Trust is what drives the relationship with clients.

    After consulting to some of the larger and more sophisticated defined benefit pension funds in the United States for several years, I changed my practice to focus on the delivery of investment products to the individual investor in collaboration with financial intermediaries such as insurance companies and mutual funds. When I changed my practice, I felt very strongly that in order to create products that would be bought they had to fill a need, be appropriate and be understood by the investor and the financial advisor. As part of my research, I attended wholesaler and top producer meetings sponsored by my clients to learn how the products were sold by the best, and to determine what they needed to provide to their clients to grow their businesses.
    I will not forget the first lunch I attended at a top producer meeting, when I asked one of the financial advisors how he convinced his clients to invest in certain products. After my experience with the larger pension fund clients, I expected the advisor would describe how he was able to articulate the investment merits of doing thorough due diligence and use of carefully constructed diversified portfolios.
    Instead he simply said, "... because I tell them to." I found this a little hard to believe so I pursued the topic a bit further and asked him why they did what he told them. Once again his response was quite simple: "... because they trust me."
    After several years, many meetings, and dozens if not hundreds of similar conversations, I no longer doubt the wisdom imparted by my first top producer. I also don't doubt that any successful FA knows that trust is what drives the relationship with the investor and ultimately the success of the fee-based advisory business.
    If trust is the cornerstone of the business, we obviously need to understand how to create it and grow it. But we also need to understand what can cause the investor to lose his trust in the FA. The diagram "The Circle of Success" is useful in understanding the important elements in creating and increasing the investors trust in the FA, which ultimately leads to a more successful practice.
    As shown in the diagram, I believe there are three key elements that are the foundation of the trust relationship: (1) care, (2) setting expectations, and (3) meeting expectations. If one of these elements is missing or fails to be executed in a thorough way, the bond of trust will not be made or it will be broken. In the prospect phase, the lack of trust will prevent the acquisition of a new client. In the case of breaking the bond with established clients, the potential consequences are much greater because it can mean the termination of several services in addition to the service where trust has become a problem.
    Care is the first element in developing the bond of trust. It is the element that captures the prospect's attention and sends the signal that this is someone they might like and may want to do business with. I will not spend much time on this element since it is fairly obvious, and most FAs have developed their own techniques such as seminars or golf outings to illustrate their concern for their prospect's unique needs and investment well being.      If the care phase is done well, the prospect will become a client and the initial trust will be established. At this point the bond is quite weak and can be easily broken if expectations are not managed and achieved. The setting and meeting of expectations will strengthen the trust resulting in client satisfaction and a growing business. It will also perpetuate the business because satisfied clients will tell friends. This is the basis of the "friends helping friends" programs that are used by many successful FAs.
    Setting reasonable expectations should start in the sales process and be refined in the client profiling process. At least three things need to be achieved in setting expectations. The first is client education, the second is testing client knowledge and the third is client profiling, including the client's attitude towards investment risk. Frequently the three can be achieved in the profiling session.
    The most useful device in setting expectations is a comprehensive risk tolerance questionnaire mapped to efficient portfolios. The questionnaire/profiling activity should develop an appraisal of the investor's attitude toward investment risk, including portfolio volatility and downside risk or loss of principal. Liquidity requirements and time-to-need also must be evaluated.
    In addition, the risk evaluation should determine if there are other considerations that may bias the investor's attitudes toward investments. Foreign securities is one example. The use of foreign securities to diversify portfolios is a widely accepted strategy to reduce portfolio volatility and should generally be included in most investor's portfolios. However, many investors will not invest in foreign securities because of irrational fear or for political reasons. If the risk profiling does not discover this "fear of foreign," the investor will not accept the advisor's recommendation, or worse, will reluctantly accept the portfolio but lose confidence at the first sign of disappointment in the foreign investment. Once disappointment sets in, the trust in the advisor will diminish.
    This latter point gets to the heart of the purpose of the risk profiling activity-that is, setting reasonable expectations that are consistent with the investor's true attitude toward risk, or said in another way,  how they will react in the future to the investments they make today. I am confident that many risk evaluation questionnaires do a poor job of identifying true risk tolerance. Further, I am equally confident that even more advisors can persuade their clients to invest in more aggressive portfolios than the investor will be comfortable with in the future. In a fee-based business, the advisor will use the inappropriate questionnaire or sell a more aggressive portfolio at his peril. The risk to the advisor is that the more aggressive portfolio will ultimately be more volatile than the investor can tolerate and the trust will be lost, resulting in a termination to the relationship. If the relationship is not lost, the investor may have a "knee-jerk" reaction and move the investment to a very conservative portfolio that will not provide for an adequate growth in wealth. The Japanese reaction to their stock market crash in the early '90s is a classic example of overreaction.
