Countering Client Anxiety with Reality-Based Risk Scores
Market volatility is part of the price of investments, but it can still surprise your clients.
When markets dive or volatility prevails, investors often let their emotions run wild, leading to feelings of anxiety (and even panic). This can lead to a premature sale, which can significantly reduce their long-term returns.
Case in point: After the stock market fell twice in the 2000s (and returned to 50.9% at its lowest point), many investors lost confidence and opted to sell. However, those who stayed the course saw their strategy pay off when the market finally rose, once again, and continued to grow for 93 consecutive months.
When you look at market trends dating back to the Great Depression, it’s clear that this scenario was not an anomaly. In fact, of the 80 overlapping 15-year periods from 1926 to 2019, none resulted in a loss. Keep in mind, of course, that past performance is not indicative of future results.
So how do you empower clients to keep a cool head while the markets are crashing? Taking the time to remind them of their long-term goals is definitely important, as is making sure their portfolio is sufficiently diversified. But preparing them for the inevitable episodes of market volatility starts even earlier, when you help them establish a true understanding of the risk they can and should take in their portfolio.
Investment Risk 101
For investors to be confident in the face of market volatility, they need to understand the difference between volatility and risk.
Volatility is a natural part of the investment cycle – a degree of price variation that is to be expected over time. Risk, on the other hand, describes the possibility of clients suffering permanent losses, not achieving their investment objectives, or realizing returns that do not keep pace with inflation.
Before even building a portfolio, it is therefore essential that your clients have a good understanding of the investment risks involved so that they can clearly establish their preference. and investment risk capacity.
Find the right place
Most investors have a rough idea of their personal risk preference. They understand that different types of investments come with different levels of risk, and they’ve probably done an assessment at some point to gauge their personal tolerance based on their age, income, and financial goals. In most cases, however, personal preference for risk is emotionally based and reflects an individual’s tolerance for risk at a specific point in time.
Risk capacity, on the other hand, is the degree of risk that investors can actually take, given their current life situation. It is based less on emotions than on numbers and is calculated taking into account their income and financial resources. It also identifies the level of risk that investors must assume to achieve their financial goals.
Most portfolios are built on investors’ initial risk preference – something that evolves and changes over time – while ignoring their risk capacity. This becomes problematic during periods of volatility, as many investors’ fundamental decisions, such as the composition of their portfolio, hinge on this emotional metric, with no hard numbers to back them up.
That’s why it’s important to both demonstrate your clients’ risk capacity and respect their personal risk tolerance to help them weather market volatility.
A multidimensional questionnaire
Advisors should consider adopting a multidimensional questionnaire that helps clients get started on the right foot and keep them on track by removing short-term emotions from the risk tolerance equation. By calculating and comparing three risk scores (Risk Capacity, Risk Preference, and Portfolio Risk), you can demonstrate both where a client wants to be and where they have the capacity to be.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.