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Investors Unprepared for Downturns

By Grace Williams February 3, 2017

It’s no secret that what goes up must come down, and the current overall bull market is chock-full of opportunity, even as some superstitious investors expect gravity to take hold and bring it down at any moment.

As an advisor, one of the toughest conversations you’ll have with a client is that frank discussion about the risk they are taking on with their investments. While this discussion is often a formality, it turns out that the sticking points tend to go in one ear and out the other.

Financial consultant firm FinMason recently released information that tackled the topic of risk tolerance. The firm surveyed 1074 investors and found that a whopping 43% do not know what risk tolerance is. If this number sounds shocking, it should.

Most advisors attempt to gauge their clients’ risk tolerance at the outset, yet a major disconnect centers on investors’ lack of understanding about the volatility and flux of the market.

When the market is great, risk tolerance often skyrockets, but when it starts to turn more bearish, fear and panic set in. As such, “When the market is down 6%, clients are calling every few minutes,” says Bill Schwartz, principal and co-CIO for Bronfman E.L. Rothschild, which manages $4.2 billion. “The risk tolerance is less than what they say it is.”

As an advisor, if you think having a conversation that outlines how your clients can withstand their potential losses is a giant buzzkill, you’re right. The survey found that 27% of respondents had an advisor explain their potential losses in another big market crash, leaving 73% with little-to-no explanation.

But advisors stress that it’s an important conversation nonetheless.

Having a “2008 scenario” conversation and explaining volatility and how it can be controlled through asset allocation is the best way to approach the understanding, says John Murphy, an advisor at Davis Capital Management, a $68 million fee-only RIA in Jacksonville, Fla.

“Risk is simply controlling the types of investments your clients own and explaining to them how volatile they may or may not be,” says Murphy. “Understanding what you own and how it is affected by market risk and interest rate risk is important.”

Owning the actual investment rather than a basket provides more control, says Murphy, as long as you keep the client diversified across all areas of the economy.

“It makes a more predictable outcome over the long term,” he says. “Anyone who thinks they can predict it in the short term will probably try and sell you a bridge too.”

Gerard Klingman, president of New York-based Klingman & Associates says no one likes to live through a down market, but “that’s when we provide our value. We become a sounding board before they push the button and sell everything.”

Klingman, who manages around $1.5 billion, says when the market is good, people might question the value of an advisor, but in a down market an advisor could be more than worth their cost for help with services like diversification or rebalancing.

Clients sometimes go through financial declines that make them rethink their risk tolerance or their model, but selling all in a decline is never a good plan, says Klingman.