Tuning in to the clients’ mindset

If you ask clients what they expect from you, most reply, “To make money, of course!” Your new clients are unlikely to have the same formal approach to allocating capital that you have (see Chapter 7 for details about asset management). More than likely, a client-made investment portfolio looks like a collection of favorite tchotchkes accumulated over time. Their measure of success is that they have more money today than they did yesterday or a year ago or ten years ago.

More sophisticated novices use one of the market indexes, such as the Dow Jones Industrial Average (DJIA) or the Standard & Poor’s 500 (S&P 500). They keep an eye on their portfolio’s performance and see how the stock market is doing by watching the nightly news or checking their favorite stock market news website to see how the Dow, S&P 500, and Nasdaq have performed. As long as their portfolio is performing as well or better than their chosen index, they claim victory. Similarly, a German-based investor who looks at the Deutscher Aktienindex (DAX) and then compares it to her portfolio would most likely come to the same assessment. If the index is up, and my portfolio is keeping pace, then all is good (or “alles ist gut” in the case of the German investor).

Recognizing the limitations of stock market indexes

Whether they’re tracking indexes in the U.S., Germany, China, Japan, or somewhere else, investors, who share the goal to make money, are using rough guides to judge their success or failure. The DJIA reflects the performance of only 30 blue chip companies in the United States, weighted by share price; the S&P 500 reflects the performance of the only the top 500 companies in the United States, weighted by market capitalization; and the DAX reflects the performance of only the top 30 blue chip German companies.

To measure success more accurately, you’d have to analyze the composition of the investor’s portfolio. Assuming a client invests exclusively in blue chip companies or those with large capitalizations in the country of the index’s origin, the client’s chosen index may be a fairly accurate benchmark for her portfolio’s performance. This is especially true if the client invests in an index mutual fund or exchange traded fund (ETF). However, considering that most investors diversify to some extent, any given index is likely to be a poor choice for an overall portfolio benchmark. After all, according to Morgan Stanley Capital International (MSCI) research, the world has 23 developed markets, each with numerous sectors and many companies with a wide range of share prices and market capitalizations.

According to the MSCI World Index, the United States represents 52 percent of the world’s stock market capitalization, which means 48 percent of the value of the world’s stock markets is outside of the U.S. More sophisticated investors, such as financial advisors, understand that there’s a world of opportunity when it comes to capital allocation. For example, according to the Callan Periodic Table of Investment Returns, the U.S. stock market has outperformed the rest of the developed world less than half, 45 percent of the time, from 1998 through 2017. For clients who invest any part of their portfolio in foreign markets, using a U.S. market index as their benchmark makes little sense.

Using a blended benchmark

Many performance-reporting programs today use blended benchmarks. A blended benchmark is a combination of market indexes that are weighted to match a portfolio’s asset allocation. For example, if a client’s portfolio comprises 60 percent U.S. stocks, 20 percent non-U.S. stocks, and 20 bonds, then a blended benchmark may comprise 60 percent S&P 500 index, 20 percent MSCI EAFE (Europe, Australasia, and Far East) index, and 20 percent Bloomberg Barclays Aggregate Bond Index. However, depending on the sub-asset allocation within U.S., non-U.S., and bonds, these indexes may or may not be relevant comparisons. For example, if the U.S. stocks are concentrated 20/20/20 across large/mid/small cap stocks, then only 20 percent of the U.S. stocks are a fair comparison to the S&P 500. Likewise, if 20 percent of the portfolio allocation is in country-specific ETFs in the United Kingdom, South Africa, and China, then the MSCI EAFE is a poor benchmark for that portion of the portfolio’s allocation.

Through the discussion presented in this and the previous section, you begin to realize the potential messiness of benchmarking portfolio performance. In an effort to try to simplify the benchmarking of portfolio performance, the industry has provided too much detail that’s mostly irrelevant to investor’s overarching need — to know whether she’s getting the performance she needs to achieve her financial goals.

Keeping it simple with your clients

Any benchmark you use to evaluate your client’s portfolio performance should be:

• Understandable to you and your client
• Relevant to the client’s goals and objectives

After years of reviewing performance reports with clients and attempting to explain the not quite tailored benchmarking system, I’ve found that simple comparisons are best. If most U.S. investors use the S&P 500, DJIA, or Nasdaq as their yardstick for assessing their portfolio performance, why fight it? A better option is to translate these indexes in a way that deepens the client’s understanding, so she can more easily grasp complicated concepts, such as risk-adjusted returns.

