Adding advice value by navigating client emotions
A growing number of financial intermediaries are turning to behavioural insights to give them an edge in building trust with clients and delivering better financial outcomes. In fact, helping clients withstand volatile or uncertain markets is rated as one of the most valuable services advisers provide.
A grounded response to rocky markets
Dr Ryan Murphy, Global Head of Behavioural Insights at Morningstar, told attendees at a recent behavioural insights’ webinar that the Morningstar research team was focused on “developing a grounded approach to guide clients through rocky markets” based on the experiences of top advisers globally.
He explained that the human brain was hard-wired for pattern recognition. “Your brain is so good at finding patterns, it will sometimes find patterns that are not even there; the brain is always trying to make sense of noisy stimuli,” he said. Countless behavioural and cognitive studies have shown that your clients have an asymmetric sensitivity to market ups and downs.
“Your clients feel the ups, because making money feels good, but they feel the downs far more so,” the presenter said. “This type of asymmetry is known as loss aversion.” Emotional responses to market movements, coupled with the brain being easily distracted and always searching for patterns, results in clients making sub-optimal financial and investment decisions. A graph of multi-decade equity returns was used to illustrate how behaviour influences investors’ perceptions.
Disciplined investors who check their portfolio at the beginning of each year would see gains 74% of the time; those who checked on a monthly interval would see month-on-month gains only 63% of the time; and those who checked the market every day would see gains in 54 days out of every 100. “The only variable changing here is how often investors check their portfolios,” Murphy said. Portfolio constituents and market returns are identical.
How frequency inflates volatility
“How often investors are looking at their portfolio can change their experience of what markets are doing to them,” Murphy said. He explained that those looking at their portfolios too frequently experienced far more volatility, and that the higher proportion of losing versus winning ‘observations’ amplified loss aversion and filtered through to poor decision-making.
A second notable observation is that large cap equities have delivered consistent annual returns going back centuries. The presenter shared an inflation-adjusted graph tracking one US dollar invested in the 1870s to illustrate the well-known benefits of compounding and value accumulation in this asset class. But the gradual upward curve is blighted by periods of significant peak-to-trough drawdowns, including the Great Depression in 1929; the Dotcom crash in 2001; and Global Financial Crisis (GFC) in 2008-9.
“Even though some of these historical events were highly disruptive to civilizations and countries, the equity market continues to churn away and produce value over time,” Murphy said. The Morningstar Global Adviser Panel, comprising established financial advisers from the United States, Canada, United Kingdom, Australia and South Africa, has spent hours contemplating optimal adviser responses to volatility.
Pre-empting volatility-related decisions
The best way to pre-empt poor volatility-related decisions is to reframe your client’s attention to an appropriate time-frame, helping them to see volatility in a richer way. If your client has a 20-year investment horizon, they are less likely to respond to negative short-term news flows. So, the idea becomes to focus each client on personalised goals and timeframes, thereby deflecting from daily market movements. Other sensible approaches include setting realistic return expectations and teaching clients that it is not possible to forecast market shifts.
Unfortunately, digitalisation has enabled investment platforms to share real-time portfolio values with investors, contributing to the market noise. Murphy argued that by showing close to real time daily performance numbers, the industry was “nudging investors to pay attention to thin representations of what the market is doing.” He added that seeing and feeling more volatility seldom led to better choices.
Commenting on a key insight from one of his recently published academic papers, the expert said: “You cannot teach people not to be loss averse, but by nudging their attention, by changing what they pay attention to, you can start to overcome their loss aversion.” The shift, as it were, is from trying to educate people not to make biased decisions to organise information in such a way that they make better choices. Advisers can use ‘choice architecture’ to focus clients on their long-term financial goals rather than short-term corrections.
Focus on what you can control
“If people can take on and endure more uncertainty and more volatility, and do so over the long term, the evidence is clear that their long term prospects are benefited by that,” Murphy said. To excel at this task, advisers need to help their clients focus on what they can control. Notably, while they cannot control what the market does, they can control how much they save. Your client’s contribution rate is a major driver of long-term savings success.
“Success is a combination of your client’s contribution rate being sufficient and allowing enough time to let full market cycles play out,” Murphy said. “Educating clients about this is the main driver of what you can do and what you have control over.” Your writer appreciated the next insight, being that your client’s ‘reason for investing’ is not to beat the market, but to achieve their long-term goals. That involves accumulating enough capital to fund a desired lifestyle in a future life stage.
One of the tricks to prepare clients for market volatility is to have them pre-commit to a response to severe downturns. If they agree upfront that their investment horizon is 10 or 20 years, and that their goal is to accumulate a certain capital sum by the end of that time, then they will feel less pressure to respond to market contagion. “It is worth reminding your clients that well-constructed, well-managed portfolios tend to lose money about four to five months every year,” Murphy said. To reframe this slightly, volatility is part of the journey.
New clients need more guidance
Feedback from advisers shows that inexperienced clients or clients relying on their investments to provide an income were most likely to reach out during market downturns. According to the presenter, the risk tolerance questionnaire is a good indicator of how your clients will react to volatility. He suggested using these results to shortlist clients who may need extra attention during market corrections.
Clients usually want their advisers to tell them what is behind market volatility, and how bad it is likely to get. In response, advisers must identify the major factors at play and prepare a sensible answer. Market pullbacks were described as a “great opportunity for advisers to remind clients that markets are not always perfect, and that sometimes there is more ‘swing’ than is warranted based on information.” This can lead to some really good, underpriced opportunities, if you are disciplined enough to act.
A valuable hint to advisers is to use clients’ outreach during downturns to remind them that short-term volatility is normal and refocus them on their long-term goals. You might say: “Your goals have not changed. Let us continue to exercise our strategy in a disciplined way, to get you where you want to go.” More broadly, financial advising has become more about coaching and mentoring clients than investments. “It is much less about investment management and much more about investor management and coaching,” Murphy said.
Six bear markets in 50 years
In his final example, the presenter reminded attendees that there have been 15 economic recessions over the past 90 years. Equity markets, meanwhile, have suffered six 20%-or-worse contractions over the past five decades; and if you drop the ‘hurdle’ to 19%-or-worse, the number goes up from six to nine. “There is a bear market drawdown happening about once every six years, so, if you have a client who has a 20-year perspective … you can explain to them that they have signed up for at least three market shocks,” the presenter said.
Advisers cannot control day-to-day market volatility. “Volatility and uncertainty are inherent parts of investing,” Murphy concluded. He said that advisers must educate and inoculate clients against volatility, to ensure they make rational, robust responses to it. Key tricks include reframing and refocusing clients’ attention on their financial plan and reassuring them that market corrections are the ‘ticket to ride’ on the rollercoaster of long-term investing.
Writer’s thoughts:
The standout insight from today’s newsletter is that your clients are not investing to beat the market, but to reach their long-term financial goals. Do you agree with that statement, and what else stands out for you? Please comment below, interact with us on X at @fanews_online or email us your thoughts [email protected].
