Author Archives: John Ndege

About John Ndege

Founder of pocketrisk.com. Risk profiling software for financial advisers.

Harold Evensky’s 5-step client on-boarding process

Harold Evensky On-boardingSuccessfully on-boarding new clients is a common concern of financial advisors. As you know, those first few experiences a client has with your practice will color the relationship you have for years to come. Failure to understand your client, set expectations and begin on a positive note will lead to dissatisfaction and churn.

 When advisors talk to me about their existing risk profile questionnaire they are often looking to revamp their entire on-boarding process. I wanted to speak and learn from the best in this area so I turned to the “dean of financial planning”, Harold Evensky. Evensky outlines his approach in “The New Wealth Management: The Financial Advisor’s Guide to Managing and Investing Client Assets.” The 480-page book goes into detail about how advisors can ensure the success of their clients and their business through a thorough investment management process. Today, I am going to focus on the client onboarding process, which is essential to setting the right tone for your relationship.

Evensky’s process can be broken into five main steps. Client relationship, client goals and constraints, risk, data gathering and client education.

 1.    Client Relationship

Evensky begins where you would expect. He states “because everything is client driven, developing a strong relationship with the client is critical”. A solid relationship must be “built on communication, education and trust”.  So why is the relationship so important?

If we look at the Evensky’s wealth management process diagram below, you can see that the client relationship is essential to gathering the data you need to service your client. Without a good relationship it will be challenging to identify the “unique characteristics” of each individual. Evensky goes on to state that a “deft” wealth manager learns his or her clients traits and biases and develops tactics to address them so as not to sabotage the client’s end goals.

Wealth Management Process

 2.    Client Goals and Constraints

“Goals must be time and dollar specific and prioritized”. Evensky refuses to accept simple goals such as “having enough to retire” or “paying for my children’s education”.  Since goals are the “foundation on which all subsequent work depends” a considerable amount of time and effort must be spent to get them right.

However, it’s not enough for advisors to simply ask a client for their goals. An advisor must look for “hidden goals” especially relating to risk management, cash reserves and anticipated large case expenses that a client may have.

Evensky then takes pains to always consider the impact of inflation on any goals, the limitation of mortality tables when retirement planning and the importance of educating the client on goal prioritization.

Beyond goals the constraints of the client also have to be considered. This typically means time horizon and liquidity needs. To avoid selling a volatile asset when the value is low Evensky and Katz have developed a cash flow reserve account system to meet the short-term cash needs of their clients (typically two years of cash flow needs). Any investment funds (excluding the cash) should be committed for at least five years.

In fact the mantra of the firm is “Five years, five years, five years!” By ensuring a client has sufficient cash on hand they avoid a client’s impulse to sell at the bottom. There is an opportunity cost to having that much money in cash but Evensky thinks it is fair price to pay given the overall benefit to the portfolio.

3.    Risk

Evensky states that risk is a responsibility of the advisor. Not just to manage it but to educate clients about it. The first step for an advisor is to get the definitions correct. They must balance a client’s risk tolerance (willingness to risk) with their risk capacity (ability to take a risk). Someone with a high-risk tolerance but little capacity should not be in an overly aggressive portfolio. Conversely someone with a low risk tolerance but a high capacity could invest more aggressively if it is necessary to meet their goals.

However, understanding risk does not stop there. Evensky thinks it is prudent for advisors to become familiar with the common behavioral finance missteps all investors are liable to make. These include availability bias, overconfidence, panic, confirmation bias, mental math, framing and others. By going through this checklist Evensky believes advisors are less likely to make mistakes on behalf of their clients.

4.    Data Gathering and Analysis

Data gathering is about capturing your client’s circumstance and looking for any inconsistencies or unrealistic expectations. Evensky captures his client’s risk tolerance, risk capacity, capital needs (typically short term) as well as the standard fact finding information (e.g. name, age, current assets etc.). This is then discussed with the client.  The goal is to ensure the advisor has the right information to conduct their analysis.

5.    Client Education

“A better educated client is a better client.” Before Evensky asks clients to fill out a risk questionnaire he gives them a 30-90 minute mini educational program. The goal of the program is simple. To explain certain investment fundamentals so they can make informed decisions.

The program covers modern investment theory (asset allocation, types of risk), vocabulary (covering terms like volatility, style, risk), information on the firm’s biases (e.g. being against market timing) and an overview of the financial planning process. When a client has this information an advisor can better manage their expectations and ensure their satisfaction.

Conclusion

So as you can see Evensky has developed a thorough on boarding process for his new clients. It’s all about educating the client and getting the information you need to give the best advice.

