As a financial planner, financial adviser or wealth manager, you build carefully crafted investment portfolios for clients and then monitor them over time. That, it turns out, can be the easy part of the adviser-client relationship. The bigger challenge is to keep clients invested when the markets turn south, as they did last week, whether the downturn lasts for a week, a month or years.
Is this the beginning of a major correction to the now nine-year-old bull market? Nobody can say with certainty, of course, but stocks have been having a bad month, with the S&P 500 Index managing to post a gain only five times so far in October. On Friday, the S&P 500 Index fell 3.9%.
But since past is always prologue for the markets, it's possible that a significant downturn may occur. After all, over the past 20 years we've had two big bear markets. In the 1998–2000 dot.com bust, the S&P 500 lost a cumulative 44.7%; in the 2008–2009 Great Recession, the S&P declined 50.9%.
You may remember those recent declines, but as
Scott Welch, chief investment officer at Dynasty Financial Partners, reminded me recently, advisers will face a unique challenge when the next significant market correction occurs.
"We have a whole generation of investors who have never experienced a longer downturn, which has resulted in a more complacent investor class," Mr. Welch said.
Even the market corrections since March 2009 "were so V-based and bounced back so quickly, whether because of central bank intervention or other factors," he pointed out, that investors "didn't feel those corrections."
What do feelings have to do with portfolios? Mr. Welch, who serves on the Investments & Wealth Institute Board of Directors, argues that the most difficult task for an adviser is to keep clients "invested and disciplined in volatile times."
Why? "Because we're human," he said. "We feel pain and want to react, to distance ourselves from that loss."
(More: Solidify client relationships in volatile times by overcommunicating)
When clients feel pain or loss from market downturns, advisers have to apply behavioral finance techniques to keep clients invested. Mr. Welch suggested a variety of approaches that would be helpful in keeping clients invested in volatile times, but not for the reasons you might think.
"As an industry," he said, "we've spent too much time telling clients what is in their portfolios rather than why" their portfolios include the securities that they hold. Mr. Welch argues that advisers must reframe the traditional definition of adviser-provided alpha — performance above a benchmark — to include "anything you do in a portfolio that your client values and is willing to pay for."
He calls it a multi-alpha approach. In addition to returns alpha, which comes from picking good active managers, that approach could comprise
tax and fee alpha, which provides "tangible value" to clients because it puts "real money in their pockets." The approach could involve illiquidity and leveraged alpha, such as hedge funds and other private investments.
Importantly, it could include what Mr. Welch calls "smooth-ride alpha," by holding securities that work to reduce the volatility of that portfolio. That alone could keep clients invested in volatile market times.
The Investments & Wealth Institute is dedicated to educating its members, but ironically the most successful advisers are those who've educated their clients. Those advisers teach their clients starting early in their relationships that sell-offs are inevitable and a carefully crafted portfolio will protect them during those dark days, weeks, months or years.
"Remind clients that these scenarios can occur," Mr. Welch recommended, but also tell them "we've added these assets to your portfolio that will help you" under those worst-case scenarios.
What shouldn't you do? Don't focus primarily on the investment alpha you provide clients relative to a benchmark.
"If you set yourself up as a benchmark-relative adviser, some other adviser will come in and show better performance than you," Mr. Welch warned.
"As an asset manager," he said, "I have to show my performance relative to a benchmark. That makes sense as an asset manager. But as a wealth manager, you have a very different agenda: to have your clients meet their financial objectives."
So wealth managers should focus on the agreed-upon investment policy or financial plan, and while "there will be fits and starts" when they meet with clients, the conversation should be around "'Am I getting you closer to where we said we wanted to go?' rather than 'Did I beat the S&P 500 this quarter?'"
Client education and a focus on client objectives is particularly important now because of the long bull market.
"Since 2008, investors want all of the upside and none of the downside," Mr. Welch said. "Their time horizon is one day; that's difficult for advisers."
"That's why," he concluded, "you need to talk to your client from Day One," saying, "we built this portfolio to meet your objectives, so don't worry about whether the market is going up, down or sideways."
(More: Bad things happen to good clients — and your response is critical)
Sean Walters is chief executive officer of the Investments & Wealth Institute.
