For sheer intensity of jargon, our industry may be rivaled only by the legal profession. As financial advisors, we seek to add alpha and mitigate risk by placing clients optimally on the efficient frontier. We worry about the inverse relationship of the yield curve. And we measure our results by basis points.
Sometimes the string of $10 words woven through quarterly investment commentaries seems designed to impress, rather than instruct as if the goal were to keep the curtain drawn so that the Wizard of Oz, all great and powerful, can operate unchallenged.
But the truth is that while we push for greater transparency in both investment products and advisory fees, we should extend transparency to communication with clients. I believe its my responsibility as a fiduciary to ensure that my clients understand all the products and strategies in their investment plan.
Im sometimes surprised by where questions surface. For example, bonds a basic portfolio building block often confuse clients. As a result, recent warnings about the impact of rising interest rates on the bond market have exacerbated the standard confusion and worry.
I sometimes describe bonds as a security blanket, designed to temper stocks inherent volatility and help create a reliable income stream. It can also be helpful to compare bonds to a financial product that clients are more familiar with: a mortgage.
I frame it this way: With a mortgage, the bank gives you a loan that you pay back over 30 years with interest; at the end of the mortgages term, you own the house. I tell clients that a bond is essentially the opposite: You give money to a government organization or company and it pays you interest over the period of your loan for the privilege of using your funds. At the end of the term, you get your initial investment back. And, in a period of rising rates, short-term bonds like shorter-term mortgages reduce interest rate risk.
For clients who fear a fixed-income bear market, I stress the differences between bond and equity bear markets. (I got some help on this a few years ago from a Vanguard newsletter.)
First, I clarify the definitions: An equity bear market is defined by a 20% decline in prices, while a bond bear market is any period of negative returns. Most clients are surprised to learn that the broad U.S. bond market has never lost anywhere near 20%; the worst calendar year ever for the broad bond market was 1994, when, due to a sudden spike in interest rates, it fell 2.9%. (Last year came close the Barclays U.S. Aggregate bond index registered a total return of negative 2.1%.)
Simply understanding the differential in volatility can help clients feel comfortable maintaining their allocation to fixed income in a period of interest rate uncertainty.
When explaining my investment approach using DFA funds, I find I have to clarify some misconceptions about active and passive management. If I asked a prospect with little financial background whether she would prefer active or passive investment management, shed likely choose active. Why? The word active implies that the investment manager is positively engaged with the portfolio, working for you, while passive suggests a manager who is disinterested and perhaps even lazy.
Even when I explain the difference between active and passive approaches, the majority of folks initially still have a more favorable view of active management, where the managers goal is to beat the market. After all, when do we settle for average when we can excel?
Of course, the truth is that the investment world is different: Time and time again, active managers fail to beat their benchmarks, making passive funds the wiser choice. I go to the data here, reviewing historical active versus passive performance.
With some clients, I even discuss Nobel Prize-winning economist Eugene Famas efficient market hypothesis, which contends that stocks will always trade at a fair price that reflects all available market information. Clients come to understand that if no stock can be over- or undervalued at a given point in time, then it makes sense to own the market instead of trying to beat it.
As a native Californian, Im particularly fond of freeway metaphors. (I like to ask clients: How can we set out on a journey without a financial GPS?) Car imagery also has helped me clarify for clients the difference between tactical allocations and market timing.
My clients invest for the long term, committing to an asset allocation appropriate to their risk tolerance, time frame and goals and then sticking with it. As passive investors, we believe in an efficient market and think active managers quest to beat the market is just as futile as day traders market timing.
So, for some clients, the tactical adjustments I made in the midst of the financial crisis either to take advantage of an emerging opportunity or to increase protection smacked of market timing. Why, they would ask, are we not staying the course? That question gave me pause.
I try to explain that the difference between tactical allocations and market timing is one of degree. A tactical shift is an adjustment, perhaps focusing on small-cap emerging markets within the emerging markets exposure. I look at market timing as a major move selling out of emerging markets or loading up on another asset class you feel is poised to perform well.
Heres how I explain it: Lets say we pack the car for a weekend camping trip. When the weather changes suddenly and we need rain gear, we stop at a sporting goods store and stock up. Or perhaps theres an accident ahead and we get off the freeway to avoid the traffic. Or we might remember a shortcut that gets us to the campsite sooner than wed planned.
Either way, we eventually arrive at the campsite in the same vehicle, although not exactly on our original schedule. Thats tactical investing.
Now for market timing: As were driving, we decide the cars not big enough or fast enough, or fuel efficient for our family. So we pull over at an auto lot to trade in our car for what we think is a better vehicle to get us to our destination.
Or maybe halfway there, one family member gets an SOS call from the office so at the next town, she rents a car to drive back home, leaving fewer people to camp. We might even decide en route that we never enjoy actually camping and head instead into the city for an arts weekend.
Clear communication doesnt have to be a jargon fighter. Ive used metaphors to advise clients on their financial relationships.
I got some great ideas from James Grubmans book, Strangers in Paradise: How Families Adapt to Wealth Across Generations. Grubman talks about wealth as a migration; a newly wealthy familys stress, he argues, can often be traced to the fact that wealthy parents who grew up middle class or poor immigrated to the Land of the Wealth. These parents must now teach their children who are affluence natives about money. Ive used this metaphor to give several parents I work with a better appreciation of how their children view the world.
Or I may use wordplay to get a concept across. I often warn clients about hopium, which deludes investors into believing that if they simply keep hoping, someone else will swoop in and solve their money problems. Sometimes thats enough to motivate clients to saving something now, rather than just waiting for that next promotion to begin saving.
Our clients rely on us for information and insight, and I enjoy presenting the details of our investment strategies. However, sometimes it seems its the simple picture thats most illuminating and really sticks with clients.
Kimberly Foss, CFP, CPWA, is a Financial Planning columnist and the founder and president of Empyrion Wealth Management in Roseville, Calif.
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