What other steps would you include in your client on-boarding?

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5 Technology Tools We Use To Grow Pocket Risk

Technology ToolsLate last year I wrote a popular list of 58 technology tools for financial advisors. It was shared over a hundred times on various social networks becoming our most visited post last year.

However, a great tool is merely the beginning. How do you use these tools to grow your business? A business coach once wrote that the key to growing your business is to make it irresistible to your market and make sure they know about it. Below I share 5 technology tools we use that help us achieve that goal.

1. Business Metrics Dashboard [Purpose: Are we building something irresistible?]

The most important tool we use is our internally created business metrics dashboard, which includes numbers and written notes. This helps us know whether we are creating something irresistible to our market. Here are the main elements.

Active Customers – How many of our customers have recently logged in and used the product.

Monthly Recurring Revenue – How much revenue are we generating on a monthly basis.

Churn – Have we lost any customers and why did they leave?

CLTV – What is the average value of a customer? This is determined by the average price someone pays for Pocket Risk and how long they remain with us (on average).

Cost To Acquire A Customer – How much are we spending on marketing (including marketing salaries) to acquire a customer?

Cashflow/Free Cashflow – Measuring the cash that is coming in and out of the business.

I review these metrics every Monday morning. Given the array of systems most businesses use it can be tricky to track all of these metrics easily but it is essential to measuring the health of the business.

I recommend every business owner have a similar dashboard. You can use Excel, Google Docs or create an internal webpage. Just remember that traditional accounting metrics do not provide good leading indicators on the health of your business. If you can’t get all of these metrics into a dashboard then at least get four or five. Whatever you do, don’t limit yourself to tools you can buy. Build your own tools.

2. ROI Calculator [Purpose: Are building something that’s irresistible and profitable?]

Once again, I built my own tool (with Excel) that measures the ROI on any major expenses. For example, if we spend x on marketing I know I need to acquire y customers for it to be profitable. Or if I ask one of our employees to spend 10 hours on a project, I know that that we need z number of new customers, retained customers or future saved working hours for it to be worthwhile.

Now it’s not always possible to predict the ROI of your investments but we make sure every major dollar spent or hour consumed has an expected ROI. This way we can measure if it is has been successful. Having this calculator limits us from making emotional decisions or succumbing to psychological biases that lead to unprofitable outcomes.

When we build new features or embark on projects at Pocket Risk we always ask whether this will make our product irresistible to customers at a profitable return. That return may take months or years but it has to be thought out. Having the calculator ensures we have the same internal yardstick for success.

3. Google Docs [Purpose: Helps us build something irresistible quicker]

As an international company with team members in London and San Francisco efficient internal communication is essential to our business. We use Google Docs to share things like marketing plans and training documents.

At first I thought everyone would be using tools like Google Docs to share information until I visited a financial planning firm and realized people still send Excel files back and forth unnecessarily. If you have a file called “Report Update v3 Final – David edit.xls” then you could probably benefit from using Google Docs.  It’s a simple way to ensure your team is on the same page.

4. Screenflow [Purpose: Helps us build something irresistible quicker] 

Have you ever found yourself writing a long email trying to explain something to a colleague, client or contact? Thankfully those days are in the past. I use Screenflow (Mac based) but you can also use Screencast to record your screen and voice for sharing with a simple link.  This has dramatically reduced our frustration and increased our efficiency. Some things are difficult to explain in text and you can’t always get someone on the phone.

5. Google Analytics [Purpose: Measures the efficacy of our marketing]

Every business should be measuring the number of qualified leads they are creating and the conversion from first contact to happy customer/client. Pocket Risk is a web-based business so we use tools like Google Analytics to measure web traffic.

A financial advisor’s business would probably have to track this in Excel or with a CRM system like Salesforce or Redtail. However if you use your website to capture leads (which you should), you can also benefit from Google Analytics. Michael Kitces has a recent post about this on his blog describing how financial advisors can get the most out of Google Analytics.

Conclusion

What you will notice, from the list above is that we don’t hesitate to create our own tools that do a better job than what we can buy. We just have to ensure the creation of our own tools (and ongoing maintenance) justify the investment.

Additionally you will see every tool has a purpose and is a part of our mission to create something irresistible to our customers.

