The first hard lesson that any clients need to learn as they begin investing in the stock market is how to manage their emotions effectively. It is virtually impossible to eliminate the impulsive nature to act when either elation or panic takes over. This is something that takes practice, patience and a willingness to trust the advice and expertise of others.
While clients can’t necessarily eliminate emotions that push their reactivity, the urge to react can be managed. It’s up to their financial advisor, more often than not, to be the voice of reason when a client is fighting the urge to buy or sell when it isn’t advantageous for them to do so in the context of their investment management strategy.
A recent study in 2015 found that a large number of investors in the U.S. allow emotions regarding risk to influence their decisions and investment behavior in ways that negatively impacted their personal financial goals. Several risk profiles help represent ways emotions can get the best of investment management clients:
Completely Avoiding Risk
A client has a good job, can meet expenses, is meeting financial goals and can live the lifestyle they desire to live. They have savings that they can leave alone, they’re utilizing retirement accounts and have plans in place to meet future needs. Generally, their financial health is in good shape. Despite their financial comfort, they refuse to invest in assets that don’t offer a fixed return or allow them to cash out quickly.
This is a risk-adverse investor. They have the financial capability to invest in higher yielding investments offering greater returns, but they choose a much more conservative path. Their dislike of risk holds them back from capitalizing on a more diverse portfolio. It is important for advisors with such risk-averse clients to make sure that these portfolios are keeping up with inflation. If not, it’s time to usher them into a portfolio allocation with more investment risk while opening a conversation about a reanalysis of their long-term investment management strategy.
Overreacting to Market Fluctuations
The only constant about the investment markets are that they are in perpetual flux. Let’s say a client plans to retire in the next 15-20 years. They’ve taken the time to do their homework and have purchased insurance to financially protect their family if they pass away early or need long-term care. After the latest market downturn in early 2016, however, they completely changed their portfolio allocation only to contain low-risk investments because they were afraid of a repeat of 2008-2009. This is a significant overreaction that additional education about diversifying strategy might help resolve.
If clients are too quick to react to external events and forget the long-term mindset needed to make a rational decision on investments, it is important to remind them that a balanced portfolio can help them weather bumps in the market that will eventually even out over time. Advisors can help these clients employ consistent strategies that rebalance assets to align to investment goals and timelines over time.
Investing Beyond Risk Tolerance
These are clients who have trouble maintaining consistent direction in their investments. They take shots in the dark when investing with no real forethought to any long-term goals.
Purchasing high-risk investments on limited assets or a short time horizon is simply asking for trouble. When clients are tempted to take bigger risks than their portfolio can handle, it’s important for prudent advisors to remind them of the potential long-term consequences of not maintaining a more disciplined approach to investing.
The early portion 2016 was very rough for many in the markets. The near-complete rebound in February and March caused a situation where virtually no one is comfortable in this market environment, except those who appreciate bargain-basement buying opportunities. The meandering range of the last 18 months or so, with January as the nadir and February-March as the apex, has created a good time to analyze portfolios, take a deep breath refocus attention to the next 10, 20 or 30 years while waiting for the market to find its footing again.
If clients call panicked about a large market dip, a prudent advisor will take a look at their risk tolerance preferences before any decisions are made. For some, a more conservative portfolio may be in order. For most, however, just steadying the ship and staying the course is often the best answer, even if it means skipping some gains when the bull market returns again.
Managing emotion can be difficult for newer investors and eventually everyone learns a hard lesson or two, but for successful long-term investing and a secure retirement account, it is imperative that advisors do everything possible to help clients avoid making rash, emotional decisions regarding investments.