BY MICHAEL FINKE
NEW RESEARCH SHEDS LIGHT ON CLIENT PANIC
DURING MARKET DOWNTURNS—AND HOW
ADVISORS CAN LIMIT THE PORTFOLIO DAMAGE
ILLUSTRATION BY JON KRAUSE
tock investors who watched the Dow drop by
nearly 50% between August of 2008 and March of
2009 were put to the ultimate risk tolerance test.
As they saw their retirement dreams dissolve with
their account balances, individuals pulled record amounts of
money out of equity mutual funds. According to the Investment Company Institute, net equity fund flows were minus
$28 billion in January 2009, minus $29 billion in February and
minus $25 billion in March. A lot of equity investors freaked
out during the great recession. And they paid for it big time.
Much of this money flowed into money market funds.
An investor who freaked out and sold $100 in stock in early
March 2009 would have earned about a dollar on her money
market investments by the summer of 2013. The patient
investors saw their stock investment climb to about $244.
This is a boon for those of us who study investor decisions,
but it was a nightmare for many advisors and their clients.
The great equity market freak-out of 2008-2009 battered
the accounts of weak-stomached investors. More resolute
investors survived the crisis unscathed. So who bailed and
who sailed through the storm? New research provides some
surprising insights into which clients might be most likely
to stick with their investment plan.
It’s hard to anticipate who will abandon their asset allocation policy during a recession. One way is to ask potential clients a battery of risk-related questions. These risk-tolerance assessment tools are a great way to both get the
client thinking about the meaning of investment risk and
also begin to assess how much volatility they can bear. Texas
Tech graduate student Michael Guillemette and I looked at
how questions from a commonly used risk tolerance questionnaire predicted whether someone shifted investments
to cash during the Great Recession.
We find that questions that measure loss aversion are
good predictors of cashing out stock investments. Examples
include whether someone focuses on the possible losses or
the potential gains from a risky opportunity. If you dwell
on the negative, you tend to react badly when your fears
are realized. Loss aversion is different from risk aversion
because it predicts that investors will overweight losses (
seriously—Daniel Kahneman won a Nobel Prize for, in part,
pointing out that people really don’t like to lose money). An
even better predictor was simply asking people how much
risk they’ve taken with investments in the past. General
questions about things like salary risk didn’t do a great job
of predicting response to a bear market.