December 2018 was the worst December on record for the S&P 500. This is an amazing factoid on its face, but what is even more astounding about the month that started the first bear market in a decade is that no one really knows what caused it. Many theories among macroeconomists at big banks are floating around sell-side reports, and the lack of a consensus means that, in reality, no one simply knows. And that means the volatility was most likely the result of something much less predictable: human psychology.
The psychology of investing and trading is often overlooked, and when young analysts read on the topic, it is often as a means to control their own urges to sell too low or buy too high. And while that is important, there is another component of asset management, capital allocation, and finance in general that is much more essential yet more rarely given the attention it deserves: client management.
To explain this concept, let’s first sketch out a rough outline of how finance works. There are people with capital and people with liquidity, and finance is the art and science (it is definitely both) of matching liquidity with capital, whether that capital is human, fixed, short, whatever. The best financial intermediary who works to bring together liquidity and capital is the one who does this by minimizing risk for both sides of the transaction as much as possible. Many financial products (derivatives, insurance, private contractural agreements) have been designed to ensure that risk is spread as much as possible.
Essentially, finance is about lowering risk as much as it is about increasing profit; in fact, many would argue that risk is the primary job of the financier: she exists to ensure that the transaction involves as little risk as possible, and this concern supersedes concerns about profit.
When done well, the financier develops a reputation for minimizing risk that increases her desirability in the industry. This is how hedge fund billionaires are made. But there is one risk that always remains in the financial industry, and that is of market participants panicking and wanting to back out too quickly.
To avoid this, the adept financier will work with clients to ensure that they do not panic sell. The financier will approach buyer and seller and insure them that market volatility is not a reason to go off plan, and that the plan’s fundamental soundness when it was first drafted remains the reason to continue executing the plan. This becomes a game of persuasion and therapy; the financier needs to teach the client providing liquidity not to panic while convincing the client requiring liquidity to not give up on their plans.
A simple and recent example of the value of this job is visible in the stock market’s recent volatility. During December’s market decline, many CFPs and financial advisors were fielding calls from worried clients panicking that this was another 2008, that maybe stocks weren’t so great after all, and maybe they should be in something else. The CFPs who are adept at managing the psychology of volatility convinced clients to stay in the market, relax, and wait it out.
Those CFPs who succeeded in doing so have seen their clients’ portfolios rise by 10% (or more, depending on the assets) in January, and the short-term period of fast declines and fast recovery is a teaching moment CFPs can use to show clients the important of ignoring short-term volatility and focusing on the long-term plan.
CFPs who failed in doing so, unfortunately, are in the worst position of all. Their clients have sold at a loss in December and, due to fear, have missed out on January’s recovery. Clients blame intermediaries for their own bad decisions far too often, and those clients who tend to make bad decisions are the ones who tend to be less introspective enough to acknowledge their responsibility in said decisions. These CFPs will lose clients and, in extreme situations, their jobs.
Good analysts who are bad relating to clients will suffer in these situations. And while the CFP example relates to individual investors, this applies just as much in other parts of finance. Sell-side analysts have had to convince hedge fund portfolio managers that their hunch that a recession is beginning is wrong. Investment bankers have had to convince corporate clients that their acquisition of a small high-growth firm still makes sense.
The stock market is a barometer of social psychology, and those who can read it and respond to it will find themselves to have a growing client list and a much more successful life in finance, regardless of where they are in the industry.