Don't dare say `standard deviation.' Advisers share how they simplify asset allocation concepts when helping clients invest their portfolios.
Explaining asset allocation to clients is a lot like winking at a pretty girl in the dark, says Frank Gleberman, a financial adviser with The Century Benefits, a Jefferson Pilot Securities affiliate in Marina del Rey, Calif. "You know exactly what you mean, but she doesn't have a clue," Gleberman says.
What's obvious to the broker from pouring over high-tech charts showing multiple asset class portfolios, standard deviations and Sharpe ratios just doesn't register with the client.
"The real payoff of asset allocation is more significant in the long run than clients imagine, but more subtle to pick out on the way," says Roger Gibson, head of Gibson Capital Management, a brokerage and RIA in Pittsburgh. "I tell them asset allocation is a real `Tortoise and the Hare' story."
Sports is a great place to begin the asset allocation story. For Gibson, it's baseball: "I say, `Asset allocation is an approach to winning baseball games - you hit singles and doubles. You won't be hitting grand slams, but you don't need grand slams to win baseball games.'"
Gleberman first finds out a client's favorite sport - usually golf. Then, he asks, "What would your game be like if you could only use a putter?" After the client answers, they talk about the types of clubs needed to craft a winning game. "You need balance to win the game. It's the same thing with your portfolio," he says.
Before diving into historical performance statistics for asset classes, take time to lay a philosophical foundation. James Kuntz of Lockwood Pacific Investment Group in San Diego tells clients about Harry Markowitz and his Nobel Prize in 1990 for developing modern portfolio theory, the underpinnings of asset allocation. "It validates for the client why we use asset allocation in our practice," Kuntz says.
Gibson first helps the client understand the importance of having a mix of fixed income and equity investments. He shows Ibbotson charts of the close relationship between Treasury rates and interest rates. He explains the impact of time on reducing the risk of stocks and increasing the risk of bonds due to inflation.
"Our aim is to boil down the risks in the client's mind to inflation versus volatility," Gibson says. "We say our focus is on anything we can do to fight inflation."
He then shows the client the range of outcomes for different fixed income/equity portfolios. "It's a way of forcing the client to make a fixed income/equity decision," Gibson says. Only then is the client ready to deal with the seven asset classes he uses in creating customized asset allocation plans.
Cool Graphics Resist the temptation to share with clients the dazzling charts and graphs you consult to craft your asset allocation strategy. A whiteboard and markers are effective in setting a solid foundation with clients, advisers say.
Daniel Moisand, head of the RIA firm Optimum Financial Group in Melbourne, Fla., draws a vertical axis to represent asset value and a horizontal axis to represent time.
He chooses an asset and draws its performance from left to right, showing its value at the end of the time period. In another color, he draws the performance of an asset with low correlation to the previous asset.
The client sees the assets get to the same place, but in different ways. Finally, in a third color, he draws a line to show the performance of a portfolio with both assets - a line that is only "semi-squiggly," Moisand says. "The client sees clearly how he can get to the same place over time, but with less volatility."
Gleberman first determines the average life expectancy of a client going forward, say 30 years, then charts on a whiteboard the inflation rate over the previous 30 years. He then charts the return over the same period of a CD or T-bill, then long-term bonds and finally a large-cap stock fund. "They start to see some jigs and jags with the Treasuries, then they see how when stocks go down, it causes the stock fund to move around a lot," Gleberman says.
Next, he hands the pen to the client. "I have the client draw a line on top of the other lines to show the return of a portfolio with both a stock fund and long-term corporate bonds," Gleberman says. "They see now how the ride is much smoother. I need them to grasp that not everything moves in the same direction, at the same time, at the same speed."
Kuntz likes "checkerboard" charts to illustrate the historically wide range of returns for each asset class. "People see that annual dispersion averages over 30% from the best performing to the worst performing class," he says. Kuntz tracks when asset classes rose and fell in popularity.
Then he takes clients through a PowerPoint presentation, first illustrating how a model of the client's current portfolio allocation would have performed historically, then how a model of his recommended allocation would have performed. Kuntz also puts the presentation on paper so the client can review it further.
Dealing With Dogs Tell clients upfront they won't always be happy with asset allocation. "I say, `Every time you get an account statement or performance report, there will be something you wish you hadn't owned and there will be a star,'" Moisand says. "We don't know when the star will be a dog and the dog will be a star."
Moisand says he continually reminds clients why some of their money is in a poorly performing asset class. "We remind them that the S&P 500 doesn't equal their portfolio," he says. "We show them that in the years prior to the stock market boom, their portfolio would have been doing better than the S&P."
It helps to walk clients through recent popularity shifts in asset classes, Kuntz says. "I'll say, `See what happened to small-cap stocks this year. If you didn't rebalance at the end of last year, you really got whipped.'" This exercise reinforces Kuntz's importance in the investment equation as someone who can keep clients' portfolios on track during volatility.
Gibson says he helps clients identify and confront what he calls "frame of reference risk." When an investor's local market outperforms other asset classes, it colors the investor's view of risk, he says. For example, an American investor tends to think domestic stocks are always better performers. "I tell clients, `Diversification is good, but you'll have times where you'll lag the domestic stock market and you won't be happy,'" Gibson says.
Because clients need to take ownership of their asset allocation decision, Gibson says he's stopped using model portfolios.
Explain it Again Never assume your client knows what you're talking about. Take the client's temperature frequently in the asset allocation education process.
"A lot of clients nod and smile at me because they want me to feel good," Gleberman says. "I ask at several points along the way, `Could you repeat back to me what I just said?'"
Gleberman meets quarterly with clients for the first year or two. "You need to reinforce everything you talked about," he says.
James Knaus, a financial planner with LaBrecque Jackson Price & Roehl in Troy, Mich., probes a client's level of sophistication in the first meeting. "I say, `Asset allocation is a concept that's been around for a dozen years. May I ask to what extent you're familiar with the concept?' You need to find a client's level of understanding, then communicate at that level."
Knaus walks new clients through a brochure on his practice that features a detailed explanation of his asset allocation strategy. "I test a client's ability to follow my explanations before I bring out all the charts," Knaus says. "I ask, `How do you feel about our discussion so far? Is it more clear or muddy?' If the client is confused, I say, `Let's back up and go over this again.'"
It's a great time to tell the asset allocation story. In the past year, investors have had a front-row seat to asset class volatility with the dramatic swings of growth stocks. Pull out your whiteboard and help your clients make sense of it all.
When Roger Gibson's clients see the chart below, they see a blank slate. Gibson wants it to be interactive.
He explains the risk and return axes, then plots only the squares and triangles - with no explanation about what the portfolios hold. Would you rather be placed in a square or a triangle, he asks. Clients pick the triangle portfolios because they see higher return and lower risk.
Next Gibson plots the diamond portfolios. Would you rather be placed in a triangle or a diamond? Clients choose the diamond. Finally, Gibson adds the circle portfolio.
Would you rather be placed in a diamond or the circle? Clients pick the circle because they see no diamond has a significantly better return and all have more risk.
"I take off the `blindfold' and say, `You didn't realize you voted first for a two asset class portfolio over a one asset class, then a three asset class portfolio over a two asset class, then four over three," he says. Involving the client drives home the lesson that asset allocation reduces risk without diminishing returns.
Gibson is head of Gibson Capital Management, a Pittsburgh RIA and brokerage, and the author of "Asset Allocation: Balancing Financial Risk" (ISBN 0071357246), published by The McGraw-Hill Companies.