In the first series of these educational articles, one of the pieces looked at how you should properly calibrate clients’ expectations in terms of return (and risk). What we didn’t look at was the appropriate framework for monitoring performance and how to assess whether you, as the adviser, are adding value.

I’m not suggesting you create a stick to beat yourself with; that you have a benchmark against which you be assessed and risk firing if you fall short of this; quite the opposite in fact.

Many advisers unwittingly are being held accountable for performance issues over which they have little control. What I am suggesting is that you take more ownership of the performance monitoring part of the advice process and provide an appropriate framework for assessing it.

What is the appropriate time frame for assessing performance? 
Most advisers meet with their clients at least once a year. Or if not actually meeting them, it is a regulatory requirement to communicate with them at least once a year and appraise them of the value and performance of their investment(s).

In the event of the portfolio suffering a loss, the standard approach to dealing with this is to refer to market movements being beyond the control of the adviser, that these things happen and that the long term prognosis remains positive so that clients should stick with it.

There is nothing particularly wrong with this, but it is a little loose, in the sense that it is a mantra trotted out for every situation. It has the hallmarks of a ‘long term buy and hold’ strategy about it. There is a better way of dealing with this.

A glance at the point-to-point returns for calendar year 2011 will elicit little more than a shrug. Markets for the most part were relatively unchanged. Yet it was a year of gut wrenching volatility. 2011 served up six days of daily movements on the US stock market in excess of 4% (positive and negative), despite finance theory dictating that this should happen roughly 3 times every four years.

The problem with extreme volatility of this nature is the impact this has on investor behaviour. Owing to what has now become an extremely short time horizon, investors for the most part are just not cut out for dealing with this level of short term volatility. The average holding period for a stock on the New York Stock Exchange is now just 6 months, compared with around 3 years in the 1990s.

One critical thing to coach your clients about relates to performance and the frequency with which they should monitor it. You can achieve better long term results if you educate your clients to focus on the real risks of investment. Short term price fluctuation is not true investment risk.

Stock markets contain far too much short term ‘noise’ making any assessment of performance over short time periods meaningless.

How frequently a client monitors a portfolio’s performance can bias their perception of it. Suppose a client is investing over a 5-year investment horizon in an equity portfolio?

Data from the US shows how you would perceive the portfolio depending on the monitoring period.

Source: Aspects of Investor Psychology, Kahneman and Riepe, 1998.

Consider the table above. Over the minimum 5-year time frame, equity performance has been positive 90% of the time, and so risky investments do not lose money more than 10% of the time. However, if you were to monitor the performance of the same portfolio on a month-by-month basis, you would observe a loss 38% of the time. Although this report is over ten years old, the data relates to 71 years of stock market history. If incorporating the past decade it would most likely show that monthly returns show a loss more frequently than 38% of the time – which would strengthen the point that monitoring performance regularly would cause investors to do undermine their own returns.

Monitoring a portfolio more frequently will cause clients to observe more periods of loss, and owing to an inherent sense of loss aversion, very likely cause emotional stress resulting in them taking on less risk than may be appropriate for their long-term investment objectives.

Worse still is the danger that clients attempt to time markets based on emotion or sentiment, the empirical results of which are simply appalling (see last section).

This is not an argument for buy and hold. This is an argument for being aware of the emotional reaction the average investor has to extreme gyrations and coaching your client into having a reasoned response to these inevitable swings. The next section outlines how you might go about this.

How do you add value to your clients?
You have no control over stock, bond or property market movements. In truth, neither do the people to whom we entrust the management of our money. But what you (and fund managers) do have control of is the process by which you give clients advice.

Many advisers find themselves in the position of having to defend themselves against disaffection on the part of clients when investment results are not what they feel they have been promised, even if they weren’t explicitly promised anything. Equally, advice that bears fruit over short time periods should not be celebrated. Advice that is judged purely on outcomes is inevitably going to reward the lucky and potentially punish the skillful (though unlucky).

Most advisers will have an idea as to where they add value to a client. It could be saving them money through tax efficient advice. It could be an investment strategy they recommended that paid off. You need to position your added value with respect to investments as being something which is distinct from the short term outcomes, without trotting out the ‘long term buy and hold’ mantra.

