You are about to read another column that is sure to displease professionals in the financial services business! In my last article, I outlined the enormous flaws of the assumptions used in writing financial plans. I covered the lack of value in these plans for clients seeking to reach their financial goals with the highest degree of certainty. And, after all, isnâ€™t that the purpose behind the financial planning process?
Now, letâ€™s look at the implementation phase of financial planning, or what comes after the presentation of your written plan for economic security. Having a plan in place offers guidance for what should and should not be done to achieve financial security, but, if the underlying assumptions for inflation, investment returns and future tax costs are badly flawed, projections made in those plans have little chance of resembling your financial situation at the end of your working career.
Of course, how do you know this in advance? Financial plans look convincing, and, in the absence of any other outline for how to save, invest, purchase sufficient insurance coverage and calculate the level of income needed during retirement, they seem better than no plan at all, donâ€™t they?
But when the assumptions are badly flawed, these plans may do more harm than good. They offer a false sense of security to investors who rely on the planâ€™s recommendations. If a client believes that the financial plan makes sense and should be implemented, then the real â€œdog and pony showâ€ begins, especially with the investing aspect.
The generally accepted methods for investing are diversification, asset allocation and Modern Portfolio Theory. But take it from someone who is much smarter than I that this is a bunch of hokum! Read
The Black Swan
, an excellent book by Nassim Nicholas Talebâ€™s, former deanâ€™s professor in sciences of uncertainty at the University of Massachusetts, Amherst. In his book, Taleb offers compelling reasons that refute the academic approach to investing.
My approach to investing also differs radically from what passes for conventional wisdom. I believe the financial services industry has done a wonderful job of making investing in the stock and bond markets seem much more complicated than it really is. Of course, if the truth were known — that investing is really quite simple, why would you need an expensive broker or advisor?
Besides, the premise behind those accepted methods for investing rely on assumptions garnered from what happened in the past. With the benefit of hindsight, anyone can devise what appears to be a great system for doing most anything. But what predictive value does the past really offer?
In another way to make the financial planning process look much too complicated for non-professionals to do themselves, financial planners add questionnaires about financial goals, time horizons and risk tolerance. Your answers supposedly allow them to offer a personalized set of recommendations for how your savings should be spent on stocks, bonds, mutual funds and other asset classes that — in the past — worked well together.
If only we could take those plans back in time — about 50 years — to get the full benefit of what we now know would have worked so well! And as long as higher education costs donâ€™t rise above the long-term average, as long as tax policies donâ€™t change, and as long as the stock market and each asset class perform as they did in the past, all of the projections offered now should prove right on the mark! But one thing we all know for sure is that change is constant, and that little nugget of reality plays no part in a financial plan!
So what about your goals, time horizon and risk tolerance? In a financial plan, they just provide more dog and pony nonsense, a reassurance that the plan will be implemented with something more than just good guessing.
Perhaps more than anything else, those agreed-upon parameters offer the financial advisor some cover when actuality goes astray from plan, as it often does. The advisor can simply say, â€œWe did everything by the book, in the way most commonly accepted and using your personal guideline!â€ So if a client loses money or doesnâ€™t realize the expected investment returns, he shares in the blame for having been willing, or not willing enough, to accept risk.
My own approach is to throw those questionnaires into the nearest trash bin and do something meaningful with my time. I believe each client has much the same basic goals, time horizons and tolerance for risk, such as volatility and investment losses.
Letâ€™s face facts here. If your account statement balance is rising rapidly, better than expected, you are enduring greater than average volatility. But do you mind? Only down-side volatility becomes bothersome.
As a financial advisor, I myself once wrote those detailed financial plans. But then I read a good book by Nick Murray called The Excellent Investment Advisor on the subject that offered an excellent concept for determining each investorâ€™s time horizon. The author advised that while too many advisors consider only the clientâ€™s expected time until retirement, much of the job remains undone.
Mr. Murray speculates that the proper time horizon to calculate for an investor is 100 years. Planning for the end of a clientâ€™s working years leaves a big hole in the planâ€™s projections, such as how long the client will live after leaving the work force.
Should the client live 30 or more years in retirement, doesnâ€™t investing for growth still make sense? Do you see Warren Buffett loading up on bonds just because heâ€™s now well into his 70â€™s? How long the surviving spouse may live should also factor into the plan, as well as what can be left for surviving children and the payment of potential, enormous health care costs in old age. Who doesnâ€™t want to leave more behind for their children? If better performance was a possibility and you missed it because of your financial planâ€™s imposed reduction in exposure to growth, would you still feel good about it?
I also believe that all clients share the same ideas about risk tolerance. In years when stock markets rise, donâ€™t investors want as much exposure as possible to growth? And in bear markets, donâ€™t all investors want as little exposure as possible to losses? Even the most aggressive investor hates to lose money. And the most conservative investor still detests gaining less than others.
All investors want to make as much money as they can in the good years, and they want to lose nothing when the markets head down. Attention to stock valuations and prices paid for any investment makes this balancing act easier than it seems. Consider the idea of seeking absolute returns, as opposed to trying to â€˜â€™beating the market.â€™â€™
Whether having goals to fund retirement savings, education costs or charitable endeavors, an investor can reach any of them with a higher degree of certainty when planning for longer time horizons and using principled, values-based investing processes. Getting as much as the market has to offer in any financial climate has an amazing way of enabling the investor to pay the costs of these and other goals.
What about insurance coverage? While financial plans may make a valiant effort to determine the right amount of coverage for each client, I believe there is never enough insurance. Almost always, investors prove to be under-insured when the need for coverage arises. Have you ever known anyone who died and left too much insurance money for his survivors?
If you are laboring under the guidelines outlined in a written financial plan that strays far from reality, take a long look at the assumptions used, the constraints imposed on your investment portfolio, and the potential use of low-cost insurance coverage (such as term life insurance) that allows you to buy more coverage than you think you will need at low rates.
Assume that you will live for another 100 years, not because you will, but because, most likely, your survivors will. And throw out all those colorful pie charts that show how your portfolio will do over time. Theyâ€™re pretty to look at, but, in most cases, overly optimistic, as they rely on asset class returns to perform in the future just as they did in the past — when so many variables were different.
A little common sense will go much further than those pretty pictures.
Have a great week.
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., firstname.lastname@example.org.