For example, a great way to explain risk-adjusted returns is to use up-market and down-market capture ratios. These ratios are the percentage of the portfolio’s returns as compared to the chosen index’s returns for the same up or down period as reflected by the index:

As long as the up-market ratio is higher than the down-market ratio, your client shouldn’t be concerned because the portfolio value is outperforming the index.

For example, if you’re managing a client portfolio that has an aggressive growth risk profile, you can highlight the percentage of U.S. large cap stocks in the client’s portfolio. Suppose it’s 30 percent. You tell your client that you’re going to use the DJIA as the portfolio’s benchmark. Forget about all the other market allocations. They don’t matter. All your client wants is a portfolio that goes up when DJIA rises and goes down less when the market crashes. Suppose the client’s portfolio value is $200,000:

• In a period when the DJIA rises 10 percent from 24,000 to 26,400, a gain of 2,400, the portfolio gains only 8 percent or $16,000 and is now at $216,000.
• In a subsequent period when the DJIA drops 10 percent from 26,400 to 23,760, the portfolio loses only 6 percent or $12,960, going from $216,000 down to $203,040.

In this example, the DJIA lost 1 percent of its value (from 24,000 at the start to 23,760 at the end), whereas the portfolio gained 1.52 percent value (from 200,000 at the start to $203,040 at the end). In this context, the fact that the portfolio gained only 80 percent of the DJIA return during the up period (8 percent as compared to the 10 percent rise in the DJIA), the risk-adjusted portfolio outperformed the DJIA overall.

Admittedly, this approach to leading a client to an understanding of risk-adjusted returns is extremely simplified. What’s important is that the client understands the trade-offs between risks and returns and the necessity to achieve a balance by limiting exposure to high-return investments that carry equally high risks. If you can deliver the message and the result, you’ll always be seen as a successful advisor in your client’s eyes.

Given how messy and complicated traditional portfolio benchmarking can be, the industry has seen a rise in alternative forms of measuring success, as the next section discusses. However, regardless of the benchmark you choose, make sure it complies with these two rules: you and your client understand the benchmark, and it’s relevant to your client’s goals.

Establishing the client’s personal benchmark

Calculating a client’s personal benchmark RRR is a form of reverse engineering. You figure out how much the client needs to fund a particular goal, such as retirement or sending a child to college, and you work back from there. Several methods are available to calculate RRR. Here’s a simple method:

1. Determine the amount of money needed to fund the client’s financial goal.

   The method for determining this amount depends on the goal. For example, if the client decides she needs 80 percent of her current income to retire comfortably, you must figure out how much money needs to be in her retirement account at the age at which she plans to retire based on her projected monthly distributions and how long she plans to live. (See Chapter 7 for details.)

2. Assist the client in deciding how much money she can afford to invest (usually monthly) toward that goal.

   This amount depends on the client’s income, savings, and desire and ability to sacrifice. Start with a ballpark figure and then tweak it in Step 4.

3. Choose a reasonable rate of return on the amount invested, such as 4 to 6 percent.

   This is guesswork; you’ll hone in on a more precise and realistic percentage in Step 4.

4. Work with the client to play with the values from Steps 2 and 3 to achieve the agreed-upon goal from Step 1.

   You may even need to change the goal in Step 1 if that goal is unreasonably aggressive.

For example, after reviewing a client’s current household expenses, you know she’ll need $100,000 per year in retirement, which is 25 years away, in addition to her Social Security income. That $100,000 needs to be adjusted at a 3 percent annual inflation rate. Using your trusty calculator, you find that she’ll need $209,377 per year in the first year of retirement to maintain her lifestyle.

If you need a refresher on how to use your analyst calculator’s time value of money function, check out this YouTube video: www.youtube.com/watch?v=nScQsMmohZ0.

Assuming a portfolio withdrawal rate of 5 percent starting her first year of retirement, she’ll have to accumulate $4,187,540 by that time. Meanwhile, she’ll be able to invest $20,000 per year starting now through year 25. With these numbers, her RRR is 14.03 percent to achieve her goal. Unfortunately, such a high required rate of return would be significantly challenging to achieve, so she’ll have to save more to reduce the required rate.

If she doubled her savings to $40,000 per year, the RRR drops to 9.73 percent per year. You can continue to edit the inputs (from Steps 2 and 3) and possibly the post-retirement income goal (from Step 1) until you find the sweet spot, which should be in the 5 to 7 percent return range, and she’d have to accept a high risk account profile to achieve that target.

This example doesn’t include additional details, such as the fact that the client’s retirement income will need to be adjusted for inflation. It also doesn’t account for whether she plans to leave a legacy payment to her beneficiaries or have the final check sent to the undertaker. These two scenarios have different ongoing required rates of return when withdrawals begin.

