The 4 biggest investment performance myths -- and how they can torpedo advisor-client trust

In 26 years in the investment industry, I have seen investor and advisor behavior from many different angles: as an advisor, portfolio manager, strategist, author and proprietor. Two things have been quite consistent during that quarter-century: 1) That clients and advisors both care deeply about investment performance and 2) that investment performance is rarely evaluated with proper perspective.

The latter point, for the most part, this is unintentional; it’s the collateral damage of world that increasingly moves too fast for many people to really think carefully about understanding the data and charts in front of their eyes. Instead, we are addicted to sound bites from the media, and the sizzle of investing overwhelms the steak.

In an attempt to deliver some of that missing perspective about investment performance, here is my list of what advisors must help their clients understand about performance — historical lessons, how it is generated, and how it can easily be misinterpreted by both client and advisor. I will also recommend how to achieve some of that perspective I noted above, so that both advisor and client can close communication gaps, which are bound to occur when they are evaluating how a portfolio has performed.

1. The historical returns of 'high quality’ bond

Past performance guarantees one thing: that you cannot have that past performance.

Why not? Because it’s in the past! I write this knowing that no matter what I or anyone else says, the concept of extrapolating past returns on an investment into the future, assuming that what did well over some standardized past period (e.g., year-to-date, one year, five years, 10 years, etc.) will persist.

Nowhere is this fallacy more severe than in the evaluation of “balanced portfolios” that mix stocks and high-quality bonds (though since the 2007-2008 credit crisis, the latter has become an oxymoron). See: Winter winds hitting bond investors, China takes a pass, alternatives posted strong gains: Morningstar data.

The simple fact is that any portfolio strategy that includes a noticeable position in Treasury bonds, municipal bonds, or investment-grade corporate bonds has been “juiced” by aggressive Federal Reserve interest rate policy, which took an era of falling interest rates and extended it in what amounts to a leveraged fashion.

Why does this distort past performance? Because while the past returns are actual profits generated by high-quality bond investing, projecting anything close to those same returns going forward is somewhere between a stretch and damn impossible. See: Five steps to get your clients out of bonds and into alternative, low-volatility investments.

Do the math: how much return can one expect when you start from 10-year U.S Treasuries yielding 1.70%, or 30-year munis yielding about double that? Sure, we could see a near-zero interest rate policy for a very long time, which would make the Japanese financial system a thought leader for once (since they have survived this way for three decades). See: How capture ratios can help you prepare for the next downturn.

But even so, the likelihood of high-quality bond asset classes representing themselves in the future as they have in the past is analogous to that old line from the Old West: The chances are slim and none…and “Slim” just left town. See: Why smart diversification and risk management are your best friends.

2. MPT and the 'classic’ asset allocation approach is tired and overrated

Past returns are not very reliable predictors of future returns … but volatility often is. To use a broad example, emerging-markets stock indexes tend to be more volatile than stocks of consumer staples companies. There is strong economic rationale for this. It’s the old paradigm of expanding-but-unpredictable economic segments versus more-established, more-predictable ones.

Ever since Wall Street marketing executives grabbed hold of Harry Markowitz’ 1952 article on “portfolio selection” in the Journal of Finance, and the ubiquitous 1980 “Brinson Study” on the importance of asset allocation, conventional wisdom has been hard to shake.

Modern Portfolio Theory and the beliefs about what produces a solid balance of reward and risk have been largely accepted as “the answer” by advisors. This has spawned an ever-expanding universe of balanced portfolios, multi-asset class products, lifestyle and target date funds, and more. I think this is the latest incarnation of Wall Street’s pattern of taking a reasonable concept, making it the in thing to do and producing — what else? — products to buy! See: Why the Yale endowment model may still be fundamentally flawed.

In my most recent discussions with investors and the financial advisors I consult with, I get the feeling that the product overdose phase of this issue is finally being recognized and remorse about how this conventional wisdom about asset allocation as the dominant driver of performance is slowly but surely gaining traction. See: Why diversification is still the go-to risk killer.

