CHAPTER 11
DO IT YOURSELF OR HIRE A MONEY MANAGER?
For the Smiths the chore of investing their own portfolio has become significantly more difficult as the secular bear market environment plays out. What a stark contrast to the conditions they faced when the year 2000 rolled around. They fondly remember back to the late 1990s, as the prior 18-year secular bull market roared ahead in full glory. Their mutual fund holdings steadily built wealth and required little attention. That period climaxed with an incredible explosion of do-it-yourself day traders entering the investment world just when the online trading frenzy kicked into high gear. Encouraged by their seemingly effortless ability to pick winning stocks (virtually anything related to technology was in the midst of a parabolic climb higher), this new breed of speculator actually believed it was easy to compound investment profits of 20 percent or more annually.
Indeed, many people left their lucrative professional careers behind to trade the stock market, especially the technology and telecom darlings. Why in the world would they consider turning over the management of their portfolio to someone else (and pay fees) when they were making so much easy money and having such fun doing it themselves? But their temporary investment success was more a reflection on the age-old adage, “Never confuse brains with a roaring bull market.” Almost a dozen years later, after a three-year 80 percent–plus decline in the Nasdaq from 2000 to 2003, followed by another 60 percent–plus decline in the overall market in 2008 and 2009, that do-it-yourself investment psychology had taken a 180-degree turn. The Smiths never joined the aggressive trading crowd; their conservative, go-slow approach was more fitting with their temperament. But now, after realizing that during the last 10 years the passive buy-and-hold approach produced less-than-adequate returns and plenty of uncertainty, the Smiths are seeking professional guidance. They ask, “How in the world are we supposed to manage our own portfolio in these volatile times?” Portfolio management certainly has not been easy lately and not as much fun for the individual investor either.
As secular trends change, individual investors’ attitudes change with them. What happened in the late 1990s is not much different from investor behavior in the late 1920s or late 1960s, as those secular bulls peaked and gave way to new secular bears. The buying stampede was in full swing as those secular bull markets reached their peaks. Some argue that we have never seen an environment like today’s, and we would disagree. It’s just that these long-term trend changes don’t come around very often. And when they do, the typical investor is just not prepared for them. It is pretty easy to understand why. Just as investors learn the rules of how to make money in a secular bull market (just buy and hang on), the rules of the game change. How unfortunate. Precisely when most participants have figured out how easy investing can be, a cruel reality sets in. They are still playing with the tactics that worked so well in a long-term bull market, but in the new deeply cyclical secular bear environment, they need to change their strategy. It takes time to first understand that you are playing a new ballgame, and then to learn the new set of rules to win.
Protecting Yourself from Yourself
Countless studies (for instance, by Dalbar) over the years have demonstrated the difference between an investment return (say a particular mutual funds’ performance) and the average return the investor earns within the fund. Put another way, a mutual fund may have a great long-term track record based on the original dollar invested on day one. Unfortunately, investors recognize a fund only after it has outperformed for a considerable time. Such a fund attracts the most assets as it gains in popularity. So the average dollar invested in the fund earns a significantly different return (and often lower) from the original dollar invested. This is a subtle yet incredibly important distinction to make. How many investors purchased a highly ranked fund with a good track record only to be disappointed in its performance a few years later?
Many investors chase past-performance results and consequently invest after a fund has demonstrated success. Often that is late in the game for that fund’s style, manager, sector, or asset class. Indeed, we could go on to say that the biggest mistake investors make is to invest when they “feel” good about a particular investment, discover a fund that has a good track record, and join the crowd as the investment’s popularity climbs. And why wouldn’t an investor feel good about that? The investment is being repeatedly mentioned favorably in the media, everyone else is buying it, overall the news background is good, and perhaps even a third-party research organization or newsletter is rating it highly. There is significant comfort in following the crowd which often validates the decision and makes it easy to justify. After all, if everyone else is recommending it, it must be good. That may work sometimes or for a short period, but very often investments disappoint the most soon after their popularity peaks. Precisely when asset levels reach their peak, a fund begins a significant period of underperformance. That was true of the vaunted Fidelity Magellan Fund (or any other popular stock fund at the time; Magellan happened to be the largest) in the year 2000. For the next 10 years performance did not live up to the expectations of investors looking back at the stellar 10- and 20-year performance history. Gobs of money poured into the fund in the 1990s, especially as it neared its price peak.
