How to Assure Clients That Volatility Is Part of the Strategy
Unquestionably, the stock market has experienced extreme volatility in the last couple of years, elevating the anxiety levels of investors who grew complacent throughout a historic 11-year bull market. Just as they did throughout the wild gyrations of the 2008-2011 market, investors have grown intolerant of the recent, wild stock market gyrations, resulting in many choosing to make wholesale changes to their portfolio, switch financial advisors, or flee the market entirely.
But, what investors may not understand is that switching between asset classes to avoid volatility can actually have the opposite effect. It is incumbent upon financial advisors to help their clients understand that, with a sound investment strategy and a long-term perspective, volatility can actually be good for a stock portfolio because it has always been the primary force that drives market gains over time.
Put market volatility in a historical perspective
Going back to the end of WW II, there has been, on average, an intra-year decline of 14 percent every year. During that time, the market has finished the year, on average, with an 18 percent loss every three years. Still, over the last 70 years, which were marked by assassinations, nuclear threats, civil unrest, oil embargos, five recessions, and global terrorism, the stock market has grown more than 150-fold. If you had invested $1000 in the S&P 500 index in 1950, it would have grown to more than $150,000, despite those market declines.
The lesson for investors is that, since the inception of the stock market, market declines have occurred regularly. Still, they have been nothing more than a momentary interruption of an enduring market advance. In the context of the long-term performance of the stock market, market volatility has been a necessary phenomenon in a market that works.
Explain to clients the “value” of volatility in an investment strategy
While you don’t have any control over market volatility, it’s essential to educate your clients on how it can enhance portfolio returns in the long term.
While periods of increasing volatility often disrupt market advances, they also help to reduce or eliminate excesses that build up during periods of relatively low risk, such as what we experienced throughout 2019. This helps to minimize the destructiveness of eventual busts. By relieving the market of excesses, volatility provides investors with the opportunity to increase their exposure to equities at a lower risk.
For 401(k) participants and anyone investing systematically with fixed monthly contributions, volatility can actually enhance their accumulation efforts through dollar-cost averaging. When stock prices decline, contributions purchase more shares at lower prices. When stock prices increase, their contribution buys fewer shares at higher prices. Because they are able to accumulate a higher number of shares when prices are low, they can average down their cost basis resulting in higher returns when prices rise.
Help your clients understand the difference between volatility and risk
The challenge for financial advisors is to keep their clients’ perceptions of volatility in check by helping them understand the differences between volatility and risk.
Volatility is not risk
Investors understand that stock prices move up and down, some more frequently than others. Some stocks experience a broader range of price changes as compared to others. Stocks with more frequent or more extensive percentage price swings appear to be riskier than stocks with slow and steady price changes. Volatility is simply the measure of the relative up and down movement of stock prices over time.
Risk is not volatility
The only risk for investors is the way they react to volatility. The real risk is selling stocks in a market downturn. Considering that the average market correction since 2010 have lasted 64 days before a full recovery begins, investors would be well-advised to tune out the hyperbolic media and not look at their accounts for two months. Then, any perceived risk would fall to zero.
While extreme market volatility may seem scary and consequential at the moment, the reality is that investors don’t invest for today, this month, or even this year. They invest for decades in the future. The inevitable, periodic market downturn does not result in losses, but merely a temporary decline.
See market volatility as an opportunity to strengthen client relationships
Periods of market volatility are ideal opportunities to conduct a review of your clients’ portfolios and refocus them on their long-term strategy. It’s a chance to reconfirm their objectives and risk profile while ensuring their portfolios are appropriately balanced according to their ability and willingness to assume risk. Market volatility also creates tax-loss harvesting opportunities, which can generate immediate tax benefits while maintaining the integrity of their asset allocation strategy.
Above all else, have a plan to communicate with your clients. Clients value communication as much as they value good investment performance. Use it as an opportunity to educate them on the “value” of volatility in boosting portfolio returns over time while keeping them focused on their long-term objectives.
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