How to coach clients through the chaos of market volatility

With major market indices in turmoil after their worst reversal since the early COVID days of 2020, investors are feeling the pain.

It's understandable because clients, no matter if they're young or old, are out of practice with volatility. After all, the stock market gained over 20% for the past two consecutive years — something we haven't seen since the mid-1990s and only a handful of times over the past century. 

Now, with tariffs in the works and the Fed in no hurry to lower interest rates, I'm sure many of your clients are wanting to take a risk-off approach and flee to safety. How can you convince them to stay invested and stick to their plan, when their friends and the media are telling them to take chips off the table? 

For starters, remind them to take the long-term view. For instance, even after last week's painful sell-off, as of midday Wednesday the S&P 500 was still up about 85% from where it was in early April 2020. That's an annualized return of over 13% for that five-year period.

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Intelligent frameworks

Here's how I frame it with our clients. In 2013, Eugene Fama received the Nobel Prize for his pioneering work on market behavior. Fama showed that it's impossible to predict the short-term movement of stock prices since new information affects prices almost immediately. That, he said, is what makes our markets so efficient. In other words, past returns have no correlation with future returns. This is referred to as the efficient market hypothesis and is the basis for modern portfolio theory.

But Fama's work has not prevented investment managers, advisors and others from speculating about where markets are headed, and social media and traditional media give them a megaphone to spread the word.

Again, it's tempting to draw comparisons between today's market climate and the mid-1990s when stocks gained 20% a year for five straight years. Certainly, there are patterns that emerge over time that look similar to historical data. Sure, history has a way of repeating itself. Some have likened today's AI bubble to the tech bubble at the turn of the century. Perhaps we do have similar economic conditions that mirror the inflation of the 1970s and the high oil prices of the 1980s. 

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But if the market is random and unpredictable, is it wise to build an investment methodology based on past history? 

Let me give you — and your clients — some reasons why the answer is no.

In his introduction to Benjamin Graham's classic "The Intelligent Investor," Warren Buffett explained that successful investing does not depend on being the smartest person in the room. It does not require investors to have uncanny business knowledge or insider information. He said it depends upon only two things: having an intelligent investment framework and not allowing emotions to corrode that framework. When the markets hit a chaotic period, as they always do, it's common for investors to become conservative and pull out. But we all know that's the wrong thing to do. According to Buffett, if you have an intelligent framework, then trust the choppy markets. When the markets hit equilibrium and rebound, he argues, you will not want to miss the run-up. Getting out of the market during a downturn almost guarantees the investor will miss the bounce.

Retiree anxiety

We all know market downturns are especially anxiety-provoking for retirees and near-retirees. What are some ways to protect their downside, without getting so conservative they can't meet their long-term goals? 

I've found the key to a successful retirement strategy is to have sufficient liquidity to ride out the market convulsions. 

By having two to three years of income in cash or cash equivalents, market turmoil is still worrisome, but knowing the retiree's income is not dependent upon the market makes riding out the market movement easier.

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Next-gen angst

Meanwhile, younger clients in their peak earning years may be asking you about ways to protect their downside without getting so conservative that they can't meet their long-term goals. 

Here's how I explain it to our younger clients: There is always a balance between time horizon, risk allocation and reaching long-term objectives. 

A young investor who is looking out 30 or 40 years should not worry about market fluctuations. Sure, it's scary to see a portfolio go down sharply, but markets historically have never stayed down for long. They tend to rebound sharply after significant downturns and stay elevated for long periods of time after rebounding. 

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But when an investor lets their emotions pull them out of the market, they have to play Russian roulette when it comes to guessing the best time to get back in. Unfortunately, they're usually too late and miss a significant bounce during the market recovery that's already underway. 

If a younger investor is concerned about capital erosion, they would be wise to have two portfolios, one that is conservative and preserves capital, and one that is more aggressive, so market losses won't be devastating. Remember what Buffett said: "Don't corrode the intellectual framework with fear."

Same as it ever was

Every investor, regardless of age, should have an allocation that reflects their risk tolerance. When the markets are doing well, it's easy to get complacent and consider taking on more risk. 

The problem is that markets are not linear. They don't go up and up and up in a consistent straight line. There is a cycle to their outcomes. Catching the market at the worst time, a top for instance, before it drops 10% to 15%, can put a lot of pressure on the long-term income prospects of the portfolio. 

As many of you know, this is called "sequence risk." To avoid it, investors must have sufficient liquidity to protect against liquidations in a down market. And every retiree should consider sequence risk when planning to take distributions.

While there are no guarantees in life, there is nothing to suggest markets will perform differently in the future than they have in the past. There may be different cadences and patterns, since markets are random, but over time there is substantial evidence that markets will behave as they have always behaved.

I've found that investors become fearful from a lack of knowledge, understanding and conviction. This is why we, as advisors, spend so much time educating investors about how markets work and what to expect from them.