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The Power of Financial Planning - Part IV: Investment Planning

| May 08, 2018
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Each and every day I read an article that questions the value of financial advisors in developing an investment plan. I read about how it is close to impossible to “beat the market” with consistency, and thus perhaps there is no need for an advisor – simply put your investments in index funds and call it a day. However, I firmly believe this line of thinking inappropriately discredits the value that an experienced, virtuous CFP® can bring to the table.

In this article, Part IV, we will discuss the value of having a financial planner assist you in your investment planning. If you missed Part I, I explained the differences between having a CFP® involved in your financial planning vs. the various other types of advisors, as well as the ethical ramifications of which type of advisor you choose. In Part II, we discussed how a CFP® can help you prepare for retirement & (if applicable your children’s college) by making the right choices now. In Part III, we discussed the importance of protecting your family from an adverse health event. In Part V, we will discuss how a qualified CFP® can assist you along with your estate planning attorney in devising a tailored, precise estate plan and also support you in titling your assets/beneficiaries appropriately.

Alpha, Gamma and other Greek Symbols

Recent research from investment researcher Morningstar Inc. gives us as advisors (and you as clients) an idea of the added value of good investment planning:

An extra 1.82% per year.

That’s not some random amount, but rather the results of a study that Morningstar released in August of 2013. Functionally, Morningstar quantified how much additional retirement income investors can generate by making better financial-planning decisions; Morningstar coined this additional income “Gamma.”

As noted in the article, the potential benefits from “good” financial planning decisions are often difficult to quantify. For any given portfolio, investment decisions can generally be decomposed into two primary components: beta and alpha. Beta can generally be defined as the systematic risk exposures of the portfolio (usually achieved through asset allocation), while alpha is the residual, or skill/luck-based, component associated with the various flavors of active management (e.g. tactical asset allocation, security selection, etc.). Alpha and beta are at the heart of traditional performance analysis. However, these traditional indicators are less important than the other decisions an advisor can help their clients with.

Gamma, as defined by Morningstar, is “the extra income an investor can earn by making better financial decisions.” In the research paper, Morningstar researchers zeroed in on several key decisions. I will break down several of these decisions, along with other ways in which an advisor can be of help to you and you/your family in the following sections.

Before I get to those decisions, I also wanted to note another article, the bastion of do it yourself passive investing Vanguard. In a 2014 article, Vanguard noted that an advisor can add approximately 3% in “alpha,” or above average return, through relationship- oriented services such as providing cogent wealth management via financial planning, discipline, and guidance. Many of the main ways in which an advisor can add value are the very same actions that Morningstar noted in its article.

Investment Strategy

This may seem obvious, but many advisors develop their investment strategy differently. Developing an investment strategy is naturally very important, and advisors can provide value in determining which investments are most appropriate given the investor’s risk tolerance. In our investment planning, we like to look at the client’s strategy at both a micro and macro level.

First, we determine risk tolerance overall for the client, as well as understanding their capacity to take on risk. Risk tolerance for the client is determined primarily through a conversation with the investor prior to building an overall plan. Capacity to take on risk is just as important, and this really depends on the level of risk a client can “afford.” For instance, if we consider an investor with $400,000 in investments, this individual has much less capacity for risk than an investor with $10m in investments (provided they have the same proportion of living expenses).

Second, we build what is known as an investment policy statement – this is the macro road map that defines general investment goals and objectives of the investor – their “personal benchmark.” It describes the strategies on a high level that will be used to meet these objectives and contains specific information on subjects such as overall asset allocation, risk tolerance, and liquidity requirements.

Third, we build a strategy on a micro level by segmenting the entire portfolio into different segments. For those clients who have worked with us, I refer to these specified segments as “buckets,” which has different investments with differing risk profiles, from conservative to aggressive. We segment these “buckets” according to potential withdrawal time horizon. For instance, if you are 40 years old, you are unable to withdraw from an IRA without penalty before 59 ½, thus you can take on more risk with this type of an account. However, if you have a brokerage account, you have a greater propensity to make use of this account if the occasion arose, thus you have less of an ability to take on risk with this sort of account.

Building the investment policy statement and its corresponding strategy is just one piece of the puzzle. Once a strategy has been built and presented, it is important for the investor to feel comfortable with the strategy, which requires feedback from the client. I have seen many instances where I have built an investment strategy after understanding an investor’s risk tolerance, and the ensuing dialogue reveals additional nuggets about a client’s risk tolerance. This conversation very well may change the strategy, and it is simply part of the fluid process of professional investment management.

Rebalancing Your Investments

After we have initially set the portfolio, it is critical for the CFP to monitor the investment strategy. I have seen throughout my career how a bull and bear market can affect a portfolio, for bad or good. For instance, when the market goes straight up, it can be difficult for a client to take some chips off the table and rebalance their investments. Why is it difficult? Everyone loves a winner. If an investment is successful, most people naturally want to stick with it. But that may not always be the best result.

