The recent broad market sell-off has been sharp and swift, fuelled by uncertainty around the economic impact of the coronavirus disease (COVID-19). Investors around the world have turned to safe-haven assets, as market sentiment has shifted to a global risk-off environment. This may intensify further in coming months with the US elections and break-neck speed of the news cycle. Australian advisers have an important role to help their clients manage the risk of emotionally driven investment decisions by protecting against cognitive bias and by keeping a laser focus on long-term financial goals.
The market’s short-term memory
Market downturns are always unsettling but looking back may help keep things in perspective. In late 2018, we witnessed a lot of volatility in the markets; investors were extremely nervous. Headlines like “head -spinning,” “jaw-dropping,” and “worst-ever,” made it easy to get caught up in the fear of a major correction. However, investors who sold stocks in January missed the market rebound; the S&P/ASX 200 Index ended the year with a return of more than 20 per cent, excluding dividends.1 This is an important message for clients who are vulnerable to selling on the dip — trying to time the market usually comes at a cost.
Two client types in particular may be vulnerable to counterproductive investment decisions: Millennials and Baby Boomers. For Millennials who started investing after the global financial crisis of 2008, anything other than a bull market may be distressing. Whether they see a market downturn as a time to buy and hold, or they fall victim to chasing returns, may depend on moving away from a benchmark-oriented view.
Baby Boomers, on the other hand, may be more concerned about their sequence of returns risk. The timing of performance dips matters a great deal for clients close to, or in, retirement, who have few or no income-earning years left to make up for losses. Instead of trying to time the markets, maintaining an equity glide path that gradually reduces market risk through retirement can help defend against emotionally charged decisions.
For investors, the key is to balance investment risk with opportunity risk in a way that reflects their capacity for total risk and their feelings about volatility. Especially during stressed markets, we can help investors by emphasising portfolio diversification with regular rebalancing.
Redefining the value of advice
When expectations are upended during a time of market volatility, clients are likely to consider making changes. But a goals-based approach should help them make better decisions. The outcome orientation can add guardrals and remind clients of their reasons for investing. We know that irrational behaviour is commonplace, even among the smartest investors. Market stress makes it even more difficult to stay the course — this is precisely when the adviser’s role in emotional governance is critical to long-term success.
Risk is not just volatility; a goals-based approach might yield a very different perspective. A few practical applications can help clients mindfully link risk to their goals, time horizon, and life stage, to take full advantage of the value that portfolio construction can bring to their investments.
1) Help clients look at the downside risk of an Investment option separately from overall volatility, which can mask outperformance.
- Introduce the idea of a portfolio budget to help incorporate risk in their portfolios where it is most likely rewarded
- Frame performance discussions in terms of expected return per unit of risk
2) Help clients balance risk relative to return expectations to properly align actual risk tolerance with asset allocation.
- Illustrate the opportunity cost and inflation impact of holding too much cash
- Review portfolio performance against purposeful priorities and long-term goals, to fuel motivation and maintain focus on achieving outcomes
3) Discuss the concepts of risk inversion and loss aversion, and how these can bias their decisions, to help clients become more effective and knowledgeable investors.
- Review objective and quantitative comparisons between investment choices
- Frame decisions in a relative context to reinforce a thoughtful buy/sell discipline
4) Balance the EQ (emotion quotient) and the IQ (intelligence quotient) in investment decision-making to help clients achieve both suitable risk levels and meet long-term goals.
- Demonstrate empathy, listen actively and show patience during the decision-making process
- Look for opportunities to tailor the investment solution to personal circumstances and align emotional constructs (such as family, security and independence) as a force for action
Volatility and market downturns are inevitable, so they shouldn’t undermine good long-term strategy. But avoiding emotionally based decisions is easier said than done.
Helping to manage counterproductive biases and behaviours is where advisers in Australia can add value and deepen relationships over the long term.