Have years of positive returns have left investors complacent? A survey released yesterday by Boston-based Natixis Investment Managers suggests that investors are unprepared for a return to normal market conditions. Natixis' Center for Investor Insight polled 2,775 wirehouse advisors, RIAs and independent brokers globally on their practices, the challenges they face and their market expectations. Of the advisors polled, 64% believe that their clients are unprepared for a market downturn.

Advisors also recognize that they need to be more proactive. Of the advisors polled, nine out of 10 believe that investors don't understand risk in their portfolios until it has already been realized. "The number one thing that advisors say that they have to work on is client communication," says David Goodsell, executive director of the Investor Insight unit. They ask, "How do I talk to clients about the issues that they have?"

Shifting Ground

While equity markets should be relatively turbulent, the past few years have seen a period of abnormal calm. The Cboe Volatility Index (VIX), frequently cited as a measure of market sentiment, increased by 80.9% in the first quarter. That's the largest upswing in the 20 most recent quarters and the third largest in nearly 10 years, according to Pensions & Investments magazine.

This year, volatility is still lower than normal, but it's a far cry from last year's calm. "The volatility we're experiencing right now really isn't bad. It's only really spectacular in the context of that haven't had any for a long time," says Simon Brady, principal and founder of Anglia Advisors, a New York City financial planning firm.

"Complacency can be dangerous during a period like this," says William Rosen, CFP, vice president at BRIX Wealth Management in New York City. "In the short run, I don't think a lot of clients appreciate how volatility or a downturn will affect their portfolio."

Recession forecasting is, of course, more sport than science. Economists currently put the target of the next recession at somewhere between the end of 2019 or somewhere in 2020, due in part to the Federal Reserve's accelerated rate tightening.

Driven by Emotion

For most investors, it's fruitless to attempt to time the market. But nearly half of the advisors surveyed found that their clients have reacted emotionally to recent volatility.

Investors are motivated by a variety of triggers, but 87% of surveyed advisors believe that investors are too focused on short-term investment results. "Most clients don't think that far ahead," says Patrick Healey, CFP, founder and president of Caliber Financial Partners. "A lot of client expectations are centered on politics and elections, while policy is just a blip."

Short-term thinking can be especially dangerous in the latter parts of the economic cycle. According to Bank of America, the end of a bull market generally produces the best returns. In an 80-year analysis of market peaks, BOA analysts found that investors who are uninvested for the final year of a bull market historically miss out on one-fifth of the rally's total return. "It's more important than ever for advisors to fortify close relationships with their clients to help them stick to their plans," said David Giunta, CEO for the U.S. and Canada at Natixis, in a press release.

"A majority of market commentary and analyst forecasts have been predicting, and even calling for, a correction for some time now," says Rosen. "There is no reason why investors shouldn't have a plan in place to avoid reacting emotionally when it does occur." (For more, see: Tips on How Financial Advisors Can Talk to Clients.)

Bucking the Passive Trend

"The biggest differences we see across surveys are how individual investors perceive active and passive [investments] and how professionals do," says Goodsell. One of the more striking results of the survey was that 83% of financial advisors believed that the current market favors actively managed investments.

According to Goodsell, professionals tend to view passive management as a strategy for reducing fees, while retail investors believe that the strategies confer diversification and risk management benefits. With passive, "you don't get the best opportunities in the market […] you get them all." Survey respondents agreed, with 73% of advisors responding that investors have a "false sense of security about passive investing."

That attitude is a departure from prevailing market trends. Last year, $207 billion flowed out of active U.S. equities, and $220 billion flowed into their passive counterparts. While Natixis notes that this may reflect increased pressure for financial advisors to generate alpha, much of the preference may also be borne out of financial advisors' desire to minimize their clients' downside risk in turbulent markets.

A Need to Plan

Regardless of the actual direction of the markets, advisors today face a number of challenges. The best advisors have the technical expertise to select the right investments and manage client assets during volatile times, while also having the emotional intelligence to work through client queries and proactively address their needs, which Goodsell refers to as using "both sides of their brain."

It's a given that advisors will have to coach their clients through an economic downturn in the future. "It's inevitable: you can't have growth indefinitely," says Healey.

The key to maintaining your client relationships during that time is being proactive and managing expectations now. "Isn't that our job?" says Brady. "A client not prepared for a downturn is more a reflection on the advisor than the client." (For additional reading, check out: Managing Client Expectations in a Volatile Environment.)