Strong stock market performance put big smiles on the faces of investors as they watched account balances grow over the past two years. But a lack of insight about how equity markets really work, and a desire to “get returns like the S&P,” may have led many investors to take on too much risk.
Just when investors began to feel that the equity market climb was unstoppable, stocks recently reversed course. In one day recently, the Dow erased all of its 2014 gains.
When markets become shaky, which they always do, financial advisers have the opportunity — and challenge — to help their clients avoid making harmful, emotionally driven decisions.
THE CHALLENGE
The fact is that clients are confused about risk, and they need both education and confident guidance from their advisers. We
recently conducted a study that focused on clients' views about investment risk and reward.
The study revealed a high level of investor confusion. Eighty-four percent said they would be satisfied if their portfolios performed as well as major stock market indices, implying that they expect to capture 100% of equity market returns. But, 68% said they are more concerned about the safety of their investments than about maximizing their returns. Clearly, many investors do not understand the value, or the cost, of portfolio diversification.
Proving the point, clients also expressed conflicting views about their own levels of risk tolerance. Study participants reported that they are willing to take high risk for high returns. Nearly half said they are willing to risk 25% or more of their assets for commensurate returns. Nevertheless, 81% of respondents consider themselves to be moderate or low risk takers in terms of their investing. Sixty-eight percent also said they are more concerned with safety than maximizing returns.
Of course, the reality is that a well-diversified portfolio will not track the returns of equities or any other single asset class, particularly over shorter periods. This is a major challenge for advisers to explain to their clients. Last year, when the S&P was up more than 30%, is a real and current example of this challenge.
THE OPPORTUNITY
Another key finding of the study is that advisers are highly regarded by those surveyed. In fact, investors most often describe their adviser as “a person of trust” or “expert” when presented a list of attributes. That trust opens a window of opportunity for advisers to teach clients about the relationship between investment risk and reward.
Advisers can also encourage clients to create portfolios that combine varying strategies that are designed to take on distinct roles so that they are better prepared for the inevitable ups and downs of investing. Combining investments that are designed to take advantage of rising markets with those that seek to diversify risk can lead to more consistent performance over time.
Careful attention to portfolio construction can help keep your clients from making financial decisions driven by emotional reactions. With less volatile and more risk-aligned portfolios, investors are less likely to panic when the market suddenly reverses course.
Charles Goldman is president and CEO of AssetMark, Inc., an independent strategic provider of innovative investment and consulting solutions serving financial advisers. Read more about his plans for AssetMark.