BONUS – Excel Shortcuts [Purpose: Helps us build something irresistible quicker] – Take a look at the link below to see how you can work a lot faster with Excel. Just imagine your life without copy and paste? Now imagine what other shortcuts you could be missing out on – https://exceljet.net/keyboard-shortcuts

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3 Uncommon Questions To Assess Your Clients’ Risk Profile

RiskIn Harold Evensky’s “The New Wealth Management” risk is described as a “four-letter word” and that echoes many of the discussions I have had with advisors. Again and again I ask myself how do we get a better grip on what Evensky calls “a client’s most restrictive investment constraint”?

Traditionally, advisors tried to figure it out alone, and then they used boilerplate risk questionnaires before adopting academically backed tools like Pocket Risk. However, the journey is not complete. I believe we can further this field by encouraging advisors to share how they tackle risk with their clients. This will allow everyone to develop best practices for tools, processes and questions. Let’s call it a crowd-sourced approach to good ideas about risk.

At Pocket Risk we allow advisors to add a few questions to our questionnaire so they can specifically target a particular concern about goals and risk. This has led to a gamut of questions we believe other advisors can benefit from. Below is a selection of questions as well as an explanation as to why they have been asked.

Question 1: How often do you watch or read financial news media (e.g. CNBC, Bloomberg, WSJ etc.)?

Possible Answers: Daily, Weekly, Monthly, Quarterly, Yearly, Never

Why: The advisor who created this question jokingly referred to this as his most important question. He says clients that watch financial news media on a daily basis (especially programs like Mad Money) will likely be too reactionary when the markets move up and down. Their desire to move in and out of investments at a rapid pace would hurt their future returns and reduce the chances of meeting their financial goal.

As a result he knows he has to work harder with such clients as they are slowly weaned off news media. The risk the advisor is looking to mitigate is the chance that this client is a trader who wants to speculate more than invest.

Question 2: Who is responsible for determining a suitable level of risk, and managing that risk on all of your accounts?

Possible Answers: It is my responsibility, It is the financial professional’s responsibility, It is a shared responsibility, I’m not sure

Why: I like this question. This firm is asking the client’s perspective on who is responsible for the risk in the account. This is isn’t about abdicating responsibility but about optimizing client communication and delivering the appropriate investment approaches.  If the client says they believe the advisor is fully responsible then this can help the advisor craft a relationship and portfolio that better suits the client. Alternatively, if the client believes they are fully responsible for the risk then the advisor may be able to provide the client a larger array of risk options and communicate with them in a different fashion. It’s all about optimizing communication about risk so the client has the appropriate portfolio.

Question 3: What is your life expectancy?

Possible Answers: 18-125

Why: This advisory firm asks their clients how long they expect to live. Rather than guess based on their age, they have used a simple life expectancy test to get an accurate reading based on a client’s health profile. One of the biggest risks investors face is running out of money in retirement. This can be partly avoided by having a realistic life expectation.

Conclusion

You can ask your clients a myriad of great questions about risk but not all of them fit nicely into a risk questionnaire. As a result it’s important to think what else can you ask to better understand your clients’ risk profile. I hope I’ve given you some ideas based on the questions above.

Share the questions you ask your client’s about risk below in the comments.

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3 Trends To Watch In 2015 From 351 Financial Advisors

2015 NotesSo what’s going to happen in 2015? Over the year I’ve seen three clear trends from discussions with 351 financial advisors. I have two books full of notes as you can see in the image and I am going to share what I am seeing. Getting insight into what other advisors are thinking and doing can better prepare you for 2015. Not just in terms of competition but getting new ideas to propel your business forward. Let’s get started.

Trend #1 – New Client Acquisition Methods

A consistent theme throughout the year, which will continue to gather pace next year, is the need to acquire clients through new methods. Historically, advisors have been very reliant on referrals and seminars. This is changing. Increasingly the advisors I speak to are keen to acquire clients through content marketing (e.g. blogging, podcasting), online risk questionnaires (to lead capture drive by website visitors) and bespoke client retirement tools and calculators like getmoreretirement.com.

Client acquisition doesn’t need to be as “local” as it once was and a sizeable number of advisors want to use online marketing to gather clients nationally. My experience tells me advisors have been threatened and inspired into action by the online investment firms (e.g. robo-advisors) and are looking for more competitive tools and approaches.

Trend #2 – More 401k Business

As you already know fee-only RIAs are increasingly interested in advising on retirement plans (401ks) for plan sponsors. This interest has not waned. Perhaps it is the increased publicity of “marketplace conflicts” that exist in commission-based models or growing self-confidence that continues to push RIAs in this area but don’t expect it to let up. The opportunity for RIAs to diversify and strengthen their business is very tempting. Unfortunately the tools and platforms that help advisors deal with high-net worth clients are more advanced than those for RIAs managing retirement plans. This is an opportunity for technologists within the industry. If you have any tools or ideas you’d like to see in this area let us know within the comments.

