By: John P. Napolitano, CFP®, CPA, PFS, MST

When you get the question, “How is the market doing?” what do you say? Perhaps the best answer to that question is, “What market? U.S., Europe, Far East, real estate, commodities, fixed income?” You and I know that markets go up and markets go down.

When portfolio values are rising, clients are happy. When markets go down, clients become concerned. Knowing how to prepare clients for the inevitable downturns in markets and portfolio values may help avoid irrational client thinking when things aren’t going so great.

We’ve all had a client now and then who likes to start a meeting off with a robust greeting and a bold question — “Did you make me any money this year?” And if you play that game, the answer is sometimes yes and sometimes no.

The game is performance. Not that performance itself is a game or insignificant, but to have your entire relationship based on performance means that there may be a lot missing in the client relationship.

The first step in preparing clients for a downturn is to make sure that they truly understand two fundamental things: Their cash flow and the level of risk they can tolerate. In most circumstances, the greater the risk, the more likely you’ll also experience increased volatility.

A good understanding of a client’s cash flow can help you forecast how much they need to earn on their portfolio in order to reach their personal and family objectives. Be sure to factor in special situations or wish-list items and the often-forgotten matters like home maintenance and repairs.

From there you can begin to sketch out an allocation that has historically delivered in that range of expectations. Of course, the past has absolutely nothing to do with the future as it relates to performance, but this is one starting point.

Also, stress-test their financial forecast. We all know that no market performs in a linear fashion. Each year is different, whether positive or negative. Use some random sequences of returns to see how that impacts your results. An early series of sequential losses could be more than your client can or is willing to bear. Think of your clients who took early retirement at age 60 right around Y2K.

The importance of cash flow

By now, you’re probably wondering why cash flow is so important for guiding a client through a period of portfolio underperformance. It is important because it is the foundation and the context within which you can advise your client on their portfolio return needs — absent an increase in income or a decrease in spending.

To use cash flow data to help focus on investment returns needed, it must be accurate. I suggest that the advisor or client monitor that cash flow regularly. Each year, my planning team attempts to reconcile a client’s actual spending to the forecasted spending. If there is material deviation, find out why and then adjust your forecast as needed. Of course, we also track portfolio performance, income, additional savings and all the other moving parts that help a client see if they are still on track. Like any other forecast, weather or economic, the way to mitigate big misses is to measure and adjust frequently. For wealthy families, a quarterly reconciliation may be advised. For any other clients, no less than annually.

If your client needs to earn an amount that is not reasonable or feasible, the advisor needs to throw up the red flag and let them know the low probability of achieving their objectives. Assuming, however, that the rate of return needed to get your client through life with all of their objectives met is achievable, then portfolio construction can commence along with the education process.

The education is one on volatility and market behavior. Once again, markets go up and markets go down. While history isn’t destined to repeat itself, it does reveal information about risk and volatility. Market cycles have been around forever and are likely to always be prevalent and cause volatility. There will be changing conditions and different results in portfolios with any risk-based investments forever.

Just how volatile will the portfolio that you’ve designed for your client become? You don’t really know and you can’t tell a client with certainty. You can, however, show the range of historical outcomes for portfolios such as the one you may be recommending. It is wise here not to focus so much on the up side, but on the down side.

Show them in terms that they can understand just how much a portfolio like theirs has fallen in prior periods of weakness. Make sure that they know how fast and deep investment drawdowns have been, and are likely to be at some point in the future. At the low point, once again examine their cash flow and ask if they’d need to make material changes to their lifestyle. If that analysis reveals that your client can tolerate that type of drawdown, then the portfolio allocation may be right.


Theory versus reality

This type of education on volatility and market cycles typically goes well in the theory stage of the planning process and when the portfolio is meeting or exceeding its investment objective. When you hit the rough spots, and there are losses, is when you may see the other, less rational side of a client’s tolerance for risk.

During these moments you have a few paths to choose. The most important thing that you can do is to proactively reach out to your clients. Don’t let them read the news and worry. Some will wonder if you are looking after them. Don’t be shy about this proactive outreach. Make calls to as many of your better clients as reasonably possible. Include a written narrative to all clients. Make sure your Web site is up to date with your communication. Host and record a webinar for clients that can be replayed at a later date if needed or shared with others. Stay with them and don’t let them feel abandoned at any time of market fluctuation.

Your communication is part reinforcement and part anxiety coach. The reinforcement part is where you would revert back to your core financial planning and forecasting services. Reassess the consequences of such a downturn, or possible downturn, and share with them the results.

Also review the volatility lesson and let them know that the experience was predictable, and expected to occur, but not without any accuracy as to when or how long it will last. This is especially true of black swan events that can devastate markets in a very short period of time.

Of course, even the history lesson, personal proactive communication, financial analysis, and the known probability of a material drawdown still can’t help some clients get over losses. In this case, you may have to show your clients what their financial world would look like if they took less risk and accepted the likelihood of lower returns on a sustained basis.

A temporary shift to less volatile holdings can also work, but if earning that rate of return long-term hampers your clients’ ability to reach their goals, then the challenge is again timing your re-entry into risky assets where the probability of higher rates of return are greater.

There are some asset managers who are more tactical than others. Tactical managers attempt to gain as much from markets as possible during good times and to avoid steep portfolio declines during bad times. Even within the tactical space, some revise their strategies annually, some quarterly, some weekly and some daily. In any cases, tactical managers typically cost more due to the more frequent trading and higher management fees.

Some tactical portfolios are built on algorithms, others are with charts and various quantitative measures. But none of them will work under all economic cycles and conditions. During your due diligence review, examine the actual past performance of the tactician’s portfolios under a variety of market cycles. Rely on back-tested numbers as the level of diligence required to verify that their assumptions and calculations may not be possible.

It’s a relationship

Education and communication are the core to helping clients navigate downturns in portfolio values. This education takes time, and if done properly will also demonstrate to clients that your value goes far beyond portfolio oversight or management.

The best method to deliver education is in the context of each client’s individual financial plan. When an advisor spends the time to make sure that all of their clients’ financial issues and moving parts are coordinated and working well together, the relationship is deeper than just that of an investment manager. For clients where you haven’t gone too deep with the overall financial plan, there is no time like the present to get started. Don’t expect a different relationship overnight. It will take them some time to realize that your value goes beyond investments and your actions are what will earn you that spot as their true trusted advisor for life.

For those who have experienced proactive and holistic wealth management and planning services from you — the conversations are different. They still need to happen, and be proactive during periods of extended volatility. But in these conversations, your best clients will be as concerned for you as you are for their portfolio.