Beware: Market Volatility Ahead!

With COVID cases on the rise, Congress’s inability to pass a stimulus bill, and uncertainty about the Elections, financial advisors and investors should expect market volatility to spike in the coming weeks. The number of COVID cases here and abroad have been rising rapidly over the last couple of weeks. While the vaccine trials look promising, most experts suggest that a vaccine will not be universally available until mid-late next year.

Speaker Pelosi and Secretary Mnuchin have sought a compromise plan to deliver additional stimulus to unemployed workers, State & Local Governments, and select industry. Unfortunately, it now seems increasingly unlikely that anything will be done until after the elections – perhaps not until a new Administration takes office in early next year.

As the Election approaches, there is growing concern that we will not know the results until well after election day. The polls have been tightening, there have been over 60 million ballots cast already, and many States preclude counting until election day. Both candidates have raised the possibility of a contested election, meaning it could be weeks or months before we know the final results - obviously, the markets do not like uncertainty.

As if 2020 has not been challenging enough, we could experience another round of shutdowns, social unrest, increased unemployment, and a dramatic rise in bankruptcies. The markets are starting to factor in a Biden victory and taxes rising in 2021. All of this will likely lead to increased market volatility.

How does this impact investors?

Investors do not always act rationally - after all, we are only human. We are prone to acting on emotions not logic. Advisors should be actively engaging their clients. How did they feel in February and March? How do they feel today? Have they made irrational decisions? Are they contemplating additional changes?

Many traditional finance theories are based on the flawed assumption that people act rationally and consider all available information when they are making investing decisions. Behavioral finance challenges this naïve assumption and explores how individuals actually behave. Behavioral finance studies the biases and traps that we all fall into when we allow our emotions to override rational reactions to events: including these common biases:

·       Loss aversion: investors will go to great lengths to avoid losses, including leaving the markets when volatility spikes, often not returning until after the markets have rebounded.

·       Confirmation bias: people are often drawn to information or ideas that validate their beliefs and opinions; this bias can be harmful to investors who should objectively evaluate a strategy or investment product.

·       Mental accounting: this occurs when a person views various sources of money as being different from others—for instance, money you’ve earned vs. money you inherited; also, investors may become emotionally invested in individual stocks or mutual funds.

·       Illusion-of-control bias: this occurs when investors believe they can pick individual stocks or managers that can outperform; they believe that since they are in control, the outcome will be better.

·       Recency bias: many investors are prone to chasing hot stocks, asset classes, and asset managers: they see strong recent results and extrapolate those results in the future, which rarely works out in the long run.

·       Hindsight bias: this occurs when investors say (after the fact) that they knew a particular stock or investment would fail: both investors and advisors tend to overstate their abilities to predict the future, which can lead to excessive risk-taking.

·       Herd mentality: although many people pride themselves on thinking on their own, humans are social animals and often fall into following the herd and doing what others have done; this affects investors who chase popular stocks or managers for fear of missing out (“FOMO”).

What should advisors do?

By understanding these behavioral biases, financial advisors may be able to improve client outcomes. Advisors may exhibit behavioral biases themselves. Once a behavioral bias has been identified, it may be possible to either moderate it or adapt to it so that the resulting financial decisions more closely match the rational financial decisions assumed by traditional finance.

Advisors should proactively engage clients and revisit some of the basics.

·       Review each client’s goals and objectives. Have there been any changing in their circumstances?

·       Revisit their risk-tolerance and current asset allocation. Does the current allocation align with their stated goals and objectives? Is it consistent with their risk profile?

·       Rebalance their portfolios to make sure that they have not taken on too much risk given recent market movements. It may be prudent to consider year-end tax-loss selling?

·       Reset client expectations regarding risk, return, and income in the current market environment. Future returns and income will likely be below historical norms, and volatility may remain elevated for the foreseeable future.

Acting on emotion rarely leads to the best outcomes. Advisors should help clients in navigating the next several months. Some clients may require counseling; while others may need portfolio adjustments to align with their stated goals and objectives. An advisor can help by providing insights, education, and empathy during these volatile times.

To learn more, please join the next Exceptional Advisor Webinar featuring John Nersesian, as we explore practical implementation of behavioral finance.

Register here.