Tag: Financial insitutions

CFP Board Commission On Standards Expands CFP Fiduciary Duties… But Can It Enforce Them?

CFP Board Commission On Standards Expands CFP Fiduciary Duties… But Can It Enforce Them?

Executive Summary

After a nearly 18-month process of working to update its Standards of Professional Conduct, the CFP Board’s Commission on Standards has released newly proposed Conduct Standards for CFP professionals, expanding the breadth of when CFP professionals will be subject to a fiduciary duty, and the depth of the disclosures that must be provided to prospects and clients.

In fact, the new CFP Board Standards of Conduct would require all CFP professionals to provide a written “Introductory Information” document to prospects before becoming clients, and a more in-depth Terms of Engagement written agreement upon becoming a client. In addition, the new rules also refine the compensation definitions for CFP professionals to more clearly define fee-only, limit the use of the term fee-based, and updates the 6-step “EGADIM” financial planning process to a new 7-step process instead.

Overall, the new Standards of Conduct appear to be a positive step to advance financial planning as a profession, more clearly recognizing the importance of a fiduciary duty, the need to manage conflicts of interest, and formalizing how CFP professionals define their scope of engagement with the client.

Ironically, though, the CFP Board’s greatest challenge in issuing its new Standards of Conduct is that the organization still only has limited means to actually enforce them, as the CFP Board can only make public admonishments or choose to suspend or revoke the CFP marks, but cannot actually fine practitioners or limit their ability to practice. And because the CFP Board is not a government-sanctioned regulator, it is still limited in its ability to even gather information to investigate complaints in the first place, especially in instances where the complaint is not from a client but instead comes from a third party (e.g., a fellow CFP professional who identifies an instance of wrong-doing).

In addition, the CFP Board’s new Standards of Conduct rely heavily on evaluating whether the CFP professional’s actions were “reasonable” compared to common practices of other CFP certificants… which is an appropriate peer-based standard for professional conduct, but difficult to assess when the CFP Board’s disciplinary proceedings themselves are private, which means CFP professionals lack access to “case law” and disciplinary precedents that can help guide what is and is not recognized as “acceptable” behavior of professionals. At least until/unless the CFP Board greatly expands the depth and accessibility/indexing of its Anonymous Case Histories database.

Nonetheless, for those who want to see financial planning continue to advance towards becoming a recognized profession, the CFP Board’s refinement of its Standards of Conduct do appear to be a positive step forward. And fortunately, the organization is engaging in a public comment process to gather feedback from CFP certificants to help further refine the proposed rules before becoming final… which means there’s still time, through August 21st, to submit your own public comments for feedback!

CFP Board Commission On Standards Proposes Revised CFP Code Of Ethics And Standards Of Conduct

Back in December of 2015, the CFP Board first announced that it was beginning a process to update its Standards of Professional Conduct, by bringing together a new 12-person “Commission on Standards” (ultimately expanded to 14 individuals), including diverse representation across large and small firms, broker-dealers and RIAs, NAPFA and insurance companies, and even a consumer advocate and former regulator.

The purpose of the new group was to update the CFP Board’s existing Standards of Professional Conduct, which is (currently) broken into four key sections:

– Code of Ethics and Professional Responsibility: The 7 core ethical principles to which all CFP certificants should aspire, including Integrity, Objectivity, Competence, Fairness, Confidentiality, Professionalism, and Diligence

– Rules of Conduct: The specific rules by which the conduct of CFP professionals will be evaluated, including a CFP certificant’s obligations to define the client relationship, disclose conflicts to the client, protect client information, and the overall duty of conduct of the CFP certificant to the client, to employers, and to the CFP Board itself.

– Financial Planning Practice Standards: The standards that the CFP certificant should follow that define what financial planning “is” and how the 6-step financial planning process itself should be delivered.

– Terminology: The definitions of key terms used in the Standards of Professional Conduct, from what constitutes a “financial planning engagement” to what it means to be a “fiduciary” and the definition of “fee-only” and what is considered “compensation” to be disclosed.

The update process would be the first change to the CFP Board’s Standards of Professional Conduct since mid-2007, which at the time was highly controversial, and stretched out for years, but culminated in the first application of a fiduciary duty for CFP professionals.

Under the newly proposed Code of Ethics and Standards of Conduct, which the CFP Board published for public comment last Tuesday, June 20th, the four sections above will be consolidated into two sections – a Code of Ethics, and a Standards of Conduct (which will incorporate the prior Rules of Conduct, Practice Standards, and key Terminology).

The full text of the Proposed Code of Ethics and Standards of Conduct can be viewed here on the CFP Board’s website.

Expanding The Fiduciary Definition Of “Doing” Financial Planning

Under the CFP Board’s current Rules of Conduct for CFP professionals, certificants owe to their clients a fiduciary duty of care when providing financial planning or material elements of financial planning. Accordingly, the reality is that the overwhelming majority of CFPs are already subject to a fiduciary duty when providing financial planning services to clients.

However, the CFP Board’s standard has been criticized as allowing for a “loophole”, in that it’s not based on simply being a CFP professional, but instead tries to identify when people are doing financial planning (or material elements thereof). Which at best isn’t always clear, and at worst allows a subset of CFP professionals to aggressively sell nothing but their own products – knowingly not serving as a fiduciary, despite holding out as a CFP certificant – because a single product recommendation was not deemed to be “doing financial planning”.

New CFP Board Fiduciary Duty When Providing Financial Advice

In its new CFP Code of Ethics and Standards of Conduct, the CFP Board takes a stronger position that CFP certificants should be held to a fiduciary standard when delivering their services. Accordingly, the very first section of its new Standards of Conduct states:

A CFP Professional must at all times act as a fiduciary when providing Financial Advice to a client, and therefore, act in the best interest of the Client.

Notably, under this new rule, the scope of fiduciary obligation is not limited to just when providing “financial planning” or “material elements of financial planning”. Instead, the fiduciary duty will apply anytime a CFP professional is “providing financial advice”, which itself is defined very broadly, as:

Financial Advice (according to CFP Board)

A) Communication that, based on its content, context, and presentation, would reasonably be viewed as a suggestion that the Client take or refrain from taking a particular course of action with respect to:

  1. The development or implementation of a financial plan addressing goals, budgeting, risk, health considerations, educational needs, financial security, wealth, taxes, retirement, philanthropy, estate, legacy, or other relevant elements of a Client’s personal or financial circumstances;
  2. The value of or the advisability of investing in, purchasing, holding, or selling Financial Assets;
  3. Investment policies or strategies, portfolio composition, the management of Financial Assets, or other financial matters;
  4. The selection and retention of other persons to provide financial or Professional Services to the Client; or

B) The exercise of discretionary authority over the Financial Assets of a Client.

In this definition, the mere suggestion that a client take or refrain from taking any particular course of action is deemed “financial advice”. Notably, the CFP Board does clarify that marketing materials, general financial education materials, or general financial communication “that a reasonable person would not view as Financial Advice” does not constitute Financial Advice. Nonetheless, most classic recommendations – from delivering a comprehensive financial plan, to merely suggesting “this product is right [or not right] for your situation”, would be captured under this definition of Financial Advice, and subjected to a fiduciary duty.

In other words, the expansion of the CFP Board’s application of the fiduciary duty to providing any kind of “financial advice”, and not just delivering “financial planning or material elements of financial planning”, eliminates the current gap where product salespeople could sell a product as a CFP certificant and claim they’re not subject to the fiduciary duty because it wasn’t “financial planning”. Although the fiduciary duty is still not defined by merely being a CFP or holding out as a CFP certificant, this new and far-broader scope of applying the fiduciary duty when “delivering financial advice” still accomplishes a substantively similar result, as even a focused, single-product recommendation, would still constitute “financial advice” under the new rules.

On the other hand, the CFP Board’s new definition of Financial Advice to which a fiduciary duty applies may actually have gone too far, as the new rules have no actual requirement that the client have agreed to engage the CFP professional in order for the fiduciary standard to occur. By contrast, for the fiduciary duty to apply to an RIA under the Investment Advisers Act, the investment adviser must give investment advice for compensation, and the Department of Labor similarly only applies a fiduciary duty to investment advice given to a retirement investor for compensation. The “compensation” requirement helps to ensure that free advice is not subject to a fiduciary duty, and also helps to ensure that suggestions that may be given in the course of soliciting a prospect are not deemed as fiduciary financial advice even if the advisor is never hired. The CFP Board may need to consider adding a similar stipulation to their current rules, to make it clear that the CFP professional’s obligation to deliver fiduciary financial advice only applies if the client ultimately actually engages the professional for advice for which at least some type of compensation is paid!

New Fiduciary Duties Of A CFP Professional

Of course, if CFP certificants are going to be held to a fiduciary duty, it’s still necessary to define exactly what that means. Most financial advisors, thanks to the recent discussions about the Department of Labor’s fiduciary rule, are familiar with the classic requirement that fiduciaries must act in the best interests of their clients, but in reality a fiduciary duty can (and should be) broader than just this Duty of Loyalty to the client.

In its new rules, the CFP Board defines the obligations of the CFP professional as a fiduciary to include:

CFP Professional’s Fiduciary Duty

A) Duty of Loyalty. A CFP® professional must:

  1. Place the interests of the Client above the interests of the CFP® professional and the CFP® Professional’s Firm;
  2. Seek to avoid Conflicts of Interest, or fully disclose Material Conflicts of Interest to the Client, obtain the Client’s informed consent, and properly manage the conflict; and
  3. Act without regard to the financial or other interests of the CFP® professional, the CFP® Professional’s Firm, or any individual or entity other than the Client, which means that a CFP® professional acting under a Conflict of Interest continues to have a duty to act in the best interest of the Client and place the Client’s interest above the CFP® professional’s.

B) Duty of Care. A CFP® professional must act with the care, skill, prudence, and diligence that a prudent professional would exercise in light of the Client’s goals, risk tolerance, objectives, and financial and personal circumstances.

C) Duty to Follow Client Instructions. A CFP® professional must comply with all objectives, policies, restrictions, and other terms of the Engagement and all reasonable and lawful directions of the Client.

In other words, the CFP Board is, in fact, applying the two core duties of a fiduciary standard: the Duty of Loyalty (to act in the interests of the client), and the Duty of Care (to act with the care, skill, prudence, and diligence of a professional). In addition, the CFP Board still affirms that a CFP professional must follow their clients’ instructions as well. (Which means a CFP professional still has an obligation to follow the clients’ instructions if the client wants to make their own bad financial decision against the advisor’s advice!)

Notably, in the past, the CFP Board’s existing Rules of Conduct for CFP professionals also stated that the CFP certificant – when acting as a fiduciary while providing financial planning or material elements of financial planning – owes to the client a duty of care, and must place the interest of the client ahead of his/her own. However, the new rules go much further in clearly and concretely defining the fiduciary duties of loyalty and care.

Managing Fiduciary Conflicts Of Interest As A CFP Professional

One of the core issues of a fiduciary duty, and the obligation to place the interests of the client above that of the advisor or his/her firm, is how to handle the inevitable conflicts of interest that may arise.

The CFP Board’s new Duty of Loyalty specifically requires that CFP professionals seek to avoid conflicts of interest, or fully disclose any Material conflicts of interest (where “material” is defined as “information that a reasonable client would have considered important in making a decision”).

In addition, a further expansion of the CFP professional’s duties with respect to conflicts of interest, in Section 9 of the new Standards, would obligate the CFP professional to obtain “informed consent” after disclosing any Material conflicts of interest (though informed consent can be handled in conversation in a prospect/client meeting, as written consent is not required).

Furthermore, CFP professionals are expected to “adopt and follow business practices reasonably designed to prevent Material Conflicts of Interest from compromising the CFP professional’s ability to act in the Client’s best interests.” Notably, this is very similar to the “policies and procedures” requirement that the Department of Labor imposes on Financial Institutions engaging in fiduciary advice with respect to retirement accounts – although the DoL fiduciary rule requires the firm to adopt policies and procedures, while the CFP Board’s standards require the individual CFP certificant to adopt those business practices (recognizing that the CFP Board has no jurisdiction over firms, only certificants, and that CFP certificants must comply even if their firms, which may have non-CFPs as well, do not adopt firm-wide policies and procedures).

On the other hand, organizations like the Institute for the Fiduciary Standard have already pointed out that the CFP Board has a history of encouraging CFP professionals to disclose conflicts of interest, but not necessarily urging them to actually avoid or eliminate those conflicts. By contrast, the Department of Labor’s recent fiduciary rule goes into far greater depth about what constitutes an unacceptable (i.e., not realistically manageable) conflict of interest, and outright bans many (as does ERISA’s fiduciary duty). For the CFP Board, though, the new standards have little guidance on whether CFP professionals are actually expected to avoid any conflicts of interest at all, as the focus of the new standards is simply on disclosing material conflicts of interest (and gaining “informed consent” from the client).

In fact, because the CFP Board allows for material conflicts of interest – as long as there is informed consent – there is arguably no requirement that CFP professionals actually avoid any conflict of interest at all, nor necessarily even manage them. After all, while the new rules do suggest that CFP professionals should adopt business practices to prevent material conflicts of interest from compromising their duty of loyalty, the rules also fully permit those material conflicts of interest anyway, as long as the CFP professional can demonstrate that it was disclosed and that the client agreed to the recommendation anyway (i.e., gave informed consent).

Doing Financial Planning And The CFP Board Practice Standards

In addition to the new rules placing on CFP professionals an obligation to act as fiduciaries to clients, including both a Duty of Loyalty and a Duty of Care, the new Practice Standards further emphasize that when providing financial advice, the CFP professional is expected to actually do the financial planning process.

In fact, the new Practice Standards presume that whenever a CFP professional provides financial advice, there should be a financial planning process that integrates together the relevant elements of the Client’s personal and/or financial circumstances to make a recommendation. Or viewed another way… not only are CFP professionals no longer allowed to escape fiduciary duty by providing narrow product recommendations – in an attempt to avoid providing “financial planning” or “material elements of financial planning” – but under the new rules, any (product or other) recommendation or “suggestion to take or refrain from a particular course of action” is presumed to be “financial planning” and necessitates following the full financial planning process, unless the CFP professional can prove that it wasn’t necessary to do so (or that the client refused the comprehensive advice, or limited the scope of engagement to make comprehensive advice unnecessary).

However, it’s important to recognize that “doing” financial planning when giving financial advice still doesn’t necessarily mean every client must be provided a comprehensive financial plan. Under the new conduct standards, “financial planning” itself is defined as:

“Financial Planning: A collaborative process that helps maximize a Client’s potential for meeting life goals through Financial Advice that integrates relevant elements of the Client’s personal and financial circumstances.”

The key term here is “relevant elements” of the client’s personal and financial circumstances. Thus, just as a doctor doesn’t need to conduct a full-body physical exam with blood analysis just to set a broken arm, neither would a CFP professional be required to do a comprehensive financial plan just to help a client set up a 529 college savings plan. Nonetheless, a full evaluation of the relevant circumstances – from the ages of children and time horizon to college, to the risk tolerance of the parents, their tax situation, and available savings and other resources for college – would still be necessary to deliver appropriate financial (planning) advice.

EGADIM 6-Step Process Becomes A 7-Step Financial Planning Process

Perhaps more notable, though, is that the financial planning process itself is changed and updated under the new conduct standards.

In the past, the standard financial planning process was known by the acronym EGADIM: Establish client/planner relationship, Gather data, Analyze the client situation, Develop plan recommendations, Implement the plan, and Monitor the plan. And each of those parts of the 6-step process had 1-3 levels of detailed practice standards about how they should be delivered.

