Bad things can and do happen; good planning incorporates these events into the process. That means when they do happen, it should be much easier to deal with. We hope for the best but plan for the worst. In the bank of skills that financial planners have, there are two things in particular that we can bring in times of crisis: comfort from robust preparations and emotional support.
Financial crisis management
Market corrections and crashes can, do, and will continue to happen. History has shown that the investment journey is rewarding if you can spend enough time in the markets, but also that there will be some tough periods. Historically, major drops in investments (known as a bear market) last for less time than the peaks. And the troughs are not as low as the highs bull markets achieve at their height.
The answer is to structure your investments to limit the effects of extreme market moves as part of your strategy. As John Wooden said: “Failing to prepare is preparing to fail”. Experiencing a crash will never be a comfortable experience. However, if you understand it will happen, and know you can come out the other side, this is a far easier journey.
Whilst we can never know exactly what the future will bring, we can use the past to keep market falls in perspective and plan accordingly.
What are the benefits of financial planning?
The biggest single worry of any investor is the possibility of running out of money. If a planner can alleviate that by ensuring a client always feels they have enough behind them, that helps.
One of the most straightforward and effective ways to do this is through a detailed analysis of income and expenditure patterns to ensure a client maintains sufficient cash reserves.
There is no hard-and-fast rule for how much any one person needs – but the foundations of financial planning generally follow the guidelines below:
- Ensure they can always cover regular spending for an agreed period e.g. six months.
- Have funds ringfenced for planned expenses.
- Make some allowances for unplanned expenditure.
Once this has been completed you would reach an agreed value for an emergency cash fund. Market dips then become less of a concern. If you have access to reserves that cover your core spending needs, you have time on your side and you can ride it out until markets recover. But if there is an income shortfall, our financial planners will try to address this to reduce your anxiety.
Benefits of stress testing
An integral part of holistic financial planning and a key financial crisis planning strategy is to stress test against potential scenarios. There are a variety of methods for doing this, but the key is to demonstrate that bad periods don’t impact on the ability of a plan to succeed.
If you know that any plan that has been put in place has assumed the worst – and made allowances for it – that helps dispel anxiety. Typically, I have an anticipated rate of return for a client’s investment plan that I use to monitor progress, knowing divergence from this can make it or break it.
Good stress tests look at a variety of situations. One test I do for all my clients is to push a financial plan to the absolute limit of what could be reasonably expected to happen – and do this regularly. This allows me to see where it fails. We can then amend this to get to as close to safe as possible.
An example of this would be to look at portfolio segmentation. Using a pension as an example, rather than managing all the funds as one overarching strategy, you could instead segregate it into two pots. If you reduce risk on the part used for shorter-term income needs, it makes this more secure.
You can then take a longer-term view with the second (growth) segment and increase the risks appropriately. This wouldn’t change the overall risk approach, but provides comfort that the income needs will be more secure. The impact of market falls on the longer-term pot would be far less concerning and can improve the success rate of the plan.
Financial planning during a crisis offers emotional support
The other key job a planner has is to provide emotional support and to coach you through the tough times. Whilst technical knowledge is important, the emotional and behavioural coaching a financial planner does will arguably be more important in times of crisis.
People can and do behave irrationally under stress. Prospect Theory shows that people are far more affected by the negative emotions of losses than they are by the positive emotions from gains. This means, when markets start to go down, we naturally worry more, which increases the chances of making a bad decision that could exacerbate the situation and even cause serious damage to a long-term strategy.
To demonstrate this, I’ve used the example of one of the most common questions we hear during a downturn – When should I sell out and go to cash to avoid any other losses? Evidence shows that up to now this has never been the correct approach as the immediate recovery from a market crash is normally the largest. Missing out on this can be catastrophic. The table below shows that you need to stay in the market to get the benefits of the best days.
If you were to panic and sell out, it would create two major problems. Firstly, it raises the question of when to go back in. If you sell out because of fear – and we know this takes longer to dissipate – you could be tempted to stay out the market for longer. By the time a you are confident enough to go back into the markets, the best returns are likely to have been achieved. Has the damage been done?
More importantly, going back to the financial plan, if one poor decision drops the long-term level of return from a portfolio, does this mean we need to make changes to the plan? If so, in the real world, this means considering significant lifestyle changes, such as retiring later, having less income in retirement or passing on less of an inheritance.
There is so much more to this area that any financial planner would be happy to talk you through, and in a crisis, financial planning advice is all about providing peace of mind. When times get tough, having an expert at your side who has both the technical and emotional knowledge to keep you safe and on track can be invaluable.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.
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This series of high-net-worth (HNW) guides brings together perspectives from Charles Stanley’s investment managers and financial planners to help you make clearer decisions around long-term planning, no matter what life throws at you.
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