The easiest way to illustrate examples of Nos. 1 and 2 above is to chart returns of the Dow Jones Relative Risk Indexes (DJRRI). These are a set of five stock-bond blends, which Dow Jones characterizes as follows:

• Conservative
• Moderately Conservative
• Moderate
• Moderately Aggressive
• Aggressive

Dow Jones maintains a set of U.S. and Global RRIs. and if you have one of the Morningstar Inc. database products or a competitor’s product, you can find these and run the graphs yourself. Or, let me know and I will send you the brief slide set I use to demonstrate just how wacky the 15-year period through May 31 was, and what conclusions we can draw from it.

Here is what I found by analyzing various past periods of DJRRI return and standard deviation, the classic representation of risk and reward to most advisors and clients:

• Over the past 15 years, they are all about the same. That is, regardless of how high your standard deviation was, your total return of the stock-bond mix was the same.

• Over the past 10 years? Also about the same, across all five indexes

• Over the past five years, the Conservative Index performed the best (highest performance and lowest standard deviation), and the Aggressive index performed the worst (lowest performance, highest standard deviation). The other three indexes fell in line between them, but in reverse of the expected order. That is, the risk-reward tradeoff was opposite of what MPT followers would predict. As you get more aggressive, you are supposed to earn more return over a period that long. Instead, the more “risk” you took, the worse you did over the five years.

• Over the past three years, the relationship is normal. Conservative allocations of stocks and bonds had the lowest standard deviation but also the lowest returns. The more aggressive you allocated, the more return you generated. This is a byproduct of the start of the measurement period, which occurred shortly after the stock market’s bottom in early 2009.

I conclude that MPT is not invalid … but it is very overrated. As the brilliant Ed Easterling of Crestmont Research notes, “MPT should come with a warning label.” His concern is that the assumptions of return and risk that one uses in MPT analysis, which are supplied by the creator of the analysis, are both critical and potentially inaccurate. If they turn out to be the latter, the carefully crafted “optimal portfolio” and the rest of the risk-return tradeoffs one might aim for are bound to be way off. See: How the Harvard and Yale endowment models changed to avoid a repeat of 2009.

Now, since we can’t predict the future, the best we can do is to be extremely cautious about what assumptions we put into the projection. If you go by the past 10, 15, 20, 25 or 30 years, my guess is that your forward-looking analysis will assume that bond prices will surge, money funds will yield 3% to 4% and stocks of all types will exhibit “normal” levels of consistency in their returns, and allow you to bag that upper single-digit to low double-digit return … just like in the good old days of the 1980s and 1990s.

As I written many times in the past, this is NOT the 1980s or 1990s. See: The 10 most likely contributors to the next market panic, if you simply take what is given in your portfolio optimizer, and continue to believe it is all about allocating to 15 different asset classes, you had better catch up, quickly. As markets and client concerns and emotions evolve, we must evolve with them, particularly in what we consider to be high-risk or lower-risk investments. As I noted above, there are patterns that persist, but I feel strongly that the standard MPT/Brinson study approach is not one of them. This is so critical at a time when baby boomers are realizing that despite the greatest stock and bond market boom in history ('80s-'90s), all many of them are left with today is a collective multitrillion-dollar shortfall in what they need to retire.

3. The key to risk-reward balance is volatility management … and that starts with beta management

I have found that the simplest way to explain what we are trying to do in managing a client’s money is to follow this process:

• Ask straightforward questions about what really makes them happy/not happy as an investor.

• Capture their responses in a format such that the results can be quantified.

• Put those results on a volatility comfort scale, but one that jibes with what volatility is really about — beta, not standard deviation.

• Show them what beta means (in English, not Wall Street lingo) and how it affects what their expected return would be in varying market conditions. This is a “stress-test” for them, with the advisor playing doctor.

• Bring manager skill into the equation by explaining alpha ... again, in English. Then show how alpha, whether positive or negative, can impact the return in various market conditions. This is a lot like the old “slope-intercept” thing we learned in math class a long time ago, but without the big textbook. The advisor is now transformed into both a doctor and a teacher. That can only help increase credibility with the client, as the client starts to understand the basic elements of what produces that return printed on his or her account statement. See: 10 advisors explain how they build sales without getting 'salesy’.