That story helps explain why the average fund performance is often much different from the average dollar invested in the fund. Since most money came in near the top, most investors were disappointed with performance three years, five years, and ten years thereafter. The point of this discussion is not to disparage mutual fund managers; they know full well that money flows in and out of their funds based on past performance, and they are keenly focused on performance. Our point is that many investors need to protect themselves from themselves. There is a tendency for investors to let emotions drive their decision making and chase past performance. In this example, the emotion was greed, or the desire to find the “best” fund, or the “best” manager with the “best” return history. This typically translates into purchasing a fund after it has done very well for a considerable period of time and when there are plenty of fans recommending it.
Contrast the comfortable feeling in buying a highly rated fund to another one that has perhaps been an underperformer and offers good value, but is not highly touted. It takes a lot of courage to go against the crowd and purchase a new potential emerging winner before it is widely recognized and becomes a popular choice. No doubt, investing is a very emotional process and investors need to be aware of their own strengths and weaknesses. Investors must evaluate whether their emotions are a handicap to making successful investment decisions, like most investors, as reported in Dalbar studies, that buy high and sell low. In addition, investors must ask themselves: “Do I want to pay the ‘tuition’ necessary to become a good decision maker?” Another question to ask is: “Do I want to spend the time each day handling the responsibilities of this full-time job?”
The Smiths, like many investors, have to consider and decide whether they have the time, knowledge, experience, and, perhaps most important, emotional fortitude to do it on their own successfully. In the Smiths’ case, after careful evaluation they concluded that by turning over the day-to-day duties of money management, they could better enjoy their retirement years and have greater peace of mind. The next step is to hire a professional money manager whose philosophy is compatible with their own needs. Their responsibility shifts from daily decision making to periodic oversight of the manager to ensure adherence to their objectives and to monitor performance. What are the considerations and questions the Smiths should ask as they evaluate financial professionals?
Finding the Right Money Manager for You
The most important thing for you to do when you’re selecting a money manager to handle your portfolio is to fully explain your investment objectives and, as best you can, your ability to tolerate risk. Explaining your past experiences, both good and bad, is another important consideration that helps the advisor understand your circumstances and emotional makeup. Have you generally had success or disappointment when dealing with your investments? Why have they been positive or negative? What are your account balances, savings goals, retirement goals, and rate-of-return expectations? Based on your own beliefs and circumstances in these areas, are your long-term goals realistic or not? A good starting point for any interview is a frank discussion relating to your ability to tolerate risk. The agreed-upon level of risk tolerance puts a cap on the realistic expected total return. Once your tolerance for risk is established, the appropriate return commensurate with that risk can be calculated from historical data. Now you and the advisor can judge whether the firm’s investment philosophy and historic return ranges are consistent with your own objectives and risk tolerances. In other words, is there a realistic match so that the advisor will be able to deliver the stated return objectives while keeping risk levels within your comfort zone?
The next step is to fully understand the investment philosophy and decision-making process of the manager. Ask good questions. Can the manager clearly explain his strategy and how long he has been devoted to it? Does the strategy make sense to you? How does the manager go about protecting your portfolio during periodic cyclical bear markets? Specifically, how did the manager perform during the two 50 percent-plus market declines over the 2000–2011 time frame? Has the manager’s performance been calculated using Global Investment Performance Standards (GIPS), the financial industry’s standard used for measuring investment management performance, which can also be used to compare managers. How does the manager communicate with clients? How often and what type of educational information is provided to keep clients informed? Has the performance been consistent, and is it repeatable? Or could the good results be just a stretch of pure dumb luck? How long has the portfolio team been managing assets following this philosophy?
On Being a Good Client
Investment management clients focus on the manager’s responsibility to them and their portfolio. But a client also has responsibilities to the manager. If you find that your objectives are consistent with the investment manager’s philosophy, it is important to fully accept the broad concepts. If you say you agree with the strategy and sign a contract to engage the firm even though you do not fully accept the decision-making process, conflicts are sure to arise. For example, if the manager has a conservative approach and regards the protection of principal as the key objective for the portfolio, you may become frustrated at the overly safe strategy if riskier asset classes begin to take off. You may read about the great gains being made in a specific market sector or part of the world and may be disappointed that you are not participating in that market. The manager cannot be faulted for sticking with the firm’s own philosophy that has served it and its clients well for years. This type of conflict between client and manager is a recipe for trouble. Only by fully buying in to the firm’s investment strategy and making a commitment to stay the course will the relationship have a chance of success.
