A new archetype in financial planning is needed for individual investors.

    Since the collapse of the so-called Internet bubble (and for some planners, much longer than that) financial planners have begun to question many of the principles that they once thought were unshakable. One of the most poignant observations on this matter appeared in Harold Evensky's April 2001 article in Financial Advisor magazine, "Heading For Disaster." I n the article, Evensky says the assumptions advisors use for investment planning may threaten their clients:
    "Although a long-term proponent of the application of mathematics to our work as financial planners, I think we've succumbed to sexy but simpleminded, psuedosophisticated analysis. In the process, we devote endless hours to touting (and inaccurately extolling) secondary issues and techniques. At the same time, we ignore fundamental issues critical to our clients' well-being."
    The need for such a paradigm shift gained momentum when Professor Daniel Kahneman was awarded the Nobel Prize in 2002. Dr. Kahneman was recognized for observing that individuals make investment decisions in ways that differ greatly from the observations about institutional investors for which William Sharpe and Harry Markowitz gained wide acclaim. In addition, today's enormous demographic pressures, including the looming retirement of tens of millions of baby boomers, are forcing advisors to confront new types of questions that old assumptions are ill-equipped to answer.
    According to Stanford University's Graduate School of Business, Professor William F. Sharpe, a Nobel laureate in economics, is researching methods to assist baby boomers in managing income streams during retirement. Sharpe's new research efforts are further validation of the growing awareness that advisors will require additional tools to manage the spending phase of life along with those that were helpful during the accumulation phase.
    The quest for a new financial planning archetype must begin with a better understanding of the individual investor's landscape. It requires understanding that planning should focus on the things that planners and their clients can control, on realizing that wealth is dependent on a host of integrated forces-not just portfolio performance-and on an awareness that clients are often more concerned about avoiding losses than about dampening volatility.
    For more than a decade, asset allocation has been accepted as the principal tool for helping individual investors protect from risk and accumulate wealth. A landmark study by Brinson, Hood and Beebower, "Determinants of Portfolio Performance," Financial Analysts Journal, July-August 1986, found that more than 90% of portfolio performance results from allocation across asset classes. Their findings have driven financial planners to focus their energies on optimizing client portfolios.
    Recent years of market volatility and underperformance have raised questions about whether portfolio optimization "science" merits such emphasis in the decisions of individual investors. Many of the questions focus on two concerns: Are there critical assumptions underlying portfolio optimization that differ from the realities of individual investors? Are there factors at work in the world of individual investors that were not present in the Brinson, Hood and Beebower study?
    To begin with, Brinson, et. al., defined "success" differently than most individual investors perceive the concept. Individuals generally define success in terms of meeting cash flow requirements. Brinson's study defined success in terms of the consistency with which a target rate of return was achieved.
    Furthermore, the mathematics of portfolio optimization depends on statistical averages of the correlations of various assets to one another. Because average correlations do not vary greatly for holding periods of three or more years, portfolio optimization calculations generally treat correlations as constants. Portfolio optimizers can afford to ignore the variability of correlation statistics found in shorter holding periods because they assume expenditures are either constant or nonexistent. In either case, cash flows are treated as if they were trivial factors.
    Unfortunately, individual investors generally do not live in worlds of averages. They are impacted by the reality that correlations differ greatly from one phase of a market cycle to another. That is because they frequently have liquidity needs that are independent of whether or not financial markets are doing well. In fact, most individual investors don't really have an investment time horizon. They often have several horizons that are driven by different goals for spending different amounts of money in different time frames.
    Individual investors also make irrational decisions that are driven by emotional factors, leading to untimely portfolio withdrawals. Financial advisors cannot ignore these factors. The psychology of the current generation of boomers has been greatly impacted by three factors that often outweigh the reality that the S&P 500 index has increased 60 times over the past 60 years (their entire lifetime). It often leads them to wonder if their portfolios can withstand economic events that are less robust than those which produced current index levels.
    First, during the one-third of those 60 years that occurred as boomers were entering adulthood (1964-1984), equity returns averaged less than T-Bills. Few boomers are emotionally or financially equipped to spend two-thirds of a 30-year retirement treading water. Second, these "boomers" were raised by a generation of people who reached maturity during the Great Depression, instilling in their offspring a latent fear of poverty. This fear has propelled boomers to great success, but during retirement it will likely lead them to focus on safety. Finally, as they stood at the portals of their own retirement, many of the older boomers watched the "Great Erosion" of portfolio values that occurred during the period 2001-2003. The media of that time was rife with comparisons to the Great Depression, which had defined the economic psychology of their parents' generation.
    Even optimized and balanced portfolios cannot assure against losses at times when liquidity is required. For instance, correlations among asset groups during growth periods are not at all similar to correlations of the same assets during recessions. And, sometimes all asset classes post negative returns at the same time.
    A review of monthly historical returns of nine common fixed-income and equity security groups for the 20 years ending December 31, 2002, showed that a portfolio containing equal weightings of the nine assets experienced losses in 33% of the months, averaging 2.375% per month. Asset groups included U.S. small-cap value, U.S. small-cap growth, U.S. large-cap value, U.S. large-cap growth, S&P 500, long-term corporate bonds, long-term government bonds, five-year Treasury notes and 30-day T-Bills.
    Not only are the fundamental assumptions underlying portfolio optimization different from the realities of individual investors, but their financial landscapes are quite different from the owners of portfolios that were studied by Brinson, Hood and Beebower. Principally, individual investors must manage not only investment returns, but they find that the timing of cash flow activities within market cycles is critical to their financial success.
    This co-dependency of investment returns and cash flows becomes more acute once people retire because they must transition from accumulating assets to spending them. Unlike the accumulation period of life, during retirement most people need to continue spending when markets underperform. They cannot suspend living and wait for a recovery to resume spending. Consequently, each drawdown after a market decline represents an increasing percentage of their capital base, which results in an acceleration of its depletion.
    Figure 1 helps illustrate that withdrawals create more drag on portfolios after negative returns. It depicts how two accounts with identical monthly returns achieve different results if the timing of drawdowns is changed. In the first case (Series 1), $100,000 was withdrawn from the portfolio at the beginning of each month that recorded negative returns. In the second case (Series 2), the $100,000 withdrawal occurred at the end of each such month.
    Financial planning for individual investors encompasses more than the important task of portfolio management. To deal effectively with the individual investor's landscape, planners should embrace three concepts:
    There is an "Integration Effect" that cannot be understood using conventional tools.
    The proximity of transactions and economic events to one another cannot be ignored.
    There are no "right answers" because the landscape is always changing.

