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What You Don't Know About Financial Advisors Will Harm You “There was a time when clients trusted professionals automatically . . . Sound character and reputation were assumed, and business was conducted with confidence . . . Although that world may be gone, the need for trust has not disappeared.” – David H. Maister, Charles H. Green, Robert M. Galford, The Trusted Advisor You are unlikely to achieve financial peace of mind if your financial advisor does not understand or agree with your goals and is unwilling to consider or discuss your investment concerns. Investors looking to choose or change a financial advisor usually decide to go with the first prospective advisor they interview. After the first meeting, they are sold on the financial advisor’s abilities, personality, and knowledge. There should be no surprise here; financial advisors have to be effective salespeople or they would soon go out of business. Naturally they are going to be skillful in addressing your concerns and making you feel comfortable about opening an investment account with them. To give yourself a fighting chance of finding a financial advisor who will match your needs, you should interview at least three candidates. Look at each advisor’s educational background. Is the prospective advisor qualified at only the minimum level, entitling him to sell only mutual funds? Does she have a financial-planning designation, or a more advanced financial certification such as Certified Financial Planner (CFP), Canadian Investment Management (CIM), Certified Financial Analyst (CFA), Chartered Life Underwriter (CLU), or Certified Investment Management Analyst (CIMA)? All things being equal, the more degrees and educational certificates, the better. Examine the advisor’s level of experience. Ideally, you want an advisor with at least 10 years of experience. It takes about that much time for advisors to learn from the mistakes they will make early in their careers. Only experience can train an advisor to keep a cool head in the midst of market turmoil, to resist the sales pressure during the weekly visits from mutual fund and hedge fund wholesalers, and to understand how highly touted packaged deals can backfire. Don’t choose an advisor who’s going to learn the ropes with your money. (I can say for certain that the advice I give my clients today is better than the advice I was able to give when I was new to the industry.) Avoid choosing a financial advisor who is too successful to find time for you. This might mean a person who only handles accounts much larger than yours or one who already has over 500 clients. Find out what size of accounts the advisor specializes in and how many clients she has. Keep away from someone who is so new she is desperate to start generating enough income to keep her job. Financial advisors sometimes are exposed to temptations to earn commissions in ways that may not be in the client’s best interest. The desire to earn commissions may result in recommendations that benefit the advisor more than the client. Education and experience are more important than the advisor’s personality. You are not selecting an advisor to find a new friend. Rather, you want one who will manage your funds to earn the rate of return you need while taking no more risk than necessary. Here are some key questions to ask your prospective advisor: • What is your educational background? What relevant professional degrees do you have? • How many years have you been in the industry, in what positions, and with what firms? (Ask to see a résumé.) • What is your investment philosophy and how do you put investment portfolios together? • Do you prepare a financial plan to determine the rate of return needed in order to achieve your client’s goals, or do you always go for the highest return possible? • How do you manage and control risk? • Do you use Investment Policy Statements and, if so, may I see one? (It should contain much of the information as shown on pages 21–25 below.) • How many clients do you have? • What is the size of your average client’s portfolio? • What fees do you charge? Bottom line: Your choice of an advisor is a momentous decision. Spend enough time on the selection process to be confident that you have the right matchup. What you can do now: Arm yourself with the questions summarized above and begin the interviewing process. With these questions answered, you are going to have the knowledge necessary to find the right advisor. When Should You Consider Changing Advisors Not every financial advisor is as experienced, honest, and competent as we would wish. If you have the wrong advisor, you may have to work a lot longer before you can retire – or you will have much less to spend in your retirement. It is never wise to rush to change financial advisors. When you think a change is needed, the first step should be to explain your concerns to your current advisor. The source of conflict could be a misunderstanding. Making a fresh start with a new financial plan and a new Investment Policy Statement (see pages 21–25) could get you back on track with less cost and pain than switching advisors. On the other hand, incompetent advisors count on your wanting to avoid the pain, aggravation, and expense of changing advisors. If changing was easy, they might lose many clients. Yet, at times, the match is just not right. In such a case, the prudent thing to do is to make the change. Here are examples of what should prompt you to do so: • Evidence of dishonesty. • Evidence that recommendations are not in your best interests. An example might be frequent trading recommendations. • When the advisor keeps on recommending individual stocks even though his recommendations have under performed the benchmark index for the past three years. (In this case you would be better off using something called an exchange traded fund (ETF), as explained in Chapter 9, pages 142–144.) • When the financial advisor does not agree to some form of an Investment Policy Statement providing a clear benchmark against which his performance can be measured. (See pages 21–25.) • When actual performance is outside the range of expected results and the advisor does not have a satisfactory explanation of what went wrong. • Evidence that the advisor is learning the ropes by handling your accounts. This is a serious decision. Not changing advisors could mean working for a few years longer than you planned. The wrong strategy could wipe out – in a single year – 20% or more of the value of your portfolio. Depending on your age, it may be difficult to recover from a loss of this magnitude. In making a decision to stay with a financial advisor, you must be mindful of the possible negative consequences. After one loss, you could lose even more if things continue to go wrong. In a bad portfolio and in a bear market, the losses can continue year after year. The financial advisor may lose a client, but you may lose your financial security. Bottom line: Some situations are intolerable. That’s when you should make a change. If you don’t, you may have to work longer before you can retire. Understand your advisor’s investment strategy Most investors do not have a strategy that they follow consistently in both up markets and down markets. Yet the most important element in ensuring investing success is having the discipline to stick with