By Michael Callahan
These days it seems everyone from fund managers to market analysts and economists has an opinion on investing. Sometimes those opinions agree, sometimes they clash. And while it’s comforting to make decisions based on a strong consensus, as Michael Callahan reports, having to decide on a course of action when there is no clear agreement can prove challenging.
There’s no shortage of investing information available to advisors — countless websites, social media, television and radio stations dedicated solely to stock markets and economic news. Making sense of all of this information, however, is not always easy. How are advisors to make decisions based on “expert” opinions when equally credible sources offer contradictory advice?
Consider Mercer’s 2012 Fearless Forecast: A Survey of Canadian and Global Capital Markets and Industry Trends, which reflects the consensus opinions of Canadian and global investment managers on capital markets, and on the economy in general. In particular, the forecast included input from 50 investment management firms, including some of the most prestigious asset managers in the world. Among other items, managers were asked to comment on what they expected would be the top and bottom performing sectors of the S&P/TSX Composite Index in 2012.
The results are anything but consistent. For example, 20 per cent of managers indicated financials would be the top performing sector. Interestingly, the same number of managers — 20 per cent — also indicated financials would be the bottom performing sector. It’s a similar story with the forecast for the consumer discretionary sector: 12 per cent of managers expect consumer discretionary to be the top performing sector and yet 12 per cent of managers expect consumer discretionary to be the bottom performing sector.
How is it that a group of financial professionals, with the same designations and credentials, and looking at the same base data, can come to opposite conclusions? And more importantly, how are advisors supposed to interpret this information and make informed investment decisions?
A Bigger Picture Approach
“The majority of one’s financial success comes from proper financial planning first, followed by strategic asset allocation decisions, and finally — of lesser importance — individual manager/stock selection. We filter out the noise by focusing on what really matters to the client,” says Dylan Reece, CFP, CLU, CIM, a financial advisor with Nicola Wealth Management in Vancouver.
Countless studies, such as the classic BHB (Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, 1986) study of 91 large pension funds, demonstrate the importance of asset allocation over individual security selection. In 2000, a similar study by Ibbotson and Kaplan examined the returns of 94 U.S. balanced mutual funds and found similar results: the vast majority — over 90 per cent — of a portfolio’s returns are attributable to asset allocation rather than individual security selection. Keep in mind that we’re referring to strategic asset allocation — the percentages of the portfolio allocated to specific asset classes (cash, bonds, equities, real estate, etc.) — as opposed to tactical asset allocation, which refers to moving in and out of various asset classes in an attempt to outperform over the next short period of time (i.e., market timing).
As Reece points out, whether now is a “good time” to buy gold or XYZ stock — or anything else for that matter — has very little connection to clients having a comprehensive plan that helps them achieve their goals. Yet, unfortunately, it seems that many financial advisory firms are more intent on analyzing the latest and greatest stock, sector or investment trends, such as high tech and the dot-com boom of the 90s, or more recently, commodities and real estate. In doing so, they may fail to look at the broader picture of a client’s overall financial situation.
“As fee-based financial advisors and investment counsellors, we provide our clients with a financial plan that covers a broad range of planning issues including retirement projections, tax and compensation planning, estate and insurance issues, real estate strategy, and business succession planning,” adds Reece.
This brings us to an important point: An investment portfolio is not, in and of itself, a financial plan. It is, however, a key element of a comprehensive plan. FORUM spoke with David Christianson, BA, CFP, R.F.P, TEP, an investment advisor and vice-president with National Bank Financial Wealth Management, about his process.
“First and foremost, my job is to make sure I know everything I need to know about my clients,” says Christianson, who is the author of Managing the Bull – Detect and Deflect the Crap. A No-Nonsense Guide to Personal Finance. “When it comes to constructing investment portfolios for clients, we start by determining the optimal asset mix for each client. Then we look at what they already own, make changes where needed, and ultimately build a portfolio of ETFs and various specialty holdings. Our clients typically only hold individual securities if they came to us with these existing positions they wish to retain. As far as individual product selection is concerned, our firm has recommended lists, but of course we have the discretion to deviate from those recommendations as appropriate.”