    In recent years financial behavioralists have done significant work in understanding why individuals make the financial decisions they do. It is apparent from their work that an effective risk profiling tool is more than a few simple questions, such as "Are you willing to take more risk to get higher returns?" or "If the value of this investment goes down 20% will you sell?" The behavioralists have found that the way the questions are framed can bias the response and thus fail to capture the "true" attitude towards risk. They have also found that relating the questions toward total wealth and not focusing on a single investment will be more likely to capture the investor's true attitude toward risk. For more insight into the behavioralists' work, I would suggest a paper by Daniel Kahneman of Princeton University, "Aspects of Investor Psychology" (The Journal of Portfolio Management, Summer 1998).
    Another aspect of client profiling that is frequently misused is the investor's age. Frequently age is used to determine the investment horizon, and even as a short cut to a portfolio mix. Thus a recommended portfolio for a 25-year-old is frequently equity oriented, and for someone 75 it is mostly fixed income. If the time horizon is clearly understood and the purpose of investment is considered, the portfolio mix could be significantly different. For example, the 75-year-old investor may be investing for her heirs and the true investment horizon could be 20 or 30 years or even more, while the 25-year-old is planning to use the investment to purchase a house in three years. In those cases, the mix should be equity oriented for the older person and more fixed-income oriented for the 25-year-old.
    At the end of the profiling session, the investor should understand the legal and general investment characteristics of the available asset classes and the purpose of diversification. The investor should also understand the difference between return volatility and downside risk, the relationship between them and why the investment time horizon is important. The investor should also have an understanding of her  investment risk tolerance, and should be comfortable with the assessment. The FA should have determined that the investor does have a working knowledge of the relevant investment and risk concepts. In short, the FA should be confident that the investor has a good understanding about the way that their investment may vary in the future. 
    Once the risk tolerance is determined, selection of an appropriate diversified portfolio is the next step in setting reasonable expectations. A common method for portfolio selection is to "map" the investor's risk tolerance to an efficient portfolio that has the appropriate level of risk. This is a critical step in setting the investor's expectations, and perhaps the most difficult.
    Since an optimization process generally is used to develop diversified portfolios that are matched to an investor's acceptable level of risk, assumptions of volatility and correlations are especially important. Of course, the return assumptions also should be carefully considered. I would suggest however, that the absolute returns are less important than the relative returns between the asset classes. If you get the risk and correlation matrix right and relative returns are close, the resulting portfolios will have risk characteristics that are consistent with the investor's preference. If the absolute returns are too high or too low, the performance of the portfolio will be greater or less than expected, but the portfolio will still be efficient and with the volatility expected, thus the best that could be achieved in the market at the time. It is sometimes said regarding capital market assumptions that you can be absolutely wrong as long as you are relatively right.
    The difficulty, of course, is creating the capital market assumptions where the concept of "Garbage-In, Garbage-Out" rules. This is especially true if historical data is used to create the assumptions and there is reversion to the mean. Under such conditions the optimization process will select the portfolio that is highly likely to be the worst-performing portfolio in the future. I expect that under such conditions the investor will be disappointed and his trust of the advisor will suffer.
    Unfortunately, historical returns are commonly used because they are easy to create and are frequently the easiest to get by the compliance officer. Furthermore, since they are based on history they may appeal more to the investor, since he will recall the recent history and be comforted with a strong representation of high-return assets in the portfolio. The obvious and painful example of this was the bubble of the late '90s, and the subsequent crash. A more current example may be hedge fund strategies based on past performance, which have lead to disappointment recently. If setting reasonable expectations is of primary importance in keeping and growing an account, chasing performance is a risky way to advise clients.
