They're on the lips everyone in the industry, but we've lost sight of what they really mean; here's a refresher course

July 10, 2012 — 6:10 AM UTC by Rob Isbitts


In my experience, several investing buzzwords have done more harm than good for investors. While they are important concepts, they have been so commoditized by the financial planning industry that their true meaning has been misinterpreted.

All the while, Wall Street firms have reaped the benefits by mass-customizing portfolio management. What started as a concerted effort to help investors has been reduced to a marketing pitch — and investors keep falling for it.

For the most part, this is unintentional collateral damage stoked by a world that increasingly moves too fast for people. This makes it more difficult for them to really think carefully about understanding the data and charts in front of their eyes. Instead, they are addicted to sound bites from the media, and the sizzle of investing overwhelms the steak.

Here are five of the biggest buzzwords around and my suggestions for how to reclaim them for the benefit of both you and your clients’.

Asset allocation

The problem

The typical approach to spreading one’s assets to diversify and conquer is to have the client complete a risk tolerance questionnaire. That survey is important not only to establish guidelines for how the assets will be managed, but also because some form of it is required by securities regulators to make sure advisors know who their clients are.

In my experience, a common shortcoming is the type of questions that are asked and the historical returns that are then used to generate the allegedly “best” or “optimal” portfolio for the client, based on Modern Portfolio Theory. See: The 4 biggest investment performance myths — and how they can torpedo advisor-client trust.

The concept is sold based on stories about Nobel-winning theories and successful results during the last century. See:Why the Yale endowment model may still be fundamentally flawed. Returns in the future are predicted to mimic those of the past century or half-century.

But the client doesn’t have 80 or 90 years to wait around to see if the projection was accurate! And the markets of yesteryear seem like a lifetime ago. Technology and globally intertwined markets have changed the investment landscape. This calls for a different approach, one built for the 21st century.

Asset allocation approaches also tend to practice “de-worsification” (a term coined by star fund manager Peter Lynch.) This happens when an advisor spreads clients’ money over so many asset classes, investment styles and securities that the portfolio resembles more of an attempt to cover the advisor’s behind than to truly pursue objectives. This strategy can prove expensive to the investor in and tends to stunt the potential for cash flow generation, which some may need to live on.

My solution

• Ask more relevant questions upfront — find out what makes the investor happy or unhappy about the movement of their portfolio’s value.

• Carefully analyze, qualitatively and quantitatively, what the client wants.

• Construct a portfolio that combines a core group of individual stocks, supplemented by exchange-traded funds and/or mutual funds. See: The basic ETF trading practices that can save your clients money.

Desired result

Better targeting of client goals, avoiding de-worsification. (For more on this, see my column 4 reasons to use options — and 4 more reasons why you should think twice.

Risk tolerance

The problem

First, let’s be clear: Risk is the possibility that you will need money but don’t have it, either because your portfolio’s value plunged or because your investments don’t have near-term liquidity, or both. See: One size doesn’t fit all, or how advisors ought to adapt their strategies for their clients’ behaviors.

What freaks investors out in the here-and-now is volatility. Yet many traditional approaches to building a portfolio don’t really account for this, other than a token survey question or two. See: Five steps to get your clients out of bonds and into alternative, low-volatility investments.

Risk tolerance approaches tend to focus on determining the optimal standard deviation in returns. That is, how varied returns will be over time. In my opinion, this is an easy way out for the advisory firm. I think there are more-relevant performance statistics to use that prevent the possibility of oversimplifying the very critical upfront analysis.

Risk tolerance evaluation also does not always account for changes in the client’s disposition as his or her life evolves or as market conditions change. In other words, even an investor with considerable risk tolerance probably wants to know in advance what their advisor will do if a violent market period ensues. See: Why smart diversification and risk management are your best friends.

My solution

• Test a client’s tolerance for volatility, not risk, to reduce investor anxiety when emotions need to be most in check — during abnormally difficult market conditions

• Put those results on a volatility comfort scale, and explain clearly to the client what that it means. Do this using beta (a measure of security and portfolio volatility), not standard deviation (a measure of the variability of returns of a security or portfolio). This is essentially a “stress test” of the client’s investment attitudes before stressful moments arise.

• Explain how returns are generated: by a combination of a portfolio’s volatility and the skill added (or subtracted) by the portfolio manager’s active efforts.

Desired result

A better-educated client and a better assessment of what will keep the client in his or her comfort zone during all markets — not just good ones. See: The 10 most likely contributors to the next market panic.