the chosen investment strategy. Does your financial advisor have a well-reasoned investment philosophy that is suited to your needs? You should not assume that every financial advisor follows an investment strategy that makes sense for your portfolio. Every advisor has an investment strategy of some kind. In the worst case, it might involve “churning” the client’s account to make the highest possible fees. Other bad strategies include: switching investments to what is hot at the moment; buying based on recommendations made on TV stock market shows; buying all of the brokerage firm’s current choices, or all the new issues; or buying on hunches and the belief that the advisor can beat the market. The point is to understand the strategy and stick with it through different market and economic cycles. Many strategies will work well. The key to success in almost every case is to stay with the strategy through the bad times as well as the good. Alarms should go off in your head if your financial advisor is unable to explain his investment strategy in terms that you can understand. The bells are telling you that it may be time to switch to a new advisor. An advisor who has a strategy has thought things through and knows why certain investments are purchased at certain times. He has a plan that looks forward and anticipates changes. Beware of the advisor who is prone to go with his emotions. Buying and selling securities based on emotion is a sure way to lose capital. Bottom line: Your financial advisor should have a well-thought-out investment strategy that can be explained in terms a lay person can understand. What you can do now: Get an explanation of your financial advisor’s investment strategy and an opinion on why it is the best strategy for you. Make sure you find out how the proposed plan will be useful in minimizing risk for the expected return. Make sure you understand how the strategy is expected to work in good markets and bad. Identify your advisor’s area of expertise You and your financial advisor must be on the same page in terms of strategy and investment philosophy. Different financial advisors will recommend very different approaches, reflecting different outlooks on the markets and different levels of experience and expertise. For instance, if they are bond specialists, they likely believe that a diversified portfolio of bonds is the best investment. Another group of advisors, who have had success in picking mid-sized Canadian resource companies, will likely suggest investing in such companies. Other advisors believe they can do better for you than the market average by investing in a few large capitalization growth companies. Still others develop an expertise in selecting mutual funds, hedge funds, income trusts, and structured investment products. If your financial advisor is one of these specialists but you believe the best approach is to own a widely diversified portfolio consisting of stocks, exchange traded funds, bonds, hedge funds, and income trusts, the two of you are likely to be in constant conflict. An advisor’s recommendations will tend to reflect different levels of professional education and experience. A highly trained advisor with experience of both bull and bear markets is more likely to offer you well-informed advice, which is especially valuable in hard times. Some financial advisors are generalists and see the big picture but choose to leave the details to associates. Others know the details and history of different stocks but offer no assessment of the overall stock market and economy. Many experienced advisors accept only clients who agree with their recommended strategies. Advisors starting out in the business need clients and will tend to take on every new prospect. In effect, they are trying to be all things to all people. I made this mistake in my early years. On occasion, I accepted clients who wanted a service that I wasn’t comfortable providing. They thought that my role was to beat the market by actively trading Canadian stocks. I saw this as an impractical objective. I believed that the advisor’s role was to help achieve the client’s objectives by designing a portfolio that could be expected to earn the necessary return with the least possible amount of risk. If these clients had asked more questions at the outset, and if I had followed my instincts, much of the misunderstanding could have been avoided. Before making a decision to select an advisor, you should know her strengths, weaknesses, expertise, and beliefs about investing. You should ask the basic questions regarding: • Areas of expertise. • Relevant investment experience. • Investment philosophy and strategy. • Method used to determine the asset mix and strategy that is right for each client. • How often the advisor recommends changes in the account. • What makes the financial advisor believe she is better than the average. Bottom line: You can avoid problems by staying away from advisors who, because of their limited investment experience, want to slot you into an investment portfolio that does not fit your style of investing. The value of a client-centred Investment Policy Statement, as described in the following section, is that the strategy is in writing and can be referred to as necessary. What you can do now: Ask your financial advisor to: (1) explain the investment strategy that he recommends; (2) review the main risks involved with the strategy; and (3) explain why he thinks this is the best strategy for you. Get an Investment Policy Statement A client-centred Investment Policy Statement (IPS) is one of the best ways to establish guidelines for your portfolio’s performance. One way to increase the chances of a profitable and harmonious relationship with your financial advisor is to develop an agreed upon Investment Policy Statement (IPS). With an IPS you and your advisor are both clear on your goals, the strategy to achieve them, and the yardstick for measuring success. With this tool you can discuss the performance of your investment portfolio calmly and rationally. There will be no need to argue when it comes time to evaluate performance. The IPS helps measure whether or not your portfolio has performed within the expected range of returns. A custom-prepared, client-centred IPS is quite different from a “boilerplate” IPS designed to protect the investment firm and to satisfy the industry’s injunction to advisors to know their clients. The boilerplate IPS is often written in language that makes it difficult for the client to measure performance. The following is an example of a client-centred IPS. INVESTMENT POLICY STATEMENT The purpose of this investment policy statement is to set out in clear terms the objectives for: 1 The target average rate of return for this investment portfolio over different time periods, e.g., the target return over any one-year period, any three-year period, or any 10-year period 2 The expected range of returns for the portfolio as a whole over different time periods, e.g., for any one-year period, the range between the best likely result and the worst likely result 3 The starting percentages in each asset class in the recommended portfolio and the permissible ranges for each asset class 4 The benchmark that will be used to compare actual performance 5 Investment constraints, if any 6 The rebalancing strategy 7 All fees that will be charged 8 Frequency of contact 9 The points to be covered in the quarterly review meeting 10 Assumptions Now let’s look at each one of these 10 points in detail, choosing a particular strategy for the sake of discussion. 