What happens when the hunter confuses the shadow for the prey? Well, you miss the shot and you go hungry or worse.
What happens if your clients buy into the wrong investment ideas, chase the high performers of yesterday instead of finding the future performers of tomorrow, buy high and sell low? Well, they do not get the returns they expect and ....
"Here Be Dragons" is a caption often seen on old maps. Have you ever seen unretouched pictures of the planets in our solar system? The dark side always seems so large. Remember, you need a source of light to see something. A single source of light will create a large shadow. In our solar system, there is a single source of light that dominates all others. You don't need to remember Pink Floyd's lyrics to fear the dark side of the moon.
I worked for a few years in a large corporation with a proud name and long history where the managerial mantra was "Perception is Reality." There was only one source of light and it shone so strongly through the political prism of the institution that it overcame people's sense of reality. Perception became reality!
However, reality is reality. Soon enough, others saw the corporation for what it was. A more "perceptive" institution bought it out and the old, proud name is now gone. Not all may be lost; I think I still have the corporate tie and perhaps even a bowtie with its beautiful logo.
We need multiple sources of light to cancel the importance of their respective shadows. We need multiple types of analysis to see what dwells on the "dark side" of the markets. However, our sources of investment light have become so single-threaded that it is hard to distinguish the shadow from the prey. Recent events remind us all that these shadows have become large enough to hide dragons.
In an excellent article in the May/June 2009 issue of the Financial Analysts Journal, "A Simple Theory of the Financial Crisis; or, Why Fischer Black Still Matters," economist Tyler Cowen points out the errors of expectations that individuals, entrepreneurs, investors and even entire societies develop when they feel wealthy. The article is helpful because it moves us away from narrow, "root cause" explanations and instead forces us to see the generalized, worldwide conditions that led us to where we are.
Since the 1980s, we have lived through a period of exceptional and worldwide wealth creation. This generalized feeling of wealth led many of us to over-invest in risky assets in the hope of greater returns. The insight "take more risk to achieve more returns" shone so brightly that we failed to see what lurked in the shadows: taking more risks also raises the odds of collapse.
Seeing Things Anew
Now that the possibility of individual, institutional, sectoral and even societal collapse has appeared, we need to create and maintain multiple sources of investment light, or one source will dominate all others and warp our sense of reality. So, what are the new investment insights, the new sources of light and understanding that we can use to peer into the dark side of portfolios?
To help answer this question, the Retirement Income Industry Association supports three major approaches to shed light on the reality of retirement income portfolios.
The first effort is pure bricolage. We call it the engineering approach. Given an immediate problem (creating retirement income), the engineer asks, "What can we make happen with the tools and materials around us?"
The second effort is theoretical. We call it the economics approach. Looking at economic theories that go beyond Modern Portfolio Theory, the professor asks, "What models seem to make the most sense?"
The third effort is based on observation. Given what people actually do, RIIA members ask, "What are the emerging empirical standards?"
These three approaches are an important part of RIIA's body of knowledge for retirement management and retirement income. They are also described in the book RIIA's Advisory Process: How to Benefit from the View Across the Silos. This book summarizes RIIA's core curriculum for the retirement management analyst (RMA) and related designations.
Practicing FAs cannot wait for the professor. They cannot wait for standards to emerge either. We have to help real clients, right now. So what can we learn from the engineering approach in the here and now?
Mike Zwecher is the co-author of the book on RIIA's advisory process and he has this to say about the engineering approach: "Only after seeing what works, usually after studying enough disasters to know what can go wrong, does the engineer invoke one or more insights to find the solutions that work while fitting into the business models that are being served." Mike is also a Ph.D. in finance whose background at Merrill Lynch included leadership roles in the creation of financial products, investment processes and trading systems.
So far, the first decade of the 21st century has provided plenty of disaster study material. Engineering retirement income portfolios is about making portfolios that at first glance look as though they are the familiar investment portfolios that clients are used to buying and advisors are used to selling.
However, retirement income portfolios differ in the sense that they "First build a floor and then expose to upside." This means, for instance, that the bond component of the portfolio is included for income and maturity rather than diversification and yield.
This and other aspects of the engineering approach to retirement income portfolios are explained in yet another book that Mike authored: Retirement Portfolios: Theory, Construction and Management. We will soon add this forthcoming book to the RMA curriculum.
Francois Gadenne is chairman and executive director of the Retirement Income Industry Association in Boston; see www.riia-usa.org.