When it comes to discussing a client’s portfolio, performance becomes a central issue. Moreover, the client’s perception is crucial in whether they feel pleased or disappointed. It's this perception, which we call "expectation," that can either derail or fast-track the relationship. In this post, I'd like to share a recent experience and lay out a plan for managing client expectations.
A Brief Case Study
During a review a few months ago, a client explained that his retirement plan through work had achieved an 8.0% return for the most recent annual period. He went on to say that he didn't expect us to reach that mark since we were positioned far more conservatively than his 401(k). When I shared that the portfolio returned 7.5%, with much less risk, he was pleasantly surprised.
In my view, as it pertains to managing client portfolios, there are three key issues to consider: absolute performance, relative performance, and performance relative to the client’s required rate of return. Each client will tend to favor one of these categories, which will have an impact on the success or failure of the relationship.
Clients without the benefit of a financial plan, or those who lack understanding about the Sharpe Ratio, Treynor Ratio, Jensen Ratio (Alpha) or other risk-return measures, may be far more likely to compare their portfolio's performance to that of the stock market in general. Because of this, they may also be more likely to change advisors during a period of market outperformance. Unless you, as advisor, have a plan to educate these clients, it's also very possible that these clients will become more difficult to manage, especially when stocks are soaring. To sum it up, these clients are more likely to chase returns and change advisors, and gaining their full commitment may prove more difficult.
Relative Returns and Goal Achievement
It's important that clients understand that an investment’s return is related to its risk. Armed with this knowledge, assuming the underlying assets of the portfolio are of high quality, the issue becomes: "How much risk are they willing to assume?" In short, a portfolio may underperform stocks by some percentage, but on a risk-adjusted basis do very well. The next logical step then is to determine what return the client needs to earn to reach his goals. This is where a financial plan becomes a priority.
A client who understands that she needs to earn a specific percentage to achieve her goals is a client with fewer worries. Understanding the needed return has a freeing effect. It also provides the advisor with the information necessary to construct a portfolio which has a high probability of goal achievement with a minimal amount of risk. By knowing the target return, the advisor will be able to determine the amount of risk necessary to accomplish the task.
Many believe the Fed is causing a bubble in the stock market with its massive monetary-expansive-easy-money policy. Managing clients' expectations during periods like these may prove more challenging. Therefore, by educating clients about the relationship between risk and return, and especially by creating a personalized comprehensive financial plan, you will not only help cement the relationship, but will remove much of the pressure that exists when chasing returns is the primary focus.