Investors are obsessed with performance. It makes sense. But are they holding you to an impossible standard?
Impossible standard? What does that mean? You might assume they are asking you to compare the equity portion of their account to the performance of the DJIA, S&P 500 or the NASDAQ. The issue would be even if your performance was close, a tracker fund with a wafer-thin cost structure would be a tough target to beat. Yet it happens. According to Morningstar, about 49% of actively managed mutual funds outperformed their passive fund competition in 2020. Active management has value, but it’s not an easy game to win.
My concern is a different problem. The client who sees a stack market index up 10% then wonders why their account isn’t up 10% or more. Clearly, you the advisor are doing something wrong. The problem is their portfolio with you isn’t invested 100% in equities. It’s a balanced portfolio in stock, bonds and some cash. There might be a foreign component too. Your client needs an apples-to-apples comparison. As their advisor, you need to show them the split between stocks, bonds and cash. It might be 55%, 40% and 5%. Next, you need to construct a blended index representing that weighting. Now, it’s an appropriate comparison.
Even with the blended index approach, it only looks at the client’s performance over a defined period. That’s fine when the market is up 10%, but what about the time when it’s down 10%? Even if your client outperformed the market, losing only 8%, your client isn’t happy about losing money. They don’t understand sometimes “not losing” isn’t an option when you are fully invested.
They might see market timing as an attractive alternative. You know how to address that issue. You’ve seen the charts showing when the market makes a sudden turn; if you weren’t present for the first or second day of the move, you’ve lost a substantial amount of the appreciation.
A better way to measure performance is progress towards goals. It has its pros and cons. The concept is you set the major goal(s) down on paper. It might be retirement. You have a dollar goal you hope to achieve by age 65. Your 30-year-old client has a portfolio focused on that goal and will be adding money on a scheduled basis in the future. From this data, you can calculate the rate of return they need to reach their goal. If you think of a 30-year mortgage getting paid off over time with monthly payments allocated towards principal and interest, it’s that calculation in reverse. Your firm has tools to help determine the return they need to earn to reach their goal.
Years ago, I met an advisor who developed a version on his own, positioning it with clients as “The Family Index.”
Here are the pros:
• With a long time horizon, often the required return isn’t that high. It’s a modest hurdle to hit.
• If you have a couple of really good years back to back, you can get substantially ahead of where you need to be at that time! Clients can choose to reduce their level of risk going forward or consider retiring earlier than expected.
• You are disconnected from the “meet or beat the market” challenge, focusing instead on a personalized goal.
• By continuously adding money over time, they are dollar cost averaging. This has advantages, especially in down markets when prices are cheaper.
Here are the cons:
• To reach your goal, the result each year needs to be a positive number. When comparing your performance to a market index, losing less than the market did in a bad year is considered a success—but not when your objective is making positive progress each year.
• Years with negative returns require you to recalculate the return needed going forward to hit your goal. Now the Family Index is a larger number.
• In those back-to-back successful years, clients are tempted to skip making the additions they committed to earlier. That’s a bad idea because the market runs in cycles.
Clients are going to expect you to focus on performance. Portfolio reviews are similar to report cards in school. Ideally, you can position a fair method of performance measurement so you aren’t competing against an almost impossible standard.
Bryce Sanders is president of Perceptive Business Solutions Inc. He provides HNW client acquisition training for the financial services industry. His book, Captivating the Wealthy Investor, is available on Amazon.