1. The target rate of return. Let’s say the target rate of return is 8% per annum. It is understood that in some years the portfolio will give a better return than 8% and in some years it will give a lower than 8% return. It is expected, however, that if the portfolio consistently performs within the expected range of returns as shown below, the actual return, over time, will be close to the target rate of return. 2. The expected range of returns may be similar to what is shown below: Highest expected return 1yr -24 3 yrs -18 5 yrs -14 10 yrs - 12 Average expected return 1yr -8 3 yrs -8 5 yrs-8 10 yrs - 8 Lowest expected return 1yr -(6) 3 yrs -(2) 5 yrs-3 10 yrs - 4 The portfolio is constructed so that 95 times out of 100, the actual return is expected to fall within the above ranges. This means that 5 times out of 100, the actual portfolio performance is expected to be worse than the lowest expected return, and 5 times out of 100, the actual portfolio performance is expected to be better than the highest expected return. 3. The initial allocation The initial allocation to different asset classes included in this portfolio, and the permissible ranges, are as follows: 5%......0–10% Cash 25%..15–35% Government bonds 15%....5–30% Other fixed income 15%....5–30% Canadian equities 15%....5–30% Foreign equities 10%....5–15% Income trusts 15%..10–25% Fund of hedge funds It is assumed that the asset allocation will be designed to be efficient from both an income tax and a risk-minimization point of view. Optimization will be used in order to develop an overall mix that is near or on what’s called the Efficient Frontier. (Optimization is the process whereby asset classes are selected to minimize risk for any given level of return.) 4. The benchmark For the above asset mix, the portfolio benchmark might be a portfolio made up of indexes in the following percentages: 5%....Government of Canada T-bills: 40%..Scotia McLeod Short-term Bond Index 25%..TSX 60 Index 15%..S&P 500 Index 15%..Hennessee Hedge Fund Index (If the hypothetical portfolio made up of these indexes produced a return of 7%, you would want your actual return to be at least 7% after fees.) 5. Investment constraints Some portfolios may be constructed with investment constraints: for example, all bonds must be government bonds, or 50% of the portfolio must be invested in Canada, or all investments in emerging markets are to be avoided. 6. The rebalancing strategy Over time, some asset classes will rise in value while others decline. Rebalancing will be required to bring the portfolio back to the desired asset allocation. Rebalancing involves selling some assets that have risen in value and buying more assets that have fallen in value. The portfolio will normally be rebalanced annually. However, if the percentage in any asset class or the cumulative change from all asset classes changes by more than 10% of the value of the portfolio as a whole, the advisor will discuss the possibility of rebalancing more frequently to take advantage of the opportunity to sell high and buy low. 7. Fees and advisor compensation Fees include any commissions, WRAP account fees, service fees, management expense ratios, administration fees, front end fees, deferred sales charges. (A WRAP account is a fee-based account in which a number of services are all “wrapped” or “bundled” into a single fee.) Advisor compensation may include trading commissions, trailer fees, program management fees, fees from deferred sales charges, and new issue commissions. The IPS should show the total of all fees (in dollars or as a percentage of assets) that the client will pay, as well as the total compensation earned by the financial advisor. It is important for the client to be aware of both the amount he or she pays and the amount the advisor may receive from other sources. 8. Frequency of contact The IPS might indicate, for example, that on a quarterly basis the financial advisor will make a telephone contact to review performance and any issues that have come up; that on an annual basis there will be a face-to-face meeting to discuss the issues set out in the formal meeting agenda; that on an as needed basis the client will call in regarding administrative issues and speak to an assistant and the assistant will discuss the issues with the advisor as appropriate. 9. Topics covered in formal review meetings. On a quarterly basis the client will receive a report that highlights actual performance compared against: • the target range of returns, and • the benchmark return. The first purpose of the quarterly review is to determine if the actual return fell within the expected range of returns. If it did not, an explanation is required. It must be determined which of the following reasons explain the deviation: • There was a once-in-a-lifetime event that caused markets to move outside the range of returns expected to occur 95% of the time. • The selected investments did not perform like their representative class. • The original range for the portfolio as a whole was calculated incorrectly. Any or all of these may have been miscalculated: the historical rate of return, the standard deviation of the asset classes, or the correlation between asset classes. • Other factors. The second purpose of the quarterly review is to determine how the portfolio performed compared with the benchmark portfolio. Even if the performance of the portfolio was within the expected range, that does not necessarily mean that performance could not be improved. If the actual performance of the individual asset classes and the performance as a whole are significantly different from the benchmark, this may mean that individual asset classes or mutual funds should be changed. Other topics that should be covered at the annual meeting include: • Fees charged during the period. • Provision of an annual capital gains and losses report for income tax purposes. • A review to determine if the level of volatility is acceptable – is the client sleeping at night? 10. Assumptions Certain assumptions will be made for the performance of investments, including the rate of inflation, marginal tax rates, and the schedule for withdrawals. These assumptions should be listed and explained. Bottom line: When large financial institutions, such as pension plans, foundations, or university endowment funds, hire investment managers, they always have an IPS in place. This ensures a good and effective relationship. Individuals should also have an IPS to make sure that expectations are reasonable and performance is evaluated objectively. What you can do now: Ask your financial advisor for a client-centered Investment Policy Statement. Use the right benchmark to measure performance If you don’t have the proper tool to measure performance, a performance problem may persist. Your benchmark is the level of performance that you and your advisor agree is necessary and achievable. This is your tool for measuring and monitoring investment performance. Recognizing a problem with your investment account is the first step on the road to correcting the situation. The problem can’t be fixed until it is identified. You also need a standard of measurement to discover the problem’s