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.