Updated Friday, July 25, 2014 as of 11:08 AM ET
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What to Do When the Client Is Wrong
Monday, May 12, 2014
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We have all grown up to respect the customer, to accept that the customer is always right. But in the case of investment advice, it is often the clients themselves who have given their advisors the wrong objectives for ensuring long-term growth of their portfolios.

Industry reports periodically criticize investment advisors for underperforming long-term global performance indices. The strong implication is that most financial advisors do not do a good job in managing money.

However, clients largely push advisors to make decisions that ensure that they beat short-term performance criteria each year. Even worse, many clients tell their advisors that they don't want any volatility (unless it is on the upside). As a result, advisors must manage a portfolio that will underperform the global multi-asset class indices over the long haul.

It is understandable that so many clients set such unattainable goals. Most people are taught to evaluate performance on a frequent basis; in this context, one year seems like a long time frame. People naturally want to know who won last year and who underperformed. Even when investors know they are supposed think long term, they are (quite naturally) afraid of picking a loser -- so if you're not a top performer, clients think they must have a bad advisor.

KEEPING CLIENTS HAPPY

The problem is that this kind of thinking takes investors down the wrong path when it comes to constructing and monitoring a long-term investment portfolio. And understandably many advisors can't help but react in a suboptimal manner in an effort to keep their clients happy each year.

Here's what we know from looking at investing over the past century.

First off, asset classes routinely will underperform for a number of years, perhaps even as long as a decade, before suddenly becoming the best performer in a year. Of course, it would be great if an expert could consistently pick the future best-performing asset class each year. Yet despite having worked for 40 years on Wall Street, I have yet to meet a person who can do this every year. (As my brother likes to say when we're playing golf together and I make a good shot: “Congratulations, that's one in a row!”)

Clients want their advisors to avoid exposure to asset classes that either are too volatile or have not performed well in recent years. Yet most money managers that try to tactically move in and out of asset classes to beat the market tend to underperform the global indices. Money managers are often out of the market at the right time, but they fail to get in at the right time.

So although many advisors do know the best approach to investing, they can't convince investors to trust them to follow the best path for a lifetime financial plan.

KEY TO GROWTH

Research shows that the key to solid long-term growth is as follows:

  • Carefully put together a portfolio across a variety of asset classes globally.
  • Except for minor rebalancing, leave the portfolio core allocation range alone for a period of a decade or more.
  • After retirement, only withdraw from the portfolio each year the amount you need to live off of.

With this approach, your return will be greater than leaving it in the bank.

Let's see how this approach would have fared during the worst possible time to be investing the last century.

Let's say a client began investing $1,000 each year into a diversified global portfolio when she was 45 years old -- once she had enough to invest -- and continued to invest about the same amount each year until she retired at 65. Now let's assume that she started investing in 1910, and was ready to retire in 1930.

The chart below shows what would have happened if, at 65, she retired fully invested -- at what was perhaps the most unlucky time to retire during in the 20th century -- but remained disciplined and only withdrew a steady $2,000 per year for living expenses.

Notice that it didn't matter if she had the worst luck of all and was fully invested at the beginning of the Great Depression. She still came out ahead and, even if she lived for 30 more years, never exhausted her nest egg. She simply didn't buy or sell too much at either the wrong or the right time.

In the final analysis, it is time and diversification that absorb the risk.

PRESSURE ON ADVISORS

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