Now, under the new rules, financial planning will entail a 7-step process of:

1) Understand the Client’s Personal and Financial Circumstances (including gathering quantitative and qualitative information, analyzing the information, and identifying any pertinent gaps in the information);

2) Identify and Select Goals (including a discussion on how the selection of one goal may impact other goals)

3) Analyze the Current Course of Action and Potential Recommendations (evaluating based the advantages and disadvantages of the current course of action, and the advantages and disadvantages of potential recommendations)

4) Develop Financial Planning Recommendations (including not only what the client should do, but the timing and priority of recommendations, and whether recommendations are independent or must be implemented jointly)

5) Present Financial Planning Recommendations (and discuss how those recommendations were determined)

6) Implement Recommendations (including which products or services will be used, and who has the responsibility to implement)

7) Monitoring Progress and Updating (including clarifying the scope of the engagement, and which actions, products, or services, will be the CFP professionals’ responsibility to monitor and provide subsequent recommendations)

Unfortunately, the new 7-step process isn’t as conducive to an acronym as EGADIM was, though a new option might be CGADPIM (Circumstances, Goals, Analyze, Develop, Present, Implement, Monitor). In practice, the primary difference under the new rules is that the prior requirement to “establish the scope of the engagement” is not considered part of the financial planning process itself (though it will still be separately required, as discussed below), the “gather client data” phase is now broken out into two standalone steps of the process (first to gather information about the client’s Circumstances, then to identify the client’s Goals), and the CFP Board has similarly separated the prior “Develop and Present Recommendations” of EGADIM into separate “Develop” and “Present” process steps.

Another key distinction of the new 7-step process, though, is that the last two steps – to Implement, and to Monitor – are explicitly defined as optional, and are only an obligation for the CFP professional if the client’s Scope of Engagement specifically dictates that the CFP professional will be responsible for implementation and/or monitoring (although notably, the presumption is that the CFP professional will have such responsibilities, unless they are specifically excluded in the Scope of Engagement).

In other words, if the CFP professional defines the scope of the agreement as only leading up to presenting recommendations (the CGADP part of the new financial planning process), but leaves it up to the client to proceed with implementation and monitoring, that is permitted under the new rules… recognizing that some clients prefer to only engage in more “modular” advice and a “second opinion” from a CFP professional, but may not wish to implement with that CFP professional.

Comparison of Current vs Proposed Financial Planning Process (EGADIM VS CGADPIM)

Introductory Information And Financial Planning Terms (And Scope) Of Engagement

Currently, the CFP Board’s Rules of Conduct when a CFP Professional is engaged by a client to provide financial planning (or material elements of financial planning) include an obligation to provide information to clients (prior to entering into an agreement), including the responsibilities of each party, the compensation that the CFP professional (or any legal affiliates) will or could receive, and, upon being formally engaged by the client for services, the CFP professional was/is expected to enter into a formal written agreement, specifying the (financial planning) services to be provided.

Under the new rules, these disclosure and engagement requirements would be expanded further, into a series of (at least) two written documents: the first is “Introductory Information” to be provided to a prospect (before becoming a client), and the second is a “Terms of Engagement” agreement provided to a client (at the time the client engages the advisor).

The Introductory Information must include:

Introductory Information

1) Description of the CFP professional’s available services and category of financial products;

2) Description of how the client pays, and how the CFP Professional and the Professional’s Firm are compensated for providing services and products;

3) Brief summary of any of the following Conflicts of Interest (if applicable): offering proprietary products; receipt of third-party payments for recommending products; material limitations on the universe of available products; and the receipt of additional compensation when the Client increases the amounts of assets under management; and

4) A link to (or URL for) relevant webpages of any government authorities, SROs, or professional organizations, where the CFP professional’s public disciplinary history or personal/business bankruptcies are displayed (e.g., the SEC’s IAPD, FINRA BrokerCheck, and the CFP Board’s own website).

The new rules state that for RIAs, the delivering of Form ADV Part 2 will satisfy the Introductory Information requirement. Broker-dealers, though, would need to create and distribute their own Introductory Information guidance. (The CFP Board has indicated that it will be creating an Introductory Information template for advisors and brokers to use.) The Introductory Information is expected to be delivered to a prospect at the time of initial consultation, or “as soon as practicable thereafter”, and it may be delivered in writing, electronically, or orally (if appropriate given a [presumably limited] scope of services).

In addition, when a CFP professional is actually engaged to give financial advice, the CFP professional must further provide a written Terms of Engagement agreement, including:

Terms Of Engagement Financial Planning Agreement

– Scope of Engagement (and any limitations), period for which services will be provided, and client responsibilities

– Further disclosures, to the extent not already provided, including:

– More detailed description of costs to the client, including:

– How the client pays, and how the CFP Professional and the Professional’s Firm are compensated for providing services and products;

– Additional types of costs that the Client may incur, including product management fees,

– Identification of any Related Party that will receive compensation for providing services or offering products

– Full disclosure of all Material Conflicts of Interest

– Link to relevant webpages of any government authorities, SROs, or professional organizations, where the CFP professional’s public disciplinary history or personal/business bankruptcies are displayed

– Any other information that would be Material to the client’s decision to engage (or continue to engage) the CFP professional or his/her firm

As mentioned earlier, the CFP Board’s current Standards of Professional Conduct already require that CFP certificants enter into a written agreement with clients that defines the scope of the engagement. But with an expanded fiduciary duty for CFP professionals, it seems likely that financial advisors may become more proactive about clearly defining the scope of what they will, and won’t, do as a part of the client engagement. Especially since the CFP Board’s new 7-step process makes it optional for the CFP to follow through on the implementation and/or monitoring phases of the process, but only if the scope of engagement explicitly excludes those steps of the process.

In addition, the mere delivery of a “comprehensive” financial plan, under a more “comprehensive” fiduciary duty, creates potential new liability exposures for financial advisors. If the advisor’s agreement says the financial plan is “comprehensive”, what, exactly, does that cover? Is it everything in the CFP Board’s current topic list? Does that mean CFP professionals could get themselves into trouble for offering a “comprehensive” financial plan, but failing to review a will or a trust, or an automobile or renter’s insurance policy? Under the new standard in the future, CFP professionals may want to become far more proactive about stating exactly what they will cover in a plan – to more concretely define the scope of engagement – rather than just stating that it will be “comprehensive”.

The new standards of conduct also require that the CFP professional disclose to the client any Material change of information that occurs between the Introductory Information and when the actual Terms of Engagement are signed, along with any Material changes that occur after the engagement begins but during the scope of the (ongoing) engagement. Ongoing updates must be provided at least annually, except for public disciplinary actions or bankruptcy information, which must be disclosed to the client within 90 days (along with a link to the relevant regulatory disclosure websites).

Cleaning Up Fee-Only Definitions And Sales-Related Compensation

One of the most challenging issues for the CFP Board in recent years has been its “compensation definitions” – specifically pertaining to when and how a CFP professional can call themselves “fee-only”, which had led to both a lawsuit against the CFP Board by Jeff and Kim Camarda, the resignation of (now-former) CFP Board chair Alan Goldfarb (who was later publicly admonished), and a series of ongoing debacles for the CFP Board as it kept trying to update its flawed interpretation of the original “fee-only” compensation definition.

The problem was that under the prior rules, “fee-only” was defined as occurring “if, and only if, all of the certificant’s compensation from all of his or her client work comes exclusively from the clients in the form of fixed, flat, hourly, percentage, or performance-based fees.” And the certificant’s “compensation” was in turn defined as “any non-trivial economic benefit, whether monetary or non-monetary, that a certificant or related party receives or is entitled to receive for providing professional activities.”

The primary problem in this context was that the CFP Board interpreted these rules to mean that if a related party could receive non-fee compensation, the CFP certificant couldn’t call themselves “fee-only”, even if the CFP professional could prove that 100% of their clients paid 100% in fees (and no commissions) for any/all client work. In other words, the CFP Board imputed the possibility of a commission to taint the CFP professional’s status as fee-only, regardless of whether the client ever actually paid a commission to anyone, ever. Such that even being able to prove that all your clients only paid fees wasn’t a legitimate defense to claiming that you were fee-only!

Under the new Standards of Conduct, the overall structure of “fee-only” is substantively similar, but updated in ways that should help to resolve many of the prior problems and misinterpretations of the definition. Now, fee-only is defined as:

Fee-Only. A CFP professional may represent his or her compensation method as “fee-only” only if:

  1. The CFP professional and the Professional’s Firm receive no Sales-Related Compensation; and
  2. Related Parties receive no Sales-Related Compensation in connection with any Professional Services the CFP professional or the CFP Professional’s Firm provides to Clients.

In turn, “Sales-Related Compensation” is defined as:

Sales-Related Compensation. Sales-Related Compensation is more than a de minimis economic benefit for purchasing, holding for purposes other than providing Financial Advice, or selling a Client’s Financial Assets, or for the referral of a Client to any person or entity. Sales-Related Compensation includes, for example, commissions, trailing commissions, 12(b)1 fees, spreads, charges, revenue sharing, referral fees, or similar consideration.

Sales-Related Compensation does not include:

  1. Soft dollars (any research or other benefits received in connection with Client brokerage that qualifies for the “safe harbor” of Section 28(e) of the Securities Exchange Act of 1934);
  2. Reasonable and customary fees for custodial or similar administrative services if the fee or amount of the fee is not determined based on the amount or value of Client transactions; or
  3. The receipt by a Related Party solicitor of a fee for soliciting clients for the CFP® professional or the CFP® Professional’s Firm.

Not surprisingly, “sales-related compensation” is defined as any type of compensation that is paid for any type of purchase or sale related to a client’s financial assets, or for a referral (that might subsequently lead to such outcomes). Thus, for instance, selling an investment or insurance product for a commission would be sales-related compensation, as would referring a client to an insurance agent or broker (or anyone else) who pays the CFP professional for referring the lead. Although under the current rules, using an outsourced investment provider – i.e., a TAMP – might also be deemed a “referral” fee, to the extent that many TAMPs collect the AUM fees and then remit a portion of the CFP professional as a solicitor/referrer fee, which would no longer be allowed, even if the cost is the same to the client as the CFP professional who hires his/her own internal CFA to run the portfolio. Will the CFP Board be compelled to refine its “sales-related compensation” rules to allow for level AUM fees as a part of standard solicitor agreements?

More generally, though, it’s notable that the new “fee-only” rules are not actually defined by whether the CFP professional receives various types of AUM, hourly, or retainer fees; instead, it is defined by not receiving any type of Sales-Related Compensation (such that client fees are all that is left). As a result, the new “fee-only” definition might more aptly be explained as being a “no-commission” (and no-referral-fee) advisor instead.

A key distinction of the new rules, though, is that for a CFP professional to be fee-only, neither the CFP professional nor his/her firm can receive any sales-related compensation, but a related party can receive sales-related compensation as long as it is not “in connection with” the services being provided to the client by the CFP professional or his/her firm. This shift is important, as otherwise, any connection between the CFP professional and any related party to his/her firm could run afoul of the fee-only rules; for instance, if a fee-only RIA was bought by a bank or holding company, which separately had another division that happened to offer mortgages (for a commission), the RIA would lose its fee-only status, even if no clients ever actually did business with the related subsidiary. Under the new rules, external related parties could still co-exist in a manner that doesn’t eliminate the CFP professional’s fee-only status, as long as no clients actually do business with that related party (so no clients ever actually pay a commission to a related party), and the CFP professional’s own firm doesn’t directly accept any type of sales-related compensation.

Notably, under these new definitions, Jeff and Kim Camarda – who had a “fee-only” RIA but referred clients internally to a co-owned insurance subsidiary that earned commissions – would still not have been permitted to call themselves “fee-only” (as clients really were paying commissions to a related party in connection with the Camardas’ financial advice). However, the strange case of former CFP Board chair Alan Goldfarb, who was deemed to violate the fee-only rules because his RIA-parent-company accounting firm also owned a broker-dealer even though it was never stated that a single client of Goldfarb’s ever actually paid a commission to that entity, would have been (appropriately) still allowed to call himself “fee-only”.

On the other hand, it’s not entirely clear whether the CFP Board considered how CFP professionals might shift towards fee-only compensation in the future. For instance, what happens if a CFP professional who currently earns commissions and trails decides to stop doing any commission-based business, and operate solely on a fee-only basis in the future… but doesn’t want to walk away from his/her existing trails for prior business? Under a strict interpretation of the current “sales-related compensation” rules, even old sales-related compensation that has no relationship to current clients would still run afoul of the rules, even though the CFP professional really does work solely on a fee-only basis now. In addition, receiving “old” trails typically still requires the CFP professional to maintain a broker-dealer registration (to remain as Broker of Record), and/or a state Insurance license (and appointment to one or several insurance companies) to remain Agent of Record… which means the CFP professional would still be affiliated with a firm that receives sales-related compensation (which also runs afoul of the rules). Does the CFP Board need to add a further clause that clarifies how CFP professionals who are transitioning to fee-only can keep old commission trails for prior sales, and “old” affiliations to broker-dealers or insurance companies to receive those trails, and still be permitted to hold out as fee-only going forward, as long as no new clients will ever again compensate the advisor via commissions or other sales-related compensation?

CFP Board Cautions Against Marketing “Fee-Based” Compensation

In addition to tightening the CFP Board’s compensation of “fee-only”, the new rules also explicitly caution CFP professionals against the use of the term “fee-based”, which was originally a label for investment wrap accounts where trading costs were “fee-based” rather than a per-trade commission, but in recent years has occasionally been used by brokers to imply they are offering “fee-only” advice (relying on consumers to not understand the difference between fee-based and fee-only).

To limit this, the new CFP Board conduct standards would require that anyone who holds out as “fee-based” to clearly state that the CFP professional either “earns fees and commissions”, or that “the CFP professional is not fee-only”, and that the term should not otherwise be used in a manner that suggests the CFP professional is fee-only. (Recognizing that the term is enshrined in SEC regulations as a part of fee-based wrap accounts, and can’t realistically be eliminated from the investment lexicon altogether.)

The caveat, however, is that while the CFP Board is explicitly cracking down on the use of “fee-based” as a marketing label, the organization is backing away from its prior “Notice to CFP Professionals” guidance from 2013, which grouped all financial advisor compensation into being either “fee-only”, “commission-only”, or “commission and fee”. Which seems concerning, as while grouping CFP professionals into “just” three buckets has limited value – when most are in the middle and operate with some blend of commissions and fees – it’s still better than not requiring consistent definitions at all. Otherwise, what’s to stop CFP professionals from just coming up with another label for being (partially) fee-compensated, that isn’t fee-only, but sounds similar… which is precisely why “fee-based” has been increasingly adopted in recent years anyway.

In other words, if the CFP Board states: “All CFP professionals must disclose that their compensation is fee-only, commission-and-fee, or commission-only, and should provide further compensation disclosure details as appropriate” then at least CFP professionals will disclose their compensation consistently. But with the CFP Board’s current approach, a CFP professional who receives at least some fees might have to stop using “fee-based”, but could just use similar words like “fee-oriented” or “fee-compensated” or “fee-for-service” financial advice, which would still focus on and imply fees (and fee-only) without stating that the actual compensation includes commissions as well (as using the term “fee and commission” is now only required when attached to fee-based).

Enforcement Of The New CFP Board Standards Of Conduct?

Notwithstanding its expansion in the scope of fiduciary duties that would apply to CFP professionals, it’s important to recognize that the CFP Board’s ability to enforce its standards is still somewhat limited.

At most, the CFP Board’s Disciplinary and Ethics Commission (DEC) can only privately censure or publicly admonish a CFP certificant, and/or in more extreme cases to suspend or revoke the CFP marks from that individual. However, that doesn’t mean the CFP Board can actually limit someone’s ability to be a practicing financial advisor, who offers (and is paid for giving) financial advice to the public. Nor can the organization fine or otherwise financially punish a CFP certificant, beyond the financial consequences that might occur to the CFP certificant’s business if he/she is either publicly admonished, or has his/her marks suspended or revoked (which is also part of the public record).