size and nature. This standard is the benchmark: the performance level that you and your advisor agree should be expected from your investment portfolio. The benchmark describes the expected average return and also the expected range of returns for the portfolio. For example, the return benchmark might be an average of 8% over five years, and the range-of-return benchmark might be between –5% and +15%. Comparing your performance against the wrong benchmark may lead you to think you are doing well when, in fact, you are doing very poorly. From a financial advisor’s point of view, the oldest trick in the book is to make a client feel good by comparing performance with the wrong benchmark. To avoid this problem, you and your advisor should agree in advance on how performance will be measured and what reference points will be used in making comparisons. When the advisor agrees to use a specific benchmark, several good things will follow: • The advisor will be accountable for results. • Underperformance can be seen clearly. • Whether or not the portfolio has underperformed can be determined without an emotional confrontation. • The advisor will have an incentive to keep fees low because performance numbers will be reduced by the amount of fees charged. • The existing asset mix will be reassessed for its efficiency. • The financial advisor is on notice that there will be no fudging of results. The way to put these steps in place is by using an IPS such as the one discussed on pages 21–25. Not having an agreed upon benchmark creates several problems. For example, assume you have an investment portfolio made up of 50% Canadian common stocks and 50% government bonds. Your account statements show that over the past three years, your return averaged 3% per annum. You tell your financial advisor that your instincts tell you that with this asset mix you should be doing much better. Your financial advisor is shocked and explains that you have in fact done very well. As evidence, he points out that over the past five years the Toronto stock market has been down by 10%, NASDAQ by 30%, and the emerging market index by 20%. He explains that, since markets are down by an average of 20%, his efforts have resulted in your earning at least a 23% improvement over the average return in the equity markets. If you accept this line of reasoning, you are being seriously misled. Consider: • You are not 100% invested in the equity markets, so the comparison is misleading. Let’s say your portfolio is a blend of 50% Canadian stocks and 50% Canadian government bonds. The performance benchmark, therefore, should be based on the average of these two specific indexes, not just one unrelated type of index. • You are not invested in NASDAQ or the emerging markets index so the performance of these markets is irrelevant. • The advisor has compared your three-year return with the five-year return on the various indexes. Not only should he use the proper index but you also must use identical time periods. Comparisons are always misleading when they are not for precisely the same period. The foregoing is an example of a “relative return” benchmark for judging the performance of a financial advisor or investment manager. Here, you are comparing your return against the external benchmark that you and your advisor have agreed is the proper one. (The benchmark should be agreed upon in advance, not after the fact.) However, another yardstick, the “absolute return,” is even more important. This yardstick is the rate of return you need to earn to reach your financial goals. You should be aware of how actual performance compares against both benchmarks. On a relative return basis, if you lose 12% but the benchmark lost 20%, you might (in theory) feel satisfied because you “beat the benchmark.” The reality, however, is that investors don’t like to lose money – even if they have lost less than the benchmark index. With an absolute return benchmark, if you need to earn 10% to achieve your goals, you want a portfolio designed to earn 10% on average. You don’t care what happens in the stock market, you only care that you are earning, on average, the rate of return you need. You should understand, however, that even with an absolute return benchmark of, say, 8%, you are not going to earn 8% every year without fail. If your plan calls for an average return of 8%, your actual return in any given year almost always will be either higher or lower than the long-term average. You should know the expected range of returns for your portfolio and you should always be within the expected range of returns regardless of what happens to the market in a particular year. Bottom line: Don’t let your financial advisor make bad or mediocre performance look good by comparing your performance results against the wrong benchmark. Agreeing in advance to the use of the proper benchmarks usually will prevent arguments about performance levels. A relative return benchmark is used to judge your financial advisor’s performance while an absolute return benchmark tells you if you are on track to achieve your financial goals. What you can do now: Talk to your financial advisor and get her agreement on the benchmark that will be used to judge performance. Don’t expect your financial advisor to beat the market When you try to beat the market, you increase your trading costs, take more risk, and make yourself vulnerable when – not if – the next major market correction occurs. The old school image of the financial advisor is of someone who understands the market and employs experience, insights, intelligence, and research to choose stocks that rise in value by more than the market as a whole. Logic, common sense, and the Internet will tell you that this image no longer fits today’s financial advisors, if it ever did. If an advisor is able to purchase stocks that consistently yield a higher return than the market’s average (without more than average market risk), he could also use that skill to become one of the world’s richest investors himself. It is simply unrealistic for you to expect your financial advisor to consistently beat the market. After all, only a minority of professional portfolio managers achieve results better than the market index, and they have greater resources than most advisors. These managers spend much of their time making investment decisions, while the average financial advisor spends more time being of service to clients, trying to attract new ones, and dealing with administrative issues. It is unrealistic that your advisor will beat the market consistently without taking higher than normal market risk. The advisor can still provide an important service: helping you determine the rate of return you need and designing a portfolio that brings solid returns with the least possible amount of risk. That said, there are some advisors who do consistently beat the market. By this I mean they earn a higher rate of return than could be earned by simply buying an index mutual fund. There may also be some cases where the advisor not only beats the market, but also does so with less than normal market risk. In most cases, however, higher than average returns are only possible when higher than average risk is taken. Bottom line: Most of the dissatisfaction between client and advisor arises from unrealistic expectations about what the financial advisor can actually do. What you