How To Define An Adviser’s Work

[This article was first published in the December 2015 issue of ETF Report UK]

It's not about beating the market, it's about achieving the client's long term needs

If I asked my grandson, "What's the definition of 'long term'?" he may answer that it's the time he spends doing homework. If I asked a university student the same question, it may be the time it takes to establish a career. A middle aged person may define it as retirement. A retired person may think for a second and answer, "It's a lot shorter than it used to be."

We investment professionals like to tell people to invest "for the long term." That sounds like an eternity. What does this mean? Is it next week, next month, next year or decades from now? Tongue in cheek, I think some investors believe the definition of a long term investment is a short term investment that didn't work out.

Jokes aside, an important question is: How can we advise our clients on what's best for their long term needs when we can't agree on what "long term" means?

Asking Clients The Right Questions

Perhaps it's better to define this elusive time frame by referring to a number of years or the future age of the client. Imagine I'm sitting with a couple in their mid-40s and we start talking about saving for retirement. Rather than ask, "Where do you want to be at age 65?"—Still alive I hope—I ask: "Where do you want your portfolio to be 20 years from now?" That question yields the most precise answer and doesn't force us to face our own mortality.

Objectives in hand, now we can do some real work. I'll look at how much money the couple has accumulated, how much they're saving each year and how that may change in the future. I'll introduce expected rates of return for asset classes, select low cost index trackers to represent asset classes, and calculate the net expected return for their portfolio. Et voila, we have a plan!

Keeping The Plan On Target

This plan is valid as long as the couple implements it fully and maintains it diligentlyover the long term. Darn, I've said it again! At least I've established in this case that "long term" means 20 years. There's no expected deviation from this plan. It's expected to be the same asset allocation for the entire investment period. A strategic (or fixed) asset allocation is created and rebalancing is done on occasion to keep the portfolio on target.

This methodology is classic modern portfolio theory. We take past asset class risks and returns, make assessments about future risks and returns, add assumptions about correlations over the investment horizon, and come up with a prudent asset allocation recommendation. This allocation does not change unless something changes with the client. Discipline is what makes the strategy work.

We commonly use past asset class returns to show clients that stocks have outperformed bonds, bonds have outperformed cash equivalents, and cash equivalents are better than putting money in glass jars and burying them in the garden. Advisers also use these historic numbers to explain risk and return over varying periods of time.

Going Up, Up And Up?

To help illustrate this concept, an adviser will often point to a colourful, mountain-type chart on the wall. The client will see a color "hill" for each asset class, with small amounts on the left side growing to much larger amounts on the right side.

People like market gains. They usually don't ask for anything more. With a little coaching, they'll understand that putting some money in equities, some in bonds and a little in cash is an attractive strategy. This can be achieved with low cost tracker funds.

Don't Preach Market Timing

Had the returns from active management been on the chart (if they were measurable), a client would certainly not be interested in pursuing them. This is because actively managed strategies would have not done as well as passive strategies. Having glimpsed the evidence, a client could then opt for a strategic mix of asset classes as the obvious choice, using tracker funds to implement the plan.

In contrast, beat-the-market strategies are sold, not bought. They are sold by people who aren't advising their clients, they're trying to sell to their clients. They're sold by people who care more about collecting high management fees than seeing their clients reach their investment goals. They are sold by people whose goal is to take money from clients, not make money for them.

The prudent strategy every adviser should take is to create an asset allocation based on a client's needs, implement that strategy using low cost index trackers and rebalance occasionally to control risk. After that, it's all about staying the course by managing the client's emotions and expectations. That's the way an adviser adds value in the long term.

Rick Ferri, founder of US-based Portfolio Solutions, is a widely recognised index investor and the author of several books on index investing