In the battle between our emotional selves and our rational selves, there is no contest: Plunging share prices almost always unleash an all-too-human sense of terror in many clients.
That leaves advisers with the unenviable task of trying to calm them and thereby save them from costly self-inflicted investment wounds.
How do advisers train investors to be less skittish about market declines and instead see them as an opportunity? The key is to get clients to view stocks as having two prices: the price at which they can be bought and sold, as well as the underlying fundamental value.
In his 1949 classic, The Intelligent Investor, Benjamin Graham tells the parable of the manic-depressive Mr. Market.
“You may be happy to sell out to him when he quotes you a ridiculously high price and equally happy to buy from him when his price is low,” he writes. “But the rest of the time, you will be wiser to form your own ideas of the value of your holdings.”
How can advisers help clients avoid being seduced and bullied by rising and falling share prices and instead have their own idea of the market’s value?
Consider these three strategies:
1. Think like a shopper. Start by encouraging clients to think like department store shoppers, who buy with gusto whenever there is a sale. Many investors, of course, do just the opposite, rushing to sell when the stock market cuts its prices.
To be sure, the analogy isn’t perfect.
When shares tumble, it is usually because the quality of the “merchandise” has been called into question, perhaps because of political upheaval or slower economic growth. These problems are often temporary and tend to unnerve professional investors, who account for most of the market’s trading volume and whose paychecks depend on their performance in the next 12 months or so.
Advisory clients, by contrast, probably plan to hold their stocks for at least a decade and often far longer. Today’s worries will be long forgotten by the time they need to sell, and any short-term market decline should be viewed not as a cause for worry but rather as a chance to buy at cheaper prices.
2. Focus on yield. Behaving like a department store shopper is easier when one has a grip on what stocks are worth. So get clients to think about how much in dividends and earnings they can buy with each dollar invested.
The S&P 500’s dividend yield is readily available. Lately, it has been a tad above 2%.
The S&P 500’s earnings yield is less frequently discussed, but it is easy enough to calculate.
Suppose the S&P 500’s price-earnings ratio is 20. To find the earnings yield, divide 100 by 20, which would provide the answer: 5%. That shows that for every $100 invested, an investor buys $5 of annual earnings.
Now, suppose stocks drop 30%, so the market’s P/E falls to 14 from 20. Due to that plunge in prices, every $100 invested buys $7 of earnings, rather than $5.
If bond yields rose to 7% from 5%, clients would immediately grasp that bonds are now a better value. By talking about the S&P 500’s earnings yield, advisers can frame the conversation with clients in the same way.
As with the shopping analogy, there is a potential glitch. If the S&P 500 did indeed fall 30%, it is probably because the economy is slowing sharply, and this would probably depress corporate earnings in the short term.
What to do when that happens? To sidestep the problem caused by weaker earnings, calculate the market’s earnings yield using peak earnings.
Alternatively, figure out the S&P 500’s earnings yield using the Shiller P/E, named after Yale economics professor Robert Shiller.
The Shiller P/E is based on average inflation-adjusted earnings for the past 10 years. Due to that averaging, the Shiller P/E is less sensitive to short-term dips in earnings.
To find the current Shiller P/E, run an Internet search for “Robert Shiller’s home page,” click on the online data tab and open the third link listed, the one with data on U.S. stock markets since 1871.
3. Walk the line. Not sure clients are ready for a discussion about earnings yields? Instead, ask them to imagine a line rising steadily at 6% a year.
That 6% is a best guess for the long-run total return on stocks, estimated by combining the S&P 500’s 2% dividend yield with 4% annual growth in earnings per share. Meanwhile, inflation will likely run at about 2% a year.
If the S&P 500’s earnings per share do indeed climb 4% a year, share prices would also climb at 4%, provided that the market’s P/E ratio stays the same. But the P/E almost certainly won’t stay the same. Instead, it will climb whenever investors grow ebullient and tumble when there is panic in the air.
Whatever happens, encourage clients to focus on that 6%-a-year growth line, and tell them to view short-term movements as deviations from that trend.
Just had a gangbuster year for stocks? Share prices will be above the 6%-a-year growth path, and advisers might caution clients that they are likely to suffer somewhat lower future returns as a consequence.
Conversely, when share prices tumble, they will fall below the 6%-a-year growth path, and advisers can explain to clients that it is reasonable to expect the market to do some catching up.
When will the catching up occur? That, alas, is a question that an adviser won’t be able to credibly answer for clients.
Still, advisers will have them engaged in a far more productive conversation. Instead of simply telling clients “don’t panic,” advisers will have them focused on the market’s fundamental value and viewing plunging share prices as an opportunity, rather than as a ticket to the poorhouse.
This story is part of a 30-30 series on ways to build a better portfolio. It was originally published on May 2.