Psychologists say emotions influence every decision we make. When it comes to financial markets, clients who let strong emotions dictate their decisions are in danger of acting against their own best interests.
“The worst time to make a financial decision is when you are feeling strong emotions, be they exuberance or fear,” says Lisa Kramer, associate professor of finance at the University of Toronto’s Rotman School of Business. “Emotions can distort perceptions, and that’s not conducive to making good financial decisions.”
Your role as a financial advisor is to help your clients avoid behaviour based solely on emotion, to steer them through the inevitable market turmoil and volatility — and even take advantage of it.
“Most people don’t realize how affected they are by their emotions when markets are behaving in an extreme manner,” Kramer says. “Advisors should have their radar on and watch out for reactive behaviour on the part of their clients, and help them stay the course.”
A rational view
Frank Murtha, a specialist in investor psychology and managing director of consulting firm MarketPsych LLC in New York, sees the advisor’s role as being similar to a pilot who flies a plane: the advi-sor’s role as a trusted professional is paramount. He or she must maintain a rational view in helping clients and remain familiar with current events that are driving market behaviour. Says Murtha: “Advisors should never show fear or indecision.”
When your clients are in an emotional state, the key is to let them talk and unburden themselves first, then discuss investment strategies and solutions that will get them where they want to go. When you recognize an emotional reaction in a client, do not minimize or try to negate it. Instead, offer empathy and understanding, which inspires trust and leads to collaboration.
“The client’s fears may not be well founded in reality,” Murtha says, “but they are real to the client. [Clients] need to know their concerns are well understood by the advisor and respected.”
When clients have been given the opportunity to speak — and feel that they have been heard — they are calmer and more receptive to conversations about what concrete steps they can take.
“Emphasize the areas in which you can take control,” Murtha says, “which is in rebalancing, if necessary, and making sure the client has enough cash or liquid investments for short-term needs. Taking some action, even if it’s not major, can be symbolic, as it gives a sense of control.”
Asking clients how they visualize their future and talking about specific things they would like to do in their lives also can be helpful. This type of conversation can help pull a client out of a mindset dominated by emotions and lead him or her toward a more rational, long-term perspective.
“When clients picture what they want in the future,” Murtha says, “they begin to engage the visual cortex, which forces them to switch from short-term emotions to a more rational state.”
Clients should know beforehand that occasional market volatility is inevitable. “Should negative events occur,” Murtha says, “clients will not be blindsided if they’ve been prepared in advance. The advisor can say: ‘We talked about this. We anticipated this, and we have a portfolio structured to withstand it.’
“If your clients feel prepared when scary things happen,” he continues, “it’s like being inoculated against mumps and measles. You need to have the defence in place before the disease starts.”
Kramer says many advisors do not have an accurate understanding of their clients’ risk tolerance levels until turbulent times hit — and neither do the clients. If the financial plan is developed during a bullish period, your client may have a false sense of security based on the assumption that the positive conditions will continue.
The seasons also can influence investment-planning decisions. Clients who devise plans in summertime, when there is lots of daylight, may be more optimistic than those who plan in the autumn or winter. Kramer points out that many of the major market crashes have occurred in the autumn, when the days are getting shorter. Recoveries, on the other hand, often happen in the early part of the year, when days are lengthening and there is an improvement in mood and risk tolerance.
Actual dollars
Another effective strategy, Kramer says, is to show your client, at the planning stage, what he or she could lose in actual dollars if the stock portion of the portfolio were to drop in extreme market conditions. For example, if your client has $100,000 in equities and the market fell by 30%-50%, how would your client feel if they lost $30,000-$50,000?
“In developing plans, the advisor needs to address downside risk,” Kramer says. “It can paint a more accurate picture if you speak in dollars and cents rather than abstract terms, and make sure the client is comfortable with those short-term losses.”
Recent history has provided a useful lesson in the pitfalls of trying to time the market, Kramer says. Retirees and other inves-tors who jumped out of equities when they couldn’t stand watching their nest eggs erode during the financial crisis of 2008-09 may have turned paper losses of 50% or so into a permanent loss of capital. Those investors who stayed the course and rode out the turmoil have seen their wealth almost replenished. Remind your clients that nobody knows when the recoveries will begin, and those who wait to feel comfortable before re-entering the equities market are likely to miss much of the rebound.
“Market downturns can be framed as opportunities,” Murtha says. “If the stock market is down, the advisor can help clients recognize that buying at these points is how the most money is made. There are useful charts that graphically illustrate market behaviour, and the lows can be seen as welcome entry points.” IE