By Bruce W. Fraser

Financial advisors, know thy client! Know their risk tolerance and their risk capacity, and educate them at the same time. Be ready because during a financial crisis, questions from clients and challenges are going to be coming at you from all directions.

In a keynote address to a packed session Thursday closing out a three-day Napfa conference in New York, Roger Gibson, chief investment officer of Gibson Capital LLC, a boutique advisory firm in Wexford, Pa., laid out details of a plan he created to work with clients during the 2008-09 financial meltdown. Especially during times of volatility, it's crucial to be proactive and anticipate clients' fears and emotions, Gibson said.

The plan consists of two different client presentations, one focused only on investment issues and the other on behavior issues. "Advisors' attention should be on the client relationship, how the client is responding to the market, and try to make sure no one panics and makes an investment decision that may not be in their best interest," said Gibson.

With Gibson Capital's low client-to-advisor ratio, the goal was to meet with each client, be certain their portfolio worked for them, in relation to both their financial goals and their ability to tolerate risk. Clients must understand the possible implications of their investment strategies down the line, he added.

"With 115 clients and three advisors we had the time and resources to work with each client individually," said Gibson.

Investment Issues
Each client meeting was tailored to run one to two hours and was accompanied by power points to illustrate various concepts. The first meeting focused solely on the investment issues involved in the financial crisis.   

"We first built context for the losses investors suffered in the equity markets," said Gibson. "History has many examples of such losses -- and of the recoveries that follow." In more normal bull and bear market conditions, the dissimilarity in patterns of returns among different equity asset classes provides investors with significant diversification payoffs, said Gibson. During panic-driven financial crises, however, people, in their rush to get out of risky assets, abandon all equity classes simultaneously, he said.

"In a panic, multiple equity asset class diversification will not save you. Instead, the financial crisis was an opportunity to stress the importance of diversification into interest-generating investments as one way to mitigate risk. "2008 was an awful year for U.S. and non-U.S. stocks, real estate securities and commodities. They all had eye-popping losses, but 2008 was also a great year for long-term government bonds. They were up almost 23%."

"Finally," Gibson continued, "by showing clients the historical relationship between normalized price-to-earnings ratios and future returns in the market, we were able to demonstrate that the steep drop in equity prices had created unusually attractive future return prospects."

Behavioral Issues

The second presentation focused specifically on behavioral issues. "Here we addressed everything we were hearing from clients that was emotional or fear driven," explained Gibson. "A couple of clients expressed the fear that the market prices might decline all the way to zero! People may make bad decisions when they let their emotions determine what happens in their portfolios rather than using their heads.

"Even though the sharp drop in market prices had set the stage for very attractive future returns, prices could certainly have gone even lower. So we calculated the additional drop in market prices should price-to-earnings multiples reach the lowest historical 10th and 5th percentile levels. The ability to live through the possibility of further market declines could be either a risk tolerance or a risk capacity issue for a client.

"After the meeting with all our clients, we found that the majority affirmed their asset allocations. A smaller percentage did change, and the changes were usually in the direction of moving money from the equity side of the portfolio to the interest-generating investment side.

"We ran Monte Carlo simulations to test client portfolios against future cash flow needs. Occasionally, clients who chose lower equity allocations would not be able to sustain the lifestyle they wanted. Rather than try to live with the volatility of higher equity portfolios that violated their risk tolerance, such clients must accept that they needed to live more modest lifestyles," he said.

To sum up, here are Gibson's main recommendations in working with clients during a financial crisis:

Separate out client by client the investment issues from the behavioral issues.    "Clients are going to be fearful about dramatic market drops, whether they express their feelings openly or not," said Gibson. "To me, that's an emotional thing infiltrating people's consciousnesses. If you don't address that as a behavioral, psychological issue, it's going to get conflated with the investment decisions they make, which is a bad combination."

Make sure you're proactive in your relationship with clients. "Not hearing from a client doesn't mean they're OK," said Gibson. "What about the client who's really worried but not picking up the phone? You've got to be proactive in terms of contacting them and taking them through a discussion of the behavioral and investment issues they face. They need to be collaboratively involved in the portfolio process."