Mike Martin of Columbia, Md.-based Financial Advantage recounts how a prospective client came to see him a year ago and said, "If I make 15 percent to 20 percent a year, I'll be fine in retirement."
The prospect was serious, and Martin immediately set up a "let's get real" talk. He didn't want the relationship to immediately head south.
"We try to accept only clients who are comfortable with our expectations for what we can realistically hope to deliver," he says.
Ideally, most clients start out with more realistic expectations about their investment returns. But it's ultimately up to the advisor to educate them on the important parameters that will drive those earnings. Timing, liquidity, needs and volatility are some of the main functions to address.
Timing is everything. Investment professionals are more comfortable dealing in longer rather than shorter time periods.
"That might be counter intuitive," says William Keller, director of investments for PNC Wealth Management in Baltimore, Wash. "It's exactly the opposite from predicting the weather. We have a better idea whether it will rain tomorrow than if it will in ten years time. On the other hand, it is easier to construct a clearer picture for investing over a decade than in the immediate term. Just consider the intraday volatility that has rocked markets in recent months."
"My number one goal is to meet my clients' immediate needs," Keller adds. "Otherwise the long-term strategies will blow up."
So if the client requires money in the near future, Keller adjusts everything to ensure that funds will be available when necessary by choosing safe and conservative instruments with less return variance.
It may be a clich?, but it's also true: no one can enjoy an equity return with a money market horizon, or at least not for long. Clients looking for higher returns must be prepared to focus on a longer time frame, and that will reflect what they want to do with the money. Tom Wilson of Brinker Capital in Berwyn, Pa., aims for 7 percent to 8 percent in a 7- to 10-year period based on real earnings growth, dividends and some inflation.
The next challenge is liquidity immunization. Investments must either mature or be highly likely to attain a certain value when liquidity needs come due. For example, consider someone with $5 million in investable assets who requires $1 million one year, and another $1 million the following year, and is then unsure when they'll need the remaining three. For year one, an advisor might suggest a cash-like, money market investment; for year two, perhaps a structured product could add a bit of risk and return; and for the final back end period, standard asset allocations that produce higher returns.
Inevitably, markets will go through periods of wrenching volatility. Rather than wait for turbulence to strike, most planners suggest preparing new clients ahead for stormy patches. When you initially do the analysis for their needs and cash flows, try to capture the likelihood of deep bear markets. Be warned, however; clients may nod and agree in advance, but when they see their bottom lines start to shrink, powerful emotions take over.
Wilson suggests describing each individual's potential losses in concrete dollar terms. He likes to demonstrate a maximum downturn, which is the largest percentage an account might lose from the top of an allocation to the trough. Once, he recalls, a prospect balked and protested that he was having difficulties understanding what that percentage would mean to him. So now Wilson depicts it graphically. Instead of telling a client the assets might fall, say, 15 percent, he would tell them they could see a loss of $250,000. He asks how it would make you feel. Would it alter your lifestyle or affect your spending? There is no wrong or right answer, of course, but the hypothetical loss resonates and brings home the point.
Planners start out with the investment policy statement tailored to each client's goals, objectives and characteristics like risk tolerance and liquidity needs. The length and detail of IPS documents vary. For instance, PNC Wealth Management divides the statement into three parts. The first deals with the client's own position (liquidity needs, tax and so forth); the second part outlines the asset allocation rationale; and the third section lists performance expectations against specified benchmarks communication protocols (regularity off meetings, statements, etc.). Keller reflects, "The first part prevents the client from surprising us, and the second part keeps us form surprising the client."
The market environment
Each advisor has a different approach to the advantages of active versus passive investing, and few are entirely agnostic on the overall market. Advisors need to incorporate some elements of their outlook as they set the context for preparing clients.
"Most clients are curious about our firms' capital market forecast and how those will impact allocations," Wilson says.
Many investors hold opinions about expected returns based on the exceptional experience of the past 18 years, over which time the Dow Jones Industrial Average has returned more than 1,000 percent. Compare that vigorous performance to the prior 17 years, during which the average actually shed one percentage point. In short, markets go through long periods of both outperformance and of meager returns.
The emotional content of stock prices inflates and deflates, but a key factor lies in the starting valuations. For instance, in the 1960s, the "go-go" bull market coasted on a technology phenomenon and so-called "nifty fifty" names, elevating price-to-earnings ratios to the top range of their historical experience. Over the following 17 years, those PE's worked their way back down to single digits. From the current position, Martin foresees a volatile and low-return environment for years to come.
"Low return is bad enough. But volatile makes it even harder to cope," he says.
Others are less willing to predict market direction. Norm Mindel of Genworth Financial sticks to broadly diversified portfolios constructed by Dimensional Fund Advisors.
"We minimize the systemic risk in the market that way," he explains.
He puts the focus on asset class allocation, according to a client's risk tolerance, adjusting the dial between fixed income and equities.
Every client wants to feel significant and expects serious attention. Advisors need to articulate specifically what they will be doing, such as how they are monitoring their clients' investments, how rebalancing will work in their clients' accounts and what type of interaction they will have with the client. Avoid confusion by establishing a minimum standard of communication, such as monthly or quarterly statements and regular meetings or phone calls.
More is not always better. Discussions with a broker every two days may even distort a long-term strategy. Clients often harbor an attitude that, since they are paying, they have a right to see some type of action. Keller must sometimes remind them that "Inaction can also be action."
Keep clients in the loop in any case. Regular contact and honesty will help tamp down their anxiety. Every time Martin executes a significant trade in their accounts, for example, he sends out a one-page e-mail explaining the reason.
"They love that," he notes.
It could relate to volatility or even just fessing up to a mistake, like an investment that does not pan out and exactly what went wrong.
Servicing is usually a team activity that goes beyond direct communication with the advisor. Martin tells each new client that they "will be hiring an entire team" consisting of three other senior advisors and three staff people behind each of those managers. Because he wants all of the 160 families he advises to know everyone, he is currently setting up several open house events at his offices.
While it is essential to be responsive, advisors cannot work 24/7 to deal with every issue single-handedly. Clients must understand that advisors delegate some administrative responsibilities to their staff. Mindel starts out by telling his customers that he has licensed assistants to handle all the paperwork, and that if they have any concerns about matters like transfers of funds or redemptions, someone will always be available. At the same time, he gives them his personal cell phone number for any questions related to investments, markets or taxes.
Make the effort to engage in these basic discussions early on and it will pay off by weeding out the good prospects from the troublesome rental clients -- those who are quickest to argue and complain, to badmouth or even to sue.