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Matching Client Expectations With What You Offer: the Portfolio

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In last week’s post, we discussed how easy it is to reach conclusions that aren’t always rooted in fact. This truth holds great influence on the broader category of expectations because all of us have beliefs which we hold to be true even though we’ve learned that past beliefs were later  found to be false. That’s just a part of life. Hence, it’s vital that we, as advisors, are in agreement with our clients in terms of what we do for them, how we do it and the possible outcomes we should expect.

To achieve this, each of us should develop our own basket of beliefs and convey them to our clients. The goal is to create realistic expectations that our clients will adopt.  Here are a few things I am doing in my practice in this area. 

As mentioned in a previous post, unmet expectations are the number one reason clients leave their advisor. If the client’s expectation is reasonable, if it has been communicated to the advisor, and if the advisor continues to fall short, then the client would be justified in leaving. 

So let’s look at portfolio management and how we can help clients understand what to expect. Let’s begin with a question. How much of a portfolio’s variance is due to its allocation to stocks? For example, if stocks comprise 100% of a portfolio, then 100% of the portfolio’s variability would be attributable to stocks. However, as the percentage of stocks declines (the remainder of which is invested in bonds for this argument), the degree that a portfolio fluctuates also declines. But stocks’ contribution to a portfolio’s variance does not decline in sync with its allocation.

To study this, I created nine portfolios ranging from 90% stocks and 10% bonds to 10% stocks and 90% bonds. Moreover, I reduced the allocation to stocks by 10% in each portfolio. When the percentage of stocks and bonds is the same, stocks’ contribution to the portfolio’s variance is around 77.4%. In fact, even when the allocation to stocks is 20% with 80% in bonds, stocks still account for 56.4% of the variance of the portfolio. At a 10% stock allocation, this number drops to 38.9%, 

Therefore, somewhere between a 10% and 20% allocation to stocks we find the breakeven point where stocks and bonds have an equal effect on a portfolio’s variance. 

How am I planning to use this information with clients? Clients need to understand that their portfolio may trend in the general direction of the stock market to a lesser or greater degree depending on its allocation to stocks. Moreover, if we can improve the portfolio by including high-alpha funds, better diversification without surrendering alpha, and, at the risk of sounding redundant, select funds with good upside/downside capture ratios, then an improvement over the models I used should be attainable. 

Until next time, thanks for reading and have a great week!


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