Trend #3 – Risk Needs, Risk Tolerance, Risk Capacity

As you would expect many advisors speak to me about assessing client risk. There has been one great trend in this area, which I welcome. This is the need to correctly balance a client’s needs, risk tolerance and risk capacity.

Historically advisors were only focused on risk tolerance but quickly realized overly conservative clients would never meet their retirement goals. They then swung towards investing based on a client’s needs, which resulted in stock heavy portfolios to make up for a lack of savings. When 2008 happened clients couldn’t stomach the declines, bailed and missed the run up in stocks from 2009 to today.

Advisors have learned that each portfolio needs to consider a client’s risk needs (goals), risk tolerance (willingness to risk) and risk capacity (risk capability). That is why at Pocket Risk we released a new feature earlier in the year allowing advisors to add questions to our questionnaire to ensure they capture this necessary information.

Final Thoughts

I expect my conversations in 2015 to continue just where we left off in 2014. How do we tackle the robo-advisor threat? In what new ways can we grow our business and how can we better serve our clients? That is what the trends in 2015 will be all about. I am excited to see how they evolve!

#Bonus Trend – One additional trend I expect to hear more about is the concern about bonds and whether they are a sufficient diversifier from stocks in the near term. Time will tell.

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Do Knowledgeable Investors Need A Financial Advisor? [A Mathematical Approach]

BrainA never-ending challenge for the financial advisory industry is quantifying the value it produces for its clients. We know advisors help people set goals, choose investments and sleep well at night but what about the dollars and cents impact? As clients get smarter they’ll be able to construct their own passive, well-diversified and regularly rebalanced portfolio. They’ll become Knowledgeable.

As Michael Kitces mentioned a few months back “a well-diversified passive strategic portfolio is on its way to being totally commoditized”. Instead of catering to the average investor, advisors will have to work for the client of tomorrow. The Knowledgeable investor.

So the question is, what is the quantifiable value of a financial advisor for the Knowledgeable investor?

First, let’s define the knowledgeable investor. In my eyes the knowledgeable investor understands the following, which an average investor may not…

  • They understand they should have a financial plan. It may not be complicated or consider all the variables but they should have something.
  • A passive diversified portfolio is likely to meet their investment needs over the long term. Most active investment strategies don’t beat the index over sustained (10 year plus) periods.
  • They should rebalance regularly.
  • They should minimize fees (fund fees, transaction fees etc).
  • Investor psychology (i.e. overconfidence, loss aversion, mental accounting etc.) can lead to actions that limit investment returns.
  • Getting started with investing today means they will benefit more from compounding.

Importantly, the knowledgeable investor may understand the points above but never act on them and this gives an advisor the opportunity to force good behavior.

Quantifiable Benefits of a Financial Advisor

 1.    A Financial Plan

Knowledgeable investors understand they should have a plan and probably have something in their head but it is not a formalized IPS, a strict budget or a retirement number. It’s more like “max out my 401k and hope for the best”. This puts them ahead of most people but may not be enough for them to live the life they want. Even for those who have used retirement calculators or read the books the variables can be overwhelming. A financial advisor will give a knowledgeable investor a specific actionable plan. In my opinion this is the most valuable contribution an advisor can make to a person’s future.

 So what is the quantifiable benefit of a financial plan? Likely several years even a decade or more of retirement. That means you can spend less time working and more time with your loved ones. Put a price on that!

 2.    Managing Investor Behavior

The DALBAR studies (which compared dollar weighted investor returns with index returns) popularized the idea that the average investor jumps in and out of investments, buying high and selling low resulting in poor performance. Their conclusion was that “The average equity investor underperformed the S&P 500 by 4.32% for the past 20 years on an annualized basis.”

Further investigation led by Harry Sit and Michael Edesess showed these numbers were exaggerated and possibly even completely false. The DALBAR methodology failed to account for the fact that poor equity market performance during the 2000’s accounted for poor dollar weighted investment performance not investors jumping in and out of the market. Furthermore, earlier this year another DALBAR study showed that 55% of the reason investors fail to meet the index is because they didn’t have the capital to invest and buy at the lows. Therefore we must conclude that the importance financial advisors have in managing behavior has been overstated.

