Earning Enough   A Rational Approach To Investing 052010
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Earning Enough A Rational Approach To Investing 052010

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An investment strategy should be tailored to the individual’s money personality - not to a firm's investment models. Money is not the client; people are.

An investment strategy should be tailored to the individual’s money personality - not to a firm's investment models. Money is not the client; people are.

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    Earning Enough   A Rational Approach To Investing 052010 Earning Enough A Rational Approach To Investing 052010 Document Transcript

    • Earning “Enough”: A Rational Approach to Investing A recurring theme in our profession relates to how investors might variously express their expectations for portfolio growth, or rate of return. Behavioral finance, a relatively new science of human behavior, has identified a number of money personality types. While there is some overlap between the types, and an investor may exhibit behaviors attributable to more than one Joel Framson & Eric Bruck, type, we can find enough common ground to Principals divide the money personalities into two camps. "Mastering the • The “I’ll never have enough” camp. For complexity this group of investors, expectations are of wealth always high and you can never earn to create and sustain enough. Behavioral finance professors tell a better life us that money is a status symbol for this Silver Oak Wealth Advisors, LLC type – it is discussed at cocktail parties and ~~~ clubs; it is a lifelong pursuit and a quest that may never be completely satisfied. • The “my money has a purpose” camp. Click here to learn These investors are generally family more... stewards for whom money translates into a means for taking care of oneself and loved ones. Certainly there is a desire to accumulate more, but there is a tempering factor of not risking a prudent level of security. This group generally is amenable to defining reasonably attainable goals and calculating a rate of return that will be sufficient to realize those goals. These two camps display fairly bright line distinctions in their expectations. From our
    • perspective in our roles as wealth advisor and money manager, it is critical that we know which camp our clients fall into. Only with an understanding of each client’s money expectations can we establish a strategy to help them succeed. Yet a fantastic strategy for one camp may almost by definition be an ineffective strategy for the other camp. One size never fits all As we meet with new clients, we have the opportunity to explore their money personality. By analyzing their existing portfolio, we can determine whether their prior advisor attempted to match their money personality with their money type. Too often, we find that the two have been out of sync. Large national money managers (and some local independents) have a one-size-fits-all approach to constructing portfolio models. They believe that four or five static models cover all the risk/return options required. Similarly, other advisors might primarily utilize only a single mutual fund family or investment house, which they require all clients to use. In each case, these money managers tout award- winning stock research or Nobel Prize winning theories to justify their asset allocation. However, from our analysis of those portfolios and getting to know the client, we have found that the advisor typically has failed to individualize the portfolio based on a true understanding of the client’s expectations. There might be any number of reasons to explain why this is true. Often, it is the lack of using a financial planning approach as a starting point to identify the goals. Risk “tolerance” is cursorily examined, but risk “capacity” is ignored. Another explanation might involve the typical asset allocation approach of large brokerage firms who assume that all investors will be better off with the ubiquitous definition of risk and return based on textbook concepts, without regard for the money personality of the client.
    • So let’s distinguish between what the textbooks teach about risk and return and what behavioral finance reveals. Are markets really rational? More art than science First, here are the basic tenets of Modern Portfolio Theory (MPT), a Nobel Prize winning theory premised on the “efficient markets hypothesis.” Risk and return are considered to be both static and predictable, based on history. Premises include: • Investors behave rationally • Investors seek to optimize their returns • Investors are the market • Investment returns follow a statistical “normal” (predictable) distribution (bell- shaped curve) • (Historical) standard deviation and correlation primarily define portfolio risk • Markets are efficient and will always return to equilibrium However, behavioral finance studies stand in contrast to these tenets, having concluded that either many of these tenets are not true or they are not particularly applicable to individual investors. In contrast, behavioral finance tells us the following: • Investors, at least as often as not, behave irrationally, acting on emotion. • Investor’s perception of their own risk tolerance changes over time, especially under different market conditions • Investors do not view upside and downside risk in the same way. On the downside, they are focused on losing out on specific objectives. Perception of risk is viewed in the context of goal attainment • Market returns are often not “normally” distributed. They exhibit skew and/or “fat
    • tails” (extreme events) which greatly impact investor goal attainment and perception of risk. Extreme market behaviors occur more frequently than is statistically predicted. Historical inputs that are used to calculate MPT (standard deviation, expected returns, correlations) are not static, fluctuate over time and are not predictive of the future. For individuals, risk is much more than a historically based statistical measurement (standard deviation). Risk for individuals is an emotional condition and includes fear of a bad outcome, fear of loss, fear of underperforming. It is likely that the biggest fear people have is the fear of failing to achieve a financial goal – not being able to retire, not being able to remain retired, not being able to assist their children or parents, and fear of running out of money. MPT holds that (statistical) risk dissipates over time; that any period of bad market returns will eventually be restored to equilibrium over (enough) time. Herein lays the key. Individuals typically do not have enough time for their portfolios to recover during a particularly steep market decline. Minimum Acceptable Return (MAR) Individuals should focus on a minimum acceptable return (MAR) which is required to accomplish their goals. This is not a new concept for those of us who provide financial planning for clients. The financial planning process is an essential tool for us in helping to define one or more MARs as we assist clients to reach their goals. The MAR is a concept that is perfectly suited to the group of investors who fall into the second camp defined above - the “my money has a purpose” camp. The clients of Silver Oak Wealth Advisors, LLC typically fall into this camp. During our Discovery
    • meeting process, we uncover a client’s money personality. We carry out our wealth management process to enable us to create portfolios that would succeed in delivering the MAR based on our understanding of each client’s risk comfort level, capacity for carrying financial risk, and personal definition of what it is about money that is important to them and their family. Through this financial planning process, we are able to determine “how much is enough” for each client – in other words, when we understand a client’s MAR, we simultaneously understand the maximum level of risk a client’s portfolio must assume to achieve it. This is a rather unique orientation, but one that we truly believe captures the essence of our firm’s effectiveness in managing and protecting the wealth of the clients we serve. Best personal regards, Joel H. Framson, President Eric D. Bruck, Principal