Clients understand volatility – except when it happens

For financial advisors, understanding core financial concepts such as variance, portfolio volatility, and systematic risk are one thing. Reckoning with their psychological effects on clients is another.

Investment professionals are, of course, well-acquainted with the concept of risk. They know that they can diversify away most of the idiosyncratic risk from individual securities but that client portfolios must still bear the risk of the overall market as it gets pummeled by the forces of economic cycles, geopolitical events, and interest-rate policy. Clients, however (including those with advanced financial acumen), are likely to get anxious almost every time the market takes even the slightest dip or volatility ramps higher.

That’s because human brains are riddled with pesky emotional and cognitive biases that can overpower even the most well-considered plans. (This isn’t only true of people who have their investments managed professionally. Those managing their own money will second-guess themselves as well.)

The market doesn’t even have to sell off to stir up such anxieties—the mere suggestion by a well-known firm or guru that stocks are vulnerable is enough to give many people the jitters. The reasons are rooted in psychology and are as inevitable as the closing bell at the end of each trading day. But if financial advisors understand the source of the anxiety better, they may not be as surprised when it happens and might even be able to prevent many clients from experiencing it in the first place.

As much as a financial advisor would like to believe they can identify the best possible stocks or indexes to own throughout all environments and predict the timing of the economy’s next move with clockwork precision, they fully appreciate that stock investing is a probabilistic exercise rooted in uncertainty and that performance perfection is unattainable.

To take advantage of the long-term benefits of owning equities, one must be able to view investing as an imprecise activity, virtually assured to be wrong some of the time—not for the lack of professional skill, but for the simple realities of chance and volatility. Fortunately, financial advisors and investment managers can access the collective wisdom of numerous Nobel laureates who have provided elegant mathematical techniques for dealing with market uncertainty. Unfortunately, none of these techniques work on client emotions.

Client reactions to volatility, news, and underperformance are natural human reactions to uncertainty. Such reactions are visceral and are tied very closely to chemical and physiological reactions in the body. They may vary in degree among different people, but they cannot be entirely shut off. Humans are simply hardwired to be uncomfortable with uncertainty, and most people will try to avoid it if they can. And while we realize that it is something we must accept with investing, that does not prevent our automatic self-protection systems from kicking in.

Why do people often have a difficult time dealing emotionally with something they reasoned out thoroughly beforehand with their financial advisor?

Kahneman’s two-system framework

Behavioral legend Daniel Kahneman provides a framework for understanding why this happens in his book “Thinking Fast and Slow.”

Kahneman distills the complex way humans think into two systems, labeled for simplicity as “System 1” and “System 2.” System 1 (or fast thinking) is instinctive, emotional, gut-driven thought that involves little if any conscious analysis. System 2 (or slow thinking) is where all higher-level reasoning, logic, and complex thought originate. System 1 decides what you want for lunch, while System 2 must be brought in to create that project analysis you need to present to your boss.

System 2 thinking requires much more effort from our brains, so it is available to us when we invoke it, but System 1 serves as the default system we use most of the time. People are often surprised to learn how much of a simple conversation, or even driving a car, is handled predominantly by our subconscious faculties.

System 1 also handles virtually all of our automatic control mechanisms, such as the environmental monitors that let us know when we are too warm, hungry, or tired. It also watches out for our safety and warns us when it senses fear or danger. That alarm system is so effective that it automatically generates responses for us. In the same way our bodies sweat without us thinking about it, they react hormonally to perceived danger, and our brains consider losing money to be one of those dangers.

So, when the market is selling off, our subliminal reaction comes from a System 1 signal that emits fight-or-flight messages to various parts of our bodies. That signal, being more primal than logical, sets off reactions that cause worry and anxiety, stirring us to action. Instead of preparing to run or fight, that action might take the form of a frustrated call or an email to our advisor. For those who self-invest, it often results in a “sell first, ask questions later” event.

Financial professionals are not immune to these feelings, but they develop a reaction tempered by their knowledge and experience and focus on the bigger picture. The advisor’s or manager’s reaction is thus typically handled more by the logic side of the brain, which is not terribly surprised or disturbed by an adverse market action. The client’s mental focus, however, is generally on their own careers and life priorities, so their reactions are more visceral and handled subliminally by System 1. As a result, the same news item generates a very different response in the client than it does in their advisor.