Despite the apparent failing of the DALBAR studies others have attempted to quantify average investor behavior. Russell Investments recently showed that if you had invested in the Russell 3000 index in 1984 and done nothing you would have performed 2.2% better than the average investor (using ICI’s monthly fund flow data to mimic the average investor). I had difficulty getting all the methodological details of this study so I’ll take it with a grain of salt.

What we can say is that the importance of managing investor behavior has probably been exaggerated but it is still significant. If an advisor can save an investor 1-2% a year through managing behavior this more than covers their advisory fee.

But what happens if you are a knowledgeable investor who needs little behavioral management? Then you’ll end up paying for something you do not need.

That’s the question knowledgeable investors have to ask themselves. Without an advisor how good will my behavior be throughout my investing lifespan? If you have serious doubts about your behavior an advisor could well be smart investment.

 3.    Fund Selection and Rebalancing

Another area where having an advisor could have a quantifiable benefit on the bottom line is in fund selection and rebalancing. Russell Investments have shown that a regular (monthly, quarterly annually) rebalancing policy can juice your returns from 0.51-0.93% annually.

However, knowledgeable investors are now well versed in passive fund selection and the importance of rebalancing. Any knowledgeable investor who has done a modicum of research knows Vanguard is highly recommended when it comes to minimizing fees and with their Life Strategy Funds you don’t have to worry about the rebalancing.

Frankly the knowledgeable investor doesn’t choose an advisor to help pick funds and rebalance unless they believe in active investing.

 4.    Tax Planning

A further quantifiable benefit of working with an advisor is the tax planning. Unfortunately, it’s difficult to find any statistics on the tax savings people accumulate from working with a financial advisor. Anecdotally it’s not uncommon to hear of advisors saving their clients 10’s of thousands of dollars. If these savings are invested, grow and compound the benefit of working with an advisor could be worth a lot more than managing behavior or selecting the right funds.

What investors have to ask themselves is whether their tax situation is complicated enough to realize significant savings. A regular W2 employee with a fixed salary is unlikely to benefit as much as business owner, with stock options and investment real estate. If I were to hazard a guess I’d estimate someone with a tax situation that is more complicated than a regularly salaried employee could save several percentage points on an annualized basis over their lifetime through working with an advisor.

 Dollar and Cents Return

So let’s put this into an example. Let’s assume you are a knowledgeable investor who is considering working with a financial advisor. Is it worth it? Well based on the details above the answer would be an emphatic yes….

Advisor Makes You Advisor Costs You
Proper Financial Plan – You end up saving an extra 5% a year Annual Advisory Fee – 1.5%
Managing Behavior – 1.5%
Fund Selection and Rebalancing – 0%
Tax Planning – 2%

Using the numbers above if we assume you have a $100,000 salary and have $250,000 in savings/investments.

Financial Plan  = +$5,000

Managing Behavior = +$1,500

Fund Selection and Rebalancing = +$0

Tax Planning = +$2,000

Advisory Fee = -$3,750

Net Benefit per Year = $4,750

 A knowledgeable investor working with a competent financial advisor is likely see a positive ROI over the long term so long as the expense is not too high.

I find it unlikely that for 20 years even knowledgeable investors can create a viable financial plan, which they can stick to, while simultaneously managing their behavior, keeping up with changes in the industry and optimizing their tax situation. It’s just a very difficult thing to do over a long period of time. Not impossible but very difficult.

The greatest achievers in any field have always needed coaches, advisors and people to keep them accountable. When it comes to investing doing it alone is as tough as it comes.

image source – www.wired.com

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3 Important Academic Studies About Risk Tolerance

Risk DiceUnderstanding risk tolerance should not be a guessing game especially when dozens of academic studies can point us in the right direction. Below is a list of important academic studies in the field of risk tolerance.

Financial risk tolerance revisited: the development of a risk assessment instrument  - John Grable and Ruth Lytton – 1999

Perhaps the most important paper on devising a risk tolerance questionnaire. Dr Grable and Dr Lytton bring scientific validation to the risk questionnaire through the use of validity and reliability testing. 

Link to paper

Measuring the Perception of Financial Risk Tolerance: A Tale of Two Measures - John Gilliam, Swarn Chatterjee and John Grable – 2010

This study compares the explanatory power of a simple question about risk versus a multi-dimensional 13-item questionnaire when trying to understand someone’s risk tolerance. Unsurprisingly the multi-dimensional questionnaire showed better results. The research helps explain why advisors should not be using boilerplate questionnaires.

Link to paper

Insights from Psychology and Psychometrics on Measuring Risk Tolerance – Michael Roszkowski, Geoff Davey, John Grable – 2005

This paper re-enforces previous studies that show risk tolerance can be measured as long as the questionnaire is long enough and asks good questions (doesn’t mix in questions about risk capacity and risk needs).

