Moving beyond the investment mentality.

    A child, however, who had no important job and could only see things as his eyes showed them to him, went up to the carriage. "The Emperor is naked," he said. ... Everyone cried: "The boy is right!  The Emperor is naked!" The Emperor realized that the people were right but could not admit to that.
- Hans Christian Anderson

    When clients are promised consistently superior, above-market returns by their financial advisors, are these promises as shallow and invisible as the clothes "weaved" by the tailors in the Hans Christian Anderson fable? Are they preying on the greed felt by many investors? If so, how long before the townspeople (average investors) discover that the emperor is naked? In addition, what will they do about it?

What Our Clients Are Looking For
    Those of you who attended the FPA Retreat in Missouri in 2004 were privileged to witness one of the most motivating sessions I have ever attended.  Videotaped interviews of four clients of financial planners were presented. They each spoke of how important their relationship was with their planner and what it had meant to them. They recounted how the quality of their lives had improved. Some of the phrases and words they used to describe their experiences were "peace of mind," "trust," "friendship," "caring," "concern for our needs," "availability" and "competence." One could not help but notice two things that all of these clients had in common: they treasured the relationship they had with their planners and not one of them mentioned investments.  I do not mean to imply that investing our client's money is something to be taken lightly or ignored. But to represent that the main reason people hire us and retain our services is to obtain superior investment results may diminish what we really do for our clients.

Constructing Portfolios
    One of the most important things we do for our clients is to construct portfolios that are designed to meet their unique individual goals. It is not the purpose of this article to get into the technicalities of constructing investment strategies. Enough been written on that subject. We all know that the basic purpose of any system is to construct portfolios that represent the highest probability of achieving success for your client. We define success as meeting goals, not beating markets.
Whether you use mutual funds, individual stocks, separate accounts or other vehicles, designing portfolios for your clients should contain two very important components. First, the expected returns, with some margins for error, need to have a high probability of your clients achieving their long- and short-term goals. Second, the strategy must be constructed in a way that it will not cause your clients to abandon the policy when markets are not doing well. Communicating realistic expectations about the returns and volatility will be vital.
    Since I believe that achieving above-market returns is something that cannot be consistently delivered to clients, I tell them that.  Moreover, as financial life planners, we do not need to "beat the market" to provide value to our clients. And I'm talking about value for their investments, in addition to all of the other things we do for our clients.

What Is Your Alpha?

    Dalbar Inc.'s 2003 update to its ongoing study, the Quantitative Analysis of Investor Behavior (QAIB), showed that investors continue to chase investment returns to the detriment of their pocket books. Most likely motivated by fear and greed, investors pour money into equity funds on market upswings and are quick to sell on downturns. Not surprisingly, most investors are unable to time the market and are left with equity fund returns lower than inflation. According to the Dalbar study, the average equity investor earned a paltry 2.57% annually, compared to inflation of 3.14%, while the S & P 500 index earned 12.22% annually for the 19 years studied (1984-2002).  
    So, why do so many financial advisors believe and communicate to their clients that getting returns that are superior to the market is the primary value they bring to the relationship? Dalbar has demonstrated that, when left on their own, average investors got returns that were almost 8.5% lower than the market.
    As advisors, you do not need to beat the S&P to deliver value to your clients. You provide discipline. You see to it that they don't overreact to market swings. You stop them from doing the things that average investors do that cause them to get returns that are 8.5% below the market. However, many advisors I talk to diminish the importance of this discipline, and judge themselves on their ability to beat some index. They fear that clients will not pay their fees if they don't do so. They must provide "alpha." What is alpha for financial life planners and their clients? We all know the technical definition of the term, but I would define it differently for my clients.
    First, if we look at what we do quantitatively, the return we provide should be better on a risk-adjusted basis than what they would have gotten if left on their own-not a return that is above some arbitrary index. That is very difficult to measure because we have no way of knowing what their results would have been had they not engaged our services. However, Dalbar has certainly provided us with a clue of how well the average do-it-yourself investor does. In fact, if the return of the equity portion of the portfolios you managed for the period studied by Dalbar were 2% below the S&P, you would have benefited the average investor by more than 6%. That may be your alpha in percentage terms.
    However, if we stray from the technical definition of alpha and define it as "value we provide for our clients," then the term takes on a much broader meaning and defines who we are as financial planners and what we do for our clients. Alpha, if we insist on a quantitative measure, could be reaching or exceeding the client's financial goals. If a client needs to obtain a return of 6% to reach every financial goal she has in life, and your portfolio returns 6.5%, have you not provided alpha? How about the clients who use their time in pursuits that they value and enjoy, rather than agonizing about their portfolio?  Is that not alpha?  Is peace of mind alpha? One of our clients managed his own portfolio for years (and did a good job), but hired us so he could devote more time to his practice and family. During the bear market of 2000-2003, he called to tell us how happy he was that we were the ones that needed to make the tough decisions about his investments and not him. That was his alpha. Beating the S&P 500? Let the money managers live or die with that bogey. Your "alpha" is the peace of mind your clients experience because of the discipline you bring to the investment management process.

What Is Risk?
    We believe that many advisors, and certainly most clients, confuse risk and volatility. To us, the greatest risk for our clients is to discover that they do not have enough assets to achieve their most important goals in life. Reaching the age of 85 and discovering that you have outlived the portfolio you designed 20 years earlier is, by far, the riskiest strategy that one could ever devise. An investor may believe that a portfolio with 100 % of assets invested in intermediate bonds may be risk-averse, but it will have no probability of succeeding if that person needs to experience a return of 5% over inflation to maintain his lifestyle for the long run. If we define risk as "running out of money before you run out of life," it is our duty to point out that a strategy that appears to be conservative may be the most risky.
    Recently a new client who was retired told us that he wanted little or no volatility from his investments. His portfolio was with a major brokerage firm and his broker had followed his client's instructions and constructed a portfolio of bonds of various maturities and no equities. . The client told us that he did not want any of his money invested in stocks because he could not handle the "risk" (of course, he meant volatility).  Our long-term projections demonstrated that he was on target to run out of money in 12 years. We asked him if this was a risk he was willing to take, or would he be willing to accept some fluctuations and years when the portfolio lost money in order to significantly increase his chances for success. 
    His broker had taken the easy way and, in spite of the fact that he was withdrawing an unsustainable amount from a portfolio invested 100% in bonds, never bothered to tell the client. We did. The result was a balanced portfolio of 50% equities and 50% fixed income. Will he fret over fluctuations? In the short run, probably. Nevertheless, as financial life planners it is our duty to help our clients achieve their goals. When faced with the prospect of either accepting more volatility or changing their goals, my experience is that clients always choose to accept portfolio fluctuation as a price they need to pay for getting what the want out of life.  In my opinion, financial advisors place too much emphasis on "risk tolerance" when portfolios are being designed for clients, and in many cases sacrifice the long-term financial welfare of their clients.
    We all know "The Serenity Prayer":  "Grant me the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to know the difference." Let us not fool our clients and ourselves by making claims that rival those made by the tailors in the Anderson story. We do enough good without having to claim more than we can deliver. 

Roy Diliberto is chairman and chief executive officer of RTD Financial Advisors Inc. A former chairman of the Financial Planning Association, he is a nationally recognized financial advisor.