The personal benchmark is attractive primarily due to its simplicity and practical application. It quantifies the financial plan while connecting it to the client’s goals and objectives, and it shifts the client’s focus from the wild swings of stock market indexes to a steady-as-she-goes metric.

Using the personal benchmark to keep calm a client’s nerves

The big drawback of the personal benchmark is that significant portfolio underperformance relative to the benchmark, even in the short term, can cause clients to be concerned, which is certainly understandable. If your client feels that he is way off track, he feel pressured to take even greater risks to score a bigger return to make up the difference. Or, if they’re nearing retirement or already in retirement, they feel the urge to cut their losses out of fear that unless they do so, they’ll lose everything.

One way to keep yourself and your clients calm during market swings is to maintain focus on the personal benchmark with the understanding that a client’s risk tolerance generally shifts significantly before and after retirement. These periods are often referred to as phases:

• Accumulation phase: The period during which a client is building her retirement nest egg, she should be less concerned about market fluctuations, as long as the average annual return hits the target (the RRR).
• Withdrawal phase: The period during which a client is taking distributions, she focuses more on the portfolio’s value. A significant drop in value causes concern or even panic. Withdrawing money from a portfolio when it’s going through a rough patch is like adding insult to injury. The portfolio will be more negatively impacted when withdrawing on an already reduced market value.

The good news is that during the accumulation phase, the sequence of investment returns doesn’t matter. Although most clients don’t understand this phenomenon, believing that fluctuating portfolio returns once a withdrawal phase has begun is the same as when she’s accumulating portfolio assets. The math shows how different these two portfolio realities are.

During the withdrawal phase (as in retirement), the sequence of investment returns matters more than the returns themselves, as shown in Table 17-1. In this table, both portfolios 1 and 2 have the same average annualized return of 9.94 percent and were invested in the S&P 500 index. The difference is that I flipped the sequence of returns for portfolio 2, so it’s opposite of portfolio 1. Even though the same amount was withdrawn over the course of those 11 years (assuming a 5 percent initial annual withdrawal rate, adjusted 3 percent each year for inflation), portfolio 2 has nearly $500,000 more value at the end of the term.

This isn’t magic, just simple math. If your client experiences big negatives at the beginning of her withdrawal cycle, then she’s going to have a big challenge getting back to par. In both cases these portfolios have more than the $1,000,000 by the end of the period (in 2017), even having gone through the second worst recession in U.S. history (2007–2008 and multiple market corrections along the way). However, in 2008, portfolio 1 worked its way down to $581,587 compared to portfolio 2’s $1,256,528. Managing to keep the client invested in portfolio 1 would be an extremely challenging project.

What this means for most clients entering into retirement, a time when they depend on their investment portfolio to provide sustainable, lifetime supplemental income, is that moving from the accumulation phase to the withdrawal phase can be disorienting and nerve-wracking.

A high-risk-profile client who’s been socking away money into her 401K plan over the course of a decade or more and owning all stock funds doesn’t care about the sequence of returns as much as the average annualized return until retirement … when all the math changes. In retirement, in the aftermath of a market crash when your client sees a significant drop in portfolio value, she’s likely to get spooked and start looking for the exits, even though remaining invested is the best way for her to keep pace with inflation. Had the owner of portfolio 1 shifted to cash in 2008 and continued withdrawing the designated amounts, she would have been nearly broke by 2017 with $42,697.23 remaining in her account. By staying invested, she has $1,132,766.94, which is $127,866.94 more than she started with.

Through the use of the personal benchmark and one or more tables like Table 17-1, you can calm your clients’ fears during both the accumulation and withdrawal phases to convince them to stick with the plan.

For clients who worry about having enough income to live on in their retirement years, consider purchasing income annuities or building cash values in whole life policies, to cover half or all of the client’s nondiscretionary household living expenses. Just keep in mind that income annuities don’t adjust with inflation, so the client probably still needs a certain amount of growth-oriented investments in her portfolio to keep pace with inflation. Regardless, she can diversify away risk from bear markets during the withdrawal phase by relieving the burden of income delivery solely from her portfolio.

Using both relative and absolute benchmarks

I recommend keeping clients informed about portfolio performance through both relative and absolute benchmarks:

• Relative benchmarks are useful for showcasing how the portfolio is performing as compared to an index or blended index.
• Absolute benchmarks (such as the personal benchmark) target a specific rate of return and are useful for ensuring that the client is on track to meet agreed-upon goals.