It is your job as a financial adviser, to use your experience of investor behaviour to coach your clients in achieving better results than they would without a professional adviser.

This essentially boils down to providing discipline and logic to clients who are often undisciplined and emotional. This is where you can add real value. This is an area where you may already be adding value, but have not thought about it in this way. It’s time to start promoting this part of your service.

How would you present this approach to a client?
The evidence that investors have a generally poor track record with investments is amply demonstrated by two charts (see below).

Chart 1 – Poor Timing

 Chart 2 – Emotional Tax

Historical studies of mutual fund cash flows show that after protracted periods of relative outperformance in one area of the market, sizeable cash flows tend to follow. Chart 1 superimposes a chart of the S&P500 onto a bar graph showing net fund flows into equity mutual funds. What is clear is that most money exits the market at cyclical low points and most money enters the market at cyclical highs. This performance-chasing behavior can seriously harm a client’s long-term returns.In addition, the evidence from Dalbar (chart 2 – emotional tax) is damning. It looked at the returns to investors in US equity funds over the twenty year period 1990-2009 comparing it to the return on the US stock market. The S&P500 returned 8.8% p.a. over the twenty years. Over the same period, the average return to investors in equity funds was a paltry 3.2% p.a. Why?, lack of patience?, loss aversion? There are several plausible explanations but it essentially boils down to investors switching into and out of funds at inopportune times.

I would present these charts to a client and position your target as being one which aims to improve upon this return shortfall by means that don’t depend on market outperformance: asset allocation, rebalancing, tax-efficient investment strategies and effective investment communications.

Having a robust approach to selecting funds is an important part of the investment process also. But the value you can add by coaching clients into making more disciplined asset allocation decisions will be of overriding importance.

This type of benchmark model relies on the experience and stewardship that the adviser can provide. We have looked at asset allocation and re-balancing previously. Tax efficient investment is rules based and can be objectively followed.

The investment communications piece is much more subjective. One approach to encouraging restraint is to have a formal, written investment policy or allocation guidelines for the entire portfolio. We looked at this previously in the first edition of the educational series. There are other aspects of communications which are aimed at educating clients, some of which we will touch upon in other articles in this series. 

Gary Connolly

Email: gary@icubed.ie.

website: www.icubed.ie

When you go to a doctor, you expect to be told how much the consultation cost you.  Similarly, your solicitor will not be shy in presenting you with the bill for his/her services.  Unfortunately, the picture is not quite so clear for financial advice where the actual cost of financial advice is not always entirely clear for the investor.  However, a confection of acronyms is coming to the rescue.

MiFID II, IMD II and PRIPS – a minefield of regulatory acronyms but one that will impact most investors and their financial advisors in the near future.  European authorities have been busy in recent years working on new legislation that aims to achieve a range of goals.  These goals include:

• A high and consistent level of policyholder protection embodied in the EU law;
• Effective management of conflicts of interest and transparency;  and
• A higher level of professional requirements for financial advisors.

The legislation will come into force between 2012 and 2014 and it will have a wide ranging impact on the way in which investment and insurance products are sold across Europe. 

This short article focuses on the impact on investment products. Many of the proposed changes will have a very positive impact on investors albeit the wider industry will need to adapt its practices to accommodate the new legislation.  While nothing has been fully finalised yet, it is likely that the new legislation will address sales commissions on investment products.  Today, when an investor purchases an investment product from a life assurance company via a financial advisor, in most cases the life company will make a commission payment to the financial advisor.  The European authorities believe that this approach to business is not sufficiently transparent and can lead to conflicts of interest.  The alternative approach is for financial advisors to charge a fee for their services akin to the fees charged by doctors, accountants and solicitors.  This would require a step change in attitudes but there may be no choice. 

There are financial advisors operating in the Irish market that have already taken the step to move away from commission based remuneration to a business model based on fee charging.   These advisors remain in the minority but they have demonstrated that the charging of fees can be the basis for a viable business.  More importantly, they have demonstrated that Irish investors are prepared to pay for a service that they place a value on.  This scenario is being played out in the United Kingdom where all financial advisors have been set a regulatory deadline of December 31^st this year to switch from commission based advice to fee based advice. Denmark and the Netherlands have also moved in this direction.  The Consumer Protection Code, which came into effect at the start of this year, has also taken a step in this direction by requiring product providers to ensure that nothing in their terms of business might be construed as introducing a conflict of interest for a financial advisor.