can do now: Talk to your financial advisor so that you are both clear on the benchmark for the account, in terms of the expected average rate of return, and the level of volatility expected. Don’t expect your financial advisor to call you before the next crash Investors who believe their advisor will call them and get them out of the market before they lose money, should a serious crash occur, may allow themselves to be in a riskier portfolio than would otherwise be the case. It is a huge mistake to think that your advisor is going to be able to protect you from the next market crash. And the question is when the next market crash will occur, not whether there will ever be another one. As long as markets continue to move based on the emotions of fear and greed, market crashes will occur from time to time. There are a number of reasons why you should not count on getting a call from your advisor recommending that you sell at the top. • It is unlikely that your financial advisor will be able to see a crash coming. • Even if an advisor wanted to call clients, there would not be enough time to call more than about a dozen of them. • Even if the advisor believed that a crash was likely, he would be reluctant to predict the sky is falling because being wrong on this score would seriously reduce his credibility with clients and peers. • Generally clients don’t blame an advisor for a crash when everyone has lost money, but they do blame the advisor if he gets them out of the market too soon and they miss a lot of growth. For this reason it is safer for the advisor not to try to predict the market. • If a crash is to occur, it will happen when most market participants are experiencing the highest level of optimism. That being the case, even if clients do receive a call, few will accept the advice to get out of the market just at the time when all their neighbours are enthusiastically jumping in. Here is another reason that you are unlikely to get a call from your advisor suggesting that you bail out. After the first serious downturn, the consensus will be that it is now too late to get out. Everyone will think that the damage has already occurred and the best strategy is to buy more, not to sell when prices are low. Sometimes, after the market falls precipitously, it is a good time to buy. At other times, a sudden drop is just the beginning of a long bear market. All we know for sure is that markets move in cycles and that it is difficult to predict short-term market movements. The best way to reduce risk is to be diversified across a number of asset classes (i.e., more than just stocks and bonds) that do not all move in the same direction at the same time. Bottom line: Do not delude yourself by thinking that your financial advisor is going to call you to let you know before a market crash happens. What you can do now: Ask your advisor to estimate how your investment portfolio would be affected if we had another market crash such as occurred in 1929 or 1987. Avoid pushing too hard and expecting unreasonable results If you demand a high return, your financial advisor can only do this by taking higher risks – risks that you may not fully understand. Investors often have an unrealistic expectation of what their investment portfolio should earn and the degree of risk or volatility associated with these earnings. This can cause a problem if investors are forceful in expressing their expectations. To please such a client, an inexperienced advisor will allow himself be pushed into recommending an asset mix that has the potential for high losses as well as high returns. Investors rarely recognize that they are in a speculative investment portfolio until the portfolio drops by 20% or 30%. Investors should understand that an investment portfolio that can go up by 20% in one year can, and most likely will, fall by an equal amount in another year. If you stick with the traditional portfolio made up of “long only” stocks and bonds (see note # 1 below), there are only a few ways that the advisor can reasonably expect to increase the average annual return. One way is by using leverage. Another is by moving to more speculative investments. Yet another way is by increasing the concentration in a few securities. In these situations, an investor may earn higher returns in a bull market but the losses may be magnified in a bear market. Some financial advisors are reluctant to tell you the truth about what you can realistically expect to earn. They are not necessarily dishonest; rather, they fear that, if you knew the truth, you would move your money to another advisor promising a higher return. When you push your advisor and complain about your rate of return, you increase the likelihood that she will recommend higher risk strategies in an effort to please. As a general rule, you should not expect that your advisor is going to be able to consistently outperform, compared with the appropriate benchmark, unless she takes higher risk. Based on the last 25 years, for a traditional investment portfolio that is 50% invested in Canadian and US stocks and 50% invested in short- and long-term government bonds, the best likely return falls in the range of 12% to 24%, the expected return is 8%, and the worst returns range from –5% to 5%. You would expect to hit the high and low ends of this range only once every 20 years. The actual return will be higher than the average return half the time and lower the other half. Yet it is tempting to assume, and many investors do, that annual returns will be above the average more frequently than below it. Statistically, this is unlikely. If you deduct the 2% to 3% that is paid in management fees and commissions, the actual average net return is probably lower than the indicated average expected return. As you look at longer time periods, the range of expected returns becomes smaller. Quite simply, the range for a 10-year period is lower because, even in the best decade, a few bad years will reduce gains. The 16-year bull market between 1982 and 1998 had the effect of raising investor expectations. A more realistic view of likely returns for the next 20 years is offered by the investment history of the past 200 years. In that span, seven major bull markets and seven major bear markets occurred. During that period, the average bull market lasted about 14 years and the average bear market lasted about 13 years. Given that history, and given that the period from 1982 to 1999 produced unusually high returns, it is unrealistic to expect that a balanced investment portfolio will earn as much during the next 20 years. Over 200 years of history, we see that periods of higher than average returns were followed by periods of lower than average returns. Experienced investors, like Warren Buffett, are predicting that equity markets will generate returns in the single digits for at least the next decade. Note #1: In some cases, when “alternative investment strategies” such as hedge funds are added to an investment portfolio, it is possible to generate higher returns while reducing the expected volatility as compared with a traditional portfolio of only “long” stocks and bonds. This happens because of the low correlation between traditional investments and alternative investments. (See Chapter 5 on how to control risk.) Note # 2: In the jargon of the industry, when you own a stock or a bond, you are said to be “long” the position. When you sell a stock or bond that you do not own, you are “short” the position. Selling securities you do not own is a strategy employed when you expect the security that is sold is going to fall in value. It is possible to sell short because the brokerage firm you deal with will “lend” you the security in order for you to sell it. At a later date you will have to return the borrowed security and you hope to do so by buying it on the open market at a lower price. If the security has fallen in value, you will make a profit. If the security has risen in value, you will lose money because you will have to buy it back at a higher price. Bottom line: Don’t be greedy. Base your return probability on 100 years of history for the investments in your asset class. Don’t push your financial advisor to produce a return that is rarely ever attained. Get a financial plan that shows the rate of return you need to earn and aim for that return, not a higher one. What you can do now: Ask your financial advisor what rate of return you can reasonably expect from your portfolio. Also ask what the expected range of returns will be. What is the worst likely performance over any one-year period? Don’t just delegate decision-making; monitor results, too Delegating without monitoring is, in effect, asking your advisor to be a judge of her own performance. The best way to monitor performance is by using a client-centred Investment Policy Statement. Investment opportunities are so complicated today that even experienced financial advisors are challenged to keep up-to-date and to understand the new complex, structured investment products that are available. It is wise, therefore, to delegate this type of research to your financial advisor. But it is always unwise to delegate without carefully monitoring performance and accepting responsibility for the results. Don’t do what most investors do: assume that the control of the portfolio, to all intents and purposes, is out of their hands. You can have the best of both worlds by monitoring your portfolio’s performance while benefiting from professional financial advice. Based on the difference in returns between highly monitored portfolios like those of university endowment funds, and the returns of the average investor, it is reasonable to assume that a properly monitored portfolio will outperform an unwatched portfolio by more than 2% per year. To monitor a portfolio simply means to: • Agree with your financial advisor on reasonable goals for volatility and performance. • Compare actual results with expected results. • Have some understanding of the strategy that is being employed. • Ask for an explanation when results are outside the expected range of results. • Be aware of the fees that you are paying on your portfolio. Financial security begins with an understanding that you are responsible for your own financial well-being. Your financial advisor, your insurance agent, and your accountant are all professionals who can help you reach your goals, but you are the one who is ultimately responsible. It is impractical to think that their efforts alone will make you financially secure. And these professionals should not be asked to monitor or judge their own performance. Monitoring performance mainly means asking questions and expecting reasonable answers. Here are examples of acceptable and unacceptable explanations for under-performance. Acceptable explanations for portfolio performance outside the range of expected returns: • The market crashed, dropping in value by more than 25% in the space of one month. • A terrorist attack caused the stock market to be closed for a week. • An earthquake caused California to slide into the Pacific Ocean. Unacceptable explanations for portfolio performance outside the range of expected returns: • Markets have been down for the year to date. • Interest rates rose unexpectedly. • The fund manager was fired for fraud. • Consumer confidence fell. • Canadian currency rose or fell unexpectedly. The foregoing unacceptable explanations are normal, expected market events. The risk of these events can be reduced by diversification. Note: The assumption that a properly monitored portfolio will outperform a portfolio that is not well managed is based on the historical fact that investment pools such as pension plans, endowment funds, and university trusts typically outperform the relevant benchmarks by about 4% per annum, while the average investor underperforms these benchmarks by about the same amount. I’m being very conservative in stating that a monitored portfolio outperforms an unmanaged portfolio by 2% per annum. Bottom line: You have to monitor performance. This is easy to do when you have an Investment Policy Statement and a clear understanding of the expected range of results (regardless of what happens in the markets). A quick look at your IPS will tell you if the actual results are outside the expected range of results. If they are, you need an explanation. What you can do now: If you do not have a client-centred IPS, call your advisor and ask for one. Then monitor your portfolio to see how it performs compared with the agreed upon benchmarks for risk and return. Ask your advisor the tough questions Your investment strategy can be compromised if you become so friendly with your financial advisor that you don’t feel comfortable asking tough questions. Financial advisors are fortunate that most investors want to be agreeable. Being friendly and likeable, however, does not always lead to better service. In fact, the most knowledgeable and demanding clients are likely to get the best performance, the lowest fees, and the most phone calls. Of course, there are limits. Good advisors will drop clients who are unreasonable or too demanding. All clients, however, should expect good service, regular contacts, and answers to pertinent questions. Sometimes the client is so easygoing that the financial advisor begins to assume that the client will stay as a client regardless of performance and service. You don’t want to be in this situation. There are occasions when a financial advisor needs to call every client to suggest an important change, and you want to be one of the first ones he calls, not one of the last. You want to be a client the advisor wants to impress, not one he takes for granted. For example, assume that the difference in performance is 1% per annum between the portfolio that the advisor monitors carefully, compared with one owned by a client that he takes for granted. The lack of attention to the latter account – because the client is undemanding – could lead to greater losses. Being taken for granted, and not receiving information about a better asset mix, could result in your having to work longer before you retire or having to live on a lower income during retirement. To ensure that you are not taken for granted, you should seek answers to the questions below. • What is the expected return on this portfolio over one, three, five, and ten years? • What is the worst likely performance over one, three, five, and ten years, based on a 95% confidence level? • What is the grand total of all the fees I will be paying on this portfolio? • What investment strategy or rationale is this portfolio based on? • What is the benchmark against which we will compare performance? • What is the rebalancing strategy? • Can we put an Investment