experiences, but not anxious.
That feeling is reserved for pain or loss that is anticipated.
A client who makes an impulsive decision about an investment isn't thinking about what he or she has already lost. He or she fears the losses that are yet to come.
RESPONDING EFFECTIVELY
Understanding impulsive behavior allows you to respond more strategically to clients, provided that you know a little bit more about neurology.
The human brain evolved over millions of years and is made up of many subsystems. The primitive systems that control action and the fight-or-flight instinct evolved a long time ago, while the parts of the brain that control both rational thought and language evolved more recently and are much less powerful.
This is why an anxious client doesn't think clearly and can't respond to a rational argument. Therefore, it is useless to try to explain to an emotional client the tendency of the markets to regress to a mean, or the merits of a buy-and-hold strategy.
A brain that has been activated by fear is taken over by instinct, turns off rational thinking patterns and can't hear or process information.
With this in mind, an effective response starts with deactivating the primitive fight-or-flight instincts and reactivating the rational parts of the brain.
The strategy for this is to get the client to start talking by asking questions about the future: “What do you think is going to happen?” Faced with this question, the brain is forced to shift gears and to activate its rational thinking and language portion.
The more the client talks, the more these structures take over, even when he or she is talking about the imaginary future losses that cause the fear.
Spend a few minutes listening carefully to these fears and then ask a second question: “How is this going to happen?” This question pushes the client more deeply into rational thinking and further deactivates the fight-or-flight instinct.
The key to working with distressed, anxious clients is to restore rational thinking by activating language skills and getting the client to talk about the future. As the rational centers of the brain engage more, the client will become more resourceful, more able to think strategically and more inclined to embrace your guidance about a decision.
Kenneth Haman (kenneth.haman @alliancebernstein.com) is managing director of The Advisor Institute at AllianceBernstein LP.
