I have posted on How to Evaluate an Investment Advisor but thought it was worth another, somewhat different take on it focused more on recent investment performance.

There are many things that we do that we believe will add value to the portfolio performance over time, but the big two are:

• Broad diversification across a variety of asset classes.
• Factor tilts (particularly to value) that have outperformed over time (and seem likely to going forward).

Lately both of those have underperformed just holding large U.S. stocks.  Our challenge as investment professionals is to keep everyone on track through this period of underperformance – and it’s not just us, all of my peers that I consider competent are in exactly the same position.  My guess is that we will lose some clients in the short run that will come back to us in the long run after their performance suffers from doing what has worked lately.  (Investing by looking in the rearview mirror is generally a mistake.)

Coincidentally, Anitha had lunch recently with an advisor that works with very high net worth clients (just under $20 million in average assets per family).  Because of this periodic underperformance problem they (quite understandably) don’t tilt to value, even though they think that is best long-term, because it is so hard to explain even to their sophisticated clients.  Arguably, if clients don’t stay clients, and they chase performance (buying high) somewhere else you haven’t really helped them.  (The advisor intends to refer us “smaller” clients because she likes our approach, and Anitha.)  It’s a marketing and sales problem for us, but since we tend to have more sophisticated clients (not necessarily in net worth, but in knowledge of investing principles) I come down on the side of doing the long-term right thing even though it will periodically make our clients feel worse – and potentially cost us a few who don’t understand – in the short run.

So, if you can’t rely on recent performance to know whether the advisor is doing a good job, what can you do?  I suggest asking two questions:

1) Is the advisor competent?  In other words, do they seem to have:

• A high enough IQ to do the job.  They don’t have to be geniuses necessarily, but smarter than average is good.
• Sufficient knowledge in their field.  Someone can be smart but know nothing about investments or financial planning, so this is where you should look for credentials like CFP, CFA, etc.
• The right temperament.  Many (most?) advisors who have the above two items can’t stick with a well-thought-out investment strategy through the inevitable periods of underperformance.  (William Bernstein made a similar point in one of his books a few years ago, as did Larry Swedroe recently in an article.)

2) Is the advisor trying to do a good job?  In other words, do they:

• Have a business model as unconflicted as possible.  If there are no incentives to do the wrong thing (sell expensive products for high commissions for example) that is obviously good.
• Eat their own cooking.  Advisors who have their personal portfolios invested like their clients seem likely to be trying to do the very best they can.
• Seem like they aren’t lazy.  Very occasionally an advisor will do a sub-optimal job out of simple slothfulness because they just ignore their clients and the portfolios.  I don’t mean hyperactive trading is good, but paying attention to things like tax loss harvesting and rebalancing is important.

So, to recap, if the advisor has every reason to do the best job they can (not lazy, not conflicted, invest personally just like their clients) and are competent (knowledgeable and smart, with the right temperament for investing) – that is a good advisor, regardless of short-term performance.

Many people, familiar with the widely-accepted notion that risk and return go together, are unaware that this formulation is both incomplete and misleading. Let me restate it thus: “Return equals risk which doesn’t equal return.” Obviously, an explanation is in order.

Return equals risk. Almost certainly, someone earning very high returns has run very high risks to do so, though it may not be obvious in hindsight. Indeed, many people who become phenomenally wealthy, not just well-off, took incredible risks and happened to get lucky. Countless others took similar risks that didn’t work out. This second group is more representative of what will likely happen, but the first group is featured more in the media. In other words, we hear much more about lottery winners and dot com millionaires than we do about people who consistently saved and invested over long periods of time or even about people who lost everything attempting to win big. The savers, however, are much more likely to become financially independent than those who took outsized risks. The fact remains though: to earn higher returns, you must accept more risk.