Although the real challenge for the CFP Board is that because it is not an actual government-sanctioned regulator, its ability to collect the information necessary to adjudicate its disciplinary hearings is a significant challenge. Because broker-dealers and advisory firms have in some cases refused to provide the necessary information to the CFP Board regarding a CFP certificant and his/her clients when a client is filed, as the firm fears that actual government regulators (e.g., the SEC and/or FINRA) might discipline them for a breach of client privacy by sharing information with the CFP Board in the first place! In fact, back in 2011 the CFP Board had to seek out a “No-Action” letter from the SEC to affirm that it was permissible for firms to share “background documents” without violating Reg S-P, and continued pushback from firms led the CFP Board to request a follow-up No-Action letter request in 2014 to further expand the scope of what firms even could share with the CFP Board.

Of course, in situations where a client files a complaint with the CFP Board, the client has authorization to release his/her own information to the CFP Board to evaluate the complaint. But the limitations of the CFP Board’s ability to even investigate complaints against CFP certificants, especially in the case of third-party complaints (i.e., where it is not the client who submits the complaint, and his/her information to document it), raise serious concerns about its ability to effectively enforce its new standards. It’s not a coincidence that the overwhelming majority of current CFP Board disciplinary actions are based almost entirely on public information (from bankruptcy filings and DUI convictions, to CFP certificants who are disciplined after the SEC or FINRA already found them publicly guilty), and/or pertain to situations that wouldn’t require client-specific information anyway (e.g., whether the advisor misrepresented his/her compensation in marketing materials).

In other words, the “good” news of the new CFP Conduct Standards is that CFP professionals will be required to meet a fiduciary standard of care when providing any kind of financial advice to clients… but what happens if they don’t? To what extent can the CFP Board enforce against those who don’t effectively comply with the rules, and then simply refuse to provide information – under the guise of Reg S-P – when a complaint is filed? Will the CFP Board have to rely on consumers to file their own complaints, just to get the information necessary to investigate such complaints? And is the CFP Board prepared to enforce against the non-trivial number of CFP certificants who have been acting as non-fiduciaries for years or decades already by using their CFP marks to sell products (which now will be subject to a fiduciary obligation for the first time)? Especially since the CFP Board doesn’t require CFP professionals to state in writing that they’re fiduciaries to their clients, which means the CFP Board’s fiduciary duty still won’t necessarily be grounds for a client to actually sue the financial advisor for breach of fiduciary duty (as the CFP certificant would simply be failing to adhere to the CFP Board’s requirement that he/she act as a fiduciary, and not an actual fiduciary commitment to the client!).

CFP Board Anonymous Case Histories And Case Law Precedents

On the other hand, one of the greatest challenges for the CFP Board may not be the consequences if it can’t investigate claims against CFP professionals, but what happens if it does see an uptick in the number of complaints and enforcement actions under the new CFP Conduct Standards.

The problem is that ultimately, a large swath of the newly proposed Conduct Standards contain potentially subjective labels to determine whether the rules have actually been followed, or not. For instance, the word “reasonable” or “reasonably” is used a whopping 26 times in the new Conduct Standards, pertaining to everything from whether a conflict of interest in Material (based on whether a “reasonable” client would have considered the information important), to whether a related party is related based on whether a “reasonable” CFP professional would interpret it that way, to requirements that CFP professionals diligently respond to “reasonable” client inquiries, follow all “reasonable” and lawful directions of the client, avoid accepting gifts that “reasonably” could be expected to compromise objectivity, and provide introductory information disclosures to prospects the CFP professional “reasonably” anticipates providing subsequent financial advice to. In addition, the entire application of the rules themselves depend on the CFP Board’s “determination” of whether Financial Advice was provided (which triggers the fiduciary obligation for CFP professionals), and CFP professionals with Material conflicts of interest will or will not be found guilty of violating their fiduciary duty based on the CFP Board’s “determination” of whether the client really gave informed consent or not.

In other words, the CFP Board’s new Standards of Conduct leave a lot of room for the Disciplinary and Ethics Commission (DEC) to make determinations of what is and isn’t reasonable in literally several dozen instances of the rules, as well as determining how they will determine when Financial Advice is given and what does and doesn’t really constitute informed consent.

To be fair, the reality is that it’s always the case that regulators and legislators write the rules, and the courts interpret them in the adjudication process. So the idea that the CFP Board’s DEC will have to make interpretations of all these new rules isn’t unique or that out of the ordinary. And frankly, using “reasonableness” as a standard actually helps to reduce the risk that a CFP professional is found guilty of something that is “reasonably” what another CFP professional would have done in the same situation. “Reasonableness” standards actually are peer-based professional standards, which is what you’d want for the evaluation of a professional.

However, when courts interpret laws and regulations, they do so in a public manner, which allows everyone else to see how the court interpreted the rule, and provides crucial guidance for everyone who follows. Because once the court interprets whether a certain action or approach is or isn’t permitted, it provides a legal precedent that everyone thereafter can rely upon. In point of fact, many of the key rules that apply to RIA fiduciaries today, including the fact that a fiduciary duty applies to RIAs in the first place, didn’t actually come from regulators – it came from how the courts interpreted those regulations (which in the case of an RIA’s fiduciary duty, stemmed from the 1963 Supreme Court case of SEC v Capital Gains Research Bureau).

The problem, though, is that the CFP Board’s disciplinary process is not public. Which means even as the DEC adjudicates 26 instances of “reasonableness”, no one will know what the DEC decided, nor the criteria it used… which means there’s a risk that the DEC won’t even honor its own precedents, and that rulings will be inconsistent, and even if the DEC is internally consistent, CFP professionals won’t know how to apply the rules safely to themselves until they’re already in front of the DEC trying to defend themselves!

Notably, this concern – of the lack of disciplinary precedence in CFP Board DEC hearings – was a concern after the last round of practice standard updates in 2008, and did ultimately lead to the start of the CFP Board releasing “Anonymous Case Histories” in 2010 that provide information on the CFP Board’s prior rulings. (The case histories are anonymous, as making them public, especially in situations where there was not a public letter of admonition or a public suspension or revocation, would itself be a potential breach of the CFP professional’s privacy.)

However, the CFP Board’s current Anonymous Case History (ACH) database is still limited (it’s not all cases, but merely a collection of them that the CFP Board has chosen to share), and the database does not allow CFP professionals (or their legal counsel) any way to do even the most basic keyword searches OF the existing case histories (instead, you have to search via a limiting number of pre-selected keywords, or by certain enumerated practice standards… which, notably, will just be even more confusing in the future, as the current proposal would completely re-work the existing practice standard numbering system!).

Which means if the CFP Board is serious about formulating a more expanded Conduct Standards, including the application of a fiduciary duty and a few dozen instances of “reasonableness” to determine whether the CFP professional met that duty, the CFP Board absolutely must expand its Anonymous Case Histories database to include a full listing of all cases (after all, we don’t always know what will turn out to be an important precedent until after the fact!), made available in a manner that is fully indexed and able to be fully searched (not just using a small subset of pre-selected keywords and search criteria). Especially since, with the CFP Board’s unilateral update to its Terms and Conditions of Certification last year, CFP professionals cannot even take the CFP Board to court if they dispute the organization’s findings, and instead are bound to mandatory arbitration (which itself is also non-public!).

Overall Implications Of The CFP Board’s New Fiduciary Standard

Overall, for CFP certificants (including yours truly) who have called for years for the CFP Board to lift its fiduciary standard for its professionals, there’s a lot to be liked in the newly proposed Standards of Conduct. The CFP Board literally leads off the standards with the application of the fiduciary duty to CFP professionals (it’s the first section of the new Standards of Conduct!), and expands the scope of the CFP Board’s standards to cover not just delivering financial planning or material elements of financial planning, but any advice by a CFP professional (for which it is presumed that delivering that advice should entail doing financial planning!).

In addition, the CFP Board has made a substantial step forward on its disclosure requirements for conflicts of interest, particularly regarding the creation of its “Introductory Information” requirement for upfront disclosures to prospects, and its expanded and more detailed requirements for setting the Terms of Engagement for client agreements. (For anyone who still believes the CFP Board is beholden to its large-firm broker-dealers, this should definitively settle the issue – as broker-dealers compliance departments will most definitely not be happy that the CFP Board as a “non-regulator” is imposing disclosure requirements on their CFP brokers! In fact, there’s a non-trivial risk for the CFP Board that some large brokerage or insurance firms may decide to back away from the CFP Board’s expansion of its fiduciary duty, just as State Farm did back in 2009 when the CFP Board first introduced its fiduciary standard.)

On the other hand, it is still notable that despite increasing the disclosure requirements associated with its expanded fiduciary duty for CFP professionals, the CFP Board isn’t actually requiring CFP professionals to change very much from what they do today. Material conflicts of interest must be disclosed, but obtaining informed consent appears to be a legitimate resolution to any actual conflict of interest. And debating whether a conflicted recommendation that the client agreed to with informed consent was still a fiduciary breach or not would quickly come back to a determination of whether the CFP professional’s advice met various standards of “reasonableness” – which, as of now, aren’t entirely clear standards, and if the CFP Board can’t effectively expand its Anonymous Case Histories, may not get much clearer in the future even as the DEC interprets what is “reasonable”, either.

In the meantime, though, to the extent that the CFP Board’s newly expanded fiduciary standard – both the duty of loyalty, and the expanded duty of care – does create at least some new level of accountability for CFP professionals, the real challenge may be the CFP Board’s own ability to enforce and even investigate complaints if and when they do occur. As the saying goes, the CFP Board needs to make sure its mouth isn’t writing checks that its body can’t cash, by promulgating standards of conduct it may struggle to effectively enforce. Whether and how the CFP Board will expand and reinvest into its own disciplinary process and capabilities remains to be seen.

But overall, the CFP Board’s newly proposed Standards of Conduct really do appear to be a good faith effort to step up and improve upon the gaps of the prior/existing standards of professional conduct. The scope of what constitutes “doing” financial planning for the purposes of the fiduciary duty is expanded (and if anything, the CFP Board may have gone too far by not limiting the scope of fiduciary duty to an established financial advice relationship for compensation), the fee-only compensation definition is improved (although the CFP Board may be starting a problematic game of whack-a-mole by just punishing “fee-based” instead of more formally establishing a standardized series of compensation definitions), and although the CFP Board didn’t crack down on material conflicts of interest to the extent of the Department of Labor’s fiduciary rule, it did still move the ball further down the field by more fully highlighting prospective conflicts and increasing the disclosure requirements for both RIAs and especially broker-dealers and insurance firms.

For the time being, though, it’s also important to recognize that these are only proposed standards, and not final. The CFP Board is engaging in a series of eight Public Forums in late July across the country to gather feedback directly from CFP professionals (register for one in your area directly on their website here), and is accepting public comment periods for a 60-day period (ending August 21st), which you can submit either through the CFP Board website here, or by emailing comments@cfpboard.org. Comments and public forum feedback will then be used to re-issue a final version of the standards of conduct (or even re-proposed if the Commission on Standards deems it necessary to have another round of feedback) later this year.

And for those who want to read through a fully annotated version of the proposed Standards of Conduct themselves, the CFP Board has made a version available on their website here.

It’s award season: Best practice and the value of awards

It’s award season: Best practice and the value of awards

In my line of work, I’m constantly thinking about annual reports; I not only read a lot of annual reports but I analyze them every day. And yes, I even believe that annual reports are important! In fact, I’d even say very important- and even useful!

I am also very aware that there is a lot wrong with annual reports – the length, the complexity, the ever changing and demanding legislative and regulatory environment, the list goes on… Despite this, I do firmly believe that you need to see the annual report as an opportunity rather than an obligation. Why? Because it’s a chance to ‘tell your story’. You have to produce an annual report every year so use it as an occasion to get your messaging right. Use the process to stimulate discussion and drive an overarching communications framework that can be used both internally and externally.

I always try to encourage organisations to not only challenge themselves, but to challenge their internal audiences, their Boards and other stakeholders and to look hard at what they are saying to their stakeholders. On top of this, it’s vital companies think about how they are communicating and that they are not missing an opportunity to better communicate their long-term strategy, value creation story and drivers of business performance in a more meaningful, connected way across their communications channels.

This is the reason why I am a huge advocate of Awards that recognise companies that make a proactive effort to promote, clear and consistent investor communications. The Investor Relations Society Best Practice Awards do just that and, now in their 17th year, celebrate those companies that ‘stand out’ across a number of different Awards, including Best Annual Report.

So what are the judges looking for?

Judges last year were looking for evidence of innovative and effective reports that communicate the strategy and investment case of the company. Companies were marked up if they used their Report as a communications tool to provide insight into the company’s main objectives and strategies, the principal risks it faces and how these might affect future prospects. For UK companies there was an additional focus on the objectives set out in the FRC’s Guidance on the Strategic Report.

Recognition across all categories

One of the most popular awards is ‘Best Annual Report’ (there were over 75 entries with 16 companies shortlisted across four categories – FTSE100, FTSE250, Small Cap & Aim and International).

In the FTSE100 category, ARM Holdings came out on top of a very strong shortlist including: British Land, M&S, Pearson, Taylor Wimpey and Sage. The judges stated ARM’s ability to present a complex business model in an easy-to-read Annual Report made them the final recipient of the Award, but it was a close contest and Taylor Wimpey, were highly commended by the judges for a well explained business model which included KPIs and impactful case studies. The judges also congratulated Taylor Wimpey for the concise and engaging presentation of their Report.

In the FTSE250 category there was another competitive shortlist of six, with judges picking DS Smith out from the crowd to win the award due to their clear and easy to understand business model, innovative use of graphics and good communication about sustainability issues.

Here are some of the other shortlists and winners in the other two categories, all which are worth a look for inspiration.

What was apparent across all categories – big and small – is that the best annual reports look to the future and show the vital link between effective governance and the business model, strategy and leadership statements. The very best also show the effectiveness of their business strategy in a way that demonstrates credible management and provide a window into the company and its culture. What is also clear to me and the judges, a good annual report can help differentiate your company, shape your reputation and build confidence with investors. So what’s stopping you? For more information go to irs.gov.

Stock Markets and the Rule of Law

Stock Markets and the Rule of Law

How many multiple points on the S&P 500 are at risk if the populace gets to a place where they no longer believe we are a country of laws – laws that apply to everyone, including the politicians who happen to be in control at a given a moment?

I don’t know the answer, but I guarantee you, it’s not zero. It’s a number for sure.

Matt Levine on this weekend’s chaos with respect to the latest executive orderfrom the Trump administration:

If the president can, without consulting the courts or Congress, banish U.S. lawful permanent residents, then he can do anything. If there is no rule of law for some people, there is no rule of law for anyone. The reason the U.S. is a good place to do business is that, for the last 228 years, it has built a firm foundation on the rule of law. It almost undid that in a weekend. That’s bad for business.

When you hear an investor compare US, UK, German and Japanese stock market valuations with the countries that make up the Emerging Markets index, try to keep in mind the fact that the discounts are nearly always warranted. We can debate about the degree of cheapness in emerging Latin American or Asian stock markets – this is subjective. What is not up for debate is whether or not there ought to be a discount. Of course, there needs to be.

And the reason why, very simply, is the presence of a rule of law that applies to everyone – or, at least, the perception of a rule of law. Shares of stocks are contracts; agreements between the owners of a business and those who manage it on behalf of those owners. And these contracted agreements – regarding the payment and allocation of cash flows, safeguarding of intellectual property, continuance of competitive business practices, respect for minority shareholders, etc – are sacrosanct.

The same could be said of the governance environment in which the companies operate. Investors need to feel that there is fairness and a set of rules that everyone must adhere to. No one would build a house on quicksand and no one would exchange currency for pieces of paper in an environment where legal protections no longer mattered.

