I wrote this a few years ago with my fellow financial professionals as the intended audience. I thought it would make a good post here as well.
I was thinking about what goes into quality wealth management. The goal, in our view, is to use wealth management to maximize long-run client happiness in the face of an uncertain future.
I think there are three inputs into the process:
- Quantitative and Qualitative Data – you have to know the facts about the client, about the tax code, about capital market return history and drivers, etc. You also need to know the “soft stuff” about the client to maximize their happiness.
- Analytical Ability – you have to be able to “do the math” to calculate whether or not a mortgage should be paid off, an IRA converted to a Roth, how Social Security or a pension should be claimed, etc.
- Wisdom – exposition below.
The first two items I think are (or should be!) just “table stakes” – they aren’t a differential advantage, a unique selling proposition, or whatever you want to call it. But I think wisdom is what separates the high quality advisor from the typical one. The Socratic paradox is the statement (based on Socrates, but not a direct quote), “I know that I know nothing.” Supposedly this made him the wisest man in Athens. Another great observation (attributed to many sources, but probably from Josh Billings originally) is, “It ain’t what you don’t know that gets you into trouble, it is what you know for sure just ain’t so.”
The problem is acknowledging our ignorance doesn’t make clients very comfortable – it might even prevent us from having any. Imagine if we re-branded Financial Architects like this:
Financial Architects, LLC
“Embracing ignorance since 2005”
But we are ignorant, particularly in our predictions of the future, whether that is the tax code, the yield curve, investment returns, etc. As the Danish proverb (not Yogi Berra!) says, “It is difficult to make predictions, especially about the future.” So, in light of our ignorance, here are a few things that I think are prudent:
- Spend lots of time trying to become wiser by reading, writing, and thinking. See here for example. Schedule time for thinking, or, even better, empty your schedule like Charlie Munger and Warren Buffett. Bill Gates, and others, take “think weeks.” Leonardo da Vinci observed, “Men of lofty genius, when they are doing the least work, are most active.” I don’t know if any of us would qualify as “men of lofty genius” but I think having free time (like I do today so I can think about this and write this) is important.
- Recognize that the best predictor of the future is frequently the present. The current yield curve is the best estimate of the future yield curve, the current tax code is probably the best estimate of the future one. I would be cautious about assuming reversion to some “normal” level of interest rates, equity risk premiums, PE ratios, profit margins, etc. – particularly over a short period of time. The exception to this would be if differences are profound, but even then, it is problematic. In 1995 the dividend yield of the market got lower than it had ever been in history, but it turned out to be much better to buy than to sell. In the spring of 2009, the earnings yield (the inverse of the PE) was also lower than it had ever been (due to minuscule earnings) just before the market soared.
- Given the paucity of information, frequently the best we can do is equal-weight. Sometimes this is called the 1/n strategy. At best it looks unsophisticated, at worst, ignorant. But it is empirically grounded. If your asset allocation models have decimal points, I would (politely) suggest you are over-fitting your data. If you have more than half-dozen or so allocations in your model you have probably sliced your asset classes too finely (you may have two or three holdings in each class, but you probably shouldn’t have all that many top-level classes).
- Be very slow to make tactical changes to a portfolio. We rarely know as much as we think we do, and we certainly will almost always know less than the collective wisdom of all market participants. It is very hard to do nothing, but doing nothing is frequently the optimal move. As Warren Buffett has said, “Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell.” He also stated, “Lethargy, bordering on sloth, should remain the cornerstone of an investment style.”
Our goal (perhaps a New Year’s resolution) should be to end every day slightly less ignorant than the day before while remaining humbly aware of our remaining ignorance.