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May 14, 201307:52 AMFinancial Perspectives

with Michael Dubis, CFP

‘You can do better!’ … Compared to what?

(page 1 of 2)

One of my jobs is to analyze performance and solicitations that clients occasionally get from outside money managers, mutual funds, and other “advisors.” I sometimes hear the saying “you can do better” or “you can do better than what you’re currently doing.” It drives me nuts. 

That overly simplistic and intellectually insulting approach is common in the sales industry. It strikes an emotional chord for sure with a client or investor, and even me. I’m human; who wants to be left behind? When you add it all up and make people feel like they’re losers or that they’re missing out by “not doing better,” you can stir up all sorts of reactions. Those reactions generally benefit the solicitor and not you. Reacting to someone striking an emotional chord is almost always a bad decision.

So how might you address a solicitation?

Start with the awareness that many proposals focus on return and offer little to no consideration to risk management or benchmarking performance to suitable indexes, or more importantly your goals. The worst proposals are the ones that are data-mined to show the best results possible of the past based on the knowledge we have today. Be sure to understand that risk and return are related and not independent of each other. 

The following are some of the better questions you might want to ask if you’re ever inspired by the idea that “you can do better.”

1. Can you prove this? 

Always start with the proof. There’s no sense in looking further until you have substantiation for the claim.

You generally want to see either a historical track record of the performance of the proposal or the track record of corresponding indexes around the proposal. Ideally, the proposal should compare its performance to benchmarks that are also consistent with the allocation.

For example, if someone shows you a theoretical portfolio that’s returned 9% a year over the past 10 years, but compared it to only the S&P 500, it’s highly likely that portfolio is not an apples-to-apples comparison. The S&P 500 is essentially a large-cap U.S. stock portfolio. This is not considered a diversified portfolio. A diversified portfolio usually consists of U.S., international, small-cap stocks, emerging markets, real estate, bonds, etc. You can see comparing the performance of one asset class like U.S. Large Cap to a portfolio of many asset classes is like comparing a moped to an SUV. As an aside, anybody on the planet could have outperformed the S&P 500 over the past 10 years – all you had to do was not invest solely in the S&P 500. 

2. How would this portfolio honor my goals and risk tolerance? 

Okay, they were able to answer No. 1 to your satisfaction, but does the proposal actually meet your unique needs?

I purposely picked a 9% return target for my discussion for two reasons:

  • In my made-up example, a portfolio that returned 9% a year over the last decade could have had a significantly high allocation to highly volatile stocks and/or high-yield bonds that in 2008-09 may have seen paper losses of over 50%. Were you made aware of that? Are you cool with this? Would you have stuck it out? You better be sure you know how this thing behaves and how you will behave as a result of owning it. You better understand that something with this high of a return history may in fact not do it again and could have a high probability of loss. Just because you take “risk” does not entitle you to a “return.” The greater the potential return, the greater the potential for loss. Real loss – as in your money is permanently gone.
  • Coincidentally, given that we’re at the tail end of a 30-year bull market in bonds, another completely opposite portfolio that returned 9% a year over the last decade could have been invested in long-term investment-grade and below-investment-grade bonds. Well, bond yields 10 years ago were double to five times the yields they are today. There is only a small mathematical possibility that bonds today that yield 0% to 5% are going to return 9% in the future. In this case, the portfolio doesn’t honor your return goals of 9% because it simply won’t happen. 

(Continued)

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About This Blog

It is an understatement to say the world has experienced a radical shift in capital markets. There are more layers of information and opinions on the direction of the world than we've seen in decades. The internet and the media do not always make it easier, but Michael Dubis' contribution through IB blogs will help you sift through the noise and give you some perspective. You can find his company online.

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