In mid-October of this year, an advisor called me to ask my advice. “How long should I wait before contacting my clients about this substantial market drop?” he asked. “I don’t want to seem to be overreacting to the situation. I figure if I wait a few days, things may blow over and we won’t have to have the conversation at all.”
On October 15, the market had indeed dropped 7.9%, the second biggest one-day drop since 1987. The advisor couldn’t have predicted that by the end of October, we would again reach positive record territory.
I’ve known plenty of advisors who avoid contacting clients immediately after a significant correction, preferring to “wait it out” to see what happens next. If there are more than a few days in negative territory, they will consider sending e-mail or a letter. If it plunges further, they may make a call or just hide. Personally, I believe that when there is an elephant in the living room, praying that it will go away before you have to clean up after it is probably Webster’s classic definition of denial. You control client behavior with your call, not without it.
In light of this recent dramatic one-day loss, it’s probably time to revisit your process around responding to frightening short-term volatility, though. It’s important to have a process so that you are not unprepared when this happens (you know it will happen again).
In advance of a major investment in the market, many clients fear that as soon as they do invest, the market will crash. This behavioral finance heuristic is known as “anticipatory regret theory,” which is anticipating and regretting an action before doing it. Behavioral heuristics or “mental shortcuts” frequently occur when people, as Daniel Kahneman suggests, are making decisions under uncertainty.
One way to try to counter this thinking is by saying something like this: “I know what you’re thinking; as soon as we invest your money, the market will collapse, and you’re right! As soon as we invest your money, the market will go down 20%, and it will be your fault. Not only that, we will send letters to all of our other clients telling them that it’s your fault.” It is amazing how much impact that line has always had. Intellectually framing the absurdity of these thoughts often works to ease a client’s mind about the uncertainty.
The day after the 7.9% point drop, our advisors were on the phone once again assuring everyone that Apple is still in business, the phone’s still working, and people are taking pictures at Disney World. Our clients are used to this dialogue too. “No, I’m not worried; I know I have enough cash in reserves to last for about a year of my expenses. I have to go now; I am taking my grandchildren to lunch.” These were the easy calls.
For clients who were a bit more uncomfortable, we prepared some on-the-spot stress-testing sensitivity analysis to see just how far down their portfolio could go before they headed for the windows. We used the sensitivity analysis feature in MoneyGuidePro, continually adjusting the expected returns downward until the client blanched. We reminded our clients that the funds they have in the domestic stock market are the funds they will need in the distant future. “In order to get market returns, you have to be in the market.”
Framing the event is essential. Reminding them that this isn’t the only market out there is a good way to do that. “This is only one of the markets you are in. Here’s what’s happening with the others … .” This gives us an entrée to discuss asset allocation, diversification and other theories they won’t remember. They will remember, however, that we called to talk and that’s the important part of the process.
By mid-morning of that day, it was clear that our most important call of the day would be to our newest client, who had just dumped a million dollars into a market that dropped 7.9% the following day. I’d love to tell you that this was the first call we made, but it wasn’t. We weren’t avoiding it either; we just needed to plan it carefully to make the best impact. We purposely waited until midday so that we didn’t convey a feeling of panic. We’re not insensitive to pain; however, it is important to think through how you manage stressful events because this is where you set the tone for the continued relationship. If you overreact or panic, your clients will too.
The difficult conversations come when clients are new to the firm, haven’t experienced much market volatility or are just generally skittish. That’s when having an investment committee meeting to strategize the discussion is invaluable. Once again we used our sensitivity analysis to determine the impact on the portfolio. The client was not taking money from his investments (his IRA account) and would not be taking his money until his required minimum distributions in about 20 years. The expected real rate of return for his portfolio was 4.8%. If the market were to turn much uglier for the rest of the year and actually tank 20%, then be followed by a second year with a 10% loss, we estimated the client would still just about be on target. That’s assuming we made no interim adjustments to his plan, which, of course, we would.
As only 60% of his portfolio was in equities, we also pointed out how unrealistic such a loss scenario would be.
We also felt that it was important for us to use this event to demonstrate how volatile markets can be over the smallest event. The media quickly announced that the drop was precipitated by weak retail sales and dour market forecasts by the Fed. The market reacted by wildly selling. I always try to explain these events in ways I think my client will respond to. So my explanation of the drop that day was something like this:
As a kid, my sister was a smart, adorable little devil who constantly got into trouble, blaming every one of her bad actions on my 2-year-old brother. “Bobby did it,” she would say, looking straight into my father’s face. Once my sister climbed up onto the kitchen counter, grabbed a handful of freshly frosted cake and jammed it into her mouth. To ensure his guilt and her innocence, she wiped her hands on Bobby’s face, leaving streaks of frosting everywhere. “Bobby did it,” she carefully explained, paying no attention to the trail of cake on her own hands and dress.
Truthfully, I think the market drop might have been due to the many investors who felt that the market was overvalued or who wanted to take some profits. Others might simply have been looking for an excuse to reduce their equity exposure. Since huge market movements are seldom at the hand of individual investors, I suspect the money managers also needed a good excuse, so they blamed it on the Fed. Whatever it was, you now know how vulnerable to chance the market can really be. This was not on anyone’s radar.
By the end of our investment committee meeting, we had our talking points, our tone and our attitude; we were ready to talk to the client. “Mr. Barstow,” I began, “I am sure you noticed the hiccup in the Dow Jones yesterday, and that’s why I am calling … .”