So what will all of this mean in practice?  Let’s use a real life example to illustrate.  Today, a major product provider is offering 108% allocation on certain investments.  This means that €108,000 will be invested on behalf of the investor for an investment of €100,000.  Alternatively, the financial advisor can take up to 8% commission and the investor continues to have €100,000 invested.  At first glance, this does not seem too controversial.  However, the client will experience surrender penalties if they elect to surrender in the first 5 years.  These surrender penalties effectively pay for the advisor’s commission.  But, does the advisor not have to disclose the commission to the client?  No.  The product provider is obliged to disclose the commission payment to the investor but this disclosure is regularly buried in a mound of paperwork that is issued with the provider’s policy documentation.  It is clear that not all investors are aware of the commission levels being paid in cases such as this; otherwise, a commission payment of €8,000 (or even €5,000 if the advisor “only” takes 5% commission) would lead to a very interesting discussion indeed between advisor and investor.  The proposed regulation would sweep away this practice and bring to the fore the need for  direct payment for financial advice.  The payment would only be made to the advisor following an explicit agreement by the investor.  This approach is patently more consistent with an overriding objective of transparency and fairness.  Indeed, those advisors that have switched to fee based remuneration are enjoying a control over their bottom line that can only be dreamt of by those relying on commission based remuneration that is driven by enhanced allocation rates paid by life companies such as the one in the example outlined above.

Nothing will happen overnight but, as the experience in the UK demonstrates, no amount of lobbying by vested interests can stop a momentum that is grounded in greater fairness, equity and transparency for the consumer.

Aidan Sherry

AXA Financial

Your clients’ perception of ‘risk’ and what the financial services industry considers to be ‘risk’ can differ entirely. Clients in my experience do not think of ‘risk’ in narrow mathematical terms, so relying solely on quantitative measures of risk, such as ‘volatility’ can lead to confusion.

Relating the risk to return and then translating the conversation into an actionable investment strategy for a client is not that straight forward (you may remember that I discussed this challenging aspect of investment strategies at greater length in one of my earlier education pieces, “Stacking the investment odds in your clients’ favour”.

Many portfolio planning tools can translate the output of a questionnaire into an investment strategy if required, however this is where financial advisers add value. At a certain point between having assessed a client’s attitude to risk via a questionnaire and ultimately recommending an investment strategy, the science of investing gives way to the ‘art’ of investment advice.

The ‘Science’ and ‘Art’ part of investment strategy…

A client’s ‘willingness’ to take risk, as measured by a questionnaire for example, is only a small part of a client’s full and true risk profile.

Three key components comprise an individual’s true risk profile:

1. Psychological willingness to take risk, sometimes called ‘risk attitude’ or ‘risk preference’
2. Financial ability to take risk, or ‘risk capacity’
3. Need to take risk, including the need to accept risk to meet an objective, avoid falling short of a goal or having wealth eroded by inflation.

The ‘science’ part is important here. The use of investment planning tools lends an element of sophistication and much needed consistency. A recent report by the FSA in the UK found widespread failings in the consistency of the advice being given to clients. The ‘art’ part of advice is critical as we will see below, but the subjective element needs to be carefully controlled. Where there is no defined and structured process for risk profiling, firms with multiple advisers are at risk of recommending unsuitable investments.

A client’s psychological willingness to take risk can sometimes clash with their financial ability to do so. For example, a client might express a preference for risk which is low, but have a financial situation which indicates a risk capacity which is higher. When such a conflict exists, financial advisers need to take time to counsel the client and explain the consequences of the mismatch. You’ll need to explain the consequences of low returns to more conservative investors with liquid wealth and vice versa.

Ultimately, a client might insist on an investment strategy that matches their risk attitude and the adviser may need to accept this. But having had the conversation, the client/adviser decision will at least be in the context of a thorough review of the investor’s risk capacity, attitude and need. These softer elements of risk assessment cannot be determined by a formula or a financial model.