Link to paper

If you want to know more about the academic study of risk tolerance please add a comment.

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What Tony Robbins REALLY Says About Financial Advisors

Tony RobbinsTony Robbins needs little introduction. The personal development guru has touched millions of lives around the world through his ability to “awaken the giant within”. He released his first book in 20 years – Money: Master The Game which tackles the issue of financial advice.  To summarize the book in a sentence Robbins advocates becoming an investor instead of a consumer, paying yourself first, having winnable goal, avoiding fees, choosing the right advisor, knowing your risk tolerance and learning from experts money makers (e.g. Icahn, Buffet, Bogle, Templeton, and others).

You can find a great summary of opinions on the book here.

So why does this matter to you? Robbins’ 600+ page tome is already an Amazon Bestseller and NY Times Bestseller. It will be a favored holiday gift and some of your clients will undoubtedly come across it.

Isn’t it useful to know what one of the most respected life and business coaches is saying about you? Here is a short summary.

1. Don’t Trust Brokers – If there is one rallying cry from the book regarding financial advice it is that you should not trust brokers. They often funnel you into expensive actively managed mutual funds, that don’t beat the market (over a sustained period), don’t perform as advertised and favour their own interests.  Robbins’ goes on to say the suitability standard is “pre-engineered to be in the best interests of the “house”” and what individuals need is the fiduciary standard.

2. You Can Trust A Fiduciary or Can You?  -  Robbins’ says the best way to “solidify yourself as an insider” is to “align yourself with a fiduciary”. However, he goes on to say, “not all advice is good advice” and a fiduciary may not be “fairly priced”.

 He recommends individuals find advisors from NAPFA and ensure they are…

a)    Registered with the SEC.

b)   Compensated as a percentage of your assets under management.

c)    Not compensated for trading stocks and bonds.

d)   Not affiliated with a broker-dealer. Robbins says “This is sometimes the worst offense when a fiduciary also sells products and gets investment commission as well!”

e)    Ensure your investments are custodied with a third-party like Fidelity, Schwab, or TD Ameritrade.

Robbins then goes on to make a final point….

“The added cost of a fiduciary may only be justifiable if they are adding value such as tax-efficient management, retirement income planning, and greater access to alternative investments beyond index funds.”

This aligns with a consistent theme throughout the book that individuals should avoid fees at all costs unless they are justifiable and most fees are not justifiable. However, Robbins falls short of calculating the value of a fiduciary.  After all it’s not a simple calculation and depends on the skill of the advisor. To wrap up, Robbins somewhat disappointingly champions his own financial advisor’s robo-advice platform Stronghold Financial in which he is in talks to become a partner.

3. Conclusion – Overall Tony Robbins is a supporter of fiduciary financial advisors. He believes they can make investors insiders and give them the advice they need to meet their goals. However, more than a supporter of fiduciary financial advisors, Robbins hates fees including expense ratios, transaction fees, cash drag, soft dollar costs, redemption fees, and countless others.

The book gives a lot of mathematical examples of how fees can eat into your returns but it does little to show how a fiduciary’s fees can help you. If you are fee-only financial advisor this book is generally supportive of your work. If you are not, I’d be wary.

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4 Ways To Deal With Clients During Market Volatility

Volatility RollercoasterHow do you deal with your clients during market volatility? I was recently reading a post on the anonymous advisor forum Advisorheads, where the community was trading ideas.  The question is, do you lay low and wait for the storm to pass or reach out to your clients and risk the chance of waking the “angry bear” as one advisor noted. Below are four strategies based on the discussion of about a dozen advisors.

1. “Leave them alone” and don’t do anything – The upside of this approach is clear. You minimize the threat of waking the “angry bear”. Pointing out volatility could lead to a client leaving your practice. On the other hand keeping quiet could result in your clients feeling you aren’t communicating properly. A Financial Advisor magazine study cited “failure to communicate on a timely basis” as the number one reason advisors loose clients.

I don’t believe any advisor wants to hide from their clients but they may want to hide from their past mistakes. Maybe you recruited a client who wasn’t an ideal fit for your business or possibly you failed to sufficiently educate them about the possibility of market declines. Reaching out now, will expose your past mistakes and could result in lost business. However, how can you build a successful business by burying your head in the sand? Leaving your clients alone is unlikely to be the best long-term approach but communicating differently with different clients could have the dual benefit of recovering from past mistakes and minimizing any market fears in your client base.