Risk doesn’t equal return. We need to differentiate between “good” risks and “bad” risks. In the financial field, these are known as systematic and unsystematic risks. Systematic risks are “good” – they have higher expected returns and are prudent. Unsystematic risks are “bad” – they have lower expected returns than indicated by the level of risk, and they are imprudent. An example of a systematic risk would be investing in a diversified portfolio of stocks rather than keeping all of your money in CDs. An unsystematic risk would be purchasing one stock instead of the entire portfolio. The expected return increases when purchasing stocks instead of keeping money in CDs. In other words, on average you will do better with the stocks.

Conversely, purchasing one stock instead of the portfolio has much higher risk, but the expected return is the same. Similarly, most gambling is not prudent because, while the risk of loss is high, the expected level of return is actually negative! The average return on lottery tickets is about 50 cents per dollar spent and the return in casinos is about 85 cents on the dollar (varying widely depending on the game). In other words, every time you spend a dollar playing the lottery you lose, on average, 50 cents. To recap, you generally can’t get higher returns without higher risk, but you absolutely can get high risk without higher returns. Here is the Venn diagram:

Gambling vs. Investing vs. Insurance. Many people mistakenly think there is no difference between gambling and investing or gambling and insurance. It is true there are some similarities in that they all are associated with chance occurrences, but there are significant differences as well. These “products” will impact a financial plan in three aspects. People generally prefer: higher returns, lower risks, and a higher probability of meeting lifetime financial goals. Using these products as they are designed to be used, we get these results:

Activity	Return	Risk	Source of Risk	Increased Financial Success
Insurance	Lower	Lower	Inherent in Life	Yes
Investments	Higher	Higher	Inherent in Business	Yes
Gambling	Lower	Higher	Artificially Created	No

 

 

As you can see, none of the products give us positive effects in all areas. In other words, as we have been stressing, you can’t get higher returns and lower risks simultaneously. Note, though, insurance can reduce certain risks and thus help achieve financial success; investments can increase expected returns and also help achieve financial success. Gambling has no such redeeming characteristics. Further, investments and insurance merely redistribute existing risk to those willing and able to bear it (for a price), gambling involves creating risk where none existed before the wager was made.

How Much? There is actually a process to determine what level of risk and return is appropriate for a particular situation. Financial plans should be designed to yield the highest level of happiness possible across all possible future scenarios. Taking prudent risks that raise the probability of reaching financial goals is generally appropriate, and taking actions that decrease the probability of financial success is unwise.

I have observed over the years that many people have serious financial issues seemingly impervious to “financial planning.” They appear to go through life from one financial crisis to another, repeatedly putting “unexpected” expenses on credit cards, not saving for retirement, and generally living from paycheck to paycheck. We are fortunate that our clients do not tend to be afflicted with these issues, and I don’t believe many of our readers have these problems. The problems, however, do seem to burden most of society and to be largely unrelated to income level, educational level, etc. This is my attempt to explain what I believe the root problem to be.

One fundamental difference between children and adults (or the immature and the mature) is their time horizon. A small child has little regard for the future. He or she doesn’t think through the long-term consequences of their actions. If you offer them one piece of candy now or two later, they will take one piece now. As they get older and if the consequences are severe enough and immediate enough, children begin to make wiser choices (whether the consequence is firm parental discipline or natural effects). In the teen years, one young person might decide to drop out of high school for immediate income from working while another might choose to study hard to get into a good college. The second teen is more mature than the first. She grasps (possibly with some parental nudging) that giving up minimum wage work to study and go to college might cause her to have less money and enjoyment in the short run but will lead to vastly superior opportunities in the long run.

Now consider the typical “man on the street.” Today he generally feels that 1) he is not financially secure and 2) having more money would solve the problem. While I accept the first premise, I reject the second. I believe he misunderstands his situation. First, let us define financial success. At a very basic level, financial success is having more than you need. In other words, there are three potential ways to achieve financial success: 1) have more, 2) need less, or 3) both. Unfortunately, no matter how much people have, their needs tend to increase proportionately. As Parkinson’s Law states: “Expenses rise to meet income.” Because of this, most people never make enough money to fix their financial issues. I would submit this is true not due to a lack of money, but rather due to financial immaturity – a childish need for immediate gratification at the expense of future comfort or goals.