In 2002, an early research conference looking at the challenges of valuing emerging market stocks, was convened at the University of Virginia. The panelists concluded the following (emphasis mine):

The valuation of firms in any market also depends on the degree to which investors’ rights are protected. Because a firm’s share price reflects the cash flow per share that non-controlling shareholders expect to receive, this share price should fall if non-controlling shareholders expect expropriation by either corrupt officials or controlling shareholders. To the extent that official corruption and poor corporate governance distort the decision-making of the firm’s management, they also destroy shareholder value.

Because emerging markets in general have a more corrupt environment and weaker corporate governance institutions, financial markets tend to price assets in emerging markets at a discount with respect to comparable assets in developed markets.

Fifteen years later, and this conclusion remains correct. The stock market valuations in emerging markets continue to earn this “corruption” discount, despite the fact that, for the most part, the economies to which these stock markets belong are growing at a significantly rapid rate compared to the developed world.

Investors don’t pay up for faster growth if it is accompanied by concerns about governance and the potential for political interference.

Let’s take a quick look at some current earnings multiples to give you a sense of how important investors’ perception of lawfulness can be.

The United States stock market currently sells at a price-to-earnings (PE) multiple of 21.8 times (trailing 12 months) and a cyclically adjusted price-to-earnings (CAPE) multiple of 26.4 times.

In comparison, the Russian stock market sells at a PE of 9.1 times and a CAPE of 5.9. It is the “cheapest” large stock market in the world. The reason for this discount is that these are shares of stock that trade in a dictatorship, wholly controlled by the whims of the Kremlin. CEOs can be jailed for operating or even speaking against those in power. Assets can be confiscated or reassigned at will. State control of corporate entities does not encourage investors to pay up for minority stakes in these businesses.

Similarly, China’s PE is 7.2 times – one third the valuation of US companies – and its CAPE is 12.8 – less than half that of the United States stock market. The country has been taking steps to liberalize its financial system and corporate environment, but these things happen very slowly. Bear in mind that official statistics put the growth rate of China’s economy at more than double that of the US. Again, governance issues and fear of political interference help the world’s second largest economy earn quite a discount for its stock valuations.

A composite index of emerging markets countries, based on Thompson Reuters data, now carries a PE multiple of 16 and a CAPE of 14. Comparatively, an index of developed markets countries has a PE of 21.8 and a CAPE of 21.9. This is a large gap, and a lot of the difference can be explained by investor confidence that their money will be treated fairly.

Put simply, US stocks, bonds and real estate are the most trusted and relied upon financial “risk assets” on planet earth. We have strong contract law and, as a result, people all over the world allocate to these instruments with confidence. We should not take this for granted or fool ourselves into believing it’s permanent.

The appearance or perception of a President who can do whatever he’d like is not going to be long-term additive to the valuations of US businesses or land or buildings or infrastructure. It wasn’t long ago that the United States itself was an emerging market on the world’s stage. If we’re not going to be a nation of laws, then attitudes toward pieces of paper that carry no weight in the absence of law will have to be rethought.

 

Cash Cows Of The Dow

Cash Cows Of The Dow

Long time readers know that I have been a shareholder yield advocate on the blog for almost a decade.  (We used to call it net payout yield back then, and we define it as the combination of dividends and net buyacks.)

People are slow to change of course, but my hopes are that eventually you all come around to a little common sense.  Sometimes books and white papers are too much, and all that is needed is a simple chart or table that will change people’s minds.

Remember the old Dogs of the Dow strategy where you just invest in the 10 highest yielding Dow stocks each year?  This strategy was popularized by O’Higgins, and historically beat the market.  But as you all know, a shareholder yield approach does even better historically.

Below we list all 30 Dow stocks, their dividend yield, their net buyback yield, and their total shareholder yield.

 

screen-shot-2017-01-14-at-11-39-35-am

We then group the Dow stocks into the Dogs strategy and the shareholder yield strategy (what we call the Cash Cows.)  Not surprisingly, the Dogs have the highest yield.  However, they also have the lowest buyback yield.  Overall the Dogs have a very similar shareholder yield to the entire Dow, but actually is slightly lower.

The Cash Cows, despite having the lowest dividend yield, have by far the largest buyback yield resulting in a total shareholder yield that is nearly double that of the Dogs and about a third higher than the Dow.

Click to enlarge

screen-shot-2017-01-14-at-11-39-06-am

Here’s where it gets even more interesting.  The Cash Cows strategy also has the cheapest valuations (median) across all variables except P/E ratio (and then it only nearly misses.

So a much higher total yield, and lower valuations.  What’s not to like?

Squaring-The-Survival-Curve And What It Means For Retirement Planning

Squaring-The-Survival-Curve And What It Means For Retirement Planning

EXECUTIVE SUMMARY

It’s become a well-recognized phenomenon that life expectancies are on the rise, and have been for more than a century now. For many, this leads to the “inevitable” conclusion that someday we’ll all be living to age 150 and beyond, and that we need to plan for drastically longer retirement time horizons – or even that retirement itself will be transformed (or become irrelevant) if medical breakthroughs allow us all to enjoy 100+ years of active lifestyles. However, a fresh look at the data reveals that this may not actually be the likely outcome.

In this guest post, Derek Tharp – our new Research Associate at Kitces.com, and a Ph.D. candidate in the financial planning program at Kansas State University  delves into the nuances behind the changes in mortality rates over the past century and in recent decades, and what they imply about the future.

Because the interesting phenomenon of recent advances in life expectancy in particular is that while overall life expectancies have been rising, most of the gains are attributable to people living closer to the maximum human lifespan (rising up towards about 115 years), and not as much from increases in the maximum age itself. And in the past two decades, the empirical data suggests that the maximum lifespan of human beings has stopped increasing altogether, peaking out around age 115. As a result, future medical advances may simply make us more and more likely to live to that maximum age, but there’s little evidence to suggest that anyone is ever going to live to 150 and beyond… a phenomenon known as “squaring the (survival) curve”.

The significance of rising life expectancy being due primarily to an increasing likelihood of living to maximum age, but not increasing the maximum age itself, is that retirement planning may need to adjust for a longer active phase of life… or more pessimistically, for prolonged periods of substandard health as what might have killed us in the past now simply slows us down! The potential for continued squaring the curve may also dramatically change the pricing and even the relevance of various types of insurance products, as long term care insurance becomes less necessary (if we’re healthy for more of our lifespan), and annuity mortality credits become less available (because people die close together at the end of their maximum lifespan).

But the fundamental point is simply to understand that the ongoing rise in life expectancies doesn’t necessarily mean that someday everyone is going to live to age 150 and beyond. It may simply mean that more of us will live to approach what appears to be a “maximum” human lifespan around age 115… and in fact, recent shifts in who is living longer (and who is not) suggests that we may have already hit that longevity wall.

Squaring-The-Survival-Curve And What It Means For Retirement Planning

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SHARES

EXECUTIVE SUMMARY

It’s become a well-recognized phenomenon that life expectancies are on the rise, and have been for more than a century now. For many, this leads to the “inevitable” conclusion that someday we’ll all be living to age 150 and beyond, and that we need to plan for drastically longer retirement time horizons – or even that retirement itself will be transformed (or become irrelevant) if medical breakthroughs allow us all to enjoy 100+ years of active lifestyles. However, a fresh look at the data reveals that this may not actually be the likely outcome.

In this guest post, Derek Tharp – our new Research Associate at Kitces.com, and a Ph.D. candidate in the financial planning program at Kansas State University  delves into the nuances behind the changes in mortality rates over the past century and in recent decades, and what they imply about the future.

Because the interesting phenomenon of recent advances in life expectancy in particular is that while overall life expectancies have been rising, most of the gains are attributable to people living closer to the maximum human lifespan (rising up towards about 115 years), and not as much from increases in the maximum age itself. And in the past two decades, the empirical data suggests that the maximum lifespan of human beings has stopped increasing altogether, peaking out around age 115. As a result, future medical advances may simply make us more and more likely to live to that maximum age, but there’s little evidence to suggest that anyone is ever going to live to 150 and beyond… a phenomenon known as “squaring the (survival) curve”.

The significance of rising life expectancy being due primarily to an increasing likelihood of living to maximum age, but not increasing the maximum age itself, is that retirement planning may need to adjust for a longer active phase of life… or more pessimistically, for prolonged periods of substandard health as what might have killed us in the past now simply slows us down! The potential for continued squaring the curve may also dramatically change the pricing and even the relevance of various types of insurance products, as long term care insurance becomes less necessary (if we’re healthy for more of our lifespan), and annuity mortality credits become less available (because people die close together at the end of their maximum lifespan).

But the fundamental point is simply to understand that the ongoing rise in life expectancies doesn’t necessarily mean that someday everyone is going to live to age 150 and beyond. It may simply mean that more of us will live to approach what appears to be a “maximum” human lifespan around age 115… and in fact, recent shifts in who is living longer (and who is not) suggests that we may have already hit that longevity wall.

(Derek Tharp Headshot PhotoMichael’s Note: This post was written by Derek Tharp, our new Research Associate at Kitces.com. In addition to his work on this site, Derek is finishing up his Ph.D. in the Personal Financial Planning program at Kansas State University, and assists clients through his RIA Conscious Capital. Derek is a Certified Financial Planner, and can be reached at derek@kitces.com.)

Life Expectancy Assumptions In Retirement

One of the most important assumptions in any financial plan is life expectancy. Assuming too short of a lifespan can result in an excessively high withdrawal rate that depletes all of a client’s assets prior to death. However, despite a desire from financial planners to avoid ever seeing clients run out of money, assuming an unrealistically long lifespan is problematic as well. Excessively low withdrawal rates may lead to a lower quality of life in retirement, a larger than desired legacy inheritance (which the heirs probably won’t complain about, but the retiree might regret!), unfulfilled life goals, and—assuming there may be a relationship between life satisfaction and longevity—possibly even a reduction in lifespan itself!

However, “life expectancy” can be a somewhat misleading term. Many people hear the term and think of it as a measure of how long they can “expect to live”. In reality, though, life expectancy is a measure of theaverage time a person within some particular population is expected to live. While the average is meaningful in many respects, it may not always provide the best measure for setting expectations about the actual age someone is likely to reach. Because mortality rates aren’t constant across a lifespan and the distribution of ages at death are heavily skewed (i.e., more people die old than young), commonly cited life expectancy measures—particularly life expectancy at birth, which is most often cited in the media—may result in misleading expectations.

For instance, a child born in 2014 has a life expectancy (average age at death) of 79. However, the median age of death for the same child is 83, and the modal (most common) age at death is 89! Given the shape of the distribution of ages at death (negatively skewed), it’s simply a mathematical fact that the mean is going to be lower than the median or the mode.

Life Expectancy and Projected Deaths Per 100,000 For Children Born In 2014

Understanding Longevity Expectations With Survival Curves

One way to explore some of the nuances within mortality figures is to visualize that data through the use of a survival curve – a figure which plots percentage of people still alive (i.e., the “survival rates” of a population) over time. Looking at the trends in how survival curves change over time can help us to not just see whether life expectancy is changing, but specifically where changes are occurring across the lifespan.

Projected Survival Curve For Children Born In 2014

As you can see in the survival curve above, only roughly 1-in-10 people born in 2014 is expected to die prior to age 60 (i.e., 90% are still alive), but beyond that point, the rate of death begins to increase substantially. However, over 60% of children born in 2014 are still expected to be alive when the cohort reaches their “life expectancy” (i.e., average age at death) of 79. The median (age 83) is equivalent to the 50th percentile, and the mode (89) is roughly around the 30th percentile. By age 100, only 2% of people born in 2014 are expected to still be alive. While simple statistics like life expectancy certainly serve a purpose, survival curves give us a much better look at the “story” behind the data.

Demographers and population biologists identify two broad forms of change that can influence the shape of survival curves over time. There can be a “scale effect”, which refers to an increase in maximum age attained (i.e., the oldest people are reaching older ages), or a “shape effect”, which refers to changes in the curvature of a survival curve (i.e., more people are surviving long enough to approach or reach those maximum ages but not necessarily living longer than the maximum age).

Shape And Scale Effects

This distinction is important because people often talk about rising life expectancy as though it goes hand-in-hand with increasing maximum age, but that’s not necessarily the case. In fact, when we look at how survival curves have shifted over time, changes have been attributable to both the shape effect (i.e., living closer to maximum age) and the scale effect (i.e., increasing the maximum age) at varying rates.

Historical Changes In Survival Curves

The graphic above shows experienced and projected survival curves from 1851 through 2031. The trends over time reveal one of the more interesting changes humans are experiencing in survival rates: while there has been some increase in the maximum ages, most of the change over time appears to be a “squaring-of-the-survival-curve” (which is also known as “rectangularization”). Squaring-the-survival-curve refers to the change in shape that results from people living closer to their maximum age without an equivalent increase in their maximum age. In a perfectly squared survival curve, nearly 100% of a population would survive to the maximum human lifespan and then suddenly pass away, forming a “curve” that takes the shape of a right angle (hence, “squaring-the-curve”).

The Impact Of Shape And Scale Effects On Historical Changes In Survival Curves

Current Changes In Survival Curves

Survival curves are constantly evolving and subject to significant variation globally. A 2012 study published in Nature found evidence of variations in scale effects and shape effects even among relatively similar, wealthy capitalist societies. Though variations exist among societies, the long-term trends over the past several hundred years have shown both increases in maximum age attained and increases in the percentage of the population living closer to their maximum age, as noted in the chart above.

However, it’s possible humans in developed nations have recently reached a pivotal point in the evolution of our mortality. A 2016 study in Nature found evidence that the lifespan was increasing up until 1990, but has not increased since. In fact, the trend since 1990 has actually been a slight decrease in lifespan.

There is disagreement among researchers regarding whether a true maximum human lifespan exists, and exactly what that lifespan might be, but the same 2016 study in Nature found evidence that the human lifespan has plateaued around 115 years. This doesn’t mean no one will live beyond 115—Jeanne Calment was the oldest documented human at an age of 122 and few other exceptions have joined her living past 115—but the maximum age for all but truly the rarest exceptions appears to be stabilizing at 115, despite continued advancements in medical science.

FORECASTING CHANGES IN ADVANCED AGE LONGEVITY

It’s important to note that researchers are dealing with a relatively small sample when evaluating those approaching a maximum lifespan, so it is possible we are currently just experiencing some noisy data and lifespan will continue to increase in the future. Still, what we do know is that since 1990, almost all of the gains in life expectancy have been due to people living closer to their maximum age, rather than increases in maximum age. In other words, squaring-the-survival-curve now seems to be the sole driver of increasing life expectancies in developed nations.

The crucial insight from the phenomenon of squaring-of-the-survival curve is that increasing life expectancy does not necessarily mean increasing lifespans. At some point, we may see many (perhaps even the most!) people living beyond age 100, yet the likelihood of living to 125 may still essentially be zero! That’s not to say that we won’t encounter dramatic breakthroughs that fundamentally change these dynamics—for instance, technology that literally reverses aging—but barring any such technological breakthroughs, there is currently little foreseeable reason to forecast life expectancies beyond 115, even with ongoing medical advances. In other words, rising life expectancies don’t necessarily mean we’re likely eventually be living to age 150 and beyond… it may just be that we’re increasingly likely to all make it right up to a “maximum” age around 115!

One potentially concerning behavioral consideration is the role that theavailability bias may play in influencing longevity forecasts. Many clients forecast their own life expectancy based on the longevity of family members. While it appears that genetics play a significant role in longevity and it’s reasonable to take family health history into consideration, ironically, squaring-the-curve may mean that individuals with the lowest longevity expectations are actually the most prone to significantly outlive their expectations!

