Financial Planning lacking

Fri, 21 Jan 2011 16:42:06 -0500

In today's Personal Finance section was a quick article by Suzanne Barlyn uncovering the GAO's study on financial planners. Once again, the financial planning trade groups seek to expand their membership instead of solving the problem. In the letter I wrote to Senator Dodd last March, I outlined the need to have a set of standards for financial planning and the need for such to be taken back from FINRA.

Broken Plans

Fri, 21 Jan 2011 12:07:46 -0500

Last fall when we were diligently working to develop Folioscore.com, an application that allows investors to audit how well their advisor is managing their portfolio towards achieving their financial planning goals, Andy Gluck sent me an insightful article, Broken Plans.

Gluck's core theme was if financial planning software would allow advisors to forecast various economic scenarios over shorter, 5 year time periods, then they could better meet their client's needs. Creating a hypothetical couple, the Smiths, Gluck illustrates how to manipulate MoneyGuidePro to show how $600,000 in assets could grow to either $875,319 or shrink to $397,959 over a 5 year period. Using some sort of simulation, his experts conclude the 'most likely' scenario results in only $32,000 in appreciation.

The largest take away from the article is an industry out of touch of investor's needs. The financial services industry still largely views planning and portfolio management as two distinct and separate practices although clients view the relationship with their advisor as seamless.

Despite all the 'expertise' to create various economic forecasts, 'most likely' scenario fails to achieve the goal. Their hypothetical portfolio needs to only generate $17,000 before inflation and taxes annually, a meager 2.8% return over the next 5 years, assuming the Smiths do not want to spend their principal.

Because I have long recognized that financial planning software is designed to illustrate how much better off an investor would be by switching firms, Folioscore is my attempt to offer investors an unbiased manner to assess if their advisor is watching the market or their goals.

Over the course of the next few months, I will illustrate how Folioscore arrives at calculations, how we will continue to monitor and evaluate the Smith’s hypothetical situation outlined by Gluck and examine what hurdles the financial services industry must overcome to provide a seamless goal based portfolio management to individual investors and institutions.

At the outset, I also might appear overly critical of Gluck, who I admire and respect as a thought leader in this industry. The reality is while I do disagree with his theory in this article, I found this to be one of the best articles written of various approaches in financial planning software. So in the spirit of a blog, lets start a conversation, debate positions and see if in the end some betterment to assisting investors can be considered.

Managing Portfolios for Goal

Thu, 20 Nov 2008 10:50:39 -0500

As the reality of an economic recession begins to appear more certain, investors are becoming increasingly skiddish as to whether they should stay the course or abandon their investment plans altogether by seeking a defensive position. While it is unknown as to the length and severity of this current crisis, fear looms we are in the midst of an unprecendented event.

From a purely economic sense, it is highly unlikely that we will see an economic depression like the 1930s, considering that an investor could purchase all the stocks in the Dow Jones Industrial Average at 70 cents for each $1.00 of revenue. Other companies such as GE are trading at values nearly identical to the worth of their assets if liquidated. While I am not making a call as to whether we have reached 'a bottom' at 7500, what does seem apparent is the belief of a greater likelihood to go significantly higher from here than lower. In fact some believe that the market is positioned for a 20% to 30% rally that could take place over a 2 to 3 day period in the near future.

The problem for investors is that for some time now, the financial services industry has espoused asset allocation and financial planning as the 'holy grail' towards achieving goals. Today faced with the conflicting reality that asset allocation does not always work, many wonder how such supposively sophisticated lifetime income plans could be so off.

At the same time many advisors are suggesting clients re-evaluate their goals and make sacrifices blaming 'unprecedented market events' I am telling clients 'sit tight, you are still on track.' In order to reinforce my message, we need to explore whether this is an unprecedented event and if not, provide verification that your portfolio is allocated to sustain this event and meet your goals.

Not unprecedented, unique nor unforeseen

We all know that investing involves risk and as such have learned to diversify portfolios across several asset classes to reduce volatility. In the last few months, this has not worked.

When all stocks and even bonds prices fall due to conditions in the economic environment, it is known as ‘market risk,’ and typically referred to as ‘crashes.’ Academically, it may be debatable whether we are currently experiencing a ‘crash,’ but if it walks like a duck and quacks like a duck…it’s a duck!

The good news is that such crashes as South American Debt Crisis of 1981, the Asian Economic Crisis of 1993 (and then again in the late 1990s), The Russian Currency Crisis in 1998 and the World Economic Crisis in 2002 are typically marked by extreme downside volatility lasting only a few weeks. Tougher US economic downturns have been events like Black Tuesday in 1987 and a 52.97% decrease in the markets over a nine month period between the Fall of 1973 and late Summer 1974 take on average a few years to work themselves out.

As I mentioned last month about identifying ‘Black Swans,’ this event was not unforeseen nor is the worst case scenario. Believing this to be an unprecedented event means an advisor was wholly unaware of 1993, 1998 and 2002 or completely disregarding October 1987 and the entire decade of the 1970s.

Recognizing the current economic crisis as neither unprecedented nor unique, how then can we verify your portfolio is allocated to meet your goals? At Carolopolis, we use a statistical ratio known as Omega as a means to ensure rhetoric is congruent with reality.

