September 07, 2017

Portfolio construction – a favorite topic for both advisors and clients alike – usually begins in a similar place. An advisor asks some stock questions that score, in different ways, what amount of risk a client is willing to tolerate and usually finds out the time horizon over which that risk will need to be tolerated. If the market is in the midst of a large upswing, clients may tell said advisor that they can handle as much risk as possible and might do so until the market goes down, at which point they may decide that they don’t like risk nearly as much as they professed, only the returns that they expect to come over time in portfolios with greater risk. Ask the same client during a bear market – a downturn – and they might tell you they want to take zero chances with their portfolio. Invoking the late Will Rogers, they may proclaim that it is the return of their capital they are concerned with, not the return on their capital. This might continue until the S&P 500 has double digit returns for 2-3 consecutive years, at which point they might be convinced their advisor is a bum.

Both of these scenarios are normal and aren’t in any way meant to depict clients in a negative light. Clients, like advisors, are human, and throughout the course of market cycles experience the full spectrum of emotions that comes with making and losing money. The ultimate success or failure of these clients, however, won’t depend on whether or not they feel such emotions – most will – it will depend on how they react to them. Because this has been true for as long as humans have invested money in endeavors with a risk of loss, it’s the advisor’s and the client’s job to address those feelings BEFORE they happen and not in the midst of an emotional breakdown. Portfolio construction and an honest appraisal of client-specific circumstances can play a role in this.

Take two hypothetical clients, client A retires with $1 million dollars and gets 90% of the income she needs from fixed sources such as a pension and Social Security. She is risk averse, but admits that she could live without any of that income and the ultimate goal is to give her kids the largest inheritance possible given her circumstance. Client B has saved $2 million, but lives a relatively extravagant lifestyle, and needs his portfolio to generate about 80% of his income and from that income, he has a withdrawal rate that leaves him vulnerable should he experience poor returns. He has told his advisor that he not only tolerates risk, but prefers it because he wants his returns to keep pace with or better ‘the market.’

In both situations, a thorough discussion and preferably, a plan, can help us build both clients’ portfolios. For client A, one might think it sensible that she put all or most of her money in stocks, as it will potentially be held over multiple decades, thereby reducing the chance that any major market downturns could impact what she ultimately passes on. But what if her aversion to risk causes her to sell her stocks down 40% in the midst of a bear market and she doesn’t get back in for several years, potentially reducing her return to one that more closely mirrors that of bonds than stocks? Would an advisor have done her a favor by telling her to do what she ‘should’ have done? Probably not – in fact, if she never returns to investing because of the emotional toll, the money’s potential for her AND her kids may be permanently damaged. This is why the second point, the ability to consistently adhere to a portfolio and plan, may prove more important than risk tolerance and more important than ‘market’ returns – if someone can’t handle market volatility, they won’t get market returns anyway.

What about Client B? He can handle the risk. He won’t sell things just because the market is down – his advisor believes him when he says that (even though, as is illustrated in the first paragraph, people may certainly change their minds depending on circumstances). Shouldn’t the portfolio be built to reflect his wishes? What if a well-thought-out plan reveals that, not only can he survive on, say, 60% of historical market returns, but a portfolio with 60% of the risk of the market also significantly decreases the risk that he runs out of money should market returns fail to meet historical expectations? It’s a tricky situation, but also a reflection of the importance of a plan – because, as Josh Brown puts it, a portfolio is not a plan.

There are multiple points in this post that I think could be worthy of their own article – that well-adjusted adults can misbehave badly in adverse circumstances, that the portfolio that ‘makes the most sense’ isn’t always the ‘right’ portfolio, that the returns in a particular market may be irrelevant to your personal situation, and that a person’s ability to tolerate risk isn’t the same as capacity to actually take on that risk. All of these points meet in one place – a financial plan. If a person doesn’t have a plan, it’s likely that even they won’t be able to predict their own behavior in the face of adversity and that recency bias - where stock market participants evaluate their portfolio performance based on recent results or on their perspective of recent results and make incorrect conclusions that ultimately lead to poor decisions based on how they believe stock market behaves - will guide their decision making. If they do have a plan, one that’s been explained to them, especially including the potential for poor scenarios, it’s no lock that they won’t revert to toddler-like behavior and abandon rational thought at the worst possible moment, but it may give them a better than average chance to do so. This is what planning and portfolio construction are all about – using objective data to make decisions based on your personal circumstances. So by all means – hold your advisor accountable, but prior to building your portfolio, agree upon what you’re holding them to. If you do that and you hold up your end of the bargain, I think you’ll have a plan in place that meets your needs.

This information is provided for educational purposes only. It is intended to be generic in nature and should not be applied or relied upon in any particular situation without the advice of your tax, legal and/or financial services professional. The views expressed may not be suitable for every situation. The hypothetical examples presented are for illustrative purposes only, do not represent any specific product and should not be deemed a representation of past or future results. Investing involves risk, including the potential for loss of principal. No investment strategy can guarantee a profit or protect against loss in declining markets. The Standard & Poor's 500® Index (S&P 500®) is comprised of 500 stocks representing major U.S. industrial sectors. Indexes are unmanaged and cannot be directly invested into. Past performance is no guarantee of future results.