To make matters worse, emotions tend to overshadow logic, so financial professionals will find it challenging to impose logic on an emotionally charged client to resolve an issue. Our brains are insistent, even when they are not right.

Recency bias and anchoring to the high-water mark

Another reason clients overreact is because they often have a different reference point. A financial advisor or investment manager will tend to focus on a reference point related to the last milestone from which their performance was measured. If that is annually, then the previous year-end is their typical reference point. (Hopefully, performance is measured over much longer time frames.)

For clients, however, it is very different. The tendency is to watch one’s portfolio closely—recency bias combined with availability bias keeps clients anchored to the most recent high-water mark. If there was a high in May, for example, that will likely become the current anchor. The media makes this more pronounced by feeding us headlines on recent events and particularly on recent highs. When the new high-water mark becomes the reference point, even a small decline becomes a source of anxiety. And as Kahneman’s prospect theory tells us, losses carry twice the emotional impact of equivalent gains.

What’s the answer?

The answer may be simple, though its execution is challenging. Faced with a client in System 1 mode who is fearful, anxious, or upset, the way to reach a constructive solution is to get them out of that mode and into System 2 mode where the problem can be thoughtfully reasoned through.

Logic and emotion don’t mix, and trying to apply logic when a client is reacting emotionally is an uphill battle. The advisor certainly doesn’t want to drop into System 1 mode to argue with a client on an emotional level, as that is a prelude to a heated discussion that will likely have negative consequences.

The key is for the advisor to remain in System 2 mode and to get the client in that mode as well. Then, both parties will at least be able to communicate with one another from the same logical state of mind. This can be challenging, but well worth the effort.

Remember that System 1 is the default mode and that a person needs to intentionally invoke System 2 to enter that state. Invoking System 2 is seamless to the individual, but they will do so only when they have to, and that is generally when a question is posed to them that requires them to do so.

When you sit down to take a test, you subconsciously enter System 2. You subtly move into a higher-level thinking mode. In so doing, you simultaneously squeeze out the emotionally charged thoughts that came from System 1. (The emotions can creep back in, but at least they are subdued in favor of reasoned thought.) The mere act of engaging your cerebral cortex causes you to focus and use more logic. The more you focus, the less likely you are to let emotions rule your thoughts.

The advisor needs to get the client out of System 1 mode, and asking questions is a great way to do that. Listening to a client rant about performance or question a holding won’t put them in System 2 mode. It just lets them vent their emotions. They need to be induced to move into System 2 mode by entering a thoughtful discussion.

Here are some approaches that I believe have merit to move clients into System 2 mode:

  1. First, ask the client to very specifically outline their current concerns. Is it an isolated aspect of their portfolio that is troubling them, overall portfolio performance, or an undefined anxiety about the market based on something they read or heard? How long has this been going on and what time frame are they referring to? Many times, their concern will be something that, when examined deeply and in context, is not as threatening as it might have originally appeared.
  2. Review again with the client their financial plan objectives and how they relate to their overall life goals. Ask them the critical question point-blank: “Are you still on track to meeting your long-term financial and investment objectives?” With a well-constructed financial and investment plan that was developed with the client’s risk tolerance at the forefront, the answer should undoubtedly be a calming “yes.”
  3. Ask the client to examine with you the rationale and assumptions that led to their original risk-tolerance assessment. If they, for example, said they could tolerate up to a 15% drawdown, why are they upset now with a 10% drawdown? Examine in concert with them whether their risk profile should be adjusted, leading to an overall different portfolio construction framework for the future.
  4. Have a frank discussion about the trade-offs of different types of portfolio allocations, the depth of exposure to equity markets, and the use of buy-and-hold passive strategies versus more active, risk-managed strategies. Would this client be more comfortable with a less-volatile portfolio construction, understanding that the consequence might be some “underperformance” versus the major market benchmarks in times of roaring bull markets? However, they must understand this is importantly counterbalanced through the use of strategies meant to mitigate the worst effects of bear markets.

Once you can engage your nervous client in a System 2 conversation, issues can be resolved in different ways, and a constructive resolution is much more likely to occur. Advisors may find additional benefit from this process by getting more clarity on a client’s risk tolerance or an additional perspective on the way the client is viewing the financial markets that they didn’t recognize before.