    One can see the "Integration Effect" by looking at the differences between the annual changes in portfolio values of a baseline case compared with the annual changes in portfolio values for each of three scenarios (see Figure 2). Annual changes in portfolio values for each scenario were compared to annual changes in the baseline case in order to isolate the unique characteristics of each scenario. The baseline represents a comprehensive financial plan that includes annual portfolio rebalancing, investment returns that are a series of historical return data from a selected time frame, normal annual cash flows, extraordinary cash flow transactions and income tax calculations based on current tax laws.
   

    The assumptions for the first scenario differ from the baseline in only one respect-a different historical market cycle was used to project future investment returns. The second scenario uses the same assumptions and historical return data as the baseline; however, the timing of one extraordinary cash flow transaction is deferred to a different point in time in the market cycle.
    In the third scenario both market cycle and the transaction timing are changed in the same way that they were in the first two scenarios. In most periods, the cumulative effect of changing BOTH assumptions in the same projection differs significantly from the combined differences when those assumptions are altered independently in different projections.
    The "Integration Effect" refers to a synergy of events that over time results in a cumulative effect that is different from that which can be explained by either summing the changes caused by all of the variables, or by the phenomenon of compounding. In the presence of an "Integration Effect," an integrated view of transactions and events is indispensable.
    The reality of the "Integration Effect" demands an integrated view of transactions and economic conditions in which they may occur. The complexity of such integration means it is impossible to find an "optimized" solution for each client's needs. Consequently, planning should be exercised in a way that searches for fault tolerances in a client's decisions. This exercise should include contingency plans to address volatile economic environments as well as frequent evaluation and revisions.
    "Business 101" describes planning as one of several activities that are a subset of managing. In its efforts to define financial planning as a "profession," the financial services industry has isolated planning from the remainder of the management functions, making it a static event rather than a dynamic process. This diversion from sound management theory lies at the root of the tendency of financial planners, as Evensky observed, to "... ignore fundamental issues critical to our clients' well-being."
    Financial planners can avoid being misled into secondary issues by applying a process that integrates planning into a client-centric management process. One fundamental rule of the process should be to run projections early and often. A corollary to that rule should be to test multiple scenarios, rather that trying to find the "right answer."
    Such a process should be cyclical, beginning with an initial plan that leads to executing action items, followed by evaluating outcomes against a changing landscape, then making revisions to the initial plan and executing new action steps. This process would encourage planners to manage, rather than predict, the future.
    Next, the process should make it possible to test-drive projected life events through a variety of historical market cycles so clients can try out choices before they commit to action steps. Then, the process should allow planners to efficiently update projections when circumstances change, so clients can make adjustments when life throws a curve. Finally, the process should encourage clients and their advisory teams to share information and responsibilities easily and quickly.
    While such a process helps clients make better choices in managing their affairs, financial planners can also benefit. They can build more reliable, recurring revenues because they create more deliverables, more often. They can feel more secure about their advice, because it's not about being right, it's about helping clients make informed choices. They can be the one their clients can't live without, because they are an integral part of their lives. 

Larry Fowler is chairman and co-founder of financeXpert.com Inc. Jeffrey Rattiner, CPA/PFS, is founder of JR Financial Group.