The opposite of your recommendations may be what's best for clients to reach financial nivana.
If you stood in front of a mirror with the words
"asset allocation" written on a piece of paper, seeing the words
backwards would help prepare you for the intellectual calisthenics you
are about to engage in. Here is my thesis:
1. Common asset allocation models make little sense
to the right (emotional, sensory, risk-gauging) side of the brain.
2. The allocation model that offers the right
emotional fit for many of your clients is the mirror opposite of what
is widely recommended.
Before we set out on this journey of emotional
perspective, let me say that I'm not here to debate asset allocation
through a mathematical lens but rather through a filter of
emotional/sensory interpretation that guides the right side of our
brain in the decision-making process.
Intuition and "gut feeling" are the right brain's
sensory faculties at work. While the left side of the brain is trying
to settle the question, "Does this make sense?" the right side of the
brain is attempting to resolve, "Does this feel right?" By and large,
models we are telling clients "make sense" in allocation do not "feel
right"--and therefore, no longer make real sense. Once you obtain a
clearer picture of the emotional impact of these models, it is the math
that you begin to doubt.
Markowitz's Theorem
I'm guessing that you don't draw out Harry Markowitz's Theorem of
Diversification when you are presenting asset allocation to your
clients.
This would only serve to confuse them further. As I
looked at this theorem, I deducted that Markowitz wasn't weighing any
right brain, abstract, contextual, emotional, intuitive, or sensory
factors in the development of his theory. I don't know how many
left-handed economists there are, but my suspicion is that
right-brainers are in short supply in this crowd.
We intuitively understand that emotional
comfort/discomfort is the engine that drives the "decisions" train.
Logic (and math) is what the engine pulls in the boxcars behind. People
make decisions when they feel comfortable. When they no longer feel
comfortable, they change their direction. Have you ever stopped to
consider how the right brain function processes asset allocation? You'd
better buckle up for this because the conclusions reached may not allow
you to continue with business as usual. Following is an example of a
right-brain approach to the subject of asset allocation.
Stairway To Financial Heaven
The following "Stairway to Financial Heaven" (©
Mitch Anthony, 2005) analogy offers a path for clients to choose an
allocation they can live with (That is a part of the equation, isn't
it?)
If there was a stairway to financial heaven and I offered you the
following two climbing scenarios, which would you prefer? In scenario
one, you would climb ten stairs in an average year. In a bad year, you
would tumble down 18 stairs. In a really good year, you would climb 38
stairs. In scenario two, you would climb eight stairs instead of ten in
your average year, but you would only fall down six stairs in a bad
year. In a really good year, you would climb 35 stairs. Which scenario
most appeals to you?
Now, what is your choice? If you are like the
majority of those who I have presented this scenario to, you will
choose the scenario with an average of eight stairs in the average
year, losing six stairs in a bad year, and gaining 35 stairs in a
really good year.
If that is your choice, you just chose a 30/70
(stocks/bonds) asset allocation based on research over a 50-year period
(Ibbotson). Not 70/30, but 30/70--the mirror opposite of what is
typically recommended to clients!
If clients understand the emotional realities of the
asset allocation recommendations they are agreeing to ahead of time, my
suspicion is that a majority would choose the exact opposite of what is
being commonly recommended. I presented this scenario to about 50
people before printing this article and the vast majority went with the
30/70 scenario. A couple of individuals asked, "Can I get a scenario in
between those two (which would be a 50/50 allocation)?" A couple others
asked, "What is the difference over time between the projected total of
the two scenarios?" Very few asked for the 70/30 allocation when
presented with an analogy that registered emotionally. Analogies and
metaphors speak to the right side of the brain and make instant
emotional sense. Percentage points--the convenient professional
parlance of financial services--are a different matter altogether in
terms of emotional comprehension.
