By David Feldman
David Feldman is director of investments at Lockwood Capital Management, Inc., an SEC Registered Investment Adviser and an affiliate of Lockwood Advisors, Inc. and Pershing LLC (member FINRA, NYSE, SIPC), all of which are BNY Mellon companies.
The following is an excerpt from Lessons From 2008: Risks and Opportunities for Investment Professionals, a paper written by the investment team at Lockwood Capital Management, Inc. The full report can be downloaded free at www.pershing.com.
Despite recent improvements in equity and fixed income markets, and some indications of stabilization in the housing market and the broader economy, we expect there to be long-lasting effects, and therefore lessons to be drawn, from the tumultuous events of late 2008 and early 2009.
It is the view of the Lockwood Capital Management, Inc. (LCM) investment team that while we continue to face significant challenges, there are steps that investors and their advisers can, and should, take to revisit and revise their financial plans, while seeking to restore savings and repair portfolios.
An honest assessment of the causes of last year's sharp market declines should acknowledge that the housing and financial asset bubbles were substantially driven by poor judgment, greed and insufficient foresight on the part of market participants, consumers, regulators, boards of directors and government officials. Beyond that, other contributing factors include decades of consumers living beyond their means, predatory lending practices, derisory regulatory oversight, overly creative financial engineering, inadequate risk assessment and management, and imprudent public policy.
Rather than focusing on the mistakes of the past, however, LCM's message remains forward looking: what to expect from a significantly transformed environment and what investors and their advisers can do now.
Keys Designed for Successful Investing in the New Era
"Investing is simple, but not easy" - Warren Buffett
Like a visit to your doctor, what follows may not be what you want to hear; but it may be what you need to do, in our view, to get back on track.
Clear definition of investment objectives. As in most endeavors, a clear understanding of objectives and a plan to achieve them, including an assessment of risks and contingencies, build an essential foundation for success. Working together, client and adviser should comprehensively evaluate financial goals such as retirement, college funding, health care (both before and in retirement), travel plans, lifestyle expectations, charitable giving wishes and legacy plans. Once objectives are specified, including time frames and dollar amounts (i.e., the liabilities are defined), planning can move on to current assets, income and other cash flows, expected future cash flows, and the effects of taxes (where applicable) and inflation.
Once these are determined, the client and adviser can assess the required rates of return to achieve the financial objectives. Often, required returns will be uncomfortably (or unattainably) high. Objectives should then be modified, in timing, amount or both, so that desired returns are more reasonable and consistent with the client's risk tolerance.
Adoption of an appropriate, generally long-term, time horizon. This can be simple ("What year will Junior head off to college?") or more challenging ("I'm in my mid 30s. When will I retire?"), but the advantage of developing a plan is that it is adaptable along the way. Time horizon length is an important factor in determining the degree of risk to be taken, and thus influences asset allocation.
Disciplined asset allocation policy and methodology. A potentially great benefit to your clients when working with an experienced adviser lies in jointly developing a policy that governs how assets are currently invested, how mid-course adjustments are made to react to unexpected financial or market conditions, how to adjust if circumstances or risk tolerance changes, and why and how often to rebalance investment portfolios.
Acceptance/expectation of interim volatility. Seeking greater returns is necessarily and inextricably linked with risk. Assets that fluctuate upwards in price can also decline, sometimes substantially, and, occasionally, to zero. One thing to keep in mind is that long-term average market returns reflect the downturns, as well as the bull markets.1 This in no way implies that the average return will be achieved, just that volatility, both up and down, is reflected in that long-term average.
Expect, do not ignore, and seek to mitigate fat tail risks. Portfolio theory often uses the assumption that returns are normally distributed. Specifically, that when plotted, returns will display the familiar bell-shaped curve. The assumption is convenient, but incorrect: real world portfolio returns are not normally distributed, and rare events-what Nassim Taleb cleverly called Black Swans-are not as rare as normality assumes. Rather, one should expect extreme events. Another way of looking at it is that most people's declared tolerance for risk rapidly shrinks when they are actually faced with it. Advisers and investors should plan conservatively and anticipate difficulties; if things work out better than expected, so much the better.
Valuation matters. A wealth of academic and practitioner literature supports the contention that the price one pays for acquiring an asset is related to the returns obtained from that asset over time. With respect to stocks, buying less-expensively priced future earnings streams (not to mention usually more stable dividend streams) is more likely to lead to successful outcomes. For an entertainingly well-written view, consider Rubble Logic: What Did We Learn from the Great Stock Market Bubble? by Clifford Asness.
