How do you, as an advisor, provide clarity, comfort and portfolio solutions to your clients without really knowing where the markets are headed?

We’re barely a month into 2008, and the U.S. Federal Reserve Board has already cut interest rates by 125 basis points. The market views this as a positive, but only to the extent that these cuts may prevent the impending slowdown from extending beyond this year. These cuts are not enough to stop the markets from grinding their way through a serious correction in the first half of 2008.

Clients need explanations from their advisors to help them understand what changed from the last quarter of 2007 to the first quarter of 2008. They need to be comforted and told that the world is not ending, despite the fact that more bumps are likely.

The fact is that the Fed, even with all its good intentions, may not have the tools to deal with what ails this economy. This slowdown is the result of unbridled excesses supported by questionable loan practices. A Ponzi scheme was buttressed by major U.S. investment banks that packaged home-equity loans as collateralized debt obligations and then marketed the packages as “insured” AAA-rated fixed-income assets to an unsuspecting investor community.

The concern is that the market is suffering a crisis of confidence. Investors are now questioning the integrity of the financial system, which makes this slowdown very different from previous ones.

I am reminded of comments made many years ago by former Bank of Montreal CEO Matthew Barrett. He was asked to comment on a survey in which consumers berated banks for their poor service and increased fees. He responded that the survey was asking the wrong question: it’s not whether consumers “like” the banks, but whether consumers “trust” the banks.

If investors have lost confidence in the integrity of financial institutions, rate cuts and liquidity infusion won’t help.

On the positive side, major institutions such as Citigroup Inc., Merrill Lynch & Co. In. and even CIBC, were able to recapitalize their balance sheets in a matter of days. This tells us that the banking institutions have the confidence of some well-heeled inves-tors. Whether this was smart money is not the issue; what’s important is that it is long-term money.

Whether clients share that confidence will determine the length of this slowdown. In the meantime, they need to be aware that market reaction will be driven by sentiment. As a result, you will have to drill deep if you are to gain your clients’ confidence. Clients want explanations geared to their circumstances, not the day-to-day garbage that comes from market dispatches.

A successful advisor is one who can provide explanations that define the problem, can establish a timeline for resolution and offer portfolio solutions to weather the turbulence. And one size does not fit all. After all, it depends whether your clients are in the accumulation or withdrawal phase of their lives.

> Accumulation Phase. Generally, clients in this phase hold either a balanced or growth asset mix, depending on their risk tolerance and time horizon.

A growth portfolio typically has a heavier weighting in equities — say, 70% — while fixed-income and cash are weighted at 25% and 5%, respectively. A balanced portfolio generally has an equal distribution between growth and safety assets — say, 50% equities, 40% fixed-income and 10% cash.

If the client in this phase is nervous in the current environment, it is not usually prudent to change the asset mix. Unless, of course, the client has reached his or her risk tolerance — in which case, a new mandate is warranted.

You must offer solutions that comfort the client without destroying his or her long-term strategy. This may include changing the securities that make up the asset mix without fundamentally altering it.

For example, within equities, you could move out of more volatile growth-type sectors, such as technology, consumer durables and transportation, and into more defensive industries with higher dividend payouts, such as utilities and — dare I say it? — Canadian banks.

You could also look at repositioning some of the fixed-income assets. If your client has been in long bonds, you could opt to move some of the money into preferred shares. With some bank preferreds yielding between 5.5% and 6%, they are attractive — especially if you believe that interest rates will continue to come down.

@page_break@But this, too, requires explanations. In this case, the higher yield on the preferreds is the direct result of the credit crisis. Helping a client understand why that is most likely an unfounded concern will go a long way toward providing comfort.

Try this explanation: the higher yield on preferred shares reflects the market’s concern that Canadian banks may not be able to pay the preferred-share dividend. But before a bank can stop paying a preferred dividend, it would have to cease paying dividends to common shareholders. How likely is that? Especially as the Big Five Canadian banks raised their common-share dividends this past year.

I would also like to comment on guaranteed investment certificates as alternatives for worried clients. In a volatile environment, clients gravitate toward GICs because of their price stability. But that’s not an investment decision; that’s a psychological decision.

Try explaining that when you buy a GIC from a bank, you are effectively lending the bank money. If you are comfortable with this, why would you not be comfortable owning the bank? In the current market, the common shares of the major banks have dividend yields that are higher than the five-year GICs the banks sell at the branch level.

In that scenario, Canadian banks would be ahead of the game using the money from the GIC sales to buy back their common shares. Explaining it that way often helps a client understand the folly of an investment decision driven by fear.

> Withdrawal Phase. Clients in this phase are more difficult to deal with. The problem is that withdrawals are occurring regardless of their portfolios’ value. In this market, clients are drawing on their assets — sometimes having to sell these assets at depressed prices — in order to get their desired income.

I had three clients in this position. All required an income stream that was approximately 6% of the value of their portfolio and all were essentially in a conservative, income-type portfolio — which is to say, one that was approximately 10% cash, 60% fixed-income and 30% equities.

The portfolios had declined in total value, meaning that the yield had risen. Remember: yield is based on the portfolios’ cash flow, and although the value of the securities had declined, the cash flow did not.

In our portfolios, about 25% of the income assets were invested in high-quality preferreds. A year ago, these shares were yielding approximately 4.5%. In early 2008, the values of these investment-grade preferreds had fallen by 15%, but their yield increased to between 5.5% and 6%. So, as long as you held the preferreds to maturity, they would be redeemed at par value — some 15% above current prices. The cash flow would also stay the same.

One of the problems is that these income assets were held inside a pool. I understand the optics because I know what is in the pool. But a client cannot readily see the securities and cannot make a judgment based on what is in the account.

The solution was to move the clients out of the pool and reinvest their portfolios directly in the same securities. Either way, their income needs were met, but seeing the individual securities brought clarity. Now, the focus was squarely on the cash flow of the portfolio, not on its value. No assets had to be sold in order to deliver the cash flow.

So, if you can deliver well-grounded explanations and offer portfolio solutions during the bad times, you will strengthen your relationship with your clients and reap the long-term rewards. IE