Crisis + fear = opportunity for advisers

Now is the time for financial planners and investment advisers to demonstrate that they are what they have always claimed to be: trained, capable, cool-headed professionals. When all about them are losing their heads, these professionals must keep theirs and remain calm and collected. They must resist the urge to panic, and help their clients resist the urge also.

They must put into practice all that they have learned over the years, especially what they have learned about behavioral finance — the way people react when making decisions involving money and the possibility of gains and losses.

The research in this relatively new field shows that contrary to economists’ assumptions, people don’t behave rationally when making such decisions. For example, investors experience more pain from a loss of $10 than they do pleasure from a gain of $10.

This implies that investors are now feeling more pain from the losses in their portfolios than they did satisfaction from gains in those portfolios during the bull market, and that could cause them to make shortsighted decisions.

Further, when investors feel a loss of control, as when the market plunges, taking their wealth with it, they are more likely to make irrational decisions based on non-existent patterns.

Financial advisers and planners must be aware that the same behavioral biases may infect their decision making and the advice that they give. If they haven’t already done so, they should sit down and read all they can about behavioral finance, and those who have studied behavioral finance should take a refresher course.

An awareness of the way the human brain makes decisions involving money, especially during times of financial stress, will help them resist their own biases and offer sound advice to each client based on his or her specific situation and needs.

The financial crisis also offers advisers the opportunity to reinforce some sound investment principles with clients.

For example, risk and return are tied together. If you want more return, you must accept more risk.

Stocks offer higher returns than bonds because they carry more risk.

Second, diversification is more than having different equity styles in a portfolio. It involves using investments that aren’t highly correlated with one another, e.g., stocks and bonds (especially Treasuries) and even some cash equivalents.

It is possible that clients are now more ready to heed these principles than they were in the past because of the dramatic nature of the stock market decline.

The size of the decline may induce a sea change in investor attitudes even though many investors resisted the changes after the dot-com bubble burst and after Sept. 11, 2001, froze the markets.

Advisers also should seize the opportunity to instill in their clients more-realistic long-term return expectations for equity investments and more-realistic return expectations from diversified investment portfolios.

They should encourage investors to take prudent risk in search of long-term returns when that is appropriate to their situation. For investors who have healthy cash positions, the market must be near to offering a great buying opportunity.

Advisers should encourage younger investors to continue to invest in their 401(k) plans, and they should help those investors determine if their asset allocation is appropriate to their long-term goals. The greatest mistake for younger investors is to stop saving and investing for retirement.

As we have said, this crisis is an opportunity for advisers to prove their worth to their clients by remaining calm, helping clients to remain calm and helping them to make sound, reasoned investment decisions.