We have our own discovery process at Koss Olinger called the “Wealth Navigator System” that shares qualities with other firms’ exploratory financial planning programs. Every firm should have a goals-based exploratory process if it doesn’t have one already.
Independent advisories have a further advantage to leading the future. Unlike larger firms, they can dictate the extent of their exploratory processes. A large brokerage firm may ask very few questions that take into account its clients as people. The firm may ask very basic things such as: “How much money do you have?” “What is your tolerance for risk?” “How do you manage your money right now?” The firm will then “optimize” a portfolio for the clients’ answers to basic questions. The firm will look at the hard data, the financials, but spend little time on the soft data.
Getting to know the client as a person means asking other questions, such as: “What do you get excited about?” “What are you grateful for?” “What keeps you up at night?”
Third Key: Conservatism
Just as the principle of conservatism in financial accounting exists to prevent the overstatement of accrued revenues on income statements, a principle of conservatism would serve our industry well, too, especially when we base our portfolio construction on uncertain income streams in the future. This is especially true with regard to expected returns on investment portfolios, since future withdrawal and spending rates depend on them.
High returns create unrealistic scenarios. By relying solely on historical returns, we can create expectations that are too high in wealth simulations. While many may build their expectations on the past, the valuation levels today justify an application of conservatism to assumptions of return.
While a cyclically adjusted price-to-earnings (CAPE) ratio is a poor predictor of short-term stock returns, its long-term predictive ability is disputed far less. The current level of the U.S. CAPE ratio (over 29) suggests that returns in the United States could be as low as 3.3% over the next 10 to 15 years. An aggressive portfolio with 80% in U.S. equities and, say, 20% in U.S. Treasurys would earn a return of approximately 3.1%, a dismal figure that might make anyone question the value of investing at all.
The average expectations for long-term returns, however, are not so dismal. In U.S. large-cap equities among institutional investors it’s approximately 6.5%. Nevertheless, the high valuation ratios in the United States (relative to low ratios in developing markets and other developed countries) suggest that investors should shed the home bias toward U.S. investments if they want to earn the returns necessary to support their withdrawals. The CAPE ratio of Europe is under 19, which augurs long-term returns of 6.4%. The ratio anticipates even higher returns in emerging markets.
The bottom line is that a deeper understanding of historical returns from various security types will take into account the valuation at the time, especially now that we are in the ninth year of one of the longest bull markets in American history.
Putting such conservative thought into play can be a selling point for advisors and pay off in the long term if clients can see their investment strategies support their goals—and by using realistic expectations.