A meeting with a prospective client several weeks ago has stuck with me in a way that few meetings have in my career. As we learn about the goals and aspirations of the people with whom we work, we also hear about their frustrations with previous financial advisors. He explained, “A typical meeting with my current advisor involves an hour-and-a-half dissertation on how rainfall in Ethiopia impacts rice production in China, which affects the U.S. stock market by so-and-so.”
Now besides the obvious silliness of this line of reasoning, it is frightening to think of how many advisors employ similar reasons to justify the investments they recommend to their clients. This is the most extreme example I’ve ever heard, but consider these less eccentric ones that are being discussed by countless financial advisors with their clients at this very moment:
“If Donald Trump/Hillary Clinton wins in November, the market will respond by doing [fill in the blank].” Or, “If the Fed decides not to raise interest rates in June, the market will surely [fill in the blank].” Or, “If OPEC decides to cut crude oil production, the market will react by [fill in the blank].” Or, “If Great Britain decides to leave the European Union, the market will respond by [fill in the blank].” They then use these predictions as the rationale for changes to clients’ portfolios: Add an energy sector ETF, or trim the bond allocation, or increase exposure to dividend-paying stocks. (For related reading, see: Why You Should Diversify and Rebalance.)
Economist John Kenneth Galbraith once said of forecasting, “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” Renowned financial theorist and author William Bernstein adds a third type of investor: “The investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.”
No one knows how any of these events will impact markets. No one. That includes financial advisors who have access to complex computer models and investment strategists in the home office with cool British accents. They don’t know, but their livelihood depends upon appearing to know. Few of them are ever held accountable for the innumerable predictions they got wrong. They simply move on to the next prediction, the next tactical move. (For related reading, see: Can You Stomach the Perfect Investment?)
If we come to the realization that this type of advice doesn’t work, what then should we focus on? In our view, there are four things:
- Risk: The way we manage volatility (translation: “downturns”) is by diversifying the portfolio across lots of investments that don’t act the same way at the same time. We create that allocation specifically to address the risk tolerance and risk needs of the individual client. More conservative portfolios hold more bonds. More aggressive portfolios hold more stocks. In this way, we can manage the level of risk that we take.
- Expenses: Keeping the internal expenses of a portfolio low is a huge predictor of future fund success. In a recent article, Morningstar provided an update to the already compelling data on this subject. We control these fees by using institutional mutual funds and ETFs with very low expense ratios.
- Taxes: No one likes paying taxes, even if they’re “feeling the Bern.” So we focus on keeping taxes to a minimum. For clients who have investments in taxable brokerage accounts, we minimize taxes by using ETFs and mutual funds with tax management as part of their mandate. We also take advantage of tax loss harvesting opportunities when they arise.
- Our behavior: Most important of all, controlling our response to the news is the biggest determinant of investment success. If we allow our emotions to drive investment decisions in reaction to bad news or predictions about future market movements, our well-designed plan is for naught. As advisors, the most valuable thing we do for our clients is helping them avoid making behavioral financial mistakes.
Please don’t ever believe that anyone knows how rainfall in Ethiopia will impact the market. Instead, focus on what you can control, have patience and put your faith in a well-designed plan. If you do, I’m confident you’ll have greater peace of mind and, in the long run, greater wealth. (For related reading, see: 6 Questions to Ask a Financial Advisor.)