Time horizon

The problem

This term can be hard to pin down. Is it the time you will invest until you leave this Earth? Is it the time until you retire? Is it a general guess as to how long you think you are supposed to be investing for before declaring victory or defeat with your current advisor? We have seen the term “time horizon” used in these and many other ways.

But just because someone has a 10-year time horizon, that does not mean that he or she will sleep soundly like Rip Van Winkle, wake up in 10 years and see how things went with the portfolio. The reality of today’s sound bite, mobile-communication society is that investors evaluate their results over shorter and shorter periods of time.

Rather than fighting investors on this, advisors should be focusing on what an investor’s evaluation horizon is. That is, what duration will they consider to be long enough to judge their results. Otherwise, the client and advisor can misinterpret each other, and, inevitably, interpret the same results differently. See: A refresher on how an advisor should approach the needs of clients as they near retirement.

My solution

• Follow the risk tolerance discussion with one about the time frame in which the client wants to judge success or failure. If that time period is too short for the advisor’s comfort, there is not a good match and they should move on. To us, the key is how far into the future the portfolio manager is looking when making an investment. Otherwise, it is like judging the winner of a basketball game at halftime.

• Understand the variability of returns over shorter time periods, and that portfolio risk-management has a lot to do with returns over longer time periods. That means that risk-management should be critical to investors of all time frames.

Desired result

• Less likelihood of client disappointment.

• A clearer objective for the advisor and portfolio manager in doing their jobs for the client.


The problem

Investors and their advisors have eased into the false-sense-of-comfort zone of evaluating investment results over standard, fixed-time periods, such as year-to-date or the past one or three or five years. These are all valid time periods to review, but we don’t think they are enough.

Why not? They are moments in time. A day after the three-year return is analyzed, another one replaces it. So, focusing too much attention on the latest 3-year period is a step in the wrong direction. It’s like dipping your hand into a big bowl of blueberries, choosing one and evaluating the entire bowl based on how that one blueberry tastes. See: Performance envy strikes investors as a familiar pattern sets in.

My suggestion

• Incorporate rolling returns in the analysis to supplement the standard to-date and trailing returns. That is, review returns over every three-year period the portfolio has experienced, not simply the latest one.

• Put the greatest weighting on the evaluation of performance over periods of three years. Very long periods of time are OK, but they can hide a lot of risky moments that the client may not stand for.

Desired result

• Provide both client and advisor with much more data to conduct a more even-handed evaluation of how things are going.

• Tune out the noise often created by volatile markets over short time periods.


The problem

Comparing one’s performance with that if one or more investment indexes helps the evaluation of results by putting it in the context of the market environment that surrounded those results. At the same time, there are so many possible benchmark indexes available that a simple exercise can become a confusing one, and leave the client feeling underinformed. See: Fidelity gives its execs a one-day crash course in RIA practice management.

My observation and opinion is that the S&P 500 Total Return Index (i.e., it includes dividends), while containing some flaws (it is heavily weighted toward the largest companies, it only covers part of the market), is one of the most recognizable market indicators around. It follows that investors likely want to know how they are doing against the S&P.

But this is not enough. Most investors we have known over the years don’t want to take on the level of volatility of the broad stock market. Thus, the S&P will often fall more than they are comfortable with for their own portfolio. To us, a more meaningful comparison to one’s portfolio is to view it versus what would have happened if they had put a fraction of their money in the S&P 500 and earned zero return on the rest. For instance, a 50% portfolio would experience half of the ups and half of the downs of the S&P, and thus produces a more conservative range of outcomes than the full S&P.

My solution

• Include three benchmarks for each portfolio or portfolio strategy: One that is based on the portion of the S&P 500’s volatility that the client is prepared to endure over time; another that represents a peer for the portfolio’s investment style: and the S&P 500 Total Return Index as this has become, over time, a very common and recognizable indicator of performance of the market.

• Calculate the portfolio’s volatility and participation in up and down markets over longer time periods, as a companion to the pure analysis of returns.

Desired result

• Creation of an evaluation of the portfolio’s results that a client can relate to.

• Emphasizing at all times the volatility endured to produce the results so that clients remain aware of what approach is being taken on their behalf.

By taking these buzzwords and re-educating clients on what they really mean, you can turn the tables in your favor and that of your clients’.That little bit of knowledge can take you a long way.

Rob Isbitts is the founder and chief investment strategist of Sungarden Investment Research, and offers advisory services through Dynamic Wealth Advisors. Rob is a 25-year investment industry veteran, author of two investment books, creator of several portfolio strategies, and former chief investment officer and mutual fund manager. He currently advises a limited number of high-net-worth private clients and provides outsourced investment strategy and research services to financial advisors from South Florida. Rob can be reached at His new blog site will launch later this month:

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