    The alternative to using historical returns is to develop "forward-looking" assumptions. Unfortunately, one of the difficulties in creating forward-looking assumptions is the development of the covariance matrix that can be factored, which is required for the optimizer. This is a time-consuming process and one that requires a good understanding of the relationships between asset classes and the process of optimization. It also has become evident over the last few years that correlations can be unstable. How many times have we heard that "... diversified portfolios never work when you need them ..."? The more sophisticated firms now consider this change in correlations when the market is stressed, and develop covariance matrices that consider both stress and nonstress periods.
    Another factor frequently overlooked when historical returns are used is the inflation component. In developing forward-looking assumptions, the anticipated rate of inflation as well as the impact of unanticipated inflation should be considered.
    The expertise, difficulty and time required to develop reasonable capital market assumptions and to create a good risk evaluation tool makes it desirable for most FAs to get outside assistance in their creation.
    Once the expectation-setting phase is completed, the hard part begins-meeting expectations. The essence of meeting expectations consists of the due diligence process, structuring the portfolio to be consistent with the investor's expectations and managing the portfolio to remain consistent with the investor's expectations. The latter two activities, "structuring" and "managing," require risk analysis software to be done properly, but can be done by the FA if he has the time and can bear the expense of the software. Due diligence is another matter, and in most cases should be left to a specialty group.
    Fund and investment manager due diligence has all the same requirements as equity research. I would suggest that they are the same, except that fund due diligence is limited to a narrowly focused group. It includes qualitative, quantitative and comparative analysis. Thorough due diligence considers business and data management as well as portfolio management. It evaluates the trading operations and how the portfolios are rebalanced. The process may require several interviews on site and significant analysis of the source of performance and portfolio risk. Due diligence requires access to the fund's top management, portfolio managers, research analysts and traders. This access is generally not available to most FAs. In the absence of significant access to the funds, the FAs are forced to select funds and managers based on less rigorous analysis. In the absence of the in-depth analysis, the probability of disappointment with the fund increases, which will lead to investor disappointment. Ongoing due diligence is also required, to ensure that when there are changes to the staff or investment process an evaluation can be made to fire or retain the fund. I am not suggesting that FAs cannot do thorough due diligence, but it is very time consuming and costly and most FAs would be better off using the due diligence conducted by organizations that have the scale to do it well. The FAs are better off spending their time advising their clients.
    I have found that one of the most common mistakes made is selecting an inappropriate manager or fund to invest in an asset class. For example, using a momentum-based manager for the large-cap equity portion of the selected model portfolio. The problem with this is that the invested portfolio will have significantly different risk characteristics than the selected efficient portfolio. With different risk characteristics, the implemented portfolio will perform differently than the selected efficient portfolio. At some point it is likely that the implemented portfolio will underperform the selected portfolio and the investor's expectations will not be met. Yes, that can lead to a loss of trust and ultimately the client. A better way is to use more than one manager and use risk analysis to structure the funds for each asset class, so that the tracking error of the underlying asset class benchmark is reduced to a modest level. With such a structure good, active managers can be used to increase the alpha while the chance of unwanted surprise is reduced.
    Management of the portfolio over time is an extension of the due diligence and structuring process. If there is staff turnover at the fund, dismissal should be considered. As relative performance differentials occur the portfolio must be rebalanced. Calendar-based rebalancing is easy to implement, but may lead to excessive trading costs and unwanted tax expense. A better method is to consider the risk of the implemented portfolio and rebalance the portfolio when it reaches the boundary of the investor's risk tolerance. Risk analysis tools are required for this approach, but it keeps the level of risk in line with the investor's preference and more likely to meet his expectations.
    The Circle of Success is an easy concept to understand but requires a savvy FA with adequate resources to implement. Those advisors who are successful will understand the importance of setting and meeting expectations, and will enter into arrangements that will provide the resources required at a cost the advisor can afford. The best provider of the resources will understand the need of the advisor to be able to brand his services in the local market, and will thus deliver the services in a way that will facilitate private labeling. Obviously Web-based systems, like most everything else these days, will be the delivery system of choice.
    Advisors who understand the "circle of success" will capture  the 401(k) rollovers that occur each year  and which will dramatically increase as the baby boomers retire. They will be in the middle of the more than $10 trillion in wealth transfer that will occur over the next 20 years. As more investors find that they are wealthy, the more interested they will be in maintaining that wealth, and consequently investment risk will become increasingly important.  

William H. Overgard is president of WHO Investment Consulting in Wilton, Conn. This article was originally published by Senior Consultant (