In a moment you will see the exact numbers from the
study of historical returns expressed in percentages, which by the way,
are not clearly comprehended by the right side of the brain. Percentage
points mean nothing to the right side of the brain. As soon as the
right side of the brain hears, "You lost 18%," it demands to know, "How
much real money is that?"
If I told little Johnny that 18% of his Hot Wheels
cars had turned up missing, Johnny would instantly want to know, "How
many cars is that?" and, "Which ones? I hope my silver Mustang isn't
gone." The right brain needs a picture-something real, visual and
tangible to understand.
Percentage points are the devil's pitchfork in
financial services--a tool that can be easily used to distort, deceive,
manipulate and cloud reality. The story of the ParaMutual Fund Company
is my favorite example of the field day a fund company could have with
the percentage point at their side. In this story, a man invested
$10,000 and in the first year, he lost 50% and was down to $5,000. The
second year he gained 50% and was up to $7,500. The third year he
gained 33% and was back up to his initial investment (less fees, of
course). Imagine this man's surprise when he received the ParaMutual
Fund Company's prospectus with their three-year returns listed as "Up
an average of 11% per year!" (-50%+50%+33%, divided by 3=11%) All this
fellow knows is that he's not even at even money after three years of a
roller coaster ride. Percentage points are but soft clay in the hands
of those with creative impulses-as ongoing accounting scandals aptly
demonstrate.
As you read The Stairway to Financial Heaven
analogy, the right side of your brain shifts through layers of
emotional reasoning. For example:
That's an awful lot of downside
risk for just two extra stairs in an average year. (Three times the
downside risk in the 70/30 scenario)
The downside in a bad year is
much more pronounced than the upside in a good year (three times the
risk in a bad year but only 9% more gain in a great year).
In mathematical terms, your emotional reasoning is
standing on solid ground. Chart 1 illustrates the scenarios in terms of
percentage points. Chart 2, which illustrates the scenarios in real
dollars based on $100,000 invested, clearly illustrates why clients are
emotionally unsettled with the allocations they are often directed
toward.
Now, as a concession to the "real money" reality
sought by the right side of the brain, let's look at these results in
terms of "real return" after one year:
Tune in to what the intuitive side of your thought
process is trying to say as you view this "real money" chart. Following
are obvious emotional conclusions (followed by the math substantiating
the thought):
Is this average year upside worth the worst year
risk? (The average year gain is 19% better, but the worst year loss is
300% worse.)
If my potential downside is that bad, shouldn't my
potential upside be just as good? (Whereas the downside is 300% worse,
the best year scenario is only 9% better.)
Who would want to take any sort of risk where the
loss in the worst-case scenario was 30 times greater than the gain in
the best-case scenario? Sounds more like Russian roulette than
investment logic to the emotional ledger-that limbic scale that
monitors our comfort levels. When you shift the discussion to the
analogy of either climbing or falling down stairs instead of percentage
points, the discussion shifts from being nebulous to easily processed.
Am I comfortable with the idea of falling down 18 stairs in a bad year?
Is that risk worth getting to climb an extra two stairs in an average
year and getting to climb three extra stairs in a really great year?
And, what is the difference between falling six stairs or 18 stairs in
a bad year? The difference between a band-aid and traction.
Reframing Asset Allocation
I can already sense the blood pressure of the
quant-focused, number-crunching, reasoning advisor going through the
roof over what I'm saying here. I can hear him or her screaming,
"That's not rational! What about the difference in returns over the
long period? The market is twice as likely to go up as it is to go
down! The rational thing to do is stay the course with a weighting
toward stocks."
Allow me to clarify my purpose here. This article is
as much about what we communicate as it is about how we communicate.
Clients deserve to understand what it is they are agreeing to-and they
deserve to be in allocations they can live with. Why do we need to
"stay the course" in some allocation theory that has no guarantees and
requires Xantax to survive?
Let's also review one inescapable fact of brain
function: It is with reasoning that we draw conclusions, but it is with
emotion that we make decisions. We need to take some time and reframe
asset allocation for our clients through the emotional filter. Here are
some of the common emotional responses to the rational, quantitative
arguments for popular allocation recommendations. It all sounds
reasonable but ...