Fundamentals drive returns (eventually). It is eminently logical that security returns are closely related to corporate earnings, levels of interest rates, inflation and taxes, costs of capital, current and expected rates of economic growth, and supply and demand. It is our view that this premise is valid. Unfortunately, also valid is the old adage that markets can remain irrational for longer than you or I can remain solvent. Advisers should help clients anticipate risk as described above and plan accordingly.
Liquidity, transparency and diversification are essential. Whenever large amounts of money are involved, disreputable types are attracted. Unfortunately, we have been confronted lately with several outsized reminders. This should serve as a caution to all investors: know what is in your portfolio, make sure you can access your money, keep it at a reputable institution and diversify appropriately.
Fees count and compound over time. This is one of the simplest, but most powerful, investing concepts. Fees are essentially negative returns on portfolios; not just the amount deducted today, but the foregone compounded growth over the entire investment time horizon. Investment professionals have an obligation to their clients and their portfolios to pay a fair price for services rendered and to deal fairly and equitably in all respects.
Hire competence; failing that, index. Many search for the Holy Grail of investing: the always outperforming active manager (preferably with no down periods whatsoever). One problem: it doesn't exist. Even the most successful investors are wrong at least some of the time. In guiding investors, reasonable judgment must be applied. If the chosen investment manager or structure is not delivering desired results over a reasonable time frame (say, three years), then, at a minimum, one should consider whether he or she should continue to pay active management fees.
Save more, spend less. This is the bitter pill, perhaps the most discouraging message of all, that clients need to hear: part and parcel of achieving long-term success is to defer gratification. Save for a rainy day. Don't buy that watch, car, boat, vacation, house that seems so appealing. Max out your 401(k) contributions and concentrate on saving strategies.
Integrity is not rare, but search until you find it. Frauds and criminals are present in the financial services industry, as they are in every human endeavor, despite substantial and long-standing efforts to rid the industry of its malefactors. Let a healthy degree of caution guide you; place your clients' hard-earned savings in the hands of people you are confident have integrity and are worthy of your trust.
Measure results rigorously, but fairly. What has your client's portfolio earned? Is it consistent with the "glide path" you determined as necessary to achieve targeted financial objectives? How much risk was taken to achieve these results? If the portfolio, or your client's plan, is off course, what action should be taken?
Communicate clearly and often. Troubled times make communication more important than ever. Reach out to clients; reassure them that, while the markets are clearly going through bad times, the plan you laid out together anticipated some tough periods. Some adjustments may be necessary, but investing for long-term financial goals is a marathon, not a sprint.
Do not expect a quick recovery, and do not take excessive risk trying to force one. With portfolios back to levels not seen in years-but no reset on the game clock-some investors may be tempted to seek much higher returns, thus taking on much greater risk in the process. Not only is this inconsistent with a well-designed financial plan, it may well result in even further steep losses, compounding the problem.
How to recover from unexpectedly severe losses if a client is already retired. Choices are, unfortunately, going to be more limited. Returning to work, even on a part-time basis, may not be an option because of availability or health reasons. Reducing planned withdrawals is one of the most certain approaches; reducing legacy plans and heirs' expectations are other alternatives.
Watch for warning signs. It is an old adage, but things that seem too good to be true often are. You should consider steering clear of returns that are unusually steady, higher than one would reasonably expect, "free," unsupported by reputable and regulated financial institutions, or cloaked in secrecy. Run, do not walk, in the opposite direction. Trust your own instincts: you do not have to be an expert on financial matters to assess a person's character, judgment and integrity.
While it is true that clients need to take more responsibility for their own finances, advisers play a crucial role in helping them hold others accountable for investment results, as well as being on the receiving end of integrity, honesty and clarity. If, collectively, we insist on transparency, liquidity, fair price and fair dealing, as well as competence from ourselves, colleagues in the investment industry, regulators and the political branches of government, we can emerge from the rubble of 2008 with a reason to be optimistic about the future and reinvigorated about our ability to help clients pursue their financial goals.
The statements contained herein are based upon the opinions of Lockwood Capital Management, Inc. (LCM) and the data available at the time of publication and are subject to change at any time without notice. This communication does not constitute investment advice and is for informational purposes only, is not intended to meet the objectives or suitability requirements of any specific individual or account, and should not be construed as a solicitation or a recommendation by LCM or its affiliates to buy or sell any securities or investments. Diversification and strategic asset allocation do not guarantee a profit nor protect against a loss in declining markets.
1 Morningstar EnCorr