In part 1 of this two-part blog, I looked at the long-term return expectation gap between investors and their wealth managers. We saw that in some cases, investors expect more than double the return that wealth firms feel is attainable, and unless addressed, this could cause an unhappy relationship.
In this blog, I will show how a traditional wealth manager’s tool can go a long way to addressing any misalignment on expectations. The key lies in delving further into the same report: 2023 Natixis Global Survey of Individual Investors.
It turns out that individual investors overwhelmingly trust their financial advisor as much as they trust themselves. They even trust other advisors more than close friends. Interestingly, social media received a low score for levels of trust on financial matters.
Further, when asked what services they preferred from their financial advisors, Financial Planning came out top.
This shows why financial planning should be the bedrock of any client and wealth firm relationship. If clients are swayed by the headline returns of Bitcoin or the Mag 7 and elevate their expected long term returns accordingly, you need to have an open conversation around goals and risk tolerance so the client understands what they could be sacrificing to achieve what they expect.
At its heart, financial planning determines a financial plan to meet a client’s goals. Broadly speaking, the steps are as follows:
The last part of that process is where risk tolerance comes into the equation. Most wealth firms bucket people in terms of risk as being conservative, balanced or aggressive and allocate a mixture of equities and bonds accordingly.
Generally speaking, you can take an educated guess based on someone’s age, financial goals and income what their risk bucket should be. However, as everyone is an individual, risk tolerance should be treated accordingly.
The degree of risk that someone is willing to take is essentially asking them how much they are willing to lose (or be underwater) to achieve the goal they want. For example, it is possible to lose everything on a single equity position, but highly improbable if investing in the SPY (an ETF proxy for the S&P 500).
I’ve taken statistics from Vanguard to illustrate what historical returns have been for the 3 buckets
Looking at the aggressive bucket, that implies an average return of 10.5% with the worse year losing 43% of its value. If investors are expecting ~15% as their long-term return rate, they would be expecting a return which beats an equity benchmark by ~5% every year. As such, they would need to either be picking stocks which outperform or outsourcing to a fund manager who also consistently outperforms. With higher expected returns, you also expect higher volatility and consequently a higher maximum drawdown. The question then becomes twofold:
Personally, I think people over-focus on the financial aspect of weathering a loss and there are many aphorisms such as “it’s not about timing the market, but about time in the market”, which seek to reassure clients to not worry about short term losses. Rationally, that may make sense, but emotionally, the client may not have the appetite to do so either.
In short, to have an effective conversation where return expectations differ between the client and their wealth advisor, the latter should have an honest dialog about risk tolerances from an emotional point of view, and spell through the logic of what drives their own investment return assumptions. Through this transparency, the client is educated and even if the outcome is still to target higher returns, at least the client is now better informed and has built a more trusting relationship with their advisor.
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