"You don't know how bad a bad year will be."
"If I have two bad years in a row, it will wipe out years of gains."
"We may never again see returns like we saw in the late '90s."
"I can't afford to gamble my life on your projections."
"Why should I have to gamble so much more on the downside for just a few points on the upside?"
"It's easy for you to tell me what I should do,
but I have to be able to sleep at night."
"You really have no idea what's going to happen
tomorrow. Eighty years of history couldn't help predict the things
we've seen happen in the last few years."
And, The Big "WHAT IF" Questions
"What if research on patterns back to the 1920s isn't sufficient for drawing any reliable conclusions?"
"What if history doesn't repeat itself?" (It rarely does.)
"What if what happens in the next 25 years doesn't follow what happened in the last 25 years?"
"What happens to all your projections and probability analysis then?"
These are questions based in emotion, and they are
valid questions. They have been certified as valid by the events of
last five years and have led many consumers to subconsciously conclude
that the industry's projections are usually far more optimistic when
compared with what happens in real life.
It's not just fees that people are paying for asset
management, but emotional fees as well. Your clients pay far more in
emotional fees in the 70/30 scenario than they do in the 30/70
allocation, and you'll pay far more in emotional fees by having clients
placed in a portfolio with manic tendencies. Emotionally it comes down
to whether a client wants to ride something resembling a roller coaster
or something resembling an escalator that occasionally stalls or speeds
up. (The plot thickens further when we stop to consider how the bond
market has likely reached a point of being overbudget and postured for
a correction.)
The Cost Of Sleep
The other day as I sat down in first class next to a
55-year-old executive, he spotted The Wall Street Journal in my hand
and said, "It's sure no fun for the 401(k) when the market goes down
170 points."
We chatted about his 401(k), and I asked about his
planned date of retirement and allocation. He said he wants to retire
in five years and had an allocation of about 80/20 overall.
I commented that he must have had more than one
restless night with that kind of exposure within that short of a time
frame.
"Way too many nights," he admitted.
I told him the "Stairway to Financial Heaven story,"
and he immediately chose the 30/70 allocation. I also demonstrated to
him that with this allocation--if all five years were average--he was
only conceding $10,000 or so. But, in the case of one bad year in the
next five years, he just removed the potential for calamity from his
retirement nest egg.
"If it's the possibility of missing out on $10,000
that bothers you, you might ask yourself what five years of peaceful
sleep are worth," I offered.
As a case in point, allow me to illustrate what
happens when things don't go as we hoped in a 70/30 allocation. This
illustration may serve as a clue as to why investors are slaves to the
emotional swings that accompany market fluctuations. Bear in mind as
you view this illustration that when you take the probability of
extreme downside market swings out of the picture, you also remove the
downside emotional swing with it.
All the extrapolation and probability analysis in
the world is a waste of time when one single variable changes such as
"when a bad year happens." If the bad year comes early, we're OK, but
if it comes late in the game, it becomes a personal financial disaster.
Chart 3 is a scenario I designed with a financial
planner and ran through probability software to play out what would
happen if things didn't turn out as rosy as projected for a 45-year-old
client in a 70/30 allocation versus a 30/70 allocation. The first
column demonstrates the returns in our "rose garden" scenario--where
returns play out to historical averages. In the scenario in the
right-hand column, the "you-never-know" scenario, the client is going
to get the historical average return in 18 out of 25 years. In two
separate years (years 9 and 19), the client will get the high return,
and in five separate years (years 5, 6, 17, 23, and 24), the client
will get the low, and two of those low years are toward the end of the
25-year period (kind of like how 2001-2002 came late in the game for a
lot o
f
unsuspecting folks looking to retire). The chart shows what happens in
real dollars to an original investment of $100,000 over 25 years for
our 45-year-old client.