From questionnaire to conversation…

Having completed a fact find and a risk profiling questionnaire, you have the basis for a broad conversation around risk and return. If you establish that a client is 3 out of 5 from a risk profiling questionnaire you would use the typical asset allocation for a 3 out of 5 strategy and apply the long term returns to guesstimate what the typical best, worst and average experience for that portfolio would have been.

As an investor’s time horizon lengthens, the greatest risks are that the investor’s assumed rate of return is not met and/or the value of the investment is eroded by inflation. Rather than discussing an investment’s risk in the context of volatility, it therefore makes sense to consider the following investment risks:

Shortfall Risk
This refers to the risk of failing to meet a long term investment goal. This can arise for several reasons. If an investor didn’t take on enough risk to generate the returns required. On the other hand, they could also be exposed to shortfall risk if they invest in too many high risk assets causing their portfolio to lose value at the wrong time.

This is a serious risk to consider. Clearly, certain assumptions about the future have to be made in terms of determining a strategy for reaching goals, which may turn out to be erroneous. But all clients have to go on is the historic experience of asset class returns.

Familiarise yourself with long term asset class returns. Don’t use long term average returns – this runs the risk of falling for the ‘flaw of averages’; between Tiger and myself, I have won seven golf major titles, on average!

A better way to use long term return data is to consider various scenarios by using rolling ten year histories (best, worst and average)for various investment strategies (the latest Credit Suisse Investment Returns Yearbook contains such information, see below).

Inflation Risk
Inflation was described by Milton Friedman as the only tax to be introduced without legislation. It is like a stealth tax eating away at the value of money. One of the hardest things for most investors to accept is that in a low inflation environment, a return of 6 or 7 percent is an attractive option. Minimal inflation makes double digit returns a practical impossibility unless you go much further up the risk scale than you really want to be.

Whilst most clients understand they want to preserve wealth, we all have a natural tendency towards thinking about money in nominal terms, i.e. without factoring in the effects of inflation. Clients may not see a smaller cash balance in their accounts, but they will definitely lose buying power. In other words, the amount that they can purchase with each euro slowly erodes over time.

The current obsession with cash may appear to be low risk in the context of avoiding alternatives which may pose some capital risk, but there is a much more subtle and definite capital loss risk with cash also. Inflation in the US over the very long term has averaged c. 3% p.a. Clients that ignore the risks posed by inflation, do so at their peril. 3% inflation reduces the purchasing power of a portfolio by one quarter over a ten year period.

It is important that your clients don’t confuse certainty and security. The certainty of cash returns does not provide security against inflation.

The latest Credit Suisse Investment Returns Yearbook (2012) devotes a whole section to a discussion on assets that provide a hedge against inflation.

Moving the conversation from risk and return to investment strategy…

• At this point a client has filled out a risk profiling questionnaire – so you have some quantitative assessment of what their risk attitude is. This forms the basis of a broader conversation on risk and return. 
• You have had a conversation with the client and explained the multi-faceted nature of investment risks and now have a better qualitative assessment of their risk profile.

It is now time to decide on the appropriate investment strategy given the clients’ objectives. Some advisers will have model portfolios which they use. Whether you use model portfolios or not, you will have formed an opinion as to what the appropriate portfolio for the client is at this stage. Now the potentially thorny issue of monitoring the portfolio both in terms of performance and investment strategy will arise.

A client’s expectations in terms of return and risk need to be properly calibrated. But critically important within this, is the framework for monitoring a portfolio’s performance. What is the appropriate time frame for assessing performance over? We will be looking at this in the next article in the series which asks the question “How do you add value to clients and what should your benchmark be?”

There is no single answer as to how to construct an investment portfolio for a client. There is no model that will provide a robust approach. Ultimately this has to be decided through careful consideration of a number of qualitative factors, whilst also drawing on the useful quantitative approaches along the way.

Find a questionnaire you are comfortable using and use it consistently. Use the output from this to provide the framework for a broader conversation on risk and return. And remember that financial security is not achieved through avoidance of all risk; this is impossible. It is achieved through appropriate diversification. A seemingly obvious, but oft ignored principle.

Gary Connolly

Email: gary@icubed.ie.

website: www.icubed.ie

“You can’t produce a baby in one month by getting nine women pregnant. It just doesn’t work that way.”:  2008, Warren Buffett on CNBC.

