How to Talk to Clients About Market Volatility

By Harry J. Lew

People have a tendency to only worry about something if it’s happening in the present, not if it might occur in the future. Even financial professionals who are trained to consider and mitigate tomorrow’s risks are prone to downplay future contingencies. Talking to clients about market volatility is a perfect case in point.

Despite many regulations requiring financial advisors to know their customers and to provide only suitable financial products and services, only about 25 percent of clients say they speak to their advisor about the risks of market volatility. Worse, according to a 2017 FinMason survey, 62 percent failed to understand their adviser’s explanation of market risk or to appreciate how much money they stood to lose in a correction.

Not only is having this discussion crucial from a compliance perspective, it’s also important from a client/asset-retention point of view. “At some point, there will be another crash, says FinMason CEO and founder Kendrick Wakeman, CFA. “If investors do not know their risk of loss, they will have an emotional response. They will feel upset, betrayed, and litigious and many will sell when they panic.”

As CEO of a firm that sells risk-profiling software, Kendrick strongly advocates that investment advisors and registered representatives speak with their customers about what they might lose in a market downturn and then make portfolio changes if the potential loss is too large. This converts “a potentially scary conversation into a healthy and productive one,” Wakeman noted. “Investors (will) now know how much they could lose and (will) agree . . . it is important to take that risk to achieve their ultimate rewards.”

Speaking with clients about market volatility has two dimensions. The first is the discussion that takes place during the sales process that allocates client funds into negatively correlated asset classes. However, creating an asset allocation should be just one piece of a comprehensive market volatility discussion. It should also involve reviewing four related concepts:

• Risk capacity: the largest market risk people can afford to shoulder based on their available financial resources. In effect, risk capacity describes how much money people can objectively afford to lose in a market downturn.
• Risk requirement: the amount of risk a client needs to have in order to meet their asset-growth objective.
• Risk attitude: the psychological meaning people assign to risk. This is distinct from the quantitative factors just discussed.
• Risk tolerance: a client’s emotional ability to process and accept a financial loss.

Risk profiling, experts suggest, should encompass all four of these risk concepts. Using a simple form to generates an asset allocation alone is not sufficient.

If you do a good job assessing a client risk status before choppy markets occur, you will make their—and your—lives much calmer. They will react to volatility with much less emotion and hysteria and be less likely to make self-destructive decisions in the heat of the moment.  That simplifies your job, of course, and also reduces your risk of getting sued and having to file an E&O insurance claim.

It’s also important to have a plan for talking to clients about volatility once it begins. The plan should define both how and when those discussions should occur and what points you will make during them. If you leave method and content undefined until market chaos strikes, you will be forced to improvise a response. Instead of appearing calm, confident, and disciplined during a crisis, you will come across as tentative and improvisational. Not great “optics” from your clients’ perspective.

In terms of “the how,” there are several options to consider. You could simply not communicate at all during a crisis. Advantage? You won’t spark client anger and a possible defection. Disadvantage? Your clients might resent that you didn’t support them during a stressful time in their financial lives. Most financial advisors opt for reaching out in some fashion. The question is how.

Many financial advisors rely on their existing client communications channels—email updates, client newsletters, blogs, etc.—to periodically remind clients that markets not only go up but can also fall, often quite dramatically. Communicating your plan for dealing with a market meltdown is also a good idea. Again, as mentioned earlier, you always want to appear to be in command of events, not at the mercy of them.

Some advisors believe in reaching out to all clients by phone during a market crisis—or at least to those who are known to be emotionally fragile about their money. If you already make it a practice to touch base with clients regularly, then this call can substitute for one of those touch points. The downside? Some clients may take advantage of you calling to order up ill-advised portfolio moves. Calling them, in effect, can generate the negative result you were trying to avoid. Still, it’s hard to downplay the long-term benefit of client contact, especially during challenging market events.

Perhaps the best advice we can offer is to get to know them as well as you can early in your relationship. Do comprehensive fact-finding during the onboarding process, stay in touch periodically throughout the year, and perform more detailed client reviews according to your firm’s policy manual. All of this will uncover which clients are most likely to over-react to market volatility—and to need significant handholding.

Once you know how to communicate with your clients during a market crisis, the challenge becomes knowing what to say. According to American Funds, a major mutual fund complex, there are four main points you may wish to make during your calls, emails, or meetings.

1. A decline in the value of securities is a feature, not a bug, of financial markets. Remind clients that stock market reversals are par for the course. They vary in magnitude and frequency, but they inevitably occur. Also predictable is the fact that they always bounce back. Although past results do not determine future results, your clients should take great comfort from the knowledge that market declines have not been permanent to date. Use relevant market statistics to support your contention. For example, according to the Capital Group, a 5 percent decline happens about three times per year, lasting an average of 47 days, while a 20 percent or more decline happens just under every four years and lasts 338 days on average. Regardless of the specifics, market declines are a natural part of investing and are self-limiting and self–reversing.
2. A long-term perspective will calm your fears. Despite all of the heat and hysteria of a downturn, it’s important for investors to apply long-term thinking to market events. This will help them see how markets invariably bounce back from losses. For example, hitting bottom in August 1939 and September 1974, the S&P 500 Composite Index came back strongly, posting average annual total returns of roughly 15 percent over the next 10 rolling 10-year periods. And investors who remained calm and invested were highly rewarded. For example, according to American Funds, even when you factor in downturns, the S&P 500’s mean return was 10.43 percent over all rolling 10-year periods from 1937 to 2017.
3. Attempting to time the market to avoid losses is a fool’s game. Part of the problem is that clients feel losses much more intensely than they feel gains. Consequently, they are emotionally “motivated” to avoid losses, even if it means hurting their portfolio’s long-term performance, which is what happens when they flee the market and then miss out on the inevitable recovery. For example, according to American Funds, clients saw returns ranging from 36.16 percent to 137.60 percent in the first year after the five largest market collapses since 1929. The average return for the five years was 70.95 percent. Advise clients that if they let their fear get the better of them and move to cash, they may miss out on the recovery if don’t re-enter the market or reinvest at the wrong time. For example, the average value of a hypothetical $10,000 investment at the end of the five-year period was $29,298.
4. Don’t let your emotions cloud your common sense. Buffeted by fear and cognitive biases, investors often buy high during the market cycle and then sell low. In other words, they buy equities when people are overly enthusiastic about rising values. But then when they begin to decline and approach bottom, their fear compels them to sell. This almost guarantees that they will sell at a loss and then get back in at the wrong time, missing out on the upturn. Advise your clients that it’s essential that they avoid rash, emotion-fueled decisions during a market crisis. Sometimes it’s better to do nothing at all than to do something self-destructive.

In short, if you’ve done your job correctly, your clients should have an investment plan in place based on a careful assessment of their financial resources, future goals, and risk profile. If that plan is still relevant during a market correction, there’s no reason to depart from it if it’s been performing well.

Finally, from your perspective, talking to your clients about market volatility, both before they invest with you and afterwards, can reduce the likelihood of them making precipitous moves in their portfolio, which can produce regret, anger, and perhaps a complaint or E&O insurance claim. To reduce your errors-and-omissions risk, encourage your clients to think long-term and to stay committed to their plan. And if the financial news is spooking them, urge them to speak with you before doing anything impulsive. This will be a win-win for both you and them!