A Cooking Tale
“THE MISSING INGREDIENT”
My wife is a great cook. Her mother was a great cook. My mom is a great Cuban cook. The thing all three have in common is they never make a dish the same way, yet every time it tastes delicious. We must have 100 cookbooks in our house. I think we collect them. My wife browses through the latest addition to her collection and soon condemns it to the bookshelf. There it sits, waiting for someone to come along and open it up. This leads me to the point of this tale.
Many cooks who follow recipes exactly often produce lackluster dishes. They fail to inject themselves into the process, and the result is edible but not memorable. In order to be a good cook or a good client you need to inject yourself into the process. You need to put your mark on the dish or the portfolio. You are the missing ingredient. When you follow a recipe, there is a list of steps, temperatures, times, conditions and ingredients. The good cook, like the good client, knows how to improvise when something is missing from the recipe.
I often speak about verifying the job your advisor is doing. It would be great if there were a way to do it, but there isn’t. Let me repeat, there is no way that I know to verify if your advisor is doing a good job for you. The best that you can hope for is to recognize if an advisor is doing a bad job for you. So, how can you tell whether it’s time for a new advisor?
Let’s examine a study, published in 2007 by two University professors, that examined the rates of return before and after very smart financial people fired investment managers. The study covered the 10-year period from 1994 to 2003. It looked at the hiring and firing decisions of 3,700 plan sponsors. Plan sponsors are the people or governing boards that make investment manager decisions for retirement plans, foundations, endowments, unions, etc. In other words, these are people entrusted with managing a substantial part of America’s wealth. These are the most educated and presumably the smartest finance people in this country. Let’s see how good they are at determining if they have the right advisor. I’ll give you a hint. They stink.
The study shows that these smart people would have been far better off owning a globally diversified portfolio of low-cost index funds. But that’s not all. When you compare the returns of the newly hired advisors to the ones they recently fired, the recently fired outperformed the recently hired. Are you kidding me! The smartest finance folks fire people when they shouldn’t, hire people when they shouldn’t and can’t outperform index funds. In the words of Forrest Gump, “Stupid is as stupid does.”
To be specific, the study looked into the practice of investment manager performance before the plan sponsors hired them and after they fired them. It seems the smartest people in this country also fall prey to the allure of chasing past performance. Even the best minds fall victim. The recently hired, on average, outperformed the given benchmark by almost 3% per year before they were hired. Then once they were hired, the performance shifted down considerably and the newly hired managers could not persist or live up to their past rate of return. Lastly, we find plan sponsors also fire managers who don’t perform. The study looked into the rate of return of those recently fired managers and compared the returns to the recently hired. Once again, we find that these “cream of the crop” smart plan sponsors got rid of managers at the wrong time because the recently fired outperformed the recently hired.
There you have it folks. The smartest minds in America consistently chase past performance, hire managers at the wrong time and fire managers at the wrong time. If they can’t find a way to make rational decisions, what hope do you have? The answer is very little, so you must improvise.
How do you improvise? In every game, the weakest player always has an advantage. In the investment game, you must accept that you are probably the weakest player. If you accept that you are competing against people who are more knowledgeable, quicker at transacting and capable of devoting all their efforts to the game, how can you win? The answer is to look for their weakness. Those who possess more knowledge are quicker and devoted, but have, as a weakness, the necessity of playing the game all the time. You don’t have to play all the time. You can choose to sit the game out. You sit the game out by structuring a globally diversified portfolio of low-cost index funds and exchange-traded funds that you rebalance periodically. You do this by hiring a competent, un-conflicted advisor who understands your situation, customizes your portfolio and charges a competitive fee. You let the advisor know exactly what you are looking to achieve, because you are the missing ingredient. Granted, you can do it yourself and save a fee, but guess what? You probably won’t. So learn what to do or hire someone that knows how to do it.
Let’s get back to the cooking part of this tale. How exactly can you interject yourself and make sure the dish tastes just right. Remember, you can follow the recipe exactly and not get the desired taste. Investing is like a new recipe. You don’t know exactly what it should taste like. You know if it tastes bad, but you don’t know if it is good. You are at a loss as to what ingredients to add. The answer is simple. Let the advisor tell you how the dish should taste. Let them do it in two ways. Let’s see how.
I favor a global approach to diversification but know many expert advisors who limit portfolios to domestic investments exclusively. If I were looking at ways to determine whether they are doing their job, I would simply ask them. Are you doing your job? Are you happy with the results? Do you think you can continue with these results? It isn’t very difficult. They should know exactly what you’re trying to achieve, and the portfolio should reflect your goals. You might even have a very short investment policy statement in which you define only three key numbers. They are rate of return, maximum drawdown and recovery time. Let them tell you what they think they can achieve in terms of an upper, lower and average range of return. Let them also tell you what they think they can achieve in terms of controlling losses when they occur. Let them tell you how many months or years it may take before your portfolio exceeds a past high point. Then make sure they follow through with what they say they can do. You do this by checking your statement every month and keeping records.
Let’s look at an example of the expert in domestic portfolios. If you hire them and you have a balanced objective of moderate growth, they might establish as a benchmark a 50% allocation to the S&P 500 index and a 50% allocation to an intermediate bond portfolio. This combination benchmark has certain historical characteristics they should know and explain. They are letting you taste the dish. It has a documented historical expected rate of return, expected maximum loss or draw down during the worst periods and a maximum recovery time. What does this mean in practice? It means you can get clues in case the cook isn’t minding the kitchen or is changing the dish. Your results should fall within certain guidelines relative to a benchmark. Let’s take a quiz, but first let’s set the rules. You meet with your advisor and they tell you to expect to make approximately 50% of what the S&P 500 returns and 50% of what the bond index returns. They tell you that your portfolio will always be higher within 48 months than it was 48 months ago. They tell you it will never lose more than 25% from a most recent high.
At your first meeting, the S&P 500 had returned 10% and the bond index had returned 5%. Your portfolio made 6.5%. Is this within the parameters? Is it good or bad? Are there any missing ingredients? The answer is that it did exactly as expected once you subtract the advisor’s 1% management fee.
The following year, the S&P 500 once again returned 10% and the bond index returned 5%. Your portfolio made 14%. Is this within parameters? Is it good or bad? Are there missing ingredients? The answer is that your result is outside of parameters. While the result is good, it is too good. This usually means the advisor has changed the dish. You asked for a moderate result, and they produced an aggressive outcome. Find out why. Ask questions. Restate your objective and make sure the advisor understands. The intent is simple. A person with a moderate portfolio should be as cautious about over-performance as with under-performance. It means something doesn’t taste right.
You check your monthly statement and determine your portfolio is down 27% from the highest point it reached. What do you do? You look for another advisor. They said 25% was the most you would lose. You didn’t ask them to give you that number. They volunteered it. It is time to find a new advisor. There is no way to save this dish.
Your new advisor promises the same things as your old one, and at your annual meeting, the S&P 500 is down 10% and the bond index is up 10%. Your portfolio lost 12%. Once again, your results are outside the parameters. It is time to find a new advisor.
You find a new advisor with the same promises, and everything is within the expected parameters for 5–6 years. You look at your statement one month and see your portfolio has not grown to new highs in the last 48 months. They promised your portfolio would always be higher every 48 months. What do you do? You get on the phone and ask for a meeting. Explain what you see and ask why this has happened. Most of the time there is a good explanation, but you need to be on your toes. This type of meeting can lead to a very productive discussion and let your advisor refine your portfolio for your palette. Of course, if they give you a song and dance or you sense dishonesty, it’s time to find a new advisor.
Always remember, you are the cook.