Omega

Omega is the probability –weighted ratio of gains or losses at a given level of return, R. R is defined as a ‘loss threshold,’ the level below which, for a specific investor, even a positive return would be a loss. Such example is an investor who needs a 7% annualized rate of return to meet their retirement income goal, achieving a 3.1% rate of return is not adequate and is therefore assigned a ‘loss’ value. Because a loss of -33% is much more severe than 3.1%, Omega also interprets the severity of losses along with the probability.

R is not an average or target return, rather it is an absolute minimum or hurdle that is determined by an investor's real life needs, goals and aspirations. It is important to note that we use monthly R, essentially dividing 7% by 12 to meet a level of frequency to provide stable returns and cash flows.

The focus on return thresholds is one of the most valuable components of Omega for two reasons:

First, because the timing of returns are so variable, the only elements that can be calculated in a retirement income plan are contributions, withdrawals and a linear rate of return which represents a goal. Omega provides a more realistic manner to project an ability to meet a goal than using current market values.
And secondly, because the goal does not shift with the market (or at least it should not) Omega provides insightful evidence as to whether a self-directed investor or an investor’s advisor is skilled in building a portfolio to achieve goals.

Omega calculates the returns distribution of a portfolio based off its asset allocation by investment style. When a portfolio is on track to meet an investor’s goal, it displays an Omega of 1.00; therefore the higher the value, the better.

Below is a comparison of the Omega of our model portfolios in October 2007 at the height of the bull market and again at the end of last month:

Deleted March, 2009

Clearly the last year has significantly deteriorated the upside potential of the models.

However, because the Omega is above 1.00 on all but the 10.50% model allocation, I am confident when I say to clients, “sit tight, you are still on track.” (It is important to note because of the long-term difficulty in maintaining an Omega over 1.00 on the 10% and 10.50% models, the advice for such clients is typically to increase contributions – that being said, none of our clients at or near retirement are counseled towards a model allocation over 9%)

Managing wealth, not returns

In order to accurately calculate Omega, the actual returns of the investments in a portfolio are not necessary. Instead a process known as Returns Based Style Analysis determines the underlying style of each holding with such a high degree of accuracy that it is possible to substitute the returns of the individual styles to obtain data back to January 1986. This allows for a better understanding of the upside potential and downside deviation of a portfolio (or investment) over several economic cycles, emergencies (1993, 1998 & 2002) and panics as October 1987. Such insight allows events like this to not suprise us in terms of occurance, it is the timing that always catches everyone, including me, offguard.

Knowing the probability that for any investor with a 20 to 25 year time horizon will experience such an event, leads us to make investment decisions based on the impact to your wealth relative to the funding status of your goals. Instead of positioning you to assume risk and then blaming the market when a crisis occurs, we set the minimum risk level necessary to have sufficient confidence for the goals you are trying to fund.

LET ME BE CLEAR, while this may be new to you or other advisors, we understood the liklihood of this event and as such do not expect it to interupt your ability to achieve your goals. Like a pension plan( whose decision making process is guided by legal precedent), this forces us to make 25_ one year asset allocation decisions instead of _one 25 year decision.

When a pension plan is over funded, trustees of the pension may act on one or more of the several choices they have because of the excess MONEY (wealth) fortunate timing of market results produced for the liabilities (spending goals) of the plan. Pension trustees may reduce future contributions (the equivalent to reducing how much you are saving towards your goals), they may increase the benefits of the plan (equivalent to increasing your spending or estate goals) or they may reduce the portfolio risk (because higher risk is not warranted for the liabilities of the plan) either by adjusting the portfolio allocation, or by immunizing a portion of the liabilities. The bottom line is that prudent fiduciaries will act upon fortunate market results to reduce contributions, increase benefits, or reduce investment risk. We perform these calculations on regular intervals and have had conversations with many of you over the years in regards to reducing risk.

Conversely, unfortunate timing of market results may cause a pension trust to become under funded. In such cases, the assets of the pension trust are insufficient to confidently support the liabilities of the plan. Prudent trustees would act on this by either increasing contributions to the trust (the personal wealth equivalent of increasing how much you are saving), freezing or limiting the accrual of future liabilities (equivalent to reducing or freezing your retirement spending or estate goals or delaying a portion of these goals), or possibly changing the asset allocation of the trust to increase the potential return, thereby also increasing the risk of the portfolio.

These are basic choices and your personal wealth goals should be treated no differently than a pension plan and we should consider all of these choices. Right now, based on the needs of our clients (recognizing each of you have differing contribution and withdrawal schedules) Omega indicates goals are currently funded.

Moving Forward

It would be naive for me to attempt to sell you on the premise that I know what the future holds and therefore there will be no changes in our models or your investment strategy. Because the goal is managing portfolios to achieve goals, the decision making process deviates from that of a typical advisor who is trying to 'beat the market.' Normally, the way asset allocation is practiced is based not really on your wealth or goals, but instead on your tolerance for risk.

Unfortunately investors love upside risk (reward) and hate losses. Because the traditional process can only answer whether you are positioned to beat the market, many investors give up figuring their goals are long lost.

Due to the fact we are allocating to achieve goals, we have much flexibility moving forward should a prolonged recession occur. In the short term, just like a pension plan, we may have to increase your target rate of return (and therefore risk) to maintain course. But what is critical to understand is that it is simply too early to make a decision until we can fully understand the economic environment moving forward. One month, one quarter nor one year will make nor break your plan...so 'sit tight, you are still on track.'