“Stocks at one-week low”: Nov 11, Irish Times online edition.

“The Fund was up 0.5% yesterday & the market was down 1.4%”: Nov 11, un-named fund manager. 

We live in a world obsessed with information. What’s more, we live in a world with a very unhealthy fixation on short term results. Be careful what you wish for!

The first quote in the trilogy above is from Warren Buffett. He makes the point (somewhat facetiously) that some things just take time, they cannot be rushed. Patience is a virtue, particularly in the world of investment.

I took a number of recent quotes (above) from a few different sources to make a point. The second quote is understandable, as it is a newspaper pandering to our thirst for information. The last quote is less forgiveable. Fund managers regularly complain to me that advisers are far too short term focussed, so it is disheartening to see one indulge this.

Our obsession with results and thirst for instant gratification is counterproductive. Yes of course outcomes are important. But the requirement for ‘proof’ in the form of short term results, only serves to incentivise its delivery at the expense of long term returns.

This edition of the investment educational series is about properly calibrating a clients’ expectations in terms of return. It will outline why short term results might not be in your clients’ interest. It will show how you can achieve better long term results if you educate your clients to focus on the real risks of investment.

Why are short term results not in your clients’ interest?

Stock markets contain far too much short term ‘noise’ making any assessment of performance over short time periods meaningless. Quarterly performance reviews are more likely to lead to poor decisions than prudent ones. One adviser I work with has a client that demands monthly performance updates. Just think, how many times Buffett would have been fired if he was working under these circumstances?

If a client obsesses over short term performance they are in danger of rewarding the lucky cranks and punishing the genuinely skilful whose style may be out of favour. Investing like many sports involves a combination of skill and luck. If measuring performance over a short time horizon, there is a reasonable chance we are measuring luck, which ebbs and flows. Proper recognition of the role that chance plays in our lives (within and outside of investment) would cause you to do things differently.

Investing in risk assets does not lend itself to regular review. If there is a genuine focus on fundamental value, how can a focus on short term results be anything but counterproductive? Investment: Theory v Reality #4 December 2011

Consider the implications of this. From a fund manager’s point of view there are 2 sets of risks in managing a fund:

1. Valuation risk: buying something at too high a price, putting capital at risk.
2. Benchmark risk: tracking error and volatility (as a bad rather than good thing) – the danger of underperforming a benchmark and losing funds under management.

Your clients are pressuring you. You are pressuring investment managers. And investment managers pander to those pressures by focusing their efforts on delivering what is in demand. This causes a focus on the second set of risks above, i.e. the risks which are of significantly less importance in terms of delivering long term returns. Short termism is counterproductive.

In the Investment Policy Statement edition of this series I referred to the emotional challenges that investing poses. This impediment to investment success is greater than any other. The temptation to abandon well thought-out but disappointing strategies moments before they work, in order to chase successful strategies just as they are about to run their course, can be overwhelming. The IPS serves well in attempting to avoid these challenges. But how do you properly advise clients in terms of return expectations?

Calibrating Clients’ Return Expectations

It is firstly important to remember that economies grow at roughly *3% p.a. (*source: Crestmont Research) in real terms over the long term. Expectations for double digit returns are therefore an exercise in hope over experience. This is a seemingly obvious error, but one that is often made. Secondly, it doesn’t really matter how well you do in good times; over the course of many years it is how you fare in the hard times that will determine success. Consider the case of two investments;

Investment 1 earns 10% a year for ten years running. The second, much more exciting fund makes 20% a year in seven years, and loses twenty percent in three years (the chronology of returns makes no difference). The mental picture of the two suggests the ‘high’ return fund as producing a return higher than the ‘low’ return fund. In fact, the return from Investment 1 is almost double that of the Investment 2.

Investment 2 has the bragging rights for 70% of the time and as a result is much more likely to attract assets. We all seek investment returns which are above average, but the route to good performance as Howard Marks from Oaktree puts it, “is through consistency and protection, not single year greatness”. (As an aside, Howard Marks most recent book is well worth a read).

So at a practical level, you have a client with a portfolio of equities, fixed interest, cash, real assets and absolute return; how do you calibrate their return expectations? One popular method is to use scenario analysis which depicts the average experience of a portfolio invested along the lines you suggest. This is normally achieved through the use of Monte Carlo simulation. There are some serious flaws in this method of analysis in its application to stock markets (which I won’t go into here).

