Most people seem to think that it’s an investment advisor’s job to help their clients select the best investments. This is true, but it depends on what exactly is meant by “best” investments? Best performing or those best suited to your financial plan?

Do you what the best collection of individual investment opportunities or the best portfolio? They are not necessarily the same thing. And how will you decide what’s best?

We would argue that it’s impossible to decide what’s “best” unless you first develop a framework to help you assess investment opportunities (i.e. compare attributes) and consider your personality, preferences, resources and objectives (i.e. your circumstances). The result of this process is a personal wealth management plan.

This is only the first step. You then need to ensure that you stick to the plan. After all, what good is a plan if you don’t stick to it? Behavioural coaching can help you maintain your patience and discipline.

The third step is to implement the plan as efficiently as possible. The fourth step is performance. We call this the “triage” model of wealth management.

Triage

The Oxford Dictionary defines triage as: “the process of determining the most important people or things from amongst a large number that require attention.”

Most of us think of triage in connection with a visit to the emergency department.  The triage nurse is the first person that we meet in an emergency department. It is their job to prioritise the patients waiting to receive treatment. The triage nurse makes sure that patients with the most serious injuries and/or urgent medical problems get treated first.

A good investment advisor often plays the role of triage nurse. Clients come in with questions, experiences, emotions, ideas, needs and goals. It’s the advisor’s job to help the client determine what’s most important.

How should an advisor determine what should be given priority? The answer is really simple. Start with what will have the biggest impact on the client’s long-term results. In other words:

  1. Planning
  2. Behaviour
  3. Costs
  4. Performance

Many people will be surprised to see performance on the bottom of this list. We’ll come to that a little later. But first, why is planning so important?

Planning

Because most of your risk and return depends on your asset allocation, which is the primary output of your wealth management plan.

Why do we invest? Of course, there are many reasons. But we can distil them all down to a single fundamental essence: we all desire to have a measure of control over our future.

Many people find making decisions about the future difficult. The future is uncertain. There are a lot of unknowns because a lot of things simply haven’t happened yet. And the outcomes of our decisions might not be known for a long time, perhaps many years.

This describes why planning is so important. Not because we can predict what will happen. But because the planning process flushes our questions and concerns out into the open where we can work through them.

The plan encapsulates our personality, preferences, resources and objectives in an asset allocation. Asset allocation is the mix of stocks, bonds, cash and other investments that we’ve chosen to implement our plan. A good plan should also allow for contingencies. And it should also guide us on how we  should act when financial markets or the economy hit turbulence.

The mix that we choose is THE most important determinant of our investment results. Its far, far more important that the performance of any one investment or even a group of investments in our portfolio.

There’s been a lot of academic research to demonstrate this. For example, Roger Ibbotson and Paul Kaplan’s paper Does Asset Allocation Policy Explain 40, 90 or 100 Percent of Performance?

We found that about 90 percent of the variability in returns of a typical fund across time is explained by policy, about 40 percent of the variation of returns among funds is explained by policy, and on average about 100% of the return level is explained by the policy return level (emphasis added).

Some clients baulk at this. They question the true  value of “planning”. This is a valid criticism. Sadly, much of what is called planning is nothing more than a combination of:

  • Back-solving a “plan” to validate and enable whatever the client wanted to do all along
  • Justifying a product(s) being pitched pitch (nearly always on the basis of performance)
  • Compliance box-ticking

Let’s be clear, this is not what we’re talking about! Real planning goes much, much further. This is a topic for a future In Brief article.

Behavioural Coaching

The next most important factor affecting investment results is whether or not we stick to the plan. It requires discipline. Most of us don’t have that discipline, at least not without some assistance from the sidelines.  

When faced with difficult situations a trusted adviser can help. This is why elite performance athletes use a coach. Coaches have an important role to play in the athlete’s physical and technical preparation. But this is not their most important function. Elite athletes already know how to play the game. They also have years of physical conditioning.

The most important role of a coach is to provide perspective and emotional support. That said, the coach has to earn the respect of the athlete.  In most cases, they do this by having been a champion athlete themselves.

In other words, they need to have invested real money, during both bull and bear markets, made mistakes and experienced all of the emotions that go with that.

But why is behavioural coaching so important? Consider the following chart courtesy of Ned Davis Research. The top-panel shows the performance of US shares (i.e. the S&P 500 including dividends reinvested) from the early 1950’s onward. The middle-panel shows the percentage of US household wealth invested in the stock market. The bottom-panel shows the total return for US stocks 10 years later.

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You’ve probably noticed that the middle and bottom charts are the mirror image of each other. Household investment in US shares was highest during the period when prospective long-term return was very poor. Even worse, investment in shares was at record lows when future 10-year returns were at record highs!

Ned Davis Research has found that the level of household ownership of stocks is one of the more accurate (contrarian) indicators of future long-term investment returns.

In other words, investors got it completely backwards. The next chart explains why. Once again, the top-panel shows the performance of the S&P 500, except this time it starts in the early 1970s.

The middle-panel shows the median earnings yield of the stock market. The median earnings yield is a measure of overall valuation of the S&P 500. The higher the earnings yield, the cheaper the S&P 500[1]. The bottom-panel again shows the returns than investors would have earned 10 years later.

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See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.

If you compare the middle and bottom-panels you’ll notice that high future returns usually follow periods where shares are cheap. And lower returns are more often, but not always, associated with periods where shares are expensive.

So, what’s going on here? Households invest more in shares when it feels comfortable, i.e. when the market has gone up. Ironically, this is when long-term future returns are likely to be at their lowest.

Avoiding a behavioural mistake such as buying high and selling low can literally add several percentage points per year to annualised long-term returns. Behaviour matters!

What about Performance?

Contrast this with trying to pick fund managers that beat the stock market. Research suggests that between 60-80% of active equity funds under-perform each year. Currently over 70% of Australian equity funds have failed to beat the market over the last 10 years.

Let’ assume that you’ve found a fund manager that you believe can out-perform the market by 2.5% per year over the long-term. Even if this were true, it still pales in comparison to the difference that avoiding a big investment mistake can make.

The more likely outcome is this. The statistics suggest that you’ve got only a ¼ chance or a 25% probability of being right. 25% multiplied by 2.5% = 0.50%. You’re probably paying the manager 0.75%, which means you’re actually paying them 1.5x their expected out-performance!

Not only is the value added by behavioural coaching a multiple of the value added through performance, the probability that you can achieve it with the right kind of coaching is far higher.

Do you see how a coach that can provide some perspective might be helpful?

We’ve considered the importance of planning, behavioural coaching and why focusing on performance is relatively less important form a “triage” wealth management perspective. What about costs? We’ll consider this topic in a future edition of In Brief.

[1] You may be more familiar with other measures of valuation such as the price/earnings Ratio. The earnings yield is the inverse or reciprocal of the price/earnings ratio. In other words, low p/e = high earnings yield = cheap and high p/e = low earnings yield = expensive.