Financial planning is not there just as a response to a crisis; but a longer-term undertaking that puts you in a better position throughout your life. 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. In the bank of skills that planners have, there are two things in particular that we can bring in times of crisis; comfort from robust preparations and emotional support.
Market corrections and crashes can, do and will continue to happen. 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, then this is a far easier journey.
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, bear markets last for less time than the peaks – and the troughs are not as low as the highs of bull markets. Whilst you can never know exactly what the future will bring, we can use the past to keep market falls in perspective and plan accordingly.
So, how do we make our clients feel comfortable? The biggest single worry of any investor is the possibility of running out of money. If you can alleviate that by ensuring a client always feels they have enough behind them, that helps. One of the most straightforward, but also the most effective ways to do this, is through a detailed analysis of income and expenditure patterns to ensure a client maintains sufficient cash reserves. Assuming a client has sufficient income, the focus is on having enough cash. There is no hard-and-fast rule for how much any one person needs, but the following acts as a guide:
- Ensure you can always cover regular expenditure for an agreed period e.g. 6 months.
- Have funds ringfenced for planned expenses.
- Make some allowances for unplanned expenditure.
Once this has been completed you would reach an agreed cash level. Market dips are then less of a concern as if you have access to more than enough money to spend, so you have time on your side. Equally, if there is an income shortfall, we can try to address this to reduce anxiety.
Test and test again
An integral part of quality lifetime financial planning is to stress test. 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 would have an anticipated rate of return for a client that I use to monitor the plan, knowing divergence from this can make or break it.
Good stress tests look at a variety of situations. One test I do for all my clients is to push a plan to the absolute limit of what could be reasonably expected 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 part of pension used for shorter-term income needs, it makes this more secure. You can then take a longer-term view with the second segment and increase the risks approach to compensate. Overall, this wouldn’t change the overall risk approach, but with the knowledge 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.
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 the positive emotions of gains. This means, when markets start to go down, we naturally worry more, which increase the chances of making a bad decision that could cause serious damage.
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, this creates two major problems. Firstly, it creates the problem of when to go back in. If you sell out because of fear, and we know that this takes longer to dissipate clients stay out the market for longer. By the time a client is confident to go back into the markets, 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 planner would be happy to talk you through, but to answer the question as to why financial planning is critical in a crisis, I would say the answer is simple. Good financial planning is at its heart all about providing comfort. 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.
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Why financial planning is critical in a crisis
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