To give just one example, most people, regardless of income level, have not saved adequately for retirement. Most people know they aren’t saving (or haven’t saved) enough for retirement. However, they do not tend to take responsibility for their decisions. Everyone makes choices, and people will have different priorities for how they choose to use the resources they have been given. Make no mistake – it is a choice. Yet, people act as though they are passive observers of their own lives, and somehow the universe has conspired against them. They complain, “I can’t save any money,” or “I can’t get ahead.” In my humble opinion, people should simply stop saying “can’t.” It is extremely rare that we “can’t” do something. The vast majority of the time we simply choose not to. Why don’t people take control of their lives and say so? It is absolutely not true that people “can’t” save money, rather they simply choose not to. People can’t afford to retire now because they chose not to plan for retirement previously. They had other priorities. (And they typically try to compensate for not having saved enough by achieving unrealistic returns on their investments.) I realize people would argue vehemently this is not true, that they had no choice. The following observations clearly reveal it is a choice; the problem is not a lack of resources, regardless of the income level.

From a historical perspective, everyone reading this lives in unbelievable opulence, with comforts unheard of just a few short years ago. For example, it wasn’t that long ago that most households had only one vehicle, only the wealthy had a two-car garage, and people rarely went out to eat. Children didn’t have their own rooms; people hung wash out to dry because they didn’t own dryers (and often washers), and few people had ever been on an airplane. In 1973, the average home was 1,660 square feet. In 2008, 35 years later, the size of the average home had increased over 50% to 2,519 square feet – despite an overall decline in family size. None of these things are inherently bad, and I certainly welcome the changes, but I wish to point out that, from a historical perspective, we have no shortage of resources; we have just spent them on things considered luxuries by previous generations. Go back just 100 years ago, and we would have made do without indoor plumbing, automobiles, TV, radio, computers, air conditioning, etc. Even in our time, from a global perspective there is no question we are unbelievably prosperous. Our middle class would be considered wealthy in most of the world today.

In spite of this unprecedented wealth, most people think their financial problems would be solved if they had just a little more money. The person making $20,000 a year could really get ahead with just $25,000; the person making $70,000 would be set with only $80,000; and, of course, the person making $200,000 needs $250,000. Obviously, the ability to save (i.e. have more than you need) is mostly unrelated to the income side of the equation. Rather, the issue is attitudinal – a surrender to the desire to have more now rather than in the future. Studies have shown most lottery winners, for example, spend virtually all of their winnings within five years, and approximately one third end up in bankruptcy.

We often tell young people that financial success is conceptually simple but operationally difficult.   Consume less than you produce. Or, put another way, spend less than you make. But to do that successfully seems to require a level of maturity and long-term thinking that is in short supply today.

We would probably do well to remember that while we are trying to keep up with the Jones’s, the Jones’s are broke from spending to keep up with the Smiths. As Robert Quillen noted in 1928, “Americanism” is using money you haven’t earned, to buy things you don’t need, to impress people you don’t like.

We don’t sell insurance, but we do work with insurance professionals to ensure that risks of all types are adequately addressed for our clients. We have found that many people use insurance improperly, and some financial professionals recommend it inappropriately. It is important to understand that on average (a very important caveat) absent government interference through tax policy or some other market distortion, purchasers of insurance will be worse off than they would be without the insurance. Individuals may be better off, but as a group, all customers will have less money than they would without insurance (assuming, of course, that they prudently use their premiums saved). This must be so, or the insurance companies would not be profitable. In other words, to the extent insurance companies have profits, administrative costs, and other overhead, etc., it is a net loss across all their customers. Indeed, insurance companies cannot pay out more in claims than they receive in premiums, or in the long run, they would go bankrupt. However, this does not imply that insurance is not needed. It is vitally important but must be used judiciously and appropriately to reduce risk.