• Bring it all home by showing how Alpha and Beta produce a projected Capture Ratio, which forecasts how much the investor may expect to participate in the up and down swings in the market. This is what they really want you to project, not a dazzling pie chart that looks diversified until the next geopolitical crisis drives correlations among asset classes up and portfolio values down. Oh yes, you can bank on bonds bailing you out again. But if you agree with anything I said above, you recognize that doing so is the advisor’s version of Russian roulette. See: Six things to know about the winners and losers in November’s market.

How do you effectively seek to target beta and manage within each client’s expressed comfort level? That’s up to you. To me, it takes a combination of stocks, hedged investments (inverse ETFs, some alternative-strategy funds, the willingness to temporarily raise some cash, and, if you have the desire, put options). This article is primarily about how to approach and understand performance, not how to generate it, but contact me if the latter is a discussion you are interested in having. In a future column, I may go there. See: The top 10 alternatives to alternative investments.

4. Choose your evaluation period and benchmarks wisely

I love Morningstar, but in the last 25 years, it has monopolized the market for performance time periods. Returns “to date” and over trailing periods are certainly helpful, but they are like dipping your hand into a big bowl of blueberries, choosing one and evaluating the entire bowl based on how that tastes.

Periods like “past 1 year” are literally moments in time. And just as an advisor or client will not want to be judged by the other based on a single word they uttered in a long planning discussion, neither do you want to take something as important as performance generation and measurement and turn it into just another sound bite. Let CNBC play that game with traders. You are working with investors. There’s a difference.

To the greatest extent possible, incorporate “rolling returns” in the analysis, to supplement the standard to-date and trailing returns. This allows for several time periods to be evaluated, almost like the Monte Carlo simulations the MPT crowd feasts on … but with real live performance about a client’s portfolio or an investment strategy or model.

After all, history is littered with examples of how, by simply shifting the evaluation period by a few months, you get an entirely different picture of what performance has been generated. For instance, you might look at a one-year return from January to January of your favorite investment strategy or product, but if you looked at April to April instead, the result could be very different.

Again, you can run this in Morningstar or similar databases, or ask me to supply you with an example or two. This, along with the DJRRI charts I discussed earlier, makes for great client presentations because they represent a sort of optical illusion to the audience. Except that it’s real, and not an illusion. It’s just a way to expand their minds and present yourself as a more informed and, dare I say, progressive, member of our industry.

The last thing you want to do is to be found “guilty” of poor performance because you only presented a very scant amount of evidence to the client. Hey, I guess in addition to a doctor and teacher, now I have made you a lawyer too!

Three’s a charm

Put the greatest weighing in your evaluation over periods of three years. Very long periods of time are OK, but they can hide a lot of risk that clients will not stand for. That was the big pitch in the 1990s — “stocks for the long run” and all that. I like the idea of using both the long and short sides of the stock market, the latter as a volatility reducer, but the buy-and-hold, long-only concept is something investors are running from in droves following the last (and lost) decade in stocks. A three-year-rolling-return analysis of an investment or investment strategy provides much more insight than a single three-year time frame, or any single or small groups of time frames.

• Stop obsessing over the short term, except for one thing: be diligent about avoiding “the big loss” which is defined differently by each client. This can be evaluated through the more progressive approach to risk tolerance testing I described earlier.

•Don’t ignore short-term performance, but look to get out of it what really valuable — what beta is your portfolio running? To turn the beta discussion from earlier in this article into action, analyze your beta frequently If its higher than the client will find comfortable, its probably time to adjust it by selling or buying something. If you know the expected beta of every security you own, this is a lot easier to assess at the portfolio level.

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Wall Street is loaded with mythology, which is created by ideas’ getting so deep into the mainstream that people stop questioning their validity and usefulness. Our job as financial advisors and investment managers is to make sure we always have our eyes open for different paths to take for the benefit of our clients and how to address what concerns them most: How to preserve and build on what they have, while minimizing the potential for big losses along the way.

Rob Isbitts is the founder and chief investment strategist of Sungarden Investment Research, and offers advisory services through Dynamic Wealth Advisors. Rob is a 25-year investment industry veteran, author of two investment books, creator of several portfolio strategies, and former chief investment officer and mutual fund manager. He currently advises a limited number of high-net-worth private clients and provides outsourced investment strategy and research services to financial advisors from South Florida. Rob can be reached at risbitts@dynamicwealthadvisors.com.