Sometimes when you've been building a skyscraper, it helps to go back and look at the architect's drawings to remember what it was he had in mind.
That's what Libby Mihalka, a CFA and founder of Altamont Wealth Management in Livermore, Calif., said she was thinking while listening to Stanford Professor, Nobel Prize winner and asset management guru William F. Sharpe, as he addressed a crowd of NAPFA members in San Diego in late-September .
Sharpe took a break from academia to break bread with advisors in the trenches and talk to them about post-retirement strategies in markets that have gone up, down and sideways. It's a world where convictions in buy-and-hold investing have been dashed for many people after the market crash in 2008, and where a traditional strategy like distributing 4% a year from assets, feels increasingly dicey in volatile markets. It's a strategy that could require clients to eat into principal since stock and bond yields are frustratingly thin. Meanwhile, clients face longevity risk as more baby boomers ponder living into their nineties or longer.
What Sharpe offered was both funny and scary. Funny because he delivered it with self-deprecating humor, in a presentation replete with such visual aids as the painting American Gothic, with the famous old couple sporting cell phones, pagers, golf clubs and an SUV.
It was scary because despite all the backward-looking data Sharpe said he can accumulate as an academic, the future is uncertain, and advisors still have to share this unfortunate news with clients. The data advisors give them is always going to be subjective, and the risks of failure are still going to be more than some investors can deal with. If the market has no memory, there's no reason 2011 couldn't be like 2008, 2000, 1973 or 1929. The more he knows, Sharpe said, the more he realizes he doesn't know.
The job of financial advisors, he said, is not only to suggest a course of action, but to frame it-and that in itself can prove ethically challenging when you're using history to predict the future. "You're using a particular history," he said, "over a particular period of time for a particular country with a particular index and projecting the frequency with which things happen."
"Now it gets metaphysical," he said. "What's the client's best interest when the way they choose is framed after the fact?"
The best you can do, he says, is both assess probabilities and then communicate probabilities.
"You can get estimates and models and programs," he told the crowd, "but in a sense your value add in large part is helping your clients understand the implications of different strategies in the capital markets and what sources of uncertainty bring to the equation."
He listed a number of different uncertainties that advisors have to factor in: the risk of living longer (and outliving money), the risk of poor investment returns, the risk of poor health (and health insurance), the risk of inflation (despite the constant drumbeat of news about deflation), the risk of government programs such as Social Security and Medicare coming up short or being cut back. Sharpe adds counterparty risk, as well-the chance that those companies helping you shore up your high upside investment product, perhaps a company like Lehman Brothers, might not be there to help out if they go belly up.
When you show the clients these risks, you have to frame them in ranges of outcomes, he says, whether you're showing them markets using analytic distributions, such as a fat-tailed bell curve with really ugly surprises, or using scenario analyses, where you look at the last 50 years and ponder what might happen if next year were anything like one of the last 50.