The reason is that people with longevity in their family already tend to die of old age, whereas families with without longevity often die of other health conditions. Yet, if squaring-the-curve results in increasing survival rates without a corresponding increase in maximum age, then the bulk of the gains in survival rates will go to those who aren’t dying of the same ailments that claimed the lives of previous generations. In other words, someone who has a family history of living into their 90s of 100s may have a good reason to believe they will also live that long, but there isn’t a huge risk they will live significantly longer. However, someone without longevity in their family who believes they will die in their 70s likely has the biggest “risk” of living 20-30 years beyond their expectations.

Individuals should also understand that average trends may not apply to them if their demographics make them significantly different from average. A recent report from the National Center of Health Statistics found that overall U.S. life expectancy dropped in 2015 for the first time since 1993. While it’s still possible this was just some statistical noise (and there’s some evidence that may be the case), it’s important to acknowledge that not every demographic experienced a decline in 2015. People seem relatively aware that differences exist among factors like gender, but it’s important to remember that race, education, wealth, income, and occupation are all important factors as well. Given the “typical” client of a financial advisor, these factors tend to be associated with more favorable life expectancies (relative to the average).

How Squaring-The-Curve Changes Retirement Planning

If we aren’t on a trajectory to live to 150, but instead, we’re on a path towards more and more people living into their 90s and 100s (and perhaps just a decade beyond), then this has some important retirement planning considerations. Most obvious, if we’re all dead by 115 but almost certain to be alive into our 90s or 100s, then (assuming norms surrounding retirement age don’t change) this will have the practical effect of increasing the length of the distribution phase of retirement, and, as a result, the assets needed for those entering retirement.

However, the good news is that for anyone who is already planning in accordance with distribution phase best practices, material changes to a plan may not be needed (at least not yet!). Most distribution research has historically used an assumption of a 30-year time horizon in retirement. Assuming a retirement age of 65, this still runs projections out until age 95, and for an average couple who has attained age 65, current joint mortality tables suggest that even just one of them living to age 95 or longer is only a 1-in-5 chance . And even with some continued squaring-of-the-curve, this assumption may be reasonably conservative for some time to come, particularly in light of how conservative the assumptions are that underlie the safe withdrawal rate, and the high likelihood that money withdrawn under the 4% rule will last more than 30 years anyway.

The more direct impact of increasing longevity will likely be on spending patterns throughout retirement. Just as we are starting to get a better grip on actual declining spending patterns of individuals in retirement, continued change among lifestyle factors may change these spending patterns further.

Notably, though, there are competing viewpoints on what these changes may look like. Some predict that squaring-the-curve will come from the ability to merely keep people alive (albeit possibly in a minimally-conscious and highly sedentary state). Under this scenario, life expectancies would be extended and healthcare expenses would increase, but it’s likely annual spending would decrease significantly within these final years of life.

More optimistic viewpoints see the extension of life coupled with more years of healthy life. In fact, gerontologists speak of different form of “squaring-the-curve” that comes from plotting quality of life over time – with an ideal of maintaining a high-quality lifestyle right up until death. Under this scenario, the decrease in retirement spending that is currently seen over time would be diminished. Not only would retirees live longer, but they would live longer with more years of higher levels of spending.

Of course, the optimistic and pessimistic views of squaring-the-curve are not mutually exclusive. It’s also possible—and perhaps, more realistic—that we’ll see a combination of longer time spent in good health and increased possibilities for extending life in poor health. Rather than the more gradual decline commonly seen in spending now, there may be an increased prevalence of steep declines in spending as the result of quicker and more dramatic lifestyle changes that coincide with rarer but more dramatic changes in health (that still can’t be overcome by future medical science).

Another consideration is that if lifestyles become healthier and more active in old age, perhaps people will “retire” less—instead opting for“semi-retirement” consisting of scaled-back or different forms of work—and the nature of the need for income in retirement will begin to change. After all, retirement originated as something for people who were too old to work and became “obsolete” as workers. Its use as a time of leisure is a recent phenomenon.

It’s likely the meaning and conceptions of retirement will continue to change as well. When a retiree’s 60s and 70s are no longer their twilight years, will retirement itself become a less relevant milestone? Will new careers, civic engagement, or philanthropic work become even more prevalent in these stages of life? Will retirement become an even more popular transition as healthier retirees have even more to look forward to? Will the prospects of a longer, but perhaps less stressful career be more enticing than trying to save up enough to not work for many decades? Cultural shifts are hard to predict, but afforded the assurance that one is likely to live into their 90s or beyond (particularly in good health), it’s hard to imagine that cultural views on retirement wouldn’t change.

Farther Reaching Consequences Of Squaring-The-Survival-Curve

While squaring-the-survival-curve has many practical implications that affect the assumptions and practice of retirement planning, there are also some farther-reaching consequences that could influence the financial services industry more broadly, and are worthy of consideration.

ANNUITY MORTALITY CREDITS

One of the key benefits of annuitization is the ability to earn mortality credits. Mortality credits serve as a way to pool and spread out risk. However, in a world with a perfectly squared mortality curve, there would be no way to earn mortality credits. Everyone would live to their forecasted maximum age and then immediately pass away. Of course, this is an extreme example we are unlikely to see for a very long time (if ever!), but the general principle remains. As the distribution of age at death becomes more concentrated and uncertainty surrounding life expectancy is reduced, the conditions that make it possible to earn mortality credits are reduced as well. This may mean it’s a good idea to lock in mortality credit pricing in annuities today, but it may also mean that credit quality of the insurer is even more important, as low-quality annuity providers could be financially threatened if there is a dramatic squaring-of-the-curve with future medical breakthroughs!

Of course, the flip side of this is that as life expectancy becomes more predictable, the need to hedge against longevity is also reduced. If at some point in the future 95% of people are surviving to, and then dying between, the ages of 95-105, then retirement planning will have become a lot easier (at least from the perspective of dealing with one of the biggest planning contingencies of an unknown time horizon until death). It’s possible that future generations will look back and have as hard of a time fathoming our current mid-life mortality rates as we have looking back and fathoming maternal and infant mortality rates from as recently as the early 1900s.

LONG-TERM CARE INSURANCE

Squaring-the-curve could have a tremendous impact on long-term care insurance, but the impact it has will ultimately depend on whether the optimistic or pessimistic perspectives on squaring-the-curve end up being more accurate.

If squaring-the-curve happens among both mortality and quality of life, then long-term care insurance could become largely obsolete. In fact, this may be what today’s still-struggling-to-be-profitable long-term care insurers are betting on (medical breakthroughs that turn their existing unprofitable policies into more profitable ones as claims decline)!

Alternatively, scenarios short of curve-squaring perfection could greatly enhance the risk characteristics of long-term care from a risk-transfer perspective. Ideally, insurable risks are high severity and low probability occurrences. With the expectation that 1-in-3 retirees will need some type of long-term care, the current characteristics actually aren’t great for creating products for the pooling and transfer of risk. However, with a healthier aging population and reduced need for long-term care services, long-term care insurance could significantly decrease in cost and begin to look much more like life or disability insurance does today – primarily used to address low frequency but high severity risks.

INCREASED STRESS ON SOCIAL SAFETY NETS

While living to 95 or 100 isn’t necessarily disastrous for the assumptions that go into current retirement distribution best practices, the reality remains that many Americans are simply not financially prepared for this type of longevity. As a result, squaring-the-curve will likely increase the amount of stress that already exists on social safety nets, such as extending and increasing the duration and amount of claims from Social Security and Medicare, not to mention the potential need to rely on Medicaid.

Of course, squaring-the-curve may have other effects that influence social safety nets as well. People in better health living more vibrant and active retirements may opt to delay retirement or engage in more work during retirement. Additionally, people may retain the ability to go back to work, even in “old” age. Particularly if the quality of life curve is squared as well, a retiree in their 90s may be much better equipped to re-enter the workforce in the event that they run out of money. Less extensive health care needs could reduce stress on certain social safety nets that provide health care as well.

DEEPER MULTI-GENERATIONAL FAMILIES

Squaring-the-curve will likely influence generational family dynamics. Families with three, four, and possibly even five living generations will become more common. As families play an increased role as financial or personal caregivers across more generations, family relationships and support systems may become more complex.

Beyond pooling resources between generations, these changes could influence housing, caregiving, and child rearing. Multi-generational homesteads could become more common, and housing may need to adapt to provide the balance of independence and cohabitation families may desire. Adult children may continue to take a more active role in caring for elderly parents or grandparents, but at the same time, more active grandparents and great grandparents may play a larger role in raising and caring for children as well.

Generational transfers of wealth may also begin to change – not only because people are living longer, spending down their assets, and bequeathing less, but because of the greater need for assets to transfer up a generation or for inheritances to skip past generations (perhaps because children may commonly be in their 60s or 70s when their parents die and grandchildren or great grandchildren will be at a stage where they have greater needs for the inheritance). Or perhaps the ability to work longer will diminish the need for generational transfers as people can remain financially independent longer.

MID-CAREER INVESTMENTS IN HUMAN CAPITAL

Few people today would seriously consider the possibility of going to medical school at age 50, but what would happen if they were relatively confident they would live to age 90? Four years of medical school and four years of residency may not seem so daunting to a 50-year old if they have a dream to be a doctor and the potential to still have a 20-year career with 10+ years in “retirement”.

In fact, a severe career reboot may be helpful in not only helping people pursue careers once they have a better idea of “who they are” and “what they want to do with their life” (i.e., they aren’t young adults with still developing frontal lobes), but also help facilitate a more efficient allocation of human capital. The effects of a higher willingness to re-invest in human capital mid-career likely wouldn’t be isolated to older adults either. The increased prevalence of older adults (even those in their 30s or 40s) pursuing entry-level positions in new fields or going back to school would likely result in competition that directly affects younger adults’ abilities to pursue these same economic opportunities.


The fact that life expectancy is rising is common knowledge, but the nuances behind that change are not. People are, on average, living longer, but that change isn’t necessarily the result of increasing lifespans. Rather, it is now the result of successfully living to our potential maximum lifespan and avoiding premature death.

That trend appears likely to continue, but if people are going to live healthy lifestyles into their 70s, 80s, and even 90s, there are implications for all areas of financial planning. Whether it’s our patterns of saving and dissaving across our life cycle, the financial products we use to achieve our goals, our living arrangements and family dynamics, or even our conceptions of work and retirement itself – squaring-the-survival-curve has profound implications to our clients’ finances and the goals we help them achieve.

The 4 Different Types Of Fiduciary Financial Advisors

The 4 Different Types Of Fiduciary Financial Advisors

While the looming DoL fiduciary rule has heightened consumer awareness of the concept of fiduciary duty, the reality is that being a “fiduciary” (or not) isn’t actually a singular concept. While conceptually, it’s about acting in the interests of the client, and honoring the fiduciary duties of loyalty and care, not all regulators define (nor enforce) those terms consistently.

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, I explore four different types of financial advisor fiduciaries, including RIAs that are SEC fiduciaries, DoL fiduciaries serving retirement investors, CFP fiduciaries providing financial planning, and voluntary fiduciaries who decide to step up to honor private/third-party fiduciary standards.

One reason for varying fiduciary standards is the fact that different industry channels are regulated by different overseers – each of which defines fiduciary obligations in their own way. Registered Investment Advisers (RIAs) are overseen by the SEC and state regulators, which have both adopted a disclosure and transparency oriented approach to fiduciary duty, but only to investment advice and investment management. While the DoL fiduciary rule impacts anyone giving advice on retirement accounts (and not taxable investment accounts), but is more stringent in its limitations on conflict of interest. And the CFP Board requires that certificants often adhere to a fiduciary duty, but the requirement depends on specifically whether the certificant is actually doing “finanical planning” for a client.

And organizations with voluntary fiduciary standard for their advisor members – like NAPFA and the XY Planning Network – have their own definitions of when a fiduciary duty applies, and what conflicts are and aren’t permitted. In addition, RIAs who are struggling to differentiate as fiduciaries – now that DoL fiduciary will apply the rule to more advisors in the future – are looking to even more stringent versions of voluntary fiduciary rules, such as the new Fiduciary Registry from the Institute for the Fiduciary Standard, or CEFEX certification.

The bottom line, though, is simply that there are many different definitions of fiduciary duties, and two advisors who are both “fiduciaries” might still have very different fiduciary obligations. And unfortunately, given the research showing that consumers struggle even to understand the difference between fiduciary and suitability standards, it’s not likely most will grasp the nuances of the many different types of fiduciary duties anytime soon.

A Call for Kintsugi Portfolios

A Call for Kintsugi Portfolios

Slate advice columnist, Dear Prudence, received this sad and poignant letter seeking guidance earlier this year.

“I keep making terrible decisions and can’t seem to stop.

“Last year I left my home, my family, my friends, a 20-year secure (if uninspired) career, to move 2,000 miles away to be with my first love. I’m 50 and I was his first love as well. He’s married and his wife invited me to their home. We decided to share him, although his wife and I were not interested in one another like that.

“My job here fell through. My dog died. The romance flopped spectacularly. I still love him desperately. And when he told me that it was over and that he didn’t love me and never had, I begged him to reconsider, only to have his wife come in and start screaming at me to keep my f***ing hands off her f***ing husband.

“I snapped. I tried to kill myself. I ended up in a coma and then went to the psych ward. I have been out for only a week. I’m back at work. I’m freshly diagnosed as Bipolar I. I’m on new meds I don’t think are helping. Of course I had to move out and I’m living a very lonely life. I do not feel stable and I cry for hours every night. The loneliness is killing me. I have psychiatric follow-up and intend to do what I can to survive and thrive.

“My former boyfriend is now making noises ab

out wanting to be ‘friends with benefits’ with me once I am ‘well again,’ which sounds more like he wants a self-supporting mistress that he can come and have sex with and then leave at will. I still love him but I realize this is a gross affront to my worth as a human being. I just don’t trust myself to say ‘no.’ Counselling may help but I still don’t trust myself to make good, healthy decisions. Everything I do blows up in my face.

“Any advice?”

We humans are shockingly prone to bad ideas, ideas that routinely grow into poor decisions and then metastasize into behavior that may undermine, severely damage or even ruin our lives and futures (see, e.g., Weiner, Anthony). In the words of Kant, “Out of the crooked timber of humanity no straight thing was ever made.” We share a pitiable and cracked nature desperately in need of a repair job nobody seems qualified to perform. We’d all like to think that we’re a lot better off than the letter-writer above, and most of us probably are (if not nearly so self-aware), but vanishingly few of us has a consistently good track record of decision-making and none of us is as good as we think we are. We’re all too much like the party girl in the Busby Berkeley movie musical Gold Diggers of 1935’s surrealist closing number, “Lullaby of Broadway,” who ends up dancing herself right out of a skyscraper window to her death.

Accordingly, the idea that we act in our own rational self-interest with any degree of regularity is, quite obviously, ludicrous and falsified every single day by our choices and our lives. Worst of all, we readily recognize such self-destructive behavior in others but consistently and tragically lack the ability even to see it in ourselves. As legendary physicist and Nobel laureate Richard Feynman warned , “The first principle is that you must not fool yourself – and you are the easiest person to fool.” The Apostle Paul also (an odd pair for agreement if ever there was one) made the same point (Romans 7:15): “What I don’t understand about myself is that I decide one way, but then I act another, doing things I absolutely despise.” We just can’t seem to help ourselves.

Despite the enormity of this problem, the investment portfolios we design, recommend and manage routinely discount or even effectively deny the overwhelming evidence of our cognitive and behavioral weaknesses and how they impact our financial decision-making and well-being in favor of technocratic attempts at efficiency and optimization. In the immortal words of Pogo, “we [may] have met the enemy and he is us,” but we don’t seem very willing to try to do very much about it.

William Goldman is an Academy Award winning screenwriter, novelist and playwright. He wrote Butch Cassidy and the Sundance Kid, All the President’s Men and The Princess Bride and some other excellent films. He famously said the following about the movies, but it applies much more broadly.

