How to Psychologically Prepare Clients for Bear Markets

Bob Veres

You’re hearing dire predictions that the next major bear market is around the corner. Others say the bear is still a year or two away. But the truth is, the next bear market will come like the proverbial ‘thief in the night,’ and none of us can predict its hour or day.

All we can do is prepare for it.

Preparing yourself and your clients for bearish times may be the most important investment activity you engage in, more important than your portfolio design work or your research into the actual investments that you recommend. You make money for your clients during market downturns, by helping them avoid locking in losses and missing the recovery, and second, through consistent rebalancing.

The value of your efforts during bearish times can be seen in the disparity between investor returns and investment returns. When Morningstar looked at the average 10-year total return for investors in seven different investment categories through the middle of 2013, its researchers found persistent differences amounting to 2.5 percentage points a year – primarily because investors abandoned a particular fund or the markets as a whole during downturns, and tended to buy funds after an anomalously good year or load up on stocks when the market was near its peak. The discrepancy was fairly consistent across asset classes: U.S. equities, sector equity funds, balanced funds, international equities, taxable bonds, muni bonds and alternative investments, with the alternative investments actually squeaking out a 1% return while their investors lost money.

This follows a 2010 study where Morningstar analysts looked back at the decade of the “aughts,” and found that investors in mutual funds overall got a total of 1.68% a year, while the funds they invested in were returning 3.18%.

The best-known survey, the Dalbar Quantitative Analysis of Investor Behavior (QAIB for short) recently calculated a 20-year investor return of 5.02% vs. 9.22% for the indices.

The disparity, depending on time periods and calculation method, ranges from roughly 1.5 percentage points to 4.1 percentage points a year. Is there anything you can do with your asset allocation, asset selection, tactical shifts or rebalancing activities that can reliably add this much return to your clients’ bottom lines?

The question, then, is how do you prepare clients so they won’t give in to the herding instinct and sell out at the wrong time? A bear market can be defined as a decline of 20% or more, or as a time period when a high percentage of investors are pessimistic about the investment markets – and, of course, your clients contribute to that group psychology.

As a result, says Ken Haman, managing director of The Advisor Institute at AllianceBernstein Investments, the challenge of navigating volatile markets is primarily psychological.

Tale of three brains

Haman, a former psychologist with a graduate degree in theology, says that it helps to understand that you, your clients and all the investors who are panicking as the bear claws its way through the markets are operating with three very different brains: (1) the Neo-cortex; (2) a set of ganglia below it that has the processing power of an unusually smart cat; (3) below that at the top of the spine, a cluster of neurons which, together, possess roughly the thinking power of a lizard.

Nashville, TN-based psychologist and coach Ted Klontz has estimated that the lizard brain and the cat brain together make 91% to 99% of all human decisions, no matter how rational we think we are. “Whenever you reach a certain level of anxiety, the lower two-thirds will completely take over,” Klontz explains. “The processing speed just overwhelms the cortex, and your rational thinking shuts down.”