Advisor’s generating Alpha for their clients.

Tis been the season of voting, and South Africa has walked into its 6th election since 1994. A large amount of discussion is being put together on the analysis and implications of election results and the effects on the economy and financial markets. The political philosophising has caused us to take stock and reflect on how one invests, specifically to consider probabilities and outcomes of decisions taken.

Let us start with a quick hypothetical example on probability. Let us assume that we are trying to pick a stock which is driven by sentiment, and hence will have its performance dependant on the outcome of the election. We believe we know the following to be true:

· Current incumbents win election with a certainty level of 70%.

· Given the above prediction occurring, the market will rise with a certainty level of 70%.

· Given the stock market rising, a specific stock will rise with a certainty level of 70%.

This would seem like a sure bet given that we are 70% certain at each stage. However, for the mathematically inclined, we have been presented with conditional probabilities and this reduces the power of certainty when many events are dependent on other events occurring. What was an initially high confidence view for each independent outcome turns into a view that has about a roughly 30% chance of all outcomes occurring as expected.

Further to this, we live in a world where even a high probability of occurrence doesn’t need to result in the expected outcome being the outcome that occurs. The case in point was the initial low probability of Donald Trump winning the US presidential election, and the associated outcome that if he did get elected as President, the stock market would see selling pressure. The exact opposite occurred in both instances, so even if you get the call right, you may not get the outcome you expect to see. So, a prudent investor would give more weight to things that they can control with certainty versus outcomes that cannot simply be known in advance with certainty.

Using this opportunity as a segue to move to financial planning, let us consider what variables need to be considered in a generalised retirement plan, and what variables may be in our control:

1.   Chosen retirement date

2.   Monthly savings and desired annual savings increase chosen

3.   Desired retirement income

4.   Debt repayment decisions

5.   Investment returns

What is evident from the above is that 80% of the variables - four out of the five listed - are firmly in an investor’s control, yet these are dwarfed in comparison to the attention that is given to investment outcomes of one’s portfolio. The standard response as to why investment returns receive the lions share of attention is because they have a disproportionally large effect on a client’s retirement position, which is not necessarily true.

By way of example – assume a client has 35 years to retirement, a 1% change in their investment growth rate (e.g. from 10% annually to 11%) has roughly twice the affect of a given 1% change in their annual contributions/savings increases (e.g. from a 5% annual increase to 6%). Now imagine that the investor’s annual growth rate decreases by 1% point over the time to retirement due to poor market performance; this loss in future projected retirement assets from investment growth can be completely offset - and some more – by a combination of a 1% increase in their annual contributions and a deferral of retirement by 18 months. The “lost” expected return is not a death wish for their retirement plan.

What we are eluding to is that individuals tend to place an excessively large emphasis on the role of investment returns in their financial planning, especially in the short term when losses occur – in economic parlance, this is referred to a Myopic Loss Aversion. Adjusting other variables in a retirement plan can have just as large an effect on securing a planned retirement, and a Financial Planner can work wonders in discussing these trade-offs with clients.

To hone in on the excessive emotional reaction investors generally display – both positive and negative – in response to their investment performance outcomes, it would be prudent for us to consider the author Carl Richards, and to draw your attention to some of his illustrations in his book, The Behavior Gap. Richards states that the reason that we lose money may have something to do with the market, but is primarily as a result of the inferior emotional decisions we make. His book is certainly worth a read!

To corroborate Richards’ claims, one can review the Dalbar Quantitative Analysis of Investor Behavior (QAIB) Study – this study assesses the performance of the market index, average fund and average investor returns compared against each other.

The most recent 2018 study highlights that the average index investor achieved 0.49% less than the index fund itself, which highlights that investors tend to detract value on average by timing their allocations to funds. This lower return is directly linked to the Myopic Loss Aversion mentioned earlier, and the fact that investors’ emotions tend to cause them long-term hardship through knee-jerk reactions. Also keep in mind that this comes from only a handful of bad decisions, and that one or two wrong investment decisions – guided by emotions – are where the problem lies. This is where the Advisor Alpha comes into play when working with clients.

Advisor Alpha is generated when a potential poor decision is averted through an unemotional assessment of the facts and reminding the investor to not make short term evaluations on long-term decisions when the fundamentals of the investment and financial plan remain unchanged. It is this Advisor Alpha that is a direct benefit to the client and does justify an advisor’s fee, in addition to the multitude of other services provided to a client.

We firmly believe advisors are worth the fees they charge, in fact we also believe that many advisors may charge too little for their professional services. This problem generally occurs when a value is provided by way of an avoidance of a problem – an opportunity cost benefit – that is implicit instead of an explicit expense. Said otherwise, it is easier to charge when one can show a client what they save them in rands and cents rather than telling them how much they would stand to lose without their advice.

So, considering the above, what constitutes a smart decision at any point in time? It would be prudent to hedge outcomes unless you have extremely high confidence in your views – this, however, is already being done by the investment professionals selected by your advisor and their associated DFM. Even then, the investment professionals need to consider the fact that they could be wrong.

It would also be wise to focus on a sound financial plan that is appropriate for your long-term needs and goals, and to always be on top of the variables in your control (savings rate, retirement age, debt repayments, desired retirement lifestyle and debt repayments).

Last, but not least, always remember that the best thing an advisor can do for a client in their lifetime is to stop the client from making a handful of decisions that lead to a poor outcomes. This is the true power of Advisor Alpha, and this “saving” would pay for an advisor’s annual fee multiple times over by preventing the decreased returns from occurring. Don’t let any short-term noise result in rash and unwise decisions; always follow the fundamentals and a sound financial plan.