It may sound counter intuitive, but it may be possible to have too much of a good thing. Over time, the performance of different investments can shift a portfolio’s asset allocation and therefore its risk profile. It is a phenomenon sometimes referred to as “risk creep,” and it happens when a portfolio has its risk profile shift over time, requiring a rebalancing of the account.

There are a couple ways that an advisor can rebalance an account. The first is to use new money. When adding money to a portfolio, a planner can allocate these new funds to those assets or asset classes that have fallen. For example, if bonds have fallen from 40% of a portfolio to 30%, a planner may consider purchasing enough bonds to return them to their original 40% allocation. The second way of rebalancing (and more frequent) is to sell enough of the “winners” to buy more underperforming assets. Ironically, this type of rebalancing actually forces you to buy low and sell high. Why do this?

Periodically rebalancing your portfolio to match your desired risk tolerance is a sound practice regardless of the market conditions. Determining the best time to rebalance is one of the most important things that a good CFP can do, and it is really an “art” rather than a “science.”

DALBAR Study & Helping a Client with Behavioral Investing

There is an annual study that a company called DALBAR releases on a yearly basis that tries to quantify the impact of investor behavior on real-life returns by comparing investors’ earnings to the average investment (using the S&P 500 as a proxy). Thus, it compares an individual who simply invested in the S&P 500 and STAYED the course over the last 20 years vs. the average stock investor’s hypothetical return over that same time frame. The results in the 2018 study found that while the S&P 500 earned 7.2% annually, the average investor earned 5.29%. That means stock-fund investors underperformed the market by just under 2% annually for two decades.

What was the reason for this difference? The study cited that the largest reason is poor investor behavior, as investors chase returns—jumping aboard after a streak of hot performance and diving over the gunwales after it goes bad. When the market is up, clients forget the pain of past plunges, such as the financial meltdown of 2008, and feel they can accept more risk. This is naturally the worst possible time to jump into the market – stocks at this point may be overvalued, and a reversion to the mean is not too far off. Investors, however, have a strong loss aversion, and are not always cognizant of the idea that investing carries financial risk. When there is a market correction, suddenly, the market has become the Titanic and clients want to run for the lifeboats of cash; I have seen this very situation happen several times during the most recent downturn.

The value of your advisor is first and foremost helping investors in understanding their specified allocation and thus understanding both the upside but also (and infinitely more importantly) the downside risk. Having set expectations at the onset is critical for understanding the emotions that may come from the type of investment you are considering. This expectation needs to be reinforced throughout the relationship. Most importantly, when there is a correction in the market, the advisor must keep the client strong and voice their professional acumen about why the correction is happening and the importance of staying the course.

Tax Management

Tax management is a critical part of our job as investment advisors. Managing taxes is both an important part of building wealth as well as an important part of withdrawal in retirement. I hope to explain how we help our clients in both timeframes in their lives.

As clients build wealth, there are many strategies that we utilize to try to minimize taxes. First, the most basic way we do so is by taking advantage of qualified accounts. We utilize our client’s traditional 401ks/Rothks, traditional IRAs, non-deductible IRAs, Roth IRAs and 529 plans (for college saving). In doing so, we try to either minimize taxes now (traditional 401k/IRAs/non-deductible IRAs) or minimize taxes in the future (Roth(k)/Roth IRAs/529 plans). If a client has a brokerage account, we utilize investments that are sensitive to taxes. For instance, mutual funds, which distribute capital gains at year end, make very little sense for a brokerage account. Instead, ETFs, which minimize these year end taxes, may be a better alternative. There are a litany of other investments that have alternatives which may make better sense from a tax standpoint.

As clients move to distribution mode, there are several strategies which can be useful from a tax standpoint. This is where our understanding of a client’s situation as a holistic financial planner is hugely beneficial. For example, let’s take two investors, client A and client B, who are both now retired and need to pull from their investments the same amount of money. Client A has a pension and real estate income for total income of $150,000, while Client B has no income in retirement and has large medical bills. Now let’s assume each investor has a traditional IRA, a Roth IRA and a brokerage account from which they can pull from. The strategies that we will utilize for distribution will be very different.

For instance, Client A has significant income in retirement, thus we would not pull from the traditional IRA since any distributions will be considered ordinary income (all withdrawals at 28% and above) – it makes much better sense to utilize the brokerage account, which will create capital gains only (at 20% tax on the gain). The strategy for Client B will be quite different – it makes much better sense to pull from the traditional IRA and create ordinary income, since the ordinary income being taxed will be at a much lower tax bracket potentially after the offset from the medical expense deductions. Also, you have now pulled from a tax disadvantaged asset in retirement and created very little income instead of utilizing tax advantaged assets that we can now use down the road.

My hope is that you now have a better understanding as to how a qualified CFP can help you achieve the “alpha” and/or “gamma” in your investment planning.

Karen L DeRose and Anthony DeRose are registered representatives of Lincoln Financial Advisors Corp.

Securities and advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (Member SIPC) and registered investment advisor.  Insurance offered through Lincoln affiliates and other fine companies. DeRose Financial Planning Group is not an affiliate of Lincoln Financial Advisors.      Lincoln Financial Advisors does not provide legal or tax advice.

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