Dos and don’ts to managing your client’s investments, and expectations, during volatility
by Larry DePaulisMr. DePaulis is Managing Director and Senior Portfolio Manager, Wealth Management, at Hingham Street Partners, Rockland, Ma. Visit here for more information.
As a portfolio manager working with many advisors across my firm, I have a unique vantage point to assess what works and what doesn’t during times of extreme market volatility. Without question, the most important place to start is the financial plan.
In my experience, one of the biggest pitfalls in client portfolio construction is the reach for return. The easiest way to make a financial plan work on paper is to increase the return assumption, especially given that other options such as working longer, saving more, or spending less might not be realistic options depending on a client’s age or fixed expenses. This can result in a portfolio with too much in stocks, and in markets such as the one we are seeing now in early 2020, can lead to clients liquidating portfolios at what may turn out to be an inopportune time.
Measuring Risk Tolerance
One of the best ways to avoid this is to get a good gauge of a client’s risk tolerance prior to creating a plan and portfolio, and stick with it. A good strategy at the outset of a relationship is to put potential volatility in terms of real dollars. Use the clients actual portfolio, and use real life scenarios such as the financial crisis of 2008. Point out how much the client would have lost in real dollars rather than percentages, and how long it took to recover. This is an effective way to make assessing risk tolerance more real, and is also a good reference point to discuss when such volatility returns in the future.
Assuming a plan and portfolio are properly constructed, good communication is vital. Especially in volatile markets, the best advisors stay in regular communication with their clients, and reinforce why each investment is in a portfolio. Stocks are first and foremost long term investments. Unlike assets such as real estate and private equity, with publically traded stocks, for better or worse, we get to see where these investments can be sold on a real time basis. In a market moving sharply down over a short period of time, this often leads to fear and panic. Good and frequent communication is vital to remind clients that stocks are long term investments.
Liquidity, Longevity & Legacy
With a properly constructed financial plan, a client should have a liquidity bucket set up such that no money is needed from their equity allocation over the short run. At UBS, we call this the 3-Ls: Liquidity. Longevity. Legacy. It is an approach that allocates client’s wealth into three strategies.
We have found adding this structure to the financial life of our clients helps them invest with a sense of purpose, and can improve financial and emotional security. In times of market turmoil, the liquidity segment of this framework in particular is very important. Timeframes may vary for each individual investor in the 3Ls approach and these strategies are subject to an individual client’s goals, objectives and suitability.
Despite its low return as a standalone investment, a liquidity bucket of cash or short term bonds actually has a great ability to boost overall portfolio returns. Even though the expected return is minimal compared with stocks, this portion of a client’s portfolio is the most valuable in periods of economic turmoil, as it prevents the forced sale of stocks in what are sometimes severe market downturns.
Even if a client is not currently drawing income from a portfolio, the optionality of this part of a portfolio is much more important than its absolute return, as it can be used as a source of funds to rebalance. Viewed this way, the value of cash and bonds is much more than the low returns they typically produce relative to stocks.
The common theme in avoiding panic within an investment portfolio is the combination of a good financial plan, frequent communication, and a well-constructed portfolio. Perhaps the most important way to prevent permanent damage to a portfolio is to avoid being a forced seller of an asset. Whether it’s a stock, bond, or real estate, it’s always best if one can decide the best time to sell, rather than require liquidity when it is in short supply. Controlling emotions can very difficult when we see the value of our holdings in steady decline, but a diversified portfolio with realistic return assumptions, in conjunction with regular communication, can help prevent clients from selling good assets at bad prices.
Over the long run, this might be one of the best ways to add value to a portfolio and a relationship.