How can financial advisors help clients manage their emotional response to recent market volatility without damaging their long-term plans? We posed that key question to Dr. Sarah Newcomb, director of behavioral science at Morningstar, in a recent episode of The Flexible Advisor podcast. Now more than ever, understanding the emotions that are driving your clients’ investment preferences is critical.
Dr. Newcomb broke down for us the three common emotional reactions that people are having about their investments through this crisis - fight, flight or freeze - and how advisors can manage each of these behaviors. Above all, she stresses that advisors can let clients have an emotional response and take the action they feel is necessary, but to keep it limited to a small portion of their investments. That way, you’re allowing clients to express themselves while minimizing any potentially damaging effects.
Here are the three common reactions and how advisors can think about them.
- Fight – The “fight” attitude refers to investors who see the market go down and want to get in on the action. They’re eager to take advantage of lower valuations and double down on their investments. While this isn’t necessarily wrong, advisors need to be wary of any extreme reactions, such as purchasing a lot of stock in a company that’s trendy without digging into the fundamentals. Perhaps they saw the rapid rise of a stock benefiting from the pandemic and feel they missed out. Now, they're pushing their advisor to find other single stocks that are going to catapult very high based on what’s going on with the pandemic.
Dr. Newcomb encourages advisors to discuss with these clients the underlying value of the company or sector, as well as the differences between long-term value investing and short-term speculating. In the end, she says it’s okay to have fun with a responsible portion of your money, as long as you have a guard rail. Allow the client to take that speculative bet, but don’t do it with money they can’t afford to lose.
- Flight – “Flight” is perhaps the more stereotypical response, which describes clients driven by fear who want to pull out of the market given discomfort with the uncertainty. They may have called their advisors earlier this year asking to pivot to cash.
Dr. Newcomb suggests advisors in this situation remind clients of three things: 1) the stock market is not the economy, 2) the stock market is not their portfolio and 3) the stock market’s activity today is far less relevant than what it will be doing in the five years before they intend to retire or need that money. If someone is just sensitive to any loss at all, then you need to talk about the realities that even a really well-crafted portfolio may lose money. Encourage clients to consider whether anything has fundamentally changed about the goals and timeline from their long-term strategy.
- Freeze – The “freeze” response categorizes the people who can’t decide what to do. This may be okay for a moment, though it can lead clients to miss out if they have money that they could be taking advantage of for objectively good investments. Clients may be sitting on cash and wondering when to get into the market.
Dr. Newcomb suggests that the better question to “when” is “why.” Is this product selling at a good price? What matters is the real value of the investments you're buying and selling, how you are getting that valuation information and what your goals are. The rest of it is noise. It's very compelling and scary noise at times, but it's ultimately noise.
In a client's financial life, sometimes it's about compromise. You can't let the “perfect” investment strategy be the enemy of the “good” investment strategy. You don't want to lose them as a client, nor do you want them to put a hundred percent into what they think is the next big thing. Consider letting the client have that emotional reaction with a small portion of their money, without affecting the long-term strategy, in order to maintain the relationship while keeping emotions in check.