Even though managers hate to turn away prospective clients, it is in their and your long-term best interests for managers to indicate that you should look for another firm if your philosophies and risk-tolerance levels are not a good match. An unhappy client will leave sooner or later anyway, and difficult client relationships can drain money managers of the energy and time they need to devote to the markets and their other clients. Likewise, if you find that the manager is not performing up to your expectations or does not communicate clearly the direction he is taking the portfolio, it is best to search for a manager who is a better fit for your needs.
Assuming that you do have a good match with a successful money management firm, there are other important considerations that will make it a positive long-term relationship. Another imperative activity is keeping an open line of communication and dealing with the constant changes in emotions as markets swing back and forth. When a manager begins a relationship with a new client, he faces more than the battle of balancing risk versus reward and generating consistent performance. This is where the clients’ responsibility steps in, which is to not let their emotions of fear and greed interfere with the manager’s decision making.
The client places assets under management with a professional because he does not have the time, expertise, experience, or emotional aptitude to invest successfully for himself. The manager will often be investing in a manner that goes against the crowd. He will be buying when news is bad and selling when news is good. If the client doesn’t have extensive market experience or an understanding of market relationships, he will likely be of the opposite emotional state. When prices decline, the news background is invariably negative. Keep in mind that the definition of a stock market bottom is the point of maximum pessimism. It is little wonder that we find the client calling up the manager when he has just made some purchases at fairly depressed levels. Similarly at the other extreme near market peaks, the manager may be selling some winning holdings to nail down profits, but the client may be second-guessing the decision to sell when the news flow is so good. Again, a stock market top is defined as the point of maximum optimism—truly a good time to sell. It is best to not interfere with a manager’s decision-making process; you only damage yourself. In fact, successful portfolio managers measure investor psychology in order to take advantage of price extremes exaggerated by investor emotions of fear and greed. One investor’s emotional crisis is another investor’s low-risk opportunity.
Once you have rigorously examined the manager’s methodology, performance, and so on and made the decision to have him handle your account, the best thing you can do for both of you is to let him alone to get on with his job. Avoid the temptation to interfere unnecessarily. Obviously, this does not mean that you cannot or should not periodically evaluate his performance, but you do need to give him the benefit of the doubt until enough time has gone by for you to be able to make an absolute judgment.
If the investment firm does not perform well for you after a period of two years or so, it may be time to reassess your relationship. It may be that the investment strategy is still relevant, but it has produced below-average returns over the past two years. This can happen to the best of investment approaches and is a simple fact of life. As long as there is no style drift (where the investment strategy changes demonstrably in an effort to catch up to the market), rough patches should be relatively short-lived. One thing a client can do before signing on with an investment firm is check the performance history of the advisor and study the results during the worst market periods. How did the manager do in comparison? Where are the slumps when the manager underperformed? How long did these weak periods last and how much time did it take for performance to get back on track? Good managers are able to successfully take portfolio valuations back to new all-time highs within a reasonable period of time. That type of information is invaluable for new clients especially as they endeavor to get through the inevitable rough stretches comfortably.
KEY POINTS
1. Secular bear markets are difficult for investors, and a simple buy-and-hold approach is frustrating and not very rewarding.
2. Individual investors need to be aware of how their emotions can interfere with the portfolio management process—that is, emotions play a critical role in portfolio performance.
3. Hiring a professional money manager is a suitable solution if you are not confident in your own abilities.
4. The more you allow the manager to do his job unencumbered the better his performance is likely to be.
5. Interviewing and finding the right professional who is a good match with your needs is possible if you ask the right questions.
IMPORTANT QUESTIONS FROM THE SMITHS
What questions should you ask when you are hiring a money manager?
The following questions are a very good starting point for learning if a particular manager is a suitable match for you:
1. What is your investment strategy? (Is the strategy easily understood? Does it make sense to you?)
2. How long have you been managing assets using this strategy? (Has it been consistently used, or has the manager more recently adopted it? How much experience does the management team have?)
3. What is the performance—what are the returns and how much risk was taken? (Is the performance history documented? How has risk been quantified? How consistent are the returns—1 year, 3 year, 5 year, 10 year—versus a benchmark?)
4. What are the worst percentage drawdowns during the bad periods? (How much time did it take for the portfolio to get back to new highs?)
5. Will you communicate what we own and why? (Does the manager communicate when performance slides and things are not going well?)