Traditional Wealth Management Approaches to Investing Aren’t Working Great for Clients or Advisors
There are a few pieces of critical information that we need to know before we can build a successful investment plan for a client. And, unfortunately, the state-of-the-art in wealth management is to guess at the answers. After 40 years of actively working with clients, I believe it’s time to stop guessing. Financial practitioners need to stop practicing and start perfecting.
Loss Tolerance
The single most important answer we need to help design a successful investment plan for a client is their loss tolerance. We intentionally want to know how much capital a client is willing to lose or see their account value fall before they will bail on their investment plan. We use loss tolerance instead of risk tolerance very deliberately. In our experience, the concept of investment risk is extremely hard for clients to understand. Read any prospectus and you will find investment risk includes geopolitical risk, default risk, economic risk, interest rate risk, concentration risk, management risk, calculation methodology risk, portfolio turnover risk, company size risk, passive risk, high yield risk, cybersecurity risk, etc. Today there are thousands of client risk questionnaires all designed to help the client understand a risk system that is far too hard for the average client to wrap their heads around.
When markets are in a bull trend investors have been taught to think in terms of percentage returns relative to an index like the S&P 500. If they are beating the index they think that is great and if they are trailing they think the investment or advisor stinks. Humans are hard-wired to imagine results that are positive or pleasing. Prove it to yourself by asking every client and prospect you meet to imagine a percentage return and then ask them what the number is. I have never had one person give me a negative percentage return number and yet historically the markets are in a negative or bear trend 42% of the time.* Markets also fall about 2 times faster than they rise. You ask any client in a bear market how they determine risk, they will quickly tell you it’s all about the amount of money they lost.
We believe this is the only investment risk question that matters: how much money are you willing to lose of your total capital before you will bail on your investment plan. We use a 2-minute educational video showing clients the roller coaster of market returns, the ups as well as the downs, and how much capital was lost in the past few bear markets. The visual reminds viewers of the gut-wrenching losses they have experienced in the past. Then we repeat the process by using the client’s total invested capital and subjecting it to a real bear market decline scenario. We ask the client to hit the “STOP” button when they have hit their personal loss tolerance. Oddly enough clients like replicating a real scenario and tend to remember the experience for years. This helps the advisor anchor the client’s perceptions about return versus risking their capital.
Required Rate of Return
The next critical piece of information is the client’s required rate of return to achieve their retirement objective. Most financial planning software programs require the advisor to make capital market assumptions about the return on various asset classes over the planning horizon. They are, in essence, asking the advisor to guess. Will stocks generate a below-average rate of return, average, or above average? The input required is not a generalization but an exact number. We routinely see advisors assume stocks will achieve an 8% – 10% rate of return even though over the past two decades the S&P 500 (market) has only generated a 6.6% rate of return.*
Many economists are predicting below average rates (3% – 4%) of return in the years to come after the historic 10-year Fed-infused bull market. If the advisor guesses wrong then the entire retirement analysis is faulty. After taking in the capital market assumptions on assets and the client’s financial data – including income needed in retirement – the financial plan will show if the client will run out of income before death. If they do the advisor will adjust the return assumptions on assets. Once they have identified a suitable rate of return, the advisor typically will build an asset allocation-style portfolio and run it through a Monte Carlo simulation to see if the portfolio design would have a high degree of probability of meeting the retirement cash flow needs of the client. If not, they adjust the income need assumptions or portfolio design, or both.
All this guessing misses the mark of what clients need to be successful by a wide margin.
We believe the correct process is to mathematically solve for the actual return required to meet the client’s retirement income goals over their life expectancy. We built into Cy a math-based algorithm to solve for the return the client needs to meet their objectives. Cy’s process analyzes the client’s current capital position, income, benefits, savings, tax rates before and after retirement, and their retirement income need based on today’s cash flow requirements, desired longevity plan, and inflation.
Personal Client Benchmarks Drive Portfolio Design
After identifying the client’s loss tolerance and having mathematically solved for their required rate of return with no capital market assumptions (guesses), Cy’s portfolio optimization engine goes to work. Cy processes massive amounts of data on the full universe of funds, ETFs, and SMAs to rank and find the top 100 equity and top 25 fixed income managers in the world for risk-adjusted returns. Then, Cy uses the top list of managers as the building blocks of portfolio construction. Cy runs millions of simulations to find the managers that fit best together within a portfolio to achieve the client loss tolerance target with the highest rate of return possible. By using an efficient frontier concept on steroids, Cy selects the managers that mathematically maximize non-correlation and covariance. Cy’s not guessing, it’s mathematically perfecting portfolio design and construction.
Cy portfolios rebalance to the original weights quarterly to help ensure the portfolio stays on track to achieve the client’s personal benchmarks. Once per year, Cy runs an updated optimization to rank the best managers and then re-optimizes the portfolios based on loss and return target profiles to keep the portfolio outcome in sync with changing market trends. Cy’s platform is super-efficient when it comes to onboarding clients and communicating with them throughout the year with updates that re-anchor them to their personal benchmarks and goals. As the client situation changes and data needs to be modified or objectives change, Cy can re-optimize to new client benchmarks and targets within minutes.
Aren’t you ready to stop guessing?
To learn more request a demo.Or better yet hop onto Cy, sign up, and build a client profile and Cy optimized portfolio solution.
* Unless otherwise indicated, the source for all price and index data used is Bloomberg.
Disclosures
The views presented are those of Don Schreiber, and should not be construed as investment advice. All economic and performance information is historical and not indicative of future results. This is not an offer to buy or sell any security. No security or strategy, including those referred to directly or indirectly in this document, is suitable for all accounts or profitable all of the time and there is always the possibility of loss. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, please consult with WBI or the professional advisor of your choosing. This information is compiled from sources believed to be reliable, accuracy cannot be guaranteed. Information pertaining to WBI’s advisory operations, services, and fees is set forth in WBI’s disclosure statement in Part 2A of Form ADV, a copy of which is available upon request.
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