What is your definition of superior money management? How many definitions do you think are out there? How many do you think you really need? Now the tough question: What is your client's definition of superior money management? How many have you asked? How many clients had the same definition as you?
Client expectations can best be managed when their definition of superior money management and your definition match, would you agree? Well, the only way you can achieve that with every client is through taking the time to properly explain your definition and show them how you will measure your results. You can only be sure they have got it when they can explain it back to you so be sure to ask. There are ways to set client expectations, construct a core/satellite portfolio to improve portfolio efficiency, and conduct a quick and easy portfolio review.
First, let's discuss setting client expectations. I recently had a conversation with an advisor who said that a particular prospect told him that his idea of superior money management was a risk-free return of 35%. Can you imagine the results if the advisor never knew what this prospect's expectations were and took him on as a client? The first rule of setting expectations is to ask what the client expects regarding their investments. Have the client (or couple) write the answer down before they verbally reply so you can get the answers from each person without one influencing the other.
Second, you need to share your definition. Use a compliance-approved report that you can show them graphically, such as the Morningstar Snapshot. Just focusing on performance and returns only provides half the picture. Risk-adjusted performance is easily understood using a scatterplot chart. Educate the client on how to interpret the chart, including how risk increases as you move from left to right and return increases as you move from the bottom to the top. You want the portfolio moving up to Alaska in the upper left hand quadrant, not down to Florida in the lower right hand quadrant.
Third, help the client understand where the benchmark (typically the S&P 500) is on the scatterplot chart. Then show them where their portfolio is on the chart and simply ask them what their opinion is of how they are positioned. Ideally, you want the client's portfolio to have a higher Sharpe ratio (a measure of risk-adjusted return) than the benchmark. You can use both the scatterplot chart for the client and the Sharpe ratio for yourself. This takes the focus off simply performance and places it on risk-adjusted performance. By the way, if you don't have written risk tolerance assessments for your clients on file, you need to start getting them as soon as possible, to determine if the portfolio is suitable for the client.
So, how do you improve the efficiency of the portfolio using core/satellite investing? I like 80% of a portfolio in core holdings which are typically mutual funds, separately managed accounts, exchange-traded funds, closed-end funds or unit investment trusts. The secret to selecting mutual funds is to select funds from the families that provide you the best wholesaling support. You can predict the performance of a top notch wholesaling team a lot easier than you can predict the future performance of a mutual fund.
Next, ask: Which has higher risk as measured by standard deviation, an all fund portfolio or a portfolio of 80% funds and 20% individual stocks? Well, if you want the answer simply take four to 15 of your firms stock analysts highly rated stocks and integrate them with the funds you selected so you have an 80/20 mix and you tell me the results in a scatterplot comparison (hint, which has more correlation a fund and another fund or a fund and a stock?) Take a look at where the portfolio has moved on the scatterplot chart. What happened to the risk? The return? The Sharpe ratio?
Now for the ultimate test; which portfolio would you put your money into? Is this more work? Yes. Will you need to review your pricing model? Can you offer both core and core/satellite styles of investing to clients at two different types of pricing? These are questions only you can answer. But, I have a white paper available by email request. I also recommend the book, Investment Survival: How to Use Investment Research to Create Winning Portfolios by Rod Hagenbuch and Richard Capalbo.
Finally, let's integrate your hard work into a great client meeting. First, set the client expectations as discussed and make sure the client understands the scatterplot chart. Update the client's risk profile if needed then review the compliance-approved report followed by the scatterplot chart. Ask the client: "What's your opinion of the portfolio?" Listen to the reply then review the alternate hypothetical report you prepared in advance-the one that includes your proposed changes. Again ask: "What is your opinion of this portfolio?" Review the changes you hypothetically made to make it more efficient, particularly if you added any satellite holdings. If the client's opinion is favorable, discuss next steps along with any pricing/fee considerations and ask what they would like to do.
Todd Colbeck is principal and founder of the Colbeck Coaching Group,
a subsidiary of General Business Center, Inc. You can reach him at this email address.