[IMGCAP(1)]Volatility isn’t new to markets, and is something that will accompany investing forever. There have always been times in markets when, in the words of famous economist John Maynard Keynes, “Markets can remain irrational for a lot longer than investors can stay solvent.”

By definition, volatility is the trait of being unpredictable. In the investment world, it is a measure of the dispersion of returns for a given security or index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or market index. If you are a CFA or a CFA candidate, you learned how to calculate volatility and understand exactly how it is determined for a specific security. For the rest of us, we can rely on the myriad tools available to research the volatility of either a specific holding or a portfolio in total.

The clearest example that I can give you is how clients react to new headlines about the major indices here in the U.S., such as the S&P 500 index. When the headlines are strong and the S&P is performing well, all clients want their portfolios to perform as well as that index. But when that index turns south, as it did in 2008, your clients may expect that they will not bear the brunt of the losses, even though those losses may be predictable and consistent over a long period of time because of the volatility inherent within that basket of 500 large-capitalization common stocks. Of course, the challenge is to know when that negative volatility is about to occur and what to do about it. Some argue that this is impossible and others have created strategies or tactics to attempt to mitigate volatility.

Either way, the best thing you can do early in any client relationship is to educate them about volatility. Help set their expectations about the historical range of outcomes for their portfolio or any particular holding.

 

WHAT TO SAY

First, this will let them know volatility will happen, and when it does, that this is a normal part of investing. Second, it will assist with designing a portfolio that may limit volatility by including less volatile asset classes (such as cash) and lower their expectations for both volatility and ultimate performance.

As witnessed in the summer of 2015, as soon as markets get jittery, clients who understand volatility and those who do not may begin to freak out. You get calls and e-mails and you may wonder what next to do.

The first thing that you should not do is to hide under your desk and avoid clients. Proactively reach out to them and talk to them about what is occurring. These conversations begin with questions such as how are you feeling or reacting to what has been happening in the markets. Many clients, especially your newer ones, will be grateful for your call and may be surprised that you cared enough to reach out to them. This has not been the norm for financial advisors over the years, yet is something that all caring advisors need to do during times of market stress.

The next topic for that phone call is a deeper dive on their holdings and their portfolio as a whole. You may need to remind them why the allocations are as they are and what inside the portfolio is causing them to experience negative volatility. During periods of extreme market stress, such as 2008, nearly everything went down. But that is not always the case, and there are times when you’ll be able to isolate the volatility and either justify your position in that holding or eliminate it from the portfolio.

This is also the time to remind them of their financial planning big picture. That means their targeted rate of return, their needed rate of return to achieve their life objectives, and the reality that any one bear market is only a part of their long-term plan that we all knew would occur at some time.

And lastly, remind them that they would be best served to focus on matters that they can control, such as their spending, and making sure that the other parts of their financial plan remain in good order.

If you are a solid, proactive and holistic wealth manager, this will not be a major challenge. But if you are like numerous advisors, where the details of wealth management are just a decoy and you are really only interested in the revenue from assets under management, you will struggle. It is never too late to deliver a more robust suite of wealth management services — but we’ll have more on that in next month’s column regarding the keys to success in financial planning.

 

AFTER THE FIRE

Assume that we are now beyond crisis mode, and you’ve called all of your clients with no more fires to put out. How do you do a better job to have this experience feel even better the next time volatility and negative news reach your clients? The answer may lie in the portfolio construction process.

When building portfolios, too much emphasis can be placed on past performance and the ratings for the products that you intend to have in the portfolio. Often, not enough emphasis is put on the volatility inherent in that portfolio and the methods being deployed to reduce volatility. The emphasis can start with a historical look back, during both good and bad times, at the portfolio being designed, and once again educating the client regarding expectations and the past performance of the collection of investments that you’ve assembled. Ask your client directly how they would feel if we entered a bad time — perhaps even worse than the previous bear market that you are showing them for the contemplated portfolio. Ask them what they would do or how they would react if the sequence of returns went against them from the inception date of your advisory services.

When constructing portfolios where volatility management is a primary objective, you may need to upgrade your suite of tools or the manager that you are using to construct client portfolios. Not all of the basic portfolio analysis tools do a very good job with the volatility analysis. You need to be able to assess the volatility in the portfolio as a whole and any of the individual holdings at any particular time. Knowing what components of the portfolio are adding to volatility is the first step at being able to control volatility. Volatility changes, and is not a static number that can be relied upon during different market conditions.

Another perfect example emerges from the conditions and market environment that we’ve experienced looking back. Since interest rates began coming down in the 1980s, the most common way to tame volatility in a portfolio has been to add fixed income. During this long period of falling rates, the fixed income component of a portfolio was a primary tool for trimming volatility. It was merely assumed that a portfolio with 10 percent fixed income and 90 percent equities contained significantly more volatility than a portfolio with 50 perent fixed income and 50 percent equities. This may be true going forward or it may not.

What happens if we enter a period of rapidly rising rates, such as in the early 1980s? Will additional fixed income dampen volatility or add to volatility? No one can answer that question at this time. What we do know is that the value of fixed income securities generally declines during periods of rising rates. But what is the benchmark for volatility during that time period? For us professionals, the benchmark is the actual standard deviation of that asset class or security. But for your clients, the benchmark may be other markets that are performing well during that time period. Although the direction of interest rates is not clear in the U.S. at this time, it is generally accepted that they will ultimately revert to the norm and rise to a level closer to the long-term averages.

 

GET READY

Another method to trimming volatility is good old diversification. As we all know and as the compliance folks try to remind us every time, “Past performance is no guarantee of future results,” and diversification does not always work when attempting to trim volatility. Again, just take a short stroll down memory lane and look at the last market meltdown where correlations all collapsed to be equal, with most asset classes getting clobbered.

But you will notice that volatility — or at least the standard deviation that a portfolio will decline when it is well-diversified across many markets and many asset classes. Once again, remind your clients who are addicted to financial porn (TV or radio shows about money and investing) that what they see in the headlines or on the air is often driven by what will improve the broadcasters’ ratings and not the results of their viewers’ portfolios. Your clients need to understand that the purpose of diversification is to own assets that may be uncorrelated, and therefore (hopefully) behave differently during specified market conditions. We do this as professionals because we understand that no one person, firm or tool can accurately and consistently predict the direction of any market over the long term.

Upgrade your tools. There are tools now available to advisors to measure the volatility of both holdings and portfolios, as well as to attempt to quantify your clients’ emotional and numerical tolerance for risk. Our firm began using such tools earlier in 2015, and it has made a difference in both our clients’ understanding of how risk relates to portfolio construction and what they can expect during a number of possible scenarios with the assets that you are managing.

Nothing is perfect when it comes to taming volatility. The best that you can do is to understand it yourself and have a solid understanding of how it might manifest itself in your clients’ accounts. Combine this with consistent education and communication with clients — and your number of crazed daily portfolio watchers will likely decline. 

For more, watch John’s video, "Client Care in Volatile Markets."

John P. Napolitano, CFP, CPA, is CEO of U.S. Wealth Management in Braintree, Mass. Reach him JohnPNapolitano on LinkedIn or (781) 849-9200.

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