Predicting Performance

By Jack Waymire

www.paladinregistry.com

 

Before choosing a financial advisor, you should figure out how much return you really need from your investments. Here’s how.

A recent study by Cerulli Associates, a research firm specializing in financial services, found that 57 percent of Americans with at least $10 million of investable assets have five or more financial advisors. That percentage was a huge jump from 2008, when only 16 percent had four or more advisors.

But the data make sense, particularly after the recent economic crisis, when many investors felt burned by the risks they’d taken. The use of multiple advisors is a way of containing the damage from any bad advice you might get from one advisor: You hope that better advice from your other advisors will offset the bad.

The approach, however, isn’t without its challenges. It will probably reduce risk, but it may also flatten performance. You may get so diversified that you’re a closet index fund—and you shouldn’t be paying advisors just to match the S&P 500.

 

There’s a better solution to the challenge of maximizing portfolio performance. It starts with determining how much performance you need and how much risk you are willing to take to achieve it. This information will help you determine how many advisors you need and the advice with the highest probability of helping you achieve your financial goals.

Don’t arbitrarily select a performance number or accept one from advisors who are trying to sell you investment advice and products. This is why pension plans have actuaries—to minimize the role of chance. Instead, calculate a rate of return by making estimates of your portfolio’s component parts.

Investment Expenses

Step one is to determine the amount you will be paying for investment services. Expenses include planners, investment advisors, money managers, custodians, trustees, CPAs, transactions, marketing fees and administrative fees. Let’s assume your fully loaded expense is 2 percent of your assets.

 

Inflation

Even a modest estimate, like a 3 percent inflation rate, doesn’t sound like much until you compound it for 20 years or so. Your desired rate of return should include an inflation assumption to protect purchasing power.

 

Taxes

If your assets are held in taxable accounts, transactions incur potential tax consequences. High-turnover portfolios produce the most tax expenses.

 

Distributions

If you’re retired, you may be taking 4 percent distributions from your assets to maintain your desired standard of living. (That number is conservative, intended to preserve equity.) If distributions are not offset by performance, you risk cutting into principal.

 

Premium Returns

After you add up the deductions itemized above, you should add a premium return to your calculation. The higher your premium return assumption, the higher your risk tolerance has to be.

For example:

Expenses . . . . . . . . . . . . . 2%

Inflation. . . . . . . . . . . . . . . 3%

Distributions . . . . . . . . . . 4%

Premium. . . . . . . . . . . . . . 3%

Total Return . . . . . . . . . . 12%

If you aren’t retired, disregard the distribution assumption while increasing your premium assumption. If you are retired, you may find the total return assumption distressing. After all, the only way to achieve it is to commit all or most of your assets to investments that appreciate aggressively in value (stocks, junk bonds). Most investors, however, would like to believe exposure to investment risk declines with age.

For your parents, this was a reasonable assumption. But increasing longevity has changed the terms of retirement. If you and your spouse retire at age 65, one of you has a 75 percent probability of living to age 95, according to the Department of Labor. A lot can happen during this 30-year period: recessions, bear markets, fluctuating interest rates, inflation, rising health costs and so on. You’ll have to take more investment risk than your parents to offset the danger of outliving your assets. That’s all the more reason to select your advisors wisely.

Curator