A Better Way Forward

We believe that investment advisers should take a forward looking investment approach when devising asset allocations.  The historic or traditional approach has been to use past performance as a predictor of future performance, when devising model asset allocations.

Taking a forward approach requires an understanding of what drives returns and then to sensibly forecast those drivers.  This approach to forecasting returns looks at 3 drivers: income, income growth, and the effect of changing valuation ratios.  The three elements can then be added together to produce remarkably reliable long term return forecasts. 

This method provides a very useful way of deciding when to increase or decrease a client's exposure in each asset class.  Unfortunately, putting this into practice, can be emotionally challenging as it may mean selling down assets that have performed very well and buying into sectors that at the time may not be performing as well as others.

Risk to an investor, has a different meaning to that of a financial institution or a fund manager.  Whenever a financial institution or fund manager refers to "Risk", they are actually meaning volatility, or the risk of their investment moving away from the norm, and what level of volatility an investor will accept.  However, most investors have quite a different definition of risk.  Generally it is the chance of losing money, and risk management is a way to stop this happening.

It is surprising that many investment advisers spend little or no time at all on risk profiling their clients.  When they do, they often only look at one aspect.  We believe that for risk profiling to be useful to the investor, plus help design the appropriate portfolio, it must focus on both the journey (e.g.  what is their psychological risk tolerance along the way), and the destination (e.g.  the risk of running out of money).

We suggest that when risk profiling a client, we should be looking for simple things such as: How much can the clients handle if there is a market downturn?  What lifestyle outcomes do they want? What are the minimum outcomes they must have?

If we want to take this all into account and provide the best outcome possible for the client, it is obvious that a 'portfolio by numbers' approach will ultimately lead to disillusioned investors.  The advantage of a portfolio by numbers approach, whereby investors are assigned a model portfolio depending primarily on the manager's approach to investment risk, lies mainly with the providers of such investments.  The portfolios are easy to manage, and the advisers' role is primarily one of sales. 

It may be surprising to learn, that invariably those advisers who actually tailor portfolios specifically for their clients' needs charge fees often significantly lower than those prevailing in the industry as a whole.

Until the main financial institutions and academia recognise that the principles of forecasting based on past returns is flawed, and that much more effort needs to go into designing portfolios that better suit investors' future needs and their risk comfort levels, many investors will continue to be disappointed by their professional advisers when their portfolio underperforms.

Unfortunately, it is not always possible to have perfect solutions.   We believe that clients should only be offered portfolios that match their specific goals and comfort levels.  While no one can predict the future with real accuracy, the aim should be to get as close as possible, minimise the chances of losing money, and achieve returns to meet clients' lifetime objectives.  Isn't that a better way forward?