2. “Send out frequent emails when things get hairy” – It’s generally better to say something than nothing but this approach seems very reactive. The advisor on the forum says, “Clients and prospects love it. They know you are watching and have a plan”. I expect this is the least an advisor should do to deal with clients during market volatility. However, as another advisor says the “past year I have told pretty [much] everyone we will see a market correction soon, curious who will remember”. The bottom line is that you should be regularly making your clients aware that the market can go up and it can go down. At the moment it appears “going down” is more likely.

3. “I called/emailed most of my clients over the past two days. All were happy to hear from me, and I used it as my quarterly touch”.  For this advisor reaching out to all of his clients worked well (it also resulted in more AUM) but it was clearly part of his regular quarterly pattern. His clients were not getting a call out of the blue. However, his approach is very time consuming. Another advisor says “I used to get on the phone and call everyone, but found it to be counterproductive since many would then want to make unwise changes.” I wonder if the desire to make changes is the result of a lack of trust in the advisor’s advice or poorly recruited clients.  A client that is well educated, well recruited and trusts you would probably not demand to make “unwise changes”.

4. “You have to know your clients” – Here is a great quote from one of the forum advisors…. “You have to know your clients. I know which one’s need a phone call, and those are the one’s I call proactively to talk about the market when things get crazy. I have been preparing for a client appreciation dinner, which was tonight, but I did call 4-5 “sensitive” clients today. I only got one incoming call today, and it wasn’t a panic call, it was just a question, the conversation was…

Him: Should we be doing anything?

Me: No, this is just noise and while it might not feel good while it’s happening, it will pass, and you will be better off doing nothing. Less is more.

Him: Ok, thanks, that’s all I needed to hear.”

Conclusion

Throughout the post the general conclusion is that you should know your clients and phone the ones most likely to react to the volatility.  At the same time you should have some sort of newsletter or quarterly touch point with all your clients so they know you are watching and have a plan.  Lastly, you need to make a bigger effort to recruit the right sort of clients. Either clients that our willing to be educated about markets and risk or clients that trust your judgment.

What other good ways are there to deal with clients during market volatility? Give me your thoughts in the comments below.

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Morningstar Risk Tolerance Questionnaire – The Good and the Bad

Morningstar LogoThere are many risk questionnaires used by financial advisors and the most common appear to be bundled in with software an advisor is already using. Morningstar is a popular tool used by financial advisors for investment research and financial planning. I often get asked my opinion on the Morningstar risk tolerance questionnaire. So today, I am taking a deeper look at the good and the bad.

Click here to get the Morningstar Risk Questionnaire pdf

Morningstar Risk Questionnaire – Time Horizon

Morningstar 1

The Good

  • The good thing about the time horizon section is that the questionnaire is attempting to establish some sort of goal for the client by asking about their age and when they expect to start drawing income. That being said this is supposed to be a risk tolerance questionnaire not a collection of goals. How much risk someone is willing to take is not the only factor in determining someone’s goals. You also have to look at their needs and risk capacity.

The Bad

  • Age in itself is not a clear indicator of risk tolerance. It’s possible that someone who is older than 75 has a higher risk tolerance than someone who is less than 45.  There is dangerous assumption in the question that to be older is to be more conservative. This is not necessarily true and can result in younger people having overly aggressive portfolios and older people having portfolios that are too conservative.
  • The second question assumes the client wants to draw income. Again this is an assumption that may not be true for all clients. That being said most clients of financial advisors are looking to draw income at some stage so I think this question is fair.

Morningstar Risk Questionnaire – Long Term Goals and Expectations

Screen Shot 2014-11-19 at 10.34.12 AM

The Good

  • Again there is an emphasis on the client’s goals, which is good to know but I am left wondering if this is the right place to ask such a question. Are we trying to establish someone’s risk tolerance or their goals? These two factors often conflict.
  • Question five is interesting and speaks well to understanding a client’s expectations.

The Bad

  • Question three is ok but I wonder if the question covers all the goals a client could have. For example, a client could have different goals for different buckets of money. Or maybe they just want to meet their retirement needs but they have no idea if this requires aggressive growth or “to grow with caution”.
  • Question four is challenging because of the use of “normal market conditions”. What is normal? Is this the last year? 10 years? 50 years. Other than that, I like the answer options.

Morningstar Risk Questionnaire – Short Term Risk Attitudes

Screen Shot 2014-11-19 at 10.34.24 AM

The Good

  • I like question 7. Again, seeing how a client feels in the short run helps an advisor manage expectations.  The specificity of the third answer option (10%) makes it clear what type of loss we are talking about.

