For decades, advisors have applied modern portfolio theory and other strategies intended for pension funds to individual investors' portfolios. A zillion pie charts and style boxes later, today's retail investors expect to be invested like multibillion-dollar institutions because that is where they've been told the best investing happens.
But here, if nowhere else, size does not matter. Trying to cater to clients in the manner of institutional investors is like selling someone a watch that looks like a fancy, famous brand when it's really a knockoff.
Wielding the allure of investing like the big boys and girls, Wall Street has pumped out an unending stream of funds and portfolios that claim to be "institutional." But the offerings can be lost in translation between what the institutions get and the version that trickles down to mom-and-pop types.
Financial advisors who primarily service individual investors have a big decision to make. Either they can base their investing philosophy and process on what large institutional investors do, or they can focus on the priorities of clients' families.
Here are some of the reasons advisors should reconsider whether the institutional approach is truly in the best interests of their clients:
Asset allocation is a wonderful concept. However, it has gone from being a useful part of an investment plan to a tool for enhancing savings and sales at large financial companies. As long as advisors continue to pile money into cookie-cutter asset allocation funds and their cousins, target-date funds, this trend toward oversimplification probably will continue.
In particular, allocating money to stocks and bonds based on age, stage of life or the target year for retirement is portrayed as institution-like.
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But there is one key difference: Pensions and endowments are perpetual. That is, their investment time horizon is "forever." With the exception of only the most well-heeled families, retail investors are more focused on getting to and through retirement themselves, one generation at a time. Their type of asset and liability matching is completely different from that of institutions, and it demands a different type of customization.
That makes it particularly surprising anytime a financial planner creates a fine, customized financial plan, then just punts on the investment part of the plan. That same financial planner uses wealth-projection software that is still based on the premise that bonds will yield what they did when rates were high and falling.
Mathematically, bonds cannot reproduce their long-term returns. And when it comes to equity returns, that market is highly cyclical long-term. That means waiting through booms and busts will require more patience than many families are willing to exercise. By contrast, institutions can be true long-term investors because their liabilities are staggered out well into the future.
For retail investors, a bear market in stocks, bonds or both at the wrong phase of their lives can be ruinous.
It doesn't have to be that way. But a 12-year bull market in stocks and a 40-year bull market in bonds has produced another bull market: one of investor and advisor complacency.
Some of the largest and loudest voices in the advisory industry have taught investors to accept massive volatility and not pay any attention to it. But bear markets and the new era of market volatility (thanks to high-frequency trading and other factors) do matter. It is the responsibility of the advisor to prepare for any market condition, not merely those that fit nicely into a slideshow.
The planning part of the client relationship is often easier to navigate than the investment part. Planning for real-life events, converting from accumulation to distribution, retiring in the manner they desire and leaving a legacy are all concepts that grab clients' attention.
Once the plan is in place to achieve those goals, however, words such as "investment objectives," "time horizon," "market cycle" and "yield curve" are a recipe for heavy eyes and blank stares. Clients trust their advisor to handle that "stock and bond nonsense." So it is up to the advisor to deliver on clients' real-world priorities, instead of slapping a pension-fund-like plan on them and calling it a day.
Institutions can lose 20% to 25% of their portfolio value in a year, then fall back on their decades long time frame to fund their obligations. Families don't have that luxury.
That's because institutions have long-term obligations to pensioners to fund generational projects.
For families, bonds need to be relegated to a garnish on the portfolio, at best. Advisors must learn hedging and tactical strategies as options to complement equity portfolios.
Retail investors are often familiar with the risks of the stock market, but they see those risks in terms of temporary volatility. Sometimes negative or low stock market returns are not so temporary, especially after this long bull cycle, for example. Interest rate and inflation risk are also back in style, so to speak, after a decades long slumber.
New risks are associated with the anticipated aftermath of the Federal Reserve's habitual money pumping. Americans have never had economic conditions comparable to today's. That, in turn, has led to all types of intangible risks that advisors must ascertain and accommodate. The fear of missing out, or FOMO, has spawned among investors who have no business taking on the type of risk they are assuming.
Your clients don't have tens of millions or billions of dollars to spread around. They have a nest egg that they cannot go back and save up again. It is the advisor's job to research, identify and implement risk-management techniques to avoid big losses.
Institutional investors are entities, not individuals. Your clients have individual dreams and goals. Treat them that way and you will be rewarded, especially when you are able to help them confront both traditional and new types of investing risk.