No matter what investment strategy is used, there will inevitably come a time when it isn’t performing 100% as expected and clients will voice what are usually emotion-based concerns. Understanding Kahneman’s two simple states of mind (illustrated in Figure 1) may not only help to deal with nervous clients, it may help reduce the number of times such anxieties even surface.


The opinions expressed in this article are those of the author and do not necessarily represent the views of Hilbert Financial Group. These opinions are presented for educational purposes only.

Source: Clients understand volatility – except when it happens

Investing is about managing stress—as well as performance

While there is no way to eliminate all market risk, an actively managed portfolio with an emphasis on risk management may produce less stress than a passive portfolio for both advisors and their clients.
In my 35-year career in and around Wall Street, I have seen the markets exact a personal toll on many investors, both retail and professional. Driven by subliminal inner forces, many people have allowed the markets to push them to extremes and, unfortunately, have done harm not only to their portfolios but also to their health and well-being as a consequence. A focus on investment strategies that avoid, minimize, or mitigate these extremes can provide more advantages—both in realized long-term performance and behavioral benefits—than a completely passive portfolio. It does so in part by eliminating the negative actions people (including advisors) often take under stress.
An extreme example of stress
The following is a true story, and one I doubt I will ever see again. Early in my career, I was an options coordinator for a major wire house in New York. The CBOE had recently opened its doors, and options trading was exploding. Since stocks had languished for months, the idea of writing naked strangles on the OEX (selling both uncovered calls above the market and puts below) was all the rage at this firm. A large options trader in the retail system (let’s call him Joe) was writing naked OEX options for many of his clients. The strategy performed rather well for months. Then came a stock explosion to the upside, and with it a return of volatility. Losses piled up quickly, and the stress of managing portfolios with naked options skyrocketed. One afternoon, I received a call from Joe’s office manager. Joe had just been carried out of the office by paramedics with an apparent heart attack. As they put him on a stretcher, he was unable to speak but motioned for a pen and paper. The manager read his note to me. Even as they were trying to save his life, Joe was trying to put in an order to cover OEX call options! Joe may have been an exception due to the extreme risk of his option positions, but even a plain vanilla portfolio of stocks will cause people stress. Financial advisors often believe that their job is to take the stress of investing off the client’s shoulders, but that can turn into an unhealthy premise for many advisors. For one thing, advisors can’t remove all of the market risk from stock portfolios, no matter what their strategy or how closely they monitor it. This is especially true for advisors who primarily rely on passive portfolio allocations since the premise behind such strategies is to hold on through the storm, no matter what level of market risk they are facing. For another, they cannot simply absorb the stress that a client might be feeling. Clients can still generally feel the effects of portfolio stress even when they believe the advisor’s tools for risk management are somehow going to keep them out of trouble or when the advisor is counseling them to just keep calm through any turmoil.
The nature of stress
We know stress mostly by its physical manifestations: headaches, nausea, insomnia, elevated blood pressure, and sometimes even chest pains. We also know that while it is part of a highly useful alarm system that is key to human survival, it is unhealthy for us to carry too much of it around with us for too long. Stress is not just behavioral, it is chemical. The American Psychological Association defines stressas the “automatic response developed in our ancient ancestors as a way to protect them from predators and other threats. Faced with danger, the body kicks into gear, flooding the body with hormones that elevate your heart rate, increase your blood pressure, boost your energy and prepare you to deal with the problem.” So, when subliminal sensory perceptions decide that we are in danger, they automatically invoke a protective protocol that unleashes a chain reaction of chemical and neurological events geared to stir us to action and making us more capable of doing so—hence the urge to panic and sell when things look vulnerable in the stock market. It is a visceral human reaction. It has been firmly established by researchers that the chemical reactions in the human brain to basic instincts such as sex, food, and survival are also stimulated by money. Dopamine, for example, the chemical neurotransmitter that passes on messages to neurons about rewards and pleasure, can be associated with the idea of making or winning money. So it should be no surprise that the idea of losing money also sets off basic chemical reactions within humans through neurotransmitters such as adrenaline and cortisol. The stimulus that sets off these chemical reactions is stress. The problem is that our biological sensors do not distinguish between a physical attack, a dress-down from one’s boss, or a stock market tumble. With stocks, they kick in not just when we actually see the market decline but can also show up when others even suggest that it might. This chemically induced urge to action is responsible not only for unhealthy levels of stress but for the pervasive underperformance of self-managed stock portfolios.
Headwinds-tailwinds asymmetry
Classic financial theory offers diversification of our holdings to reduce the idiosyncratic risk of individual securities, but that is no antidote for market risk, without also removing your opportunity for gain. Consequently, many advisors and wealth managers, along with their clients, are forced to accept the ups and downs of the market and to take a long-term perspective on investing. This, however, flies in the face of human nature when the market declines, and even in climbing markets. Long-term optimism is simply no match for short-term loss aversion and fear of uncertainty. Exacerbating the problem is a psychological effect called “headwinds-tailwinds asymmetry.” We tend to relax when the wind is at our backs and things are going well. (Running and cycling enthusiasts know this well, hence its name.) But when we face problems of any kind (a headwind), it is natural to become anxious. The reaction is asymmetrical in that the anxiety occurs with every headwind, no matter how infrequent, while there is no offsetting joy during tailwinds since we tend to expect that. For investors, this lopsided effect causes anxiety almost every time the market goes down, despite the long-term trend moving up. It is pervasive, even if only slight in magnitude, but it can also be cumulative over time and increase along with the size of the portfolio and other factors. If you are invested in stocks, it is almost impossible to be totally immune to headwinds-tailwinds asymmetry. The anxiety of declining days subtly builds up in us. Abnormally large sell-offs cause a proportionately greater reaction, and the effect can remain with us well beyond the point when the market has recovered the loss. It is the slow buildup of anxiety that leads to stress.
Coping with the unavoidable
To address the problem of stress, we can counter the body’s reaction to it, or we can reduce or eliminate the cause. Today’s emphasis on good health offers a bevy of stress-management techniques that generally include relaxation activities such as yoga, meditation, tai chi, or almost any type of exercise. So that type of advice is readily available. But how can an advisor reduce the cause of stress to clients in the first place? Part of the fear that accompanies ownership of a stock portfolio is the fear that an investor has little or no control over what happens next. For a passively managed portfolio, this fear creates a continuous dilemma about when, if ever, to sell, creating a subsequent stress about when to repurchase. This gets more complicated through loss aversion, regret, hindsight bias, and a host of other stress-producing biases. Investors with personal financial advisors certainly have an advantage in this regard versus self-directed investors. Yet, as seen in a 2017 study from Wells Fargo and Gallup, even those investors with advisors still stress out over the market—only 39% “strongly agree that they are prepared for a market correction.”
Source: Wells Fargo/Gallup Investor and Retirement Optimism Index, July 28–Aug. 6, 2017.