The Bad

  • Question six starts off good. I like the question. However, the answer options are too vague.  Someone may be comfortable with a “small loss” but what is a “small loss”? 1% 10%, 15% or more? It is unclear from the options resulting in the advisor having to make an assumption.

Conclusion

The Good

  • The questionnaire makes a decent effort at understanding client expectations and there is a fair attempt at understanding their goals.

The Bad

  • Frankly, this doesn’t appear to be a risk tolerance questionnaire it’s more of a hodgepodge of questions designed to understand the very basics about a client and it struggles to do that conclusively.
  • Too few questions. It’s unlikely that someone’s investing future can be determined by 7 questions.  There’s just not enough detail to make the final result reliable.
  • Where have these questions come from? Was there any science or academic research behind its development? Without this its accuracy can and will be questioned.

For those advisors who wish to go deeper with their clients and have a thorough understanding of their risk tolerance I would be a little cautious about the Morningstar risk questionnaire.  It’s basic and you would most likely need to ask many face-to-face questions on top to learn more about your client.

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[CLIENT GUIDE] Explaining The Difference Between Average Annual Return and Compounded Annual Growth Rate (CAGR).

CAGR

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I was on the phone with an advisor two weeks ago and he was bemoaning the lack of client education surrounding the difference between average annual return and compounded annual growth rate (CAGR).

His argument was that the leading measure used to evaluate financial products was “completely broken”.  The result being sub-optimal investment selection at its best and fraud at its worst.  I decided to investigate.

There is no denying that by using an average annual return statistic, investments tend to have a higher performance percentage (as you will see below). Yet its also true few clients fully understand CAGR and its implications.

If everyone understood CAGR then I believe it would be a better measure than average annual growth rate and you will see this in the examples. But first I want to you copy, print or download the guide below that will simply explain the difference between average annual return and compounded annual growth rate.

Average Annual Return

The average annual return for a set of investment years is calculated by summing the results of each year and dividing by the total number of years. Below is an example based on the returns of Vanguard’s Total Stock Market ETF (VTI) from 2004-2013.

Year

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Return

12.73%

6.15%

15.70%

5.36%

-36.81%

28.73%

17.28%

1.00%

16.45%

33.48%

The average annual return calculation would be….

12.73% + 6.15% + 15.70 + 5.36% + -36.81% + 28.73% + 17.28%  + 1.00% + 16.45% + 33.48% Divided by 10 years  = 10.01%

 Source: Vanguard.com

Compounded Annual Growth Rate

The compounded annual growth rate (CAGR) measures performance over a series of years and represents what you actually get from your investments at the end of the investing period. It accounts for compounding and volatility (unlike the simpler average annual return calculation). This is best explained with an example.

If you invest $100,000 dollars over two years and the returns are 10% and -10% the average annual return is 0% (10% + -10% / 2 = 0%). However, this doesn’t represent what you actually get at the end of the two year investing period.

At the end of the first period you will have $110,000 dollars but after a 10% decline at the end of the second year, which is $11,000, you will have a loss ending on 99,000.

Year End of Year 1 End of Year 2
Return 10% -10%
Investment $110,000 $99,000

The average annual return statistic would have you believe that you ended the two period on $100,000 (because of the 0% average annual return) but this isn’t the case.  The compounded annual growth rate formula would have picked this up and given you an annual return of -0.5%. So if you returned -0.5% in the first year and -0.5% in the second year you would have $99,000.  Which is exactly what you got at the end of the period.

Investment $100,000
CAGR -0.05% – End of Year 1 $99,500
CAGR -0.05% – End of Year 1 $99,000

The formula for CAGR is outlined below. It is a little complicated so you can use an online calculator at websites such as Investopedia.

 CAGR = (B/A) 1/n – 1

A = Original investment amount

B = Value of your investment at the end of the period

n = number of periods (e.g. years).

Implications for Investors

In the example above we only used a two year period however the difference between the average annual return and the CAGR tends to grow larger over longer time periods and periods of volatility. Using the example of the Vanguard Total Stock Market ETF quoted earlier the average annual return is 10.01% but the CAGR is 8.13%. Put simply, average annual return ignores compounding, which is critical factor in an investor’s returns. So what should an investor do?

  • Where possible calculate the CAGR before selecting any investment product.
  • Expect your return to be a little less than any quoted average annual return statistic.
  • When evaluating investments do your best to evaluate like with like.

Download our free client guide to help you explain the difference between annual average return and compounded annual growth rate to your clients.

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