“Nobody knows anything…… Not one person in the entire motion picture field knows for a certainty what’s going to work. Every time out it’s a guess and, if you’re lucky, an educated one.”

Josh Brown stated why perfectly: “People can’t be accurately modeled. And it’s people who work and vote and invest and trade and make deals and stick things into themselves that require a trip to the emergency room.”

This dangerous reality implicit in our portfolio construction choices ignores an irrefutable fact: no matter how fantastic the financial plan or how perfect the portfolio, they don’t do a bit of good if the plan isn’t followed and the portfolio maintained when times, markets, situations and feelings change…as they inevitably do. Or, to turn the problem on its head, as Josh would have it: “You can boil down whether or not a financial advisor is adding value into a single metric, you might even say it’s the only metric that matters: Retention. Do clients stay?” Therefore, a “Mary Poppins” portfolio – “practically perfect in every way” (when the “every way” means analytically and not behaviorally) – won’t usually be good enough, to the extent it even exists.

Our lives change. Our goals change. Our outlooks change. Our situations change. Our risk tolerances and profiles change. Emotions run high. Life gets messy. Are our financial plans and investment portfolios robust enough from a behavioral perspective to cope when that (inevitably) happens?

In my experience the answer is, “Usually not.” For example, we (clients and advisors alike) are always prone to performance chasing – buying what has been working well recently and selling what hasn’t been working and thus buying high and selling low – which inevitably leads to losses when mean reversion sets in and to excess trading generally. “In hot markets, money flows in,” says Professor Ilia Dichev of Emory. “In down markets, people get scared and leave.” As a result, stock investors lagged behind the stock market itself by 1.3 percentage points annually between 1926 and 2002, according to Dichev’s research. Even pension plans and other institutional investors earn an average of at least three percentage points less than the funds they buy. In other words, “past performance is indicative of future beliefs.”

How we might strengthen portfolios so as to withstand the weaknesses of human behavior is thus the enormous challenge this analysis sets out to explore.

 

A Nonfinito Approach

kintsugi-1

La Montagne Sainte Victoire vue des Lauves, 1901 – 06, Paul Cézanne

 

Earlier this year, New York’s revered Metropolitan Museum of Art took over the Whitney Museum of American Art’s Marcel Breuer building on Madison Avenue and rebranded it as the Met Breuer in an effort to broaden and deepen the Museum’s involvement with modern and contemporary art. Its largest opening show was Unfinished: Thoughts Left Visible. Its focus was unfinished works of various kinds from masters such as Titian, Leonardo, Turner, Manet, Rembrandt, Cézanne, Pollack and Rubens. Among them are “nonfinito” works. It’s a term that came into active use during the Renaissance and refers primarily to works that the artist deems finished even though they may look incomplete. For example, the artist may let the blank white canvas show through, in order to create an effect or to make a statement, as in the Cézanne shown above.

But how does an artist know when a work is complete?

Over the past couple of centuries or so, that question has become more and more important in the art world as well as more difficult to answer. It has grown into a common debate among artists, critics and scholars, such that it may sometimes be impossible to tell the difference between a completed work and one left intentionally incomplete. Early examples have gaps and missing parts such that it is easy to see that something is missing. But with modern art, the idea of the nonfinito became much more complex in that “ambiguity is part of the project of modernist painting.”

For example, as Cézanne aged, he left more and more blank canvas visible in his paintings. For Cézanne, this seeming incompleteness may have been a metaphor for the process of sight. Or he may simply have been unsatisfied with them. It’s impossible to tell.

As we expand our scope of vision (at least metaphorically), this problem is compounded because we so routinely miss things that are painfully obvious, perhaps because we are distracted or focused elsewhere. Moreover, anything like true objectivity either doesn’t exist or can’t be obtained. Even photographs, which we tend to think of as clear images of simple reality, are created and utilized so as to meet our stated and unstated expectations.

In today’s investment world, our client recommendations will necessarily be nonfinito in at least two senses. Initially, they should be intentionally less than optimal (and in that sense, unfinished) from a technical perspective so as to meet the behavioral and psychological needs of clients and thus be “stickier” for and to those clients. A good portfolio that is used always beats a great or even perfect portfolio that is abandoned. Secondly, a good advisor is always looking to improve technically (so as to create better portfolios) and psychologically (so as to make the created portfolios stickier). Thinking one has “arrived” in either sense is the best possible evidence to the contrary. So let’s get to work. Every good advisor has unfinished business to attend to, both literally and figuratively.

 

Investing as Science and Art

There is a new, growing and vital movement in our industry toward so-called evidence-based investing (“EBI,” which has much in common with evidence-based medicine). As Robin Powell puts the problem, “[a]ll too often we base our investment decisions on industry marketing and advertising or on what we read and hear in the media.” EBI is the idea that no investment advice should be given unless and until it is adequately supported by good evidence. Thus evidence-based financial advice involves life-long, self-directed learning and faithfully caring for client needs. It requires good information and solutions that are well supported by good research as well as the demonstrated ability of the proffered solutions actually to work in the real world over the long haul – which is why I would prefer to describe this approach as science-based investing.

But let’s not kid ourselves about how precise scientific investing can be in the real world. Physics – the hardest of the “hard” sciences – can be minutely accurate. We can know precisely when comets will return or how long various orbits take, for example. It is thus possible to engineer an astonishingly intricate space rendezvous or moon landing. But the more that humans (and especially human decision-making) become part of our study and analysis (as in the “soft” or social sciences), the less precision is possible. As London School of Economics philosopher John Gray explained in his book, Straw Dogs: Thoughts on Humans and Other Animals, “Science increases human power, and magnifies the flaws in human nature.”

That reality explains why our expectations and forecasts of markets and economies are most often wildly inaccurate. As Ronald Reagan famously quipped (even though the phrase was probably coined by Walter Heller), “an economist is someone who sees something happen in practice and wonders if it would work in theory.” Warren Buffett put it even more succinctly: “Beware of geeks bearing formulas.” We can send a rocket to the furthest reaches of the solar system with pinpoint accuracy but have no idea how the markets will perform tomorrow (or even later today). Many of our clients think that we should be able regularly and systematically to beat the market during a rally while avoiding any downturn and are all-too-ready to fire us when that doesn’t happen.

As if. There is not a lick of evidence that such expectations are remotely plausible.

The great Joseph Schumpeter, in the words of his biographer, appropriately concluded “that exact economics can no more be achieved than exact history, because no human story with the foreordained plot can be anything but fiction…. The best mathematics in the world cannot produce a satisfactory economic proof wholly comparable to those in physics or pure mathematics. There are too many variables, because indeterminate human behavior is always involved.” EBI, as economics generally, is therefore far less science-based than we’d like and much more crude art than we’d care to admit. Human action is a much different thing than the movement of planets or even the development of cells.

Legendary economist F.A. Hayak put the problem nicely.

“The term ‘science’ came more and more to be confined to the physical and biological disciplines which at the same time began to claim for themselves a special rigorousness and certainty which distinguished them from all others. Their success was such that they soon began to exercise an extraordinary fascination on those working in other fields, who rapidly began to imitate their teaching and vocabulary. Thus the tyranny commenced which the methods and techniques of the Sciences in the narrow sense of the term have ever since exercised over the other subjects.”

Hayak went so far as to assert that even careful attempts to use scientific methods have “contributed scarcely anything to our understanding of social phenomena.” Yet economics generally and investing more particularly still suffer from acute “physics envy.” Instead of looking to be and settling on being generally right, we rush headlong into being precisely wrong.

Despite what television procedurals routinely espouse, decisions based upon “the gut” are notoriously inaccurate. But the all-too-frequent “expert” decisions whereby the alleged authority claims or assumes to know more than s/he truly does, often based upon advanced math (and usually to multiple decimal places), are pretty lousy too.

Over seven years of generally strong markets has not erased the memory of the 2008-2009 financial crisis. No one should forget the failure of Long-Term Capital Management in 1998 either, despite participation from some of the best mathematicians, economists (including two Nobel laureates), and bond traders on Wall Street. LTCM ended up holding a portfolio that lost a major multiple of what they thought was their worst case scenario. It was a spectacular failure.

LTCM’s strategies worked extraordinarily well for a while, generating annual returns in excess of 40 percent over several years. But then, due to financial problems in the Far East and a governmental default on debt in Russia, they stopped working, seemingly overnight. I sat on a cavernous and eerily quiet Wall Street fixed income trading floor in 1998 and watched a fax machine expurgate page after page listing (largely derivative) securities for which LTCM sought liquidation bids, often in vain. Genius indeed failed and failed utterly. Our most complex and carefully crafted investment theses work right up until they don’t.

Even when these strategies work, we are rarely patient enough to stick with them when they go through inevitable periods of difficulty so that we can reap their rewards. Sometimes an investor or investment approach can be fundamentally rock solid but experience disappointing investment results for several years. A good case in point would be the tremendous underperformance by globally diversified portfolios relative to their domestically focused counterparts for most of the past 8 years. Similarly, value outperforms over the long-term but has underperformed for seven years (see below).

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With the gift of hindsight, every single one of us would be proud to call Warren Buffett’s investment record our own. In the postwar era, American business has racked up an average return on capital of about 10 percent annually. Berkshire Hathaway, in the 51 years since Buffett took command, has compounded its book value at 19.2 percent annually. That enormous advantage, sustained over half a century, represents a standard of outperformance that has no close rival and probably never will. His stock price has vaulted from $18 a share to $223,000.

But how many of us would have been willing to live through the drawdowns and long periods of underperformance he endured to get there? (See below, complements of Newfound Research.) Investors in Berkshire Hathaway have had to endure underperformance as compared with the S&P 500 more than half the time (over various time-periods) and have suffered huge drawdowns in order to outperform so dramatically in the aggregate. No pain, no gain.

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For many, EBI focuses primarily on the creation of optimal portfolios, which means that one’s investment process is the paramount consideration. Indexing (of various potential sorts) will be a crucial default setting for many because of the poor track records of active investors. Low fees will be sought as the best indicator of good performance. Diversification will also be required. If active management is used, concentrated and smaller portfolios or particular risk-mitigation strategies should be sought from managers with significant “skin in the game.”

Asset allocation will trump security selection both because it has more influence on performance and because it enhances a portfolio’s risk/reward characteristics. Because certain investment factors (such as size, value, quality, low volatility and momentum) repeatedly and persistently crop up over time in various global markets and different market conditions as indicators of investment success, they will be sought out for investment. And investment choices based upon predicting the immediate future are avoided because it simply can’t be done with any degree of consistency – there are, as noted, too many variables.

That is the science of investing, broadly construed. I agree with and advocate it despite a few minor qualifications and adjustments. But because humans are involved at every level and in every step, markets are always less predictable than we think and our human responses to those markets are always less rational than we’d like (and like to think). Accordingly, art is necessarily involved in the investment process too. To be clear, I don’t mean that our solutions should be any less evidence-based because of our human frailties. Indeed, they should be more evidence-based in that they also consider the science of human behavior and how that behavior manifests itself, especially under stress. Accordingly, our proffered solutions will necessarily be more realistic too.

Jon Stein of Betterment: Investing shouldn’t be so hard. “It’s just math.” w/ @CoryTV

At a conference I attended recently, Betterment CEO Jon Stein seemed to claim that investing is essentially easy because “[i]t’s just math.” That claim (if I understood him correctly) cannot be supported. It’s not just wrong. It’s shockingly and demonstrably wrong, wrong with the arrogance of an ideologue with something to sell. As Charlie Munger famously said to Howard Marks, “none of this is easy, and anybody who thinks it is easy is stupid.”

“It’s supposed to be hard. If it wasn’t hard, everyone would do it.                                 The hard is what makes it great.”

Investing successfully over the long haul is really, really hard, largely because human behavior cannot be predicted with anything like mathematical precision. There is certainly no certainty. There is no technocratic Nirvana, no quant-generated (or otherwise generated) safe harbor. Historical interrelationships between valuation and price, various correlations, and ongoing market cycles are neither consistent nor uniform. Good ideas work for a while. Great ideas persist but bumpily and uncertainly. Our best strategies, approaches and ideas work…but only until they don’t anymore.

Great interpretation of difficult data sets, especially those involving human behavior, involves more sculpting than tracing. Portfolio optimization is a wonderful scientific ideal. But portfolio optimization alone pays insufficient attention to the needs, desires and vagaries of the investor who owns it. As AQR founder Cliff Asness stated succinctly, “The great strategy that you can’t stick with is obviously vastly inferior to the very good strategy you can stick with.” If we can’t cope with our human failings and shortcomings, we can’t and won’t get very far. The analysis that follows is designed to help us do just that to the extent possible – which is to say generally but not very specifically.

 

“You can have it all.”

“[T]he test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function. One should, for example, be able to see that things are hopeless and yet be determined to make them otherwise.” F. Scott Fitzgerald, “The Crack-Up“, Esquire magazine (February 1936).

 

We want it all. It’s part of being human. We want big returns without risk. We want healthy food to taste great. We want the lowest price to provide the best quality. We want to have our cake and to eat it too.

But in our saner moments, we recognize the inherent disconnect in that sort of thinking.

In psychology, the uncomfortable tension that results from having two conflicting thoughts at the same time, from engaging in behavior that conflicts with one’s beliefs, or from experiencing apparently conflicting phenomena is called cognitive dissonance. The underlying theory holds that contradictory cogitative states serve as a driving force that compels the mind to acquire or invent new thoughts or beliefs, or to modify existing beliefs, so as to reduce the amount of dissonance (conflict) between these states. At the simplest of levels, it would be crazy to believe that the world is both round and flat at the same time, so we have to adjust. But when human behavior is involved, when we move from harder to the softer sciences, the demarcation between what is correct and what is incorrect is often murky at best.

The 2016 Global Survey of Individual Investors demonstrates this reality by showing that advisors will increasingly have to manage inconsistent and unreasonable client expectations. On average, worldwide, individuals in the 2016 investor survey say they are expecting annual returns of 9.5 percent above inflation. American clients expect a still crazy 8.5 percent above inflation. Fully 70 percent of investors say they can realistically reach that level of return over the long term. Millennials are even more optimistic, with American investors between the ages of 18 and 34 expecting long-term annual real returns of 8.7 percent. Meanwhile, advisors expect (a still aggressive) 5.9 percent above inflation.

Given low bond yields, high stock valuations and inconsistent equity returns, those expectations are problematic to say the least. U.S. stocks have returned an annualized 10 percent from 1926 through August 2016, according to Morningstar. Inflation during those decades has averaged nearly three percent annually, which very roughly works out to an annualized seven percent real return in the aggregate. Those historical numbers alone show how far from reality client expectations are. Yet despite that historical data, Research Affiliates projects that the U.S. stock market could provide just a 1 percent annualized real return over the next 10 years. GMO’s well-respected projections (see below) don’t provide any comfort either.

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Still, and despite their outsized expectations, more than three-quarters of investors said they would prefer safety in their investments over performance.

Thus we humans not only have unrealistic expectations, we also frequently want inconsistent things and resist the idea that they’re inconsistent. We want high returns without risk and frequently succumb to sales pitches that ridiculously promise both. We crave simplicity but, when in doubt and under pressure, readily assume that the more complex solution must be smarter and better. We rightly recognize that broad and deep diversification makes sense – “don’t put all your eggs in one basket” – but still want to beat the market, even though those two ideas work at cross purposes. Thus we want our portfolio approaches and holdings to be “different” somehow but will still fire our money managers when what is different doesn’t perform well (as every approach and strategy necessarily will a significant proportion of the time).

