Portfolio managers are often asked, “What’s your alpha?” The average investor might not be aware of what this phrase means, but it is asking “What makes you better than other portfolio managers?”
The traditional definition of “alpha” in the investing world refers to “risk adjusted return.” A higher number indicates more return received for the risk the investor took. A negative number indicates the investor took on more risk than they should have, given the paltry return received.
Many financial advisers also discuss “beta.” Beta is a measurement of an investment’s sensitivity to the broad benchmark (like the S&P 500). A beta of “1.00” indicates the investment’s value should move in lockstep with the benchmark. A beta that is lower indicates it is less sensitive to market movements and a beta that is higher than 1.00 indicates that the investment could move to a greater degree in the same direction than the benchmark.
These Greek letters are designed to help an investor make wise investment decisions. However, what is never asked of a financial adviser (and should certainly be asked) is “What is your theta?” Translation: “What value does your financial planning deliver at the beginning of our working relationship, during the critical points of my financial life, and during the funding of my legacy upon my death?”
WHY? Did you know that most financial advisers outsource at least some of the investment management, and some outsource all of it?!
Even if the adviser does do all of the management of the stocks and bonds, it is still fair to ask, “What is your theta?”
Although there are a lot of investors who don’t work with a financial adviser, they should consider how much clearer their financial future could be with assistance of one.
Financial planning is one of the most important functions between a financial adviser and the investor. It humanizes the importance of investment allocations, insurance policy recommendations, discussions around tax consequences, legacy planning, and overall risk management.
However, the financial services industry has become lazy.
Easy access to subscription based financial planning software programs allows financial advisers to engage in a conversation with prospective investors that is nothing more than input/output data collection of a canned, boilerplate financial plan.
These plans often run between 50 and 300 pages. However, the adviser usually spends time reviewing only about 5-7 pages. What is the reason for this? The other pages represent someone else’s idea of a financial plan!
The 5-7 pages that are reviewed are the calculations of the Present Value/Future Value figures that will help set the “goal posts.” This data is delivered through a combination of boring spreadsheets and old-school bar graphs that allow the viewer to follow the cash flow, but it leaves them confused over the strategic discussion moving forward.
Generally, the consequence of this confusion is mistrust. The investor doesn’t completely understand why certain recommendations are being made, which then prompts the question, “Is this person acting in my best interest or their own?” Input/output methods should be reserved for calculators but cannot be the method of real financial planning.
Financial planning calculators come in all shapes and sizes.
A good financial planner will use a financial calculator to calculate things like “net present value” which determine if an investment has good risk/reward qualities.
More frequently, present value/future value calculations are made in order to determine how much money will be needed at a point in time to fund a major life event (college tuition, weddings, retirement, etc.).
Many financial planning calculators still use Polish math, which requires patience during the learning curve. [If you don’t have the patience to learn Polish math, you can download a more intuitive financial planning calculator called “Dynamic Map” on iPad (Apple) or Google Android tablets (Samsung). This app does not require any time for a learning curve and all of life’s major expenses can be calculated and visualized within ten minutes.]
Once the calculations have been made, the next discussion should be around funding strategies both during the accumulation phase and the distribution phase.
These strategies should manage the inevitable toxic emotions (fear and greed) that occur during unique periods of extreme market movements. Unfortunately, most financial planners rely on the “institutional” method of financial planning. This is a “set it and forget it” method that relies on past performance over long periods of time as evidence of the method’s relevance.
The average “balanced portfolio”
We often hear of the classic 60/40 allocation of stocks to bonds for investors as a measurement of a balanced portfolio. I prefer to define “balanced” as something that meets my funding objectives as the distribution date approaches. For this reason, I am a firm believer in “aging” portfolios instead of creating an allocation appropriate for my risk profile and rebalancing back to it.
Creating an allocation based on a risk profile questionnaire is flawed because the risk profile questionnaire is a snapshot in time. In years like 2019, I’m likely to be more confident about taking on risk than in other years. In years like 2020, I’m likely to be much more risk averse than other years. Yet, I answered the same questions on the risk profile questionnaire in each year.
A systematic rebalancing program moves my allocations back to the flawed allocation time and time again! Worse yet, when market downturns occur near my distribution date under this method, I’m at risk of not being able to fund important events like college tuition or retirement.
Aging of portfolios is a great solution and one that adds to an adviser’s “theta!”
Imagine separating each of life’s major expenses into separate accounts that have their own unique distribution date.
- For accounts that have long periods of time before the distribution date, the allocation towards risk is significant due to the lack of concern over volatility.
- For accounts that are closer to their unique distribution date, the risk has been removed gradually and continues to migrate to a safe, liquid investment allocation.
This method avoids the panic of a catastrophe when the market crashes right before the distribution date. Add to that concept reserve strategies to tackle challenges like inflation, bear markets, and premium stabilization and you know you are dealing with a professional who demonstrates a high degree of “theta.”
Distribution planning can also be exceptionally challenging in a low interest rate environment like this one. Pay careful attention to strategies that address income generation and inflation management. The idea of systematic withdrawals at a fixed percentage rate is not practical and can be devastating in a falling market.
Financial plans should be very customized, not boilerplate like they are currently from most software packages. These custom plans manage towards the family purpose, suggest a higher quality service model than the normal experience, and always re-evaluate strategies to deliver the most desirable outcome.
Jeff Mount is president of Real Intelligence LLC. Jeff has been active in the financial services business for the last 25 years.
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