This is where active management can add value beyond performance. Active management reduces the fear of lack of control. Active managers tend to shine in down markets because they know how to manage a portfolio or strategy throughout the process rather than try to time a wholesale liquidation and re-entry, which almost everyone will get wrong. Thus, by its very nature, active management provides a solution less prone to stress than passive. In addition, just knowing that someone is managing their portfolio during periods of declines and elevated market risk can assuage the fears of many clients and reduce their stress. Next, advisors need to recognize the natural focus of clients on the negatives and do their part to redirect that. Part of headwinds-tailwinds asymmetry holds that if clients are examining the performance of their portfolio, they will tend to focus more on the declining stocks or sectors than advancers. Unfortunately, the media will also, so advisors need to be prepared with the offsetting positives when talking with clients, focusing on the big picture of performance over several years, not what happened yesterday, last week, or last month. A market sell-off of 5% will induce much more fear from the perspective of the most recent high than it will from the perspective of the past 12-months’ performance.
Lastly, don’t underestimate the power of communication with your clients in reducing stress. In many cases, clients just want to know what you are thinking or planning in order to feel less fear. You will likely find your own stress reduced through such conversations as well. Stress is a silent and sinister enemy. It can wreak havoc on your health, your performance, and your clients. It certainly might be worth taking that morning yoga class several times a week, but it is probably a more effective plan to help reduce stress through sound portfolio-management practices and strong client relationships. Active investment management and active communication with clients will go a long way toward this goal.