What I propose is the creation and use of multiple investment strategies and approaches, each designed to have desirable characteristics – not just technically, but for “human consumption” too. From a behavioral perspective, I’m after “portfolio hacks” to make the difficulties and vagaries of investing easier for emotional and excitable humans to abide. Not all of these hacks will be sure-fire winners. None will work in every instance. Some may not work at all. But it’s worth the effort and ongoing discussion (please share any others you may have with me). Again, a perfect portfolio abandoned is worthless.

 

Portfolio Hacks

  1. Needs and Goals

Focusing on investment performance in the abstract, without relation to the holder of any investment’s needs and goals is counterproductive and spectacularly misses the point. When a client’s needs and goals are met – that’s a win for the client and the advisor (Full. Stop.). Advisors should want good investment performance but only as a means to an end. Ultimately, it’s client outcomes that matter most.

Good advisors provide substantial real value and most of that value extends beyond investment performance. The 2016 Global Survey of Individual Investors shows that two out of three investors worldwide say professional advice is worth the fee and believe that investors with advisors are more likely to meet their financial goals. But the survey discloses two other common and telling issues that trouble clients: a) failing to understand their savings and investment goals; and b) investment views that differ from their advisor’s.

These issues can be dealt with both specifically and generally. For example, most active managers market themselves based upon their pre-tax returns but, quite obviously, the specific investor results that matter are after-tax results – the absolute bottom line – thus suggesting the use of active “asset location” strategies. Moreover, and perhaps more fundamentally, if a client’s needs and goals are being met, the advisor’s mission is accomplished and the client is unlikely to deviate from the plan or leave the advisor. By remaining laser-focused on client goals and needs, an advisor can help clients stay the course when markets are scary or performance is less than ideal.

  1. Values

One area where advisors may want to listen more closely to clients is in finding investments that more closely align with clients’ personal values. Respondents in the 2016 Global Survey of Individual Investors, for example, demonstrated a clear demand for ESG (environmental, social, governance) strategies. Thus seven in ten investors want to invest in companies with sound environmental records. Millennials are particularly focused on sustainability.

More broadly, in excess of three-quarters (78 percent) of individuals say that it’s important to invest in companies that are ethically run. Three-quarters say it’s important to invest in companies that reflect their personal values. Almost seven in ten want to invest in companies that have a positive social impact. But even given this strong indication of interest in connecting their investments to their values, only 51 percent of investors say their advisor has spoken to them about strategies to do so.

Clearly expressed client wishes that aren’t being met by the marketplace provide real opportunities for growth. Moreover, and more significantly as it pertains to this study, careful focus on client values as they relate to investing (which can be both difficult and problematic) allows advisors more broadly to meet client needs and to increase retention. An investor convinced s/he is doing the right thing is much less likely to leave an advisor.

  1. Beta

According to the 2016 Global Survey of Individual Investors, when investors who had terminated advisor relationships over the prior year were asked why, the number one answer was investment performance. That’s a recent phenomenon. In an earlier study, for example, performance trailed lack of contact and a failure to provide good ideas. An even earlier study had performance trailing further. And the further back one looks, the less important performance is to clients. Clients are increasingly caring when they aren’t getting market performance and getting market performance is increasingly scarce. That problem begins with poor performance by active managers generally and is compounded by poor investor decision-making.

According to the most recent data from Morningstar, over the 10-year period ending December, 2015, investors cost themselves from 0.74 percent to as much as 1.32 percent per year by mistiming their purchases and sales. The average annualized investor-returns gap for the 10-year periods ended 2012 to 2015 was negative 1.13 percent. And when investments are held in volatile vehicles or in vehicles with high tracking error (remember, the higher the tracking error, the more a portfolio deviates from the benchmark), investor performance was worse and the likelihood that they underperformed was higher. Therefore, an investor with a high volatility portfolio and/or one that deviates a lot from standard benchmarks – for good or for ill – is much more likely to make bad choices. As the great Benjamin Graham sagely warned, “Individuals who cannot master their emotions are ill-suited to profit from the investment process.”

What that means in our current context is that a significant allocation to market beta will help to limit poor decisions. It also suggests that such an allocation will keep clients stickier. Many advisors assiduously avoid beta portfolios because they fear that clients won’t think they are needed.

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But that view is short-sighted because of the longer-term stickiness a beta allocation offers. Smart advisors use multiple investment strategies and investments to “smooth” returns over time and to limit major downturns. But including a beta allocation as one part of an overall portfolio will provide additional diversification and thus protection. Long-time advisors recognize the risks of a portfolio that doesn’t seem “normal” to clients, especially when the clients’ understanding of it is less than optimal. A beta allocation is a readily understandable and low cost option that it as “normal” as anything in the markets. It’s a really good idea even for those committed to some form(s) of active management.

  1. Ballast

Bonds have performed spectacularly for roughly 35 years.

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An investment in U.S. Treasury 10-year notes from 1981 to present would have returned nearly 7 percent per annum. That’s very good on its face, if a good bit less than the historical returns of stocks, but downright remarkable when the relative lack of risk is considered.

However, what has essentially been a 35-year rally in bonds has tended to obscure the primary purpose of bonds in an investment portfolio. It is not to generate high returns (the recent past notwithstanding) but, rather, to dampen total portfolio volatility by balancing out riskier holdings such as equities and real estate. Bonds provide ballast. In particular, high-quality bonds generally help insulate a portfolio when stocks suddenly and unexpectedly plunge.

From August of 2000 through September of 2002, after the tech bubble burst, the S&P 500 fell 41.3 percent. During that same time frame, short-term U.S. Treasuries (as measured by the Bank of America Merrill Lynch 1–3 Year U.S. Treasury Index) returned 18.3 percent while 10-year note return exceeded 12 percent annualized. From October of 2007 through February of 2009, when the housing bubble popped, stocks declined by 50.2 percent but short-term Treasuries gained 8.7 percent and 10-year note return exceeded 13 percent annualized. Over time, investors who held U.S. Treasuries along with their riskier assets experienced a substantially smaller drawdown at the total portfolio level during severe market downturns than did equity-only investors during those times.

Over the period from January of 1975 to date, the worst three-year period for stock performance was from April of 2000 through March of 2003, when the S&P 500 lost 16.1 percent annualized. Adding a 40 percent allocation to 10-year U.S. Treasury notes to an all-stock (S&P 500) portfolio over this period would have cut the annualized loss to less than 6 percent, a dramatic reduction in volatility and much easier to withstand, practically and emotionally.

As Andrew Miller has explained and as outlined above, bonds have provided significant diversification benefits during really bad periods for stocks. However, most of that excess performance has been driven by the income return component of bonds, and not by price appreciation, which makes their diversification benefits in a very low interest rate environment problematic at best.

Indeed, the prospects for bonds from today forward aren’t very good generally. When one subtracts a reasonable inflation forecast from current (really low) yields, the real expected return on short-to-intermediate U.S. Treasury notes is effectively zero. That is, an investment in a U.S. Treasury portfolio can be expected to just keep even with inflation. TIPS (Treasury inflation-protected securities) do just a bit better. Investing at a zero real return is better than earning no nominal yield at all, as investors in money market funds and other cash instruments did until recently. But that is about the best one can say about it.

Portfolio ballast is an important characteristic to ameliorate the loss aversion of clients. Given the prospects for bonds going forward from today, you might consider other forms of potential ballast too, but ballast in some form is imperative. A portfolio with insufficient ballast is, quite simply, a recipe for disaster.

  1. Be Different

The famous Volkswagen advertising campaigns, originally introduced in 1959, changed the way automobiles were marketed to consumers. Frequently applauded for their visual and verbal wit as well as their dramatic, uncluttered layouts, these Volkswagen ads also stand as a triumph of segmentation marketing. Consider the challenge. VWs were small, slow, Spartan, ugly and foreign. Adolph Hitler had proclaimed it the “people’s car.”

VW couldn’t win by playing by advertising’s normal rules. Cars at that time (much as now) made important statements about their owners and so-called muscle cars dominated the landscape. But Volkswagen didn’t need to become the dominant brand to sell a lot more cars. So the new ads differentiated Volkswagen from the then-reigning brands by appealing to a different sort of consumer.

Bold headlines proclaimed VWs as ugly and small and that their design had barely changed over the years. The Volkswagen buyer, in the eyes of marketers, shunned convention and ostentation, taking pride in practicality and value instead. One famous ad invited buyers to “Live below your means,” presenting a car for people who could afford to spend more but chose restraint. This wildly successful, long-running advertising pitch was selected by Advertising Age magazine as the greatest advertising campaign of the twentieth century.

But whether the appeal is segmented or broad, the idea is to differentiate the products and services offered from what is available elsewhere or more typically. Marketing has long purported to offer the “new and improved,” or at least the “different.”

This Steve Jobs classic – featuring Albert Einstein, Bob Dylan, Martin Luther King, Jr., Richard Branson, John Lennon (with Yoko Ono), Buckminster Fuller, Thomas Edison, Muhammad Ali, Ted Turner, Maria Callas, Mohandas Gandhi, Amelia Earhart, Alfred Hitchcock, Martha Graham, Jim Henson (with Kermit the Frog), Frank Lloyd Wright and Pablo Picasso – was instrumental in Apple’s resurgence once Jobs famously returned to the company he had founded and left.

For investors, it is axiomatic that the only way to beat a benchmark is by being different from the benchmark, as discussed here. Most clients also want something they perceive to be different, even though “different” may mean different things to different people. Thus investors typically overpay for perceived innovation while they discount stability. Yet in the present context, figuring out what investments are truly “alternative” – the most obvious sort of difference available – by delivering both healthy returns and low correlation during bad markets, is difficult business indeed. But being different in this sense or in a broader one remains highly desirable.

Advisors want products and services that readily differentiate themselves from their competition, often because they are insecure about the services they provide. Clients respond positively to them too. Accordingly, portfolios that can be shown and perceived to be different (however defined) will have inherent advantages from a “stickiness” perspective.

  1. Goldilocks Simplicity

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My grandsons love their Legos. As a kid, I loved my Legos and I still love to join the kids on the floor to build an endless variety of elaborate and complex structures. Legos don’t invite simple, clean lines. Sure, once in a while some insane person (but not a kid) makes a Lego Fenway Park or something like that, but crazy and complex is the norm (not that a Lego Fenway Park isn’t a different sort of crazy). That’s why they’re so much fun. And maybe it’s putting too fine a point on it but, as Einstein didn’t really say but might have, “Logic will get you from A to B. Imagination will take you everywhere” (what he really said was, “I am enough of the artist to draw freely upon my imagination. Imagination is more important than knowledge. Knowledge is limited. Imagination encircles the world”).

We love complexity. It’s why it is so hard for us to employ the law of parsimony established  in the 14th Century by William of Ockham (Ockham’s Razor*): “Entia non sunt multiplicanda praeter necessitate,” which boils down to the more familiar “All other things being equal, the simpler solution is the best.” We should of course go with the simpler explanation or approach unless and until something more complex offers greater explanatory power. But we don’t. We want to include our pet political ideas, convoluted conspiracy theories or favored market narratives. We are ideological through-and-through, and the more complex the better.

As Edsger W. Dijkstra explains, “Simplicity is a great virtue but it requires hard work to achieve it and education to appreciate it. And to make matters worse: complexity sells better.” One key goal of simplicity is to reduce decision fatigue, the psychological phenomenon in which the more choices we make in any given day, the worse we are at making them.

We think that complexity offers security. In the investment management world, complexity is often deemed necessary for both protective and marketing purposes. Complexity says, We’re doing all we can (and thus, It wasn’t my fault).  Or, What we were really after was….  Or, I’m an expert. We’re afraid that if the answer were truly simple, clients wouldn’t need or want us. No matter how simple the proper approach, clients would always need us to protect them from themselves, of course, but we’d rather see ourselves as market gurus than as psychologists. After the 2008-2009 financial crisis, there was a lot of press about the supposed “lost decade” in the markets. But with the markets having subsequently roared back, that talk has disappeared (even more so because the most commonly proposed antidotes, typically employing strategies described as complex and proprietary, such as hedge fund investments, have performed so dreadfully in comparison). As with Ockham’s Razor, simplicity should be our default choice.

For many years, the famous card wizard Ralph Hull bewildered even professional magicians with a trick he called “The Tuned Deck.” He claimed that the deck was magically tuned so that he could “hear” which card had been selected by a volunteer asked to “pick a card, any card.” No matter how many times Hull did the trick, even for expert audiences, nobody figured it out. As it turns out, the problem was that everyone was expecting and looking for something too complex.

Hull’s audience would expect a singular and complex trick. Instead, Hull would start by doing a relatively simple and common card presentation trick (call it a Type A trick, perhaps a false cut). His professional audience would recognize that possibility and seek to test it and thus asked Hull to do it again. He would, but this time he’d do a Type B – but still common – card presentation trick (perhaps a palm), making it obvious he wasn’t using a false cut. The experts would thus recognize it wasn’t Type A and would consider Type B. They would test that hypothesis on the next viewing but, this time, Hull would use a Type C trick while making it clear he wasn’t palming. And so it would go for as many kinds of tricks as Hull knew before he would circle back around again, always at least one step ahead of the posse, because the experts thought they had already ruled out the earlier types of tricks.

Hull’s expert audience was fooled into thinking they were seeing a singular but complex (and heretofore unknown) trick. Notice that the trick was called “The Tuned Deck.” Instead, they got a series of simple tricks but in a relatively random order. They were expecting uniformity and complexity. They wanted complexity. They wanted new and different. What they got was repeated but adaptive simplicity.

Of course, the right answer really was simple. But it wasn’t simplistic. The trick was set up beautifully and the multiple but simple (to the initiated) tricks were rolled out randomly so as to confuse the experts (a routine audience would likely have been fooled by constant repetitions of Type A tricks). Per what Einstein (this time, sort of) said, the trick was as simple as It could be but no simpler.

That’s significant because, in a fascinating paradox, we also love the simplistic as well as the complex. We want sure-thing formulae. We want black-and-white. We don’t want the hassle of fine distinctions and careful analysis. We want big returns without risk. We want to think that we can tune the markets.

Markets are binary. They can only move up or down. That makes it seem as though it ought to be simple. We even talk that way. The market rallied today due to positive earnings releases. But markets are actually moved by the interrelationships of an infinite number of variables. We tend to want to focus on one big thing – e.g., the Fed, trading sentiment, or the political landscape – and to concoct if/then scenarios in response. We want a tuned market.

Unfortunately, markets are anything but tuned. They exhibit the kinds of behaviors that might be predicted by chaos theory — dynamic, non-linear, sensitive to initial conditions. Even a tiny difference in initial conditions or an infinitesimal change to current, seemingly stable conditions, can result in monumentally different results. Thus markets respond like systems ordered along the lines of self-organizing criticality – highly complex, unstable, fragile and largely unpredictable – at the border of stability and chaos. A single grain of sand dropped on a big sandpile can (but won’t predictably or necessarily) cause a catastrophic avalanche.

Accordingly, an overly simplistic analysis – guided perhaps by a singular variable – is a disaster waiting to happen. Complex solutions don’t often offer more (and usually less), but cost a lot more. The best we can hope for is to create and test an appropriately probabilistic outlook, recognize its limitations, and act accordingly.

Unfortunately, doing so is far easier said than done. Our inherent biases and perceptual difficulties make our success rates all too low. Our lack of sufficient knowledge (we can’t begin to know all the relevant information) can doom us from the start. And (paraphrasing what Mark Twain is alleged to have said but didn’t) what we think we know that just ain’t so makes matters far worse.

Our problems are compounded at the personal level. Intuitively, we tend to think that the more choices we have the better off we are. However, the sad truth is that while choice is indeed good, too many choices can lead to decision paralysis due to information overload. In one famous and remarkable study (which has since come under some attack, mostly to the effect that for people who know a domain well – experts – more choice seems better than less, and if options are organized into categories, the too-much-choice effect is mitigated), shoppers at an upscale food market saw a display table with 24 varieties of gourmet jam. Those who sampled the spreads received a coupon for $1 off any jam. On another day, shoppers saw a similar table, except that only six varieties of the jam were on display. The large display attracted more interest than the small one. But when the time came to purchase, people who saw the large display were just one-tenth as likely to buy as people who saw the small display.