Dylan Reece has a similar approach: “Once the planning is complete, we look at strategic asset allocation, which we approach like a pension plan. We have a number of model portfolios that reflect our macro-economic views and investment philosophy, but we adjust the models based on the clients’ unique objectives, risk tolerance and external holdings.” Reece “eats his own cooking” too, since the partners and staff of Nicola Wealth Management invest alongside of their clients in similar investment portfolios.
It seems one way advisors can effectively filter out the noise is by focusing on larger, more important issues such as financial planning and asset allocation. Yet, ultimately, advisors must make investment recommendations to their clients. So how do they wade through the sea of information available and develop advice in accordance with their investment philosophies?
“Conflicting information in our business is sometimes a good thing. We can read about different points of view and ultimately be better prepared to formulate our own investment thesis,” says Reece. “For example, you may see two analyst reports — one with a strong buy and one with a strong sell. By reading both viewpoints and valuation methodologies, we can get a sense of how each analyst interprets the company’s business prospects and their rationales, thereby helping us formulate our own opinions.”
It’s like Warren Buffet says about successful investing: while filtering out the noise may sound simple, it’s anything but. “It’s is a huge challenge. One method is to narrow it down to a couple of sources that you trust, and focus on them. Otherwise, it can overwhelm,” adds Christianson. “Unfortunately, there’s no easy answer. For me, a lot of it is experience and instinct, and exercising common sense. Mutual fund road shows can be informative and very persuasive. But we must keep in mind they are typically focused on what can be sold now, and what’s hot now, which is often at the time when that trend has run its course.”
As for digesting forecasts, research and reports, Christianson offers this advice: “Analysis reports and hot tips [should be taken] with a grain of salt, and for the most part ignored. If you come across two conflicting reports, chances are there is a middle ground that is the right answer.”
Advisors know that helping their clients focus on bigger issues, such as comprehensive planning and establishing an appropriate long-term asset mix, is much more important than trying to figure out if security X is going to outperform security Y over the next period of time. But what about when clients ask such questions? How do you manage things when, after watching TV or surfing the web or reading a newspaper, they have become convinced that now is the time to move out of oil and into gold, or out of energy and into financials?
Barbara Stewart, CFA, an investment advisor with Cumberland Private Wealth Management in Toronto, discusses the importance of educating clients. As Stewart points out, advisors learning how to filter out the noise for themselves is one thing, but helping their clients do the same is equally important. “I think this topic is an extremely important one. In fact, I would say that coaching clients on this issue of filtering out noise is a fundamental part of our job as advisors,” says Stewart. “It is our job to educate clients as to how noise is or is not relevant to their investment strategy. Once they understand the role of noise in their plan or strategy, they will be less vulnerable to all of the conflicting opinions in the marketplace.”
Stewart describes her approach for setting the proper framework with clients. “I start by defining three concepts: strategic asset mix; capital market conditions; and tactical asset allocation. Your strategic asset mix is determined from a thorough discussion about return requirements, risk tolerance, time horizon, liquidity needs, and more. These would typically be the items identified in an investment policy statement.”
By establishing these fundamentals, Stewart is able to work with her clients to determine an appropriate asset allocation. For example, a typical allocation might look something like zero to 20 per cent cash equivalents, 20 to 40 per cent fixed income securities and 40 to 60 per cent equities.
“Next, I discuss capital market conditions. This is essentially the ‘noise’ we need to keep a handle on. But it’s important we discuss an overall perspective and view on the economy and world markets,” adds Stewart. “And finally, we discuss tactical asset allocation, which is where the first two points come together. Depending on our perspective regarding capital market conditions, we will decide whether to be more or less invested in the range for each of the specific asset classes.”
As Stewart points out, it needs to be clear to clients how the market environment is factored into their investment plans. “Get them to understand that they have a well-thought-out strategic asset mix, which is based on their own input, personality and situation. Also, they should understand that there is an associated tactical asset allocation decision, which is based on a well-thought-out perspective on capital markets. If this is understood, there is far less likelihood that they will become concerned about conflicting views.”
For Stewart and the other advisors FORUM spoke with, it isn’t about being right all the time. “It’s about having a well-defined plan that will work over time,” she says. “And by engaging in this type of discussion, whenever there is a lot of noise and conflicting opinions, we have something concrete to guide us.”