Policy Statement in place that will set down in writing the strategies and expectations for this portfolio? Most of the more experienced and highly qualified financial advisors want their clients to have a comprehensive IPS because this helps investors understand how portfolios may be expected to perform during the bad years. During the occasional bad year, these advisors will receive fewer calls from nervous clients. Bottom line: Your financial advisor will treat you with more respect and work more diligently on your account when he knows that you are fair but expect a high standard of performance. When your advisor expects tough but fair questions, he will prepare for meetings and work harder to see that no opportunity is overlooked. You earn this respect when you insist on a written Investment Policy Statement and on getting complete answers to all reasonable questions. What you can do now: If you do not already have an Investment Policy Statement, you should call your financial advisor and ask for a meeting to put one in place. Hold your advisor accountable for results The squeaky wheel gets the grease. There are times when we are likely to complain – for instance, if our cars don’t work properly after servicing or an appliance goes on the fritz. Yet, we rarely hold our financial advisors responsible for a specific level of performance. We assume that the advisor does not control the stock market and therefore cannot control the risk or the return of the investment portfolio. This is the wrong way to look at the situation. While the advisor does not control the stock market, she can increase or reduce the risk of the portfolio. The advisor can do this by recommending a larger or smaller allocation to the higher-risk part of the investment portfolio. She can also reduce risk by recommending investments that have a low correlation with each other. For instance, she can select investments where the loss on one is normally offset by the gain on another. You want to take no more risk than the minimum level of risk necessary to achieve the average return your financial plan shows is necessary to reach your financial goals. A competent financial advisor can put together a portfolio that can be expected to earn your required rate of return, within an agreed upon, predetermined range of results. The expected range of results – agreed to by advisor and client – will be part of the Investment Policy Statement. (See pages 21–25.) A good advisor will also tell you if your “required” rate of return is realistic. If you decide you want a higher average rate of return, the range of possible returns will also be higher (good years should be better and bad years are likely to be even worse). The range of returns, although higher, is still predictable. There should be very few surprises in a properly designed portfolio. It may perform near the bottom of the range, the middle, or the top, but you can anticipate that 95% of the time the actual results will be within the expected range. As a client, you are owed a sound explanation for results outside the expected range. The advisor is not liable for any losses, but the explanation should be reasonable. It is not enough just to say that results are poor because the markets were down this year. All advisors know that markets have good years and bad years. A properly designed portfolio will make allowances for this. In a bad year, the performance may be near the bottom of the expected range, but the return should not be significantly lower than what was expected in the worst likely year. The advisor should not be able to escape accountability by providing such a wide estimate of volatility that results are bound to fall within the predicted range. The advisor who says that it is impossible to predict the market, and that your overall portfolio, therefore, might be up or down by 50%, may be trying to avoid being held accountable. In one way, your relationship with your financial advisor is like your relationship with your spouse. You need good communication, If something is brothering you, the issue should not be allowed to fester; it should be discussed. Bottom line: Your financial advisor should be able to design an investment portfolio in which the results fall within a predicted range. Holding your advisor accountable means that you demand a reasonable explanation if results are outside the expected range. A loss, outside the expected range, should not be explained away simply by saying it was a bad year for the market. What you can do now: Ask your financial advisor for an IPS that shows what range of returns your portfolio could be expected to yield over one, three, five, and ten years. Understand the biases of the financial industry It is risky to think the industry is on your side, because to some degree investing is like a competition. If you don’t know the way the other side plays the game, you are at a serious disadvantage. As Joseph Nocera of Fortune magazine has put it: “A broker with a clientele full of contented customers was – and is – a broker who will soon be looking for a new job. Brokers need trades to make money.” The banks and brokerage firms that form the backbone of the investment industry need profits to survive. They look on you, the investor, as a potential source of profit. Enlightened self-interest on their part ensures that, for the most part, they will treat you fairly, but a company that doesn’t make profits is soon out of business. One source of profit, of course, is the commissions on transactions generated in your account. In a commission-based account, the brokerage firm and the financial advisor both make more money when the client trades frequently. Obviously, this can create a temptation for your advisor to make more trades than necessary. When this is excessive, it is called “churning,” and fortunately, it happens infrequently. Although some plausible reason – such as recent performance – may be given, the real reason is that the purchase of the new position results in additional commissions being earned. Some investors’ accounts are charged a management fee instead of commissions. In these cases, the company earns revenues by managing investment assets. In this type of account, the brokerage firm receives a fee that is usually between 0.5% and 1.5% of the assets in the account. Sometimes this fee is a “trailer fee” paid by mutual funds and sometimes it is a management fee paid directly by the client. In this latter type of account, as the account grows, the remuneration grows as well because it is calculated as a percentage of the value of the account. In theory, this fee-based type of account, sometimes called a WRAP account because a bundle of services are all wrapped into one fee, is better for the client. It removes the incentive for the financial advisor to make unnecessary trades in the account. Since the client does not pay commissions on trades, he or she does not need to be concerned that a recommendation is being made simply to generate revenue for the financial advisor. In a fee account – where the advisor’s fee grows with the growth of the account – the advisor’s incentive is to have a larger account. Both you and your advisor benefit as the account grows. One risk of a fee-based account, however, is that it may encourage the advisor to take unnecessary risks with your money. A higher return means the portfolio