Category Archives: Client Guide

3 Things Your Clients Must Understand Before You Assess Their Risk Tolerance

I recently had a discussion on Facebook with two financial advisors about risk tolerance questionnaires. The advisors expressed their frustrations with managing client behaviour. In one advisor’s words “there is an emotional element that is difficult to quantify” in questionnaires. Pocket Risk helps here but we agreed a certain level of client education is necessary to ensure people “stay the course”.

The academic and practice literature supports this. The University of Michigan’s Health and Retirement Study has shown that people with lower levels of education are less likely to take investment risk. This means they are at risk of forgoing the gains in holding equities and missing their retirement goals. Practice professionals such as Harold Evensky in his book “The New Wealth Management” have stressed the importance of client education before building a financial plan and investing.

So what do your clients need to know?

1. Your Clients Must Understand The Risk-Return Trade-off

In order to be comfortable with risk your clients need to understand what risks they are taking. At the beginning they should understand the risk return trade-off. That is the idea that as an investor you are expected to get higher returns for taking more risk.

Here is a real life example you can share with your clients. In 2004 Google IPO’ed and became a public company. The shares traded at $54 (accounting for stock splits). There was a lot of uncertainty about the company’s business model and investors were largely reluctant to invest because of the dot com collapse four years earlier. Most investors did not want to take the risk.

However, today, Google’s shares have been trading at over $750 per share. Those investors who were willing to take the risk (on a company that was eventually very successful) have received high returns. This is how the risk-return tradeoff works in action.

Conversely, people who invested in Twitter which IPO’ed in 2013 at $41 have seen their value drop to $18 dollars. These investors took a risk most people were not willing to make and they lost money.

Your clients should know, that if they wish to make more money they are probably risking greater losses.

2. Your Clients Must Understand Time Horizon
Your clients should appreciate that assets can go up and down in value but over the long term they have a trend. In the short term (0-3 years) volatility can be wild but over longer periods of time there tends to be a pattern. Therefore, the longer you invest the more certain you can be about how much money you will make.

Below is a real life example you can share with your clients with historical returns of the MSCI World Stock Market Index 1970-2015 (dividends reinvested, before fees and taxes).  This diagram shows your clients that investing over a longer time period means less chance of loss.

By jumping in and out of investments when assets drop in value, they will likely miss the gains on the upside. As proven by Geoffrey Friesen and Travis Sapp in their paper – Mutual fund flows and investor returns: An empirical examination of fund investor timing ability – 2007. We recommend you use diagrams like the below to explain key concepts to clients.

Risk Tolerance Client Education Time Horizon


3. Your Clients Must Become Comfortable With Uncertainty

Once your clients understand the risk return trade-off and the importance of time horizon there is one last thing they must understand…

Sometimes great plans don’t hit the mark. There is a luck factor in everything that we do as humans. Your clients must understand there is no certainty in investing. However, we can use probabilities to increase our chances of achieving our goals.

Communicating this to clients can be difficult. They are paying you for results and you have to explain to them why there is a small chance you won’t deliver.

But if you use simple analogies, it can be explained. For example there is a high probability of getting into a car accident if you run red lights. There is a low probability if you follow all the rules but you can still get into an accident. It’s your job to explain how you will increase the chances of them hitting their goals.

I recommend you read a book by Nick Murray called “Simple Wealth, Inevitable Wealth”. Focus on the epilogue titled “Optimism Is The Only Realism”. Nick Murray has been a financial advisor for 50 years and a coach to thousands of advisors over the last two decades.

He believes that the dominant determinant of long-term, real-life return is not investment performance but investor behavior. Second, that behavior modification ought to be an advisor’s true value proposition, because great behavioral advice is at critical moments in an investor’s life, worth so much more. I completely agree.

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.

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























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%


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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