First, a brief disclaimer: Nothing in this article is intended to be politically motivated. OK, with that out of the way, let’s talk about a most critical issue in our industry that is easily forgotten in today’s madcap, have-it-now, sensationalized world: investment evaluation horizon.
On Nov. 6, people will either vote for a guy who wants a second term, or replace him with a guy who seeks his first term. One of the key aspects that voters are considering right now is whether the past four years are enough of a sample size. This is no different than any election anywhere in which an incumbent is running against a challenger. See: In this election season, cast your vote for president in private — not in your firm’s newsletter.
But what about you and your work for your clients — particularly when it comes to the investment plan you chose for them? How much time gives them a good indication of whether the strategy is working, or should be tweaked or replaced? You talk to clients ad nauseam about time horizon, and when they can expect to use the money they have entrusted to you. You plan around that for them, and run projections of how long the money will last if it earns a specific return.
What number is 'just right’?
But you know what we don’t do enough? Find out how long they think they should wait before they truly judge the effectiveness of the strategy. And, if they are thinking about replacing the strategy, are they also thinking about replacing you? This sounds like a very simple yes or no decision to the client, but it is far from it. As you know, there are so many factors that go into whether an investment program is successful over any period of time. And while you might be tempted to say that it is as simple as whether the client is beating the market or making money, I think that that s perhaps the single biggest fallacy in our industry’s ongoing conversations with the investing public. See: How 5 seriously overworked buzzwords can come between you and your client.
My conclusion: Three years is the Goldilocks of investment evaluation horizons. Anything shorter is, well, shortsighted, unless the investment strategy is designed to flip stocks every week. Do you leave a football game at halftime if your team is down 10-3? I’d think not. See: 5 counterintuitive reasons why the investment vehicle of the the decade is … stocks.
Here are five aspects of the “investment evaluation horizon” issue I suggest using in your practice starting right now, if you don’t already use it:
1. Set expectations before the money is put to work.
At our firm we designed our own risk tolerance questionnaire. We felt we had to, since the industry often uses a very weak set of questions in the name of simply satisfying the regulatory requirement to define a client’s risk tolerance. “CYA” is not what RIAs do, so we decided to think very hard about scenarios clients could reasonably expect, while teaching them about the basics of the reward/risk trade-off along the way. See: First, own all the risk.
The result: We feel we have a true understanding of what will please them and irk them along the way. With that work behind us early in the relationship, we can focus on managing the portfolios the way we claim to, without fear that clients will exert irrational pressures on us because of shortcuts we took at the start of the relationship. See: The 4 biggest investment performance myths — and how they can torpedo advisor-client trust.
2. It’s not about risk — it’s about volatility.
We use the word risk a lot in our business, and clients habitually adopt it as well. But I think risk is more of an Armageddon concept — not having the money you need when you need it. This can occur because you suffered a huge decline in value, because your investments were not sufficiently liquid or because you did not plan effectively for key goals. It can also occur because you gave in to your client’s overreactions to market shocks or threatening economic and geopolitical risks, because you exposed them to too much volatility in the first place. I firmly believe that what freaks out investors is a combination of intermediate-term market volatility combined with a lack of sufficient planning — yours or theirs — to combat it. See: Why the Yale endowment model has potentially calamitous pitfalls according to … Yale itself.
3. Invest with a mindset of “volatility management,” not “asset allocationThat is why the RTQ process we created at our firm is focused intently on defining a client’s acceptable long-term level of volatility and establishing some “comfort zones” around that long-term target, within which we can allow the portfolio to fluctuate.
4. Benchmark their portfolio to something meaningful, and explain it to them in their language, not Wall Street’s.
One way to lose clients is to mis-benchmark them. They may come to you thinking that the S&P 500 should be their benchmark. In reality, very few retirees and baby boomers are up for that level of volatility. The amazing thing to me is how many of them simply accept it as the cost of doing business with the financial markets. I get the impression that for every investor that is hyperfocused on avoiding all risk in the wake of the financial crisis of a few years ago, there is another that assumes that the only way to increase assets is to ride out the full impact of ups and downs. See: 6 reasons why RIAS can’t — or don’t want to — have track records.
Perhaps 20 years ago this was the case, but we have a lot of tools at our disposal now, and if they are used properly, you can target nearly any level of volatility you wish to deliver to a client. Help them to understand this. The way I do it is by benchmarking all of our strategies to a combination of the Russell 1000 Index and the three-month U.S. Treasury bill. Since such bills yield about zip these days, we are effectively saying “this is how much of the market’s ups and downs we want to compare ourselves with.” Make your client understand that it is not an all-or-nothing game, and that they don’t have to resort to stuffing money in bubbly bond funds as so many have, and you just may find that you are their hero in a few years. See: Five scary investment scenarios.
5. It is not “no pain, no gain” — but there’s gonna be some pain.
As readers of my columns in RIABiz know, I think that the new definition of “balanced” portfolio is not stocks and bonds, it’s long and short. Focusing on a “net long” exposure is something that was the exclusive property of hedge fund managers for decades. You don’t need a hedge fund to run what is effectively a long-short portfolio today. But it is not a panacea. Even if you experienced 25% of the S&P’s drop in 2008, you were still down over 9% that year. Prep your clients for that as part of the method of flushing out their true tolerance for volatility in your RTQ process.
Finely aged advice
While I know very little about wine, I do know the basics: it is available in many varieties, it has a language all its own, and it is best judged after it has aged. The investment management business can go head to head with any vineyard in that respect. There are many ways to deliver what clients want, and you can spare them the lingo, but only if you understand some vital concepts (such as those discussed in this article). Most importantly, if you focus on “aging” the client’s results three years at a time, and keep them focused on the importance of letting the strategy work for them, you and they will have a very peaceful existence, even in the face of raucous market conditions.
Take a good look at your approach to the concept of client expectations. If you don’t realize that this part of the business has changed dramatically over the past ten years, I fear you are way behind and need to catch up quickly.
Rob Isbitts, a 26-year industry veteran, is the founder and chief investment strategist of www.sungardeninvestment.com (firstname.lastname@example.org). He publishes “Investment Climate Weekly,” a new private-label newsletter that helps financial advisors deliver insightful communication to their clients each week. Sungarden provides outsourced investment strategy, research, portfolio management and communication assistance to financial advisors. Rob has written two investment books, created several portfolio strategies, and is a former chief investment officer and mutual fund manager. He offers advisory services through Dynamic Wealth Advisors and can be reached at email@example.com.