will grow faster and generate a higher amount in fees. If the higher-risk strategy fails, the advisor will lose a small amount of fee income, but you may lose your financial security. Another industry bias to watch for is promotional material masquerading as information to educate the public. Assume that most of the brochures, newsletters, and advertisements coming out of the financial industry are guilty until proven innocent. You have likely heard, many times, the following bit of advice: invest in the market and stay for the long term. It is generally good for the industry when investors stay in for the long term, but it is not always good for the investor, and herein lies another industry bias. For example, when investors take their money and buy treasury bills (the lowest-risk investment), few commissions are generated and the brokerage firm’s profits are reduced. However, in a period when the stock markets are overvalued by many traditional indicators, common sense would suggest that very low-risk investments might indeed be the right investment for the average investor. Brokerage firms and financial advisors are sometimes reluctant to recommend strategies that, while they might be good for the individual, would be disastrous if followed by the industry as a whole. The problem is that an individual may be able to protect himself in the event of a market crash by removing his money from the equity market. But if everyone removed their money, it would cause the very same market crash that they all want to avoid. If the advisor moved all of his clients to cash because he feared a market crash, he would be out of business because, typically, no fees are generated on cash. When the advisor stops generating fees or commissions, he is literally out of business and his office is given to another advisor who is generating more commissions. An example of biased advice is the illustration that is often presented in financial seminars showing how an investor’s average return would be reduced if she missed the 20 best days in the market. This example is used to support the argument: Don’t try to time the market. Obviously, if you are out of the market during the best up days, your overall return will be significantly lower. But the other side of this argument is rarely discussed in these seminars. If an investor misses the 20 worst down days in the market, she would avoid losses – in fact, the difference is even greater. If you could choose being out of the market either for the 20 best up days or the 20 worst down days, you would be better off missing the worst down days. Bottom line: Never forget that in the eyes of the financial industry you are a profit centre. Some of the industry’s “educational advice” is conventional wisdom: for example, start saving at an early age. Yet other often quoted advice, such as to stay in the market for the long term, may be more beneficial to the industry than to the individual investor. What you can do now: Study impartial books, newsletters, and websites. These are written or sponsored by firms or individuals who are not trying to sell you something. Compare their viewpoints with the information supplied by industry sources. Know how your financial advisor gets paid It may not happen often, but occasionally a financial advisor can be influenced by the different level of commissions that can be earned on different investment recommendations. Most financial advisors are completely honest and go the extra mile to do what is best for their clients. Intelligent advisors know that their most important asset is their reputation for honesty and integrity. Enlightened self-interest is therefore enough to ensure that they will always do what is best for their clients and avoid any action that might hurt their reputation. However, as in every industry, we do hear about financial advisors who, in order to generate fees, make recommendations for changes that are at best unnecessary and at worst may even be detrimental (after fees) to the client. It is not always wrong when an investment advisor recommends the investment that pays the higher commission. Sometimes a change in the portfolio is necessary. For example, consider a situation in which two investments are being considered and all other things (e.g., potential return, potential risk, liquidity, tax efficiency, and correlation with the rest of the portfolio) are equal. An advisor can hardly be faulted for recommending the investment that pays the higher commission. It is unlikely, however, that all other things will be completely equal. Financial advisors must therefore always be on their guard to ensure that their recommendations are those that serve their clients’ best interests. Some compensation arrangements remove most of the potential for conflict of interest and other arrangements remove all such potential. It is worthwhile, therefore, for the client to understand the different types of compensation arrangements that are available. The Financial Advisors Association of Canada (Advocis) describes the following four common types of compensation arrangements: Fee only: The advisor is compensated through fees as determined based on the time and complexity of the planning needs. Implementation of any recommendations may be facilitated through the advisor but will be done by third parties who are duly licensed for the products being acquired. The advisor will not be compensated over and above the fees as identified in the engagement agreement. Fee plus commission: The advisor is compensated through fees based on the time and complexity of the planning needs and will also receive compensation through commissions, finder’s fees, and/or brokerage fees. These additional revenues will be received as a result of the placement of investment, insurance, and other financial products as part of the implementation of the action plan. Fee offset: The fees will be determined based on the time and complexity of the planning needs but will be reduced to reflect any commissions or referral fees received for transactions undertaken as a part of the implementation of the action plan. More specifically, the advisor will calculate how much annual fee revenue is required to carry out the engagement and ongoing continuous service, and deduct from this the estimated annual compensation expected in the form of commissions or referral fees, in order to arrive at a net amount payable annually. Commission only: The advisor is compensated through commissions, finder’s fees, and/or brokerage fees. These revenues will be received as a result of the placement of investments, insurance, and other financial products as a part of the implementation of the action plan. Managed account: Another type of compensation arrangement that exists within the brokerage industry is the managed account arrangement. In this case, no commissions are charged on trades within the account. Instead, an annual fee (usually between .75% and 1.5%) is charged on the assets in the account. Bottom line: Even if it is only to put your mind at ease and satisfy yourself that your advisor always has your best interests at heart, you must understand completely how your advisor is compensated. What you can do now: If you are not certain as to how your financial advisor is being compensated, ask for clarification. © 2005 Warren Mackenzie |
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