In my last article in the August issue, we discussed how total return is often used to compare different asset classes, products and strategies, even though the comparisons mean very little. It's normal to make these comparisons using absolute (or relative) total return in institutional and tax-free environments-but it doesn't necessarily work for taxpayers. Instead, we should be evaluating our clients' investment returns after taxes, expenses and inflation to get a real picture of what their portfolios have earned. Most reported investment returns don't consider these factors, and thus mislead the investing public.
Total return, as we said before, is based on historical performance. It's nothing more than a visual display of the past, and not an indicator of the future. And yet it has become the primary financial gauge investors use to review investment performance. In fact, in the minds of the investing public, there are no other measures. But historical performance operates much like an odometer on your car-it only measures backward and is not designed to tell you how many more miles are required to reach your destination. If an odometer were the only gauge on an automobile, no one would purchase cars, because it would tell drivers only a fraction of what they need to know to successfully operate the vehicle.
The current general consensus is that we may remain in a low-return environment for a significant time to come. (See Figure 1.)
After seeing the adjusted historical total return for the effects of inflation, taxes and investment expenses, the first reaction of most advisors is: "I knew this instinctively, but never saw it illustrated this way." Their second reaction is panic, followed by the demand to know how higher real, real returns can be achieved. Of course, a common problem of chasing higher returns is that it increases risk. And if it is unacceptable to accept higher risk, then we must change the subject and start talking instead about increasing savings, investing earlier or delaying retirement and working longer.
Historically, many wealthy families have had their money managed by private bankers and institutional money managers who didn't focus on total return but on building wealth. We may now be going back to the mantras of risk control (avoiding loss) and real return generation, as well as more saving discipline. These three fundamental tenets of investment may be the only way for baby boomers to accumulate a sufficient amount of wealth to survive in retirement.
In difficult times such as now, it becomes much more important to focus on the two things that can be controlled or managed somewhat-taxes and expenses. Whenever the investing environment is favorable and everything is going up, people tend not to dwell on these two. But they become much more important in difficult environments or periods of flat investment return.
These considerations require you to become more diligent in your investment selection process and expand your focus beyond total return and absolute returns. You must add different screens and criteria to your searches, all the while becoming more disciplined in managing the portfolio, because taxes, expenses and inflation have a bigger and more significant impact on the task of accumulating real wealth.
The Biggest Opportunity Of An Advisor's Lifetime
Most investors who work with financial advisors are keenly aware of how much money they have and how much they will need to accomplish a defined financial goal. But these nominal dollar figures may be misleading. While current retirees have already established their net worth goals and spending patterns and have successfully accomplished the mission of "having enough," their children may not be in such an enviable position. Only if they have run the "real" numbers will they know what their task is.
Many people, unfortunately, simply won't have enough time. Others must confront the seriousness of their mission to accumulate real wealth. The entire focus will shift from chasing the latest, greatest performer in both the mutual fund and managed account industries toward finding the most efficient and most-likely-to-succeed investment strategy that contributes to the accumulation of real wealth.
Money managers will need new tools to help the maturing population seek after-tax, after-expenses dollars and meet real adjusted goals. The shift from a total return model to an after-tax, after-inflation total return model will make comparisons to indices less important. And advisors will need to begin to talk in terms of "real" returns with the new adjustments embedded in them.
And your clients will then need to change the way they view investments, dramatically altering their whole frame of reference as they assimilate this new definition of investment returns and then determine their real needs and goals in this framework. The concept of time to accumulate and the time to spend will become more crucial, and historical reviews of long-term "real returns" will be necessary. For those who start early and understand these concepts, time will be their friend. For those who start late or fail to recognize the significant impact of inflation, taxes and expenses, time will become their greatest enemy.
The shift in thinking means a bigger role for the financial advisor. Clients will develop a greater dependence on their advisors as they begin to realize how difficult it is to generate real returns within constricted risk parameters.
The advisors, must learn to ask new questions and have new kinds of discussion with the client to present the more realistic objectives, understanding the probabilities of accumulating real wealth since taxes, inflation and expenses hinder most, if not all, investments.
Why Probability?
Most people understand the probabilities involved in winning at lotteries or at the slots, or the chance of suffering an insurable loss. They understand the role that chance plays in professional sports, even if the players are highly skilled. Investing doesn't rely solely on random events, either; the probabilities of success can be increased somewhat by understanding and applying some fundamental principles that have in the past had a major impact on the returns generated.
When looking at the probability of achieving success, you can subtly shift the emphasis in your advice away from the intangible things you can't control (inflation and markets) and focus on the things over which you do have some control-taxes and investment expenses, along with the portfolio's structure. And then you can more accurately respond to your clients' most pressing question: "What are the actual chances that I will achieve my financial goals?" Most clients are not as concerned about the volatility of periodic returns as they are about not having enough money to meet their real financial goals.
You begin by discussing the real return chart and the absolute dollars required to satisfactorily meet clients' investment objectives at some time in the future. Then you apply the investment strategies that have the highest probability of achieving those results. But, again, hitting the dollar target alone is not enough. That goal must be adjusted to represent the "real wealth" required to satisfy the financial objective, whatever it may be. Once your client has determined the adjusted dollar value of the goal, the only portfolio strategy that should be discussed is the one that relates historical real returns. In this way, you have changed the nature of the conversation from one about seeking maximum total return to one about seeking the accumulation of wealth, using a realistic target and realistic expectations of return. It's a serious challenge, but it forces an investor to become realistic, too.
Your objective is to get your clients to view their financial goals as future liabilities-money the clients owe themselves at some point in the future. By setting hard dollar goals and understanding the risks and constraints inherent in various investments (inflation, taxes and expenses), you can develop strategies that have a better chance meeting these goals. A target goal is what the investor would optimally like to have, and a fallback goal is what the investor must achieve at the very least. By identifying all the known variables-such as time periods, tax rates, required cash flows and fees-and then attempting to solve for unknown variables such as future capital market returns, the advisor can make choices based on expected real returns and thereby increase the accuracy of projections. With realistic total return analysis using historical real rates of return, and with more realistic client expectations of what is required in the future, the value of an advisor's advice is eminently enhanced. It can be the opportunity of a lifetime when so many are in need.
Take Away:
Advisors have to start calculating returns after taxes and expenses instead of on a total return basis.
Your clients do not live in a tax-free environment.
Every investment should be analyzed based on real, real returns.
You must identify all the known variables.
You must set both target and fallback goals.
A re-education is needed to shift gears and go against the past conventional wisdom.