Further study has established that choice paralysis can be a real problem. It might explain why Costco has a wide variety of products but few choices among competitive products (4,000 products at a typical Costco versus 80,000 at a typical Target – also explained by efficiencies). For example, participation in 401(k) plans among employees decreases as the number of investable funds offered increases. We are readily paralyzed by too many choices, especially when we don’t understand the choices very well. On the other hand, we also suffer from “single option aversion.” We want some choice.

Choice is generally good for us, but its relationship to satisfaction appears to be more complicated than we typically assume. There is diminishing marginal utility in having alternatives; each new option subtracts a little from the feeling of well-being, until the marginal benefits of added choice level off. What’s more, psychologists and business academics alike have largely ignored another outcome of choice: More of it requires increased time and effort and can lead to anxiety, regret, excessively high expectations, and self-blame if the choices don’t work out. When the number of available options is small, these costs are negligible, but the costs grow with the number of options. Eventually, each new option makes us feel worse off than we did before.

As always, investing is really hard. We should resist complexity for its own sake. Proper default settings and a data-driven approach are vital. The markets aren’t tuned. They are a boisterous cacophony of competing forces and interests. If we are to succeed, we need to keep things as simple as possible, but no simpler. As the great Benjamin Graham actually said (page 524, emphasis in original), “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.”

Overly complicated systems, from financial derivatives to tax systems, are difficult to comprehend, easy to exploit, and possibly dangerous. Simple rules, in contrast, can make us smarter and create a safer world.

But, as NASA’s Gavin Schmidt explains, the world we live in is really complex. Similarly, the interworkings and interrelationships of the markets are especially complex. It is natural for us to ask simple questions about complex things, and many of our greatest insights have come from the profound examination of such simple questions. “However, the answers that have come back are never as simple. The answer to big questions in the real world is rarely ‘42’.”

Still, we keep acting as though simplistic answers always exist. It’s easy to find investment managers eager to explain how they’ve found “it,” how they’ve calculated the complexities and vagaries of the markets and come up with “42” (or at least that the right answer is between 40 and 44). We cling to the idea that the investment markets can be solved. Only charlatans claim to have done so, and maintain the charade by hiding behind unnecessary complexity.

Simple processes are more robust to uncertainty than complicated ones, which is an important factor in delivering consistent, repeatable results. What that means is that high complexity is a prelude to vulnerability. The level of fragility of a given system is the product of the complexity of that system and of the uncertainty of the environment in which it operates. In other words, in an environment with a given level of uncertainty or “turbulence” (sea, atmosphere, stock market, etc.) the more complex system will be more fragile and thus more vulnerable. In a turbulent economy, which is to say all economies, highly complex portfolios and financial products are more exposed and more volatile. Complexity can manifest itself in a variety of ways, such as excess trading, complex strategies and complex instruments (such as many derivatives). We are thus almost literally (modifying Andrew Zolli‘s telling phrase slightly) tap dancing in a minefield.

We don’t quite know when our next step is going to result in a monumental explosion. Our goal, therefore, must be first to survive and then to thrive in that sort of disruptive and dangerous environment. We need to be resilient. As the complexity of a system grows, both the sources and severity of possible disruptions increases. Resilient systems are not perfect or even perfectly efficient. Indeed, regular modest failures are essential to many forms of resilience (adjusting and adapting are crucial to success). In this context, then, efficiency can be a net negative and redundancy a major positive. Hedges matter. Learning from mistakes is vital.

Fortunately, diversification is already a well-established virtue in our world, even though its value is often honored only in the breach. In this context, resilient diversity means fluidity of structures, strategies and approaches but it does not extend to goals, values and core methodologies. An effective risk mitigation and management approach is thus much like playing jazz. We must be able to improvise often and well but within an established and consistent structure. The goal, then, should be a sort of “Goldilocks” simplicity – a simplicity that isn’t simplistic, that employs complex solutions when they are helpful and can be shown to work – that’s “just right.” As with limits in calculus, that “just right” balance of simplicity and complexity isn’t wholly obtainable. But the best advisors will keep striving for it just the same.

  1. Collaboration

According to the 2016 Global Survey of Individual Investors, individuals believe professional help is necessary, but they are looking for a collaborative relationship that goes beyond advice to help them become better informed and more confident investors. They want their advisors to take them beyond traditional portfolio models with strategies that help them manage risk and give them better diversification.

This sort of constructive collaboration will involve lots of communication, ongoing education, a regular review and restatement of needs and goals, and careful management. A client committed to a vision and process created collaboratively, with pre-agreed decisions and adjustments over time where appropriate, offer the best opportunity for the client to reach his or her goals and objectives. That sort of relationship also offers the best opportunity for client loyalty and the client’s ongoing advocacy for you with prospective clients and referrals. A client advocate isn’t just sticky. A client advocate is essentially a committed partner. An advisor can’t have too many of them.

  1. Diversification of Strategies

According to the Uniform Prudent Investor Act, “Because broad diversification is fundamental to the concept of risk management, it is incorporated into the definition of prudent investing.” The theory behind diversification is simple: Don’t put all of your eggs in one basket. A single holding has huge potential for gains if the right instrument is selected, but even huger risks (because investing “home runs” are so hard to come by). In general, the greater a portfolio’s diversification, the lower its risk. Lower risk is a good thing, but only if the portfolio’s potential return is healthy enough to meet the client’s needs. Fortunately, a well-diversified portfolio captures most of the potential upside available with much lower volatility.

A diverse portfolio – one that reaches across all market sectors – ensures that at least some of a portfolio’s investments will be in the market’s stronger sectors at any given time – regardless of what’s hot and what’s not and irrespective of the economic climate. At the same time, a diverse portfolio will never be fully invested in the year’s losers. For example, according to Morningstar Direct, about 25 percent of U.S. listed stocks lost at least 75 percent of their value in 2008 but only four of over 6,600 open-ended mutual funds lost more than 75 percent of their value that year. Thus a diversified approach provides much smoother returns over time (even if not as smooth as desired!). On the other hand, a well-diversified portfolio will always include some poor performers, and that’s hard for us to abide.

Diversification works at the portfolio strategy level too. A diversity of sound investment approaches provides the same sorts of benefits as a diversity of individual securities or asset classes. Every security, asset class and investment strategy will have periods and almost surely extended periods of underperformance. That hurts. We like the idea of diversification much more than the reality because diversification is hard. If a portfolio doesn’t have assets that are doing poorly, it isn’t well diversified. Diversification is painful. But it’s healthy and it’s easier to abide if other securities, asset classes and investment strategies are doing better.

Losses happen, but diversification works over the long-term to mitigate that risk. It should deliver a smoother ride and decent returns over the years ahead. But diversification can’t and won’t swing into action on cue. Correlations can and do “go to 1” in a hurry during crisis periods.

Bill Bernstein provides a nice summary on all of this. “First and foremost, don’t even think about trying to extrapolate macroeconomic, demographic, and political events into an investment strategy. Say to yourself every day, ‘I cannot predict the future, therefore I diversify.’”

  1. Volatility Management

Most investors today have suffered through two monumental market meltdowns. The “tech wreck” of the turn of the century and the more recent financial crisis of 2008 pummeled investors with major portfolio losses. From March 11. 2000 to October 9, 2002, the tech-heavy Nasdaq Composite Index lost 78 percent of its value. Similarly, the S&P 500 Index fell 57 percent from its high on October of 2007 to its low in March of 2009. Those losses were obviously dreadful and difficult to bear, but they felt even worse because of our inherent loss aversion, which Nobel laureate Daniel Kahneman describes as the “real enemy” of wealth accumulation. In fact, we react to losses at least twice as strongly as we react to similar gains.

As Harvard’s Cass Sunstein purports, “…people dislike losses more than they like equivalent gains. Golfers really don’t want to lose a stroke to par. Teachers don’t want to lose money they now have. Even a small tax counts as a loss, and it affects people’s behavior.” As Andre Agassi explained, “A win doesn’t feel as good as a loss feels bad, and the good feeling doesn’t last as long as the bad. Not even close.” Or David Letterman: “Maybe life is the hard way, I don’t know. When the show was great, it was never as enjoyable as the misery of the show being bad. Is that human nature?” Accordingly, the threat of financial loss is valued as greater than the potential of financial gain. Thus we tend to respond too actively to downward fluctuations in our portfolios.

Many millennials came of age during the most terrifying financial crisis since the Great Depression, which shaped and still impacts their investing decisions today. Others got double-dipped – suffering through both the dotcom bubble circa 2000 and the 2008 financial crisis. It’s not altogether surprising then that nearly 60 percent of millennials in a recent survey say they distrust financial markets while just one millennial in three is invested in stocks, even though stocks have performed spectacularly since 2009 and are the most rewarding investment over time by far. Perhaps worse, only 43 percent of Americans own stocks, including 51 percent of people who are 36 to 51 years old (Generation X), and 48 percent of Baby Boomers, who are aged 52 to 70.

For investors who do own stocks, negative news causes performance-chasing. In other words, we abandon those holdings that aren’t doing well at a particular time to buy that which has been “hot.” The research is unequivocal. Performance-chasing is not restricted to specific groups or segments of investors. Both retail and institutional investors do it. The results are monumentally disconcerting. One ten-year Vanguard study showed that performance-chasing cost roughly three percent per year. Another study (of ETFs) got similar results. Morningstar demonstrates a lesser but still very significant impact.

The sad fact is that serious drawdowns are simply par for the course in the financial markets. Investing requires that we be prepared for them. That risk is the price we pay for the excess returns provided by stocks relative to other investment choices. Even during a terrific bull market, serious drawdowns are part of the package. Note the extent of the drawdowns during the post-financial crisis period during which the S&P 500 has seen tremendous gains (shown below).

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A broad index of U.S. stocks increased more than 2,000-fold between 1928 and 2015, but lost at least 20 percent of its value 20 times during that period. If you can’t stomach significant volatility as a price paid for much higher returns, you shouldn’t be in the market. Fully 64 percent of all years experience double-digit declines at some point but 57 percent of them finish the year in positive territory.

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Even so, 27 percent of years end up negative for stocks, and that’s really hard to handle.

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But we abide difficult markets because volatility is the price paid pay for much higher historical returns. Josh Brown, paraphrasing Emanuel Derman, explains things nicely, as usual: “Investors need to focus more on volatility acceptance than risk avoidance if they intend to ever make any money.” But what we usually do is something – anything! – to try to avoid further losses.

However, numerous studies have shown that those who trade the most earn the lowest returns. Remember Pascal’s wisdom: “All man’s miseries derive from not being able to sit in a quiet room alone.” As Brad Barber and Terry Odean showed via landmark 2000 research, “trading is hazardous to your wealth.” Nobel laureate Eugene Fama Jr. has a related saying, “your money is like soap, the more you touch it, the less you have.” Trading costs, taxes, bid-ask spreads all eat away at clients’ capital even before the consequences of buying high and selling low are felt. Yet our instinctive reaction to every market correction or downturn is to change something and almost always to sell something.

Thus most people need pressure relief when stress is high. It’s human nature.

One helpful possibility is essentially an If you can’t beat ‘em, join ‘em approach. Buy and hold advocates such as William Bernstein, Rick Ferri and even John Bogle himself have talked about adjusting asset allocation in the face of changing market valuations. In other words, you sell off a few percentage points of a particular asset class when its future return expectations are low.

This strategy, involving very small and infrequent policy changes opposite large market moves, more often than not improves overall portfolio performance. It’s a step-up from normal rebalancing – not just pruning the over-performing asset to its target allocation, but cutting it back still more in a maneuver Bernstein calls “overbalancing.”

“Simply put, although the individual investor will likely come to grief manipulating the selection of individual securities, the judicious adjustment of policy allocations according to expected returns – increasing an allocation slightly when its expected return is very high, decreasing an allocation slightly when it is very low – will on average slightly enhance long-term results” (even though overbalancing can fail). Better yet, it should keep clients more involved and more loyal – their advisor is acting on their behalf. Clients hate to be told to be patient (“You’re a long-term investor”) and do nothing (“Stay the course”), that things will get better (“The market will come back”). They want action.

Another strategy of this sort is a more direct “pressure relief valve,” a tactical overlay of the kind described here. No matter how skeptical you are about tactical strategies (and you should be very skeptical), a hack designed to allow some pressure relief selling under carefully controlled and pre-arranged conditions while limiting trading carefully and systematically will provide some real relief to nervous clients. And a prior commitment by both the client and the advisor with respect to what will and won’t be done will provide an accountability mechanism that should increase the ability of the client to hang on when the going gets tough.

  1. Incentives

Economics has few axioms, but one is that incentives work. We tend to do what we are incentivized to do. Thus advisors should take every opportunity to provide incentives for clients to remain loyal to them. Doing so should begin with quality work, communication and service, of course. But other amenities can help a lot too. I think education is one of those. Actively educating clients about what financial planning and investing are, what they can and cannot do, their limitations and their struggles is the right thing to do. That should be obvious. But education will increase client loyalty too, partly because clients will better understand the inherent limitations an advisor faces.

More specifically, our money management practices should also incentivize good client behavior using what Cass Sunstein and Richard Thaler call “nudges” – small incentives offered to induce good decisions. We could thus incentivize looking at portfolios less and provide loyalty rewards, for example, with fee reductions. The benefit of having patient capital – looking overwhelmingly at the longer-term – is one of the few truisms in investing. It should be rewarded and incentivized.

However, these incentives must be carefully constructed to make sure that they don’t backfire or produce undesirable unintended consequences. As the Harvard Business Review has explained, for example, when a group of day-care centers “began fining parents for late pickups, the number of tardy parents doubled. The fine seems to have reduced their ethical obligation to avoid inconveniencing the teachers and led them to think of lateness as simply a commodity they could purchase.” There is a great deal of experimental research demonstrating that rewarding self-interest with economic incentives is ineffective when those incentives undermine what Adam Smith called “the moral sentiments.”

Smart advisors will offer their clients healthy incentives that work. When they do, both clients and advisors benefit.

 

Kintsugi Portfolios

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Kintsugi (“golden joinery” in Japanese) is a Japanese technique for repairing broken pottery and other ceramics with a special lacquer mixed with gold, silver, or platinum made to look like pure precious metal (see above). The philosophy behind the technique is to recognize breakage and repair as crucial aspects of the history of the object and therefore visibly to incorporate the repair into the piece instead of disguising it. The process often results in something more beautiful than the original. It is related to the Japanese philosophy of wabi-sabi, which encourages one to embrace the flawed and imperfect.

Investment portfolios that do not take our human foibles and shortcomings into account during their construction are broken even before they are implemented. By focusing a little more on human reality and a little less on technical perfection, we have an opportunity to improve our portfolios and even turn them into something more beautiful than the cold originals. If we are most meaningfully going to help our clients and if our clients are going to be able to stick with us and our portfolios, we must visibly incorporate our humanity into portfolio construction instead of disguising it or pretending it doesn’t exist. If we embrace the inevitability of our flaws and imperfections by creating kintsugi portfolios, portfolios that provide approaches, strategies, mechanisms and hacks to help us to withstand inevitable periods of turbulence and difficulty by trying to account for and patch up our metastasized poor judgment and behavior, we can give our clients a far better chance of real rather than just theoretical success – success that is substantive, obtainable and built to last.

 

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* Or its modern corollary, Hanlon’s Razor: “Never ascribe to malice that which can be explained by incompetence” (which really comes from Goethe: “…misunderstandings and neglect create more confusion in this world than trickery and malice. At any rate, the last two are certainly much less frequent”).