Investment advice is typically based on the belief that education and disclosure will lead to rational investor behavior and prudent decision making. It also is based on the idea that an adviser understands the risk tolerance of a client. With that knowledge, a portfolio can be constructed that will provide value to a client. Sometimes, however, an adviser's recommendations and the client's wants can be two different things.
Investors bring inherent conflicts in the door with them:
- They want maximum growth and safety at the same time.
- They want a pool of money that allows them to enjoy life after work, and they have a wonderful list of things they want to enjoy today.
- They want equity-like returns without volatility.
- When markets move upward, investors want to get a "piece of the action" and jump on board, doing the opposite when markets go down. This sets up a buy-as-prices-get higher-sell-as-they-get-lower paradigm.
What clients want can be thought of as personal financial goals rather than investment goals. Goals often times get muddled by everyday life. People work hard, raise kids, pay a mortgage—it becomes difficult to even think about a big picture.
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I have found that eliciting goals from clients is a dynamic, ongoing process: You need to set aside money for near-term spending, or for an emergency or for a rainy day fund. Or you need current income to cover house utilities. You may have an idea that you want to travel to Australia for a month, but who thinks of these scenarios as you are working?
You may be so busy working that it is hard to envision current and future goals! It takes time and patience; sometimes life throws you curveballs, and sometimes you have those moments when a realization hits you and your priorities change. Goals change. Goals are part of a dynamic process.
How does an investor invest for personal needs or wants? Most people tend to view their portfolios' performance in comparison to the capital market indices, i.e. Standard & Poor's 500-stock index or the Dow Jones industrial average. This seems to occur no matter what the composition of a portfolio is. Historical risk and return characteristics of these indices are well-documented and highly visible, and we have become accustomed to using them as a guide of our future investment experience. So the theory goes, by using capital market index outcomes, an investor can produce the return and risk outcomes that will help them achieve their goals.
Most often, or I should say, too often, the practice of using capital market indices to create investment strategies leads to a beat-the-index mentality. Clients ask, "How am I doing in comparison to the S&P? Did I beat it?" My question is, what relevance does beating the S&P have to a client who has specific goals they are trying to reach? It may be important, but how important it is depends on the personal goals themselves.
It also may be that the S&P has no bearing on the client achieving a particular goal whatsoever. Goals, elusive as they may be, have to come first. Not beating certain indices. The success of your portfolio can then be measured by whether your goal is achieved and whether you have the money when you need it.
Don't get me wrong. I think that market indices have tremendous value. An appropriate index is a marker for institutions which construct portfolios. The indices go to the heart of all the theories and controversies about the efficiencies of markets, quantitative strategies or the debate over active investing (higher fees) versus passive investing (lower fees). In that regard, comparing the results of a methodology designed to beat the S&P, or designed to achieve a certain upside relative to the S&P with less risk, makes perfect sense.
When these portfolios are subsequently put to use for individuals, though, the questions are different—and more personal. The questions are about individual needs and wants.
These questions are the beginning of the real conversation about your portfolio.
Michael Krumholz has run a financial advisory practice for over 25 years. He received an economics degree at Williams College in Williamstown, Mass. He prefers being outside as much as possible playing tennis or biking, enjoys playing the guitar and piano, and is an avid reader.
Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC.
Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor.
Cambridge and CFG, are not affiliated.
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