There are 3 Classes of Investors—Behavioral Science can Help Advisors Deal with the Other 2Advice to the Advisor
Mitigating panic seems to have become, these days, part of your job description as a financial advisor. Dr. Stephen Wendel, head of behavioral science at Morningstar, advises using a behavioral approach. Not only can dialing down the panic meter help you cope, Wendel suggests, but it is likely to improve investor outcomes.
Wendel describes investors in simple terms: There are those wealthy enough to meet all their financial goals with cash, and then there’s everybody else. Members of the first class need not bother themselves with market volatility; the other two classifications of investors face an unavoidable trade-off—staying in the market and running the risk of failing to generate sufficient returns to meet their financial goals, or derailing their own goals through panicked selling. In the Journal of Financial Planning (February issue), Wendel points out the obvious: both panic selling and insufficient returns are unambiguously negative.
There have been two different ways financial advisors have approached the competing demands caused by market volatility, the researcher observes:
- The risk capacity approach: You worked with the client to identify the financial goals and the optimal investments most likely to meet those goals. Factors considered were the investor’s time horizon and liquidity needs. The planning included construction of a “glide path” to move assets from one asset mix into another (usually stocks into bonds) over time, as the date of need approaches. Your risk capacity approach might have included optimizing allocations for multiple goals and changes in income and/or spending.
- The risk preference approach: You assessed clients’ risk tolerance through some combination of interviews and questionnaires to help identify where they fell on a scale from “conservative” to “aggressive.” A mix of assets was initially selected based on those risk preferences, with a focus on steering risk averse individuals away from risky investments. (The irony, Wendel notes, is that risk-averse investors are typically placed in less volatile investments that have historically underperformed stocks! )
In practice, Wendel notes, many planners combine the two approaches, basing the asset allocation first on a risk capacity glide path, then adjusting the allocation based on the person’s risk preferences. In the real world, Wendel notes, where investors can and do deviate from their investment plan, the value of each approach is unclear; each is flawed.
Here at Sheaff Brock, we were very interested in Wendel’s findings that, in both approaches, the effect of panic was significant. The extent to which individual investors underperform the markets by entering and exiting at the wrong times derails their own long term investment success.
One important piece of advice Wendel offers financial advisors and investors alike, is very much in keeping with the Sheaff Brock approach: Select investment managers who limit downside risk. In fact, in each of the Sheaff Brock portfolios, trying to mitigate downside risk is the first driver of security selection. As Sheaff Brock Managing Director Dave Gilreath stresses, disciplined investors focus on building long-term wealth, ignoring short term “noise.”
Since very few of your clients have sufficient wealth to avoid the volatility market “game” entirely, mitigating panic is likely to remain part of your job description for the foreseeable future.
As Dr. Wendel posits, a combination of asset allocation and behavior tools to limit stress could significantly help both you and your clients!