Risks may be categorized two ways: by their severity and by their frequency. To simplify, we could think of four combinations of these two factors:

• For risks that have high severity and high frequency, absent government distortions in the market, no insurance will be available. You should try to reduce or avoid these risks. Take, for example, drivers who have accidents every month or homes that flood annually. Those homes should not be rebuilt, and obviously, those people shouldn’t be driving.

• For risks that have low severity and low frequency, you simply accept them. For example, I have carried the same pen for many years. Losing it would obviously not be catastrophic to my financial situation, and since I have had it so long, I must not be prone to losing pens. These types of risks should simply be accepted. They rarely happen, and when they do, it is of no great consequence.

• Some risks have low severity and high frequency. For example, suppose I were prone to losing pens. The solution here would be to reduce the risk. I might start carrying cheap plastic pens, or the branch manager of a bank might decide to chain the pens to the table.

• The fourth category of risks, high severity and low frequency, is the one for which insurance is the appropriate answer. The odds of you having a serious auto accident, dying in the prime of life, or having your home burn down are small, but if one of those events should occur it could be catastrophic to your family. For these risks, insurance is vitally important.

In short, if you can easily afford a risk, you should not insure it. But, if you can’t easily afford it, and the chance of it occurring is low, insurance is frequently the correct solution.

The investment process can be a very complex topic, but I will cover it here in abbreviated form. The main steps are as follows:

1. Determine your Goals and the Available Resources. The first step is to determine what you want to accomplish. For example, many people have retirement as one of their goals (which we prefer to call “achieving financial independence”). Think about what this means to you. Visualize it. How you will spend your time each day? Now identify the earliest time you would like to retire. If that isn’t possible, how long is the maximum you would work? What standard of living would you like to enjoy in retirement? If that standard isn’t possible, how much could you live on? How much are you saving now toward retirement? How much can you save? How much would you like to save? How much volatility in your investments would you prefer? How much can you tolerate? There are tradeoffs in all these factors. Saving more can “purchase” an earlier retirement date. Retiring later can enable a more comfortable retirement lifestyle. Taking on more investment volatility (and thus earning a potentially higher return) may allow you to save less. Clarifying and identifying all of your goals and the resources available to meet them is an important first step to achieving those goals.

2. Develop your Capital Markets Assumptions and Optimized Portfolios. This section is necessarily technical and will no doubt not make much sense to you if you are not an investment professional. However, while most people (and, appallingly, even many advisors) don’t understand these concepts, they remain vitally important to the process. The second step is to develop a list of the categories of investments you will consider investing in. For each of these asset classes, you will need to develop an estimate of the future arithmetic mean return (as opposed to the geometric mean), the future standard deviation, and the future correlation with every other asset class. This data is then put into an “optimizer” (a type of software program) to develop (combined with experience and judgment) a set of model portfolios (or asset allocations) that are expected to be optimal for different levels of risk and return.  (This step, now called Modern Portfolio Theory or MPT, earned Harry Markowitz the 1990 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel aka the Nobel Prize in Economics.  The original, 1952 paper can be found here among other places.)

3. Perform a Monte Carlo Simulation. A Monte Carlo Simulation is a quantitative technique for developing projections under conditions of uncertainty – like not knowing what the market will do in the future. This process combines the portfolios developed in the previous step with the goals and resources identified in the first step and determines the feasibility of the combinations. In other words, there may be no portfolios that give a high probability of meeting goals such as retiring tomorrow on a very high income. We recommend continuing to adjust the plan (step one, not step two) until there is an acceptable probability of success in meeting your goals with a given portfolio.

4. Implement the Plan. It isn’t until this step that the actual investments are selected. The criteria here should be how efficiently and effectively the optimal portfolio determined byt the last step can be implemented by the actual investment choices – in some cases the lack of acceptable choices by influence the asset classes included in the second step.

5. Monitor the Plan. After the plan has been implemented, it must be monitored for changes in the goals and resources (step one) or for changes in capital markets assumptions or available investments (step two).

That’s it.  Simple, but not easy.