My preference, albeit simplistic and by no means precise, is to take the long term returns for each of the asset classes and present best, worst and average 10 year returns. For example, the following table uses Sarasin & Partners data to show real return experience (i.e. after inflation) over rolling 10 year periods for equities, bonds and cash using 111 years of data. The numbers are annualised.

The above data provides the basis for a proper discussion about return (and risk) with a client. The key points to emphasise are:

• Ignore short term performance – so long as the client is adequately diversified, and is properly educated about returns, then you should appraise them of the dangers of focusing on the short term (as outlined above).
• The nature of compounding returns is an important concept to get across. There is any number of charts you could present to demonstrate the power of this (e.g. Barclays Equity Gilt study or Credit Suisse Global Investment Returns Yearbook).
• The emphasis on consistency and protection is well depicted in a simple slide or graph which shows the impact to a portfolio from varying levels of losses (see graph below from Crestmont Research).

If your clients understand the nature of compounding money, are seeking consistency and protection, understand the dangers of a short term focus, and are presented with a best, worst and average scenario for their portfolio, their expectations for return are most likely to be sufficiently calibrated.

Finally, if your clients are not going to obsess over quarterly performance, they must be comfortable with your investment process. All of the above presupposes you have one. This series of investment articles goes a long way to providing you with the outlines of a structure for putting an investment process in place.

Gary Connolly

Email: gary@icubed.ie.

website: www.icubed.ie

I was at an investment conference recently at which the following question came from the floor; “Is there a bubble in risk aversion?”

It was the most interesting question posed all day. Investors have been through a disastrous decade for equities, including two fifty percent bear markets. Investment flows into risk assets have slowed to a trickle.

After a bad experience, Mark Twain’s cat never sat on a hot stove again, but he never sat on a cold one either. Are investors now so chastened that like Twain’s cat, they will not consider risk assets again?

It is critical for clients to understand what the true investment risks are. Unfortunately standard finance theory is unlikely to provide help here. 

Problems with Finance Theory

In finance, volatility is the standard measure of risk.

Have a look at the chart below from GMO*. Using volatility as the measure of risk forces you to sell at precisely the wrong time. Periods of high volatility are usually associated with periods of below average prices, i.e. the points at which the investment odds are stacked in your favour.

Unfortunately finance theory far from helping, is in fact a hindrance.

Daily stock market movements in excess of 4% (either positive or negative) are supposed to be a rare event. In fact, finance theory dictates that such ‘extreme’ events should happen roughly three times every four years. This year alone, how many of those ‘rare’ events do you think we have endured? Six! So much for finance theory.

The impact this (high volatility) has on investor behaviour is significant. We are all inherently risk averse which is why most of us would not wager a large sum of money on the flip of a coin, despite it being a fair bet. In the world outside of finance, this is a good thing for evolutionary reasons. It helped our ancestors survive on the Savannahs. But it is counterproductive in the world of finance. It means we like to be right and seek investments with a high probability of success. It is not the frequency of success that matters, but the payoffs from being right versus wrong. This is incongruent with the way the stock market works. If an investor prefers to be frequently correct, then they are best pursuing a strategy of investing in cash and accepting the inevitable loss of real return this will involve.

Beware of certainty when investing in financial markets

Investing in the stock market right now, probably has a low probability of success in the short term (the market may be more likely to continue to go down based on recent momentum), but the potential payoff if markets rise looks considerably better based on the price we are buying it at (Europe in particular). If there is a 70% chance that the market will go down over the next 12 months by 20%, but a 30% chance that it goes up, but by 75%**, then the expected value of that proposition favours being ‘long’ the market.

If only it was this easy. Obviously the stock market doesn’t offer such defined bets where you can calculate the odds of success as easily as I have done here. The financial world is far too complex for that. Anyone using a decimal place in financial market estimates is only showing you that they have a sense of humour. Yet, you probably find that very often your clients are quite certain about (future?) financial market events.

Consider a very recent phone call I received from an adviser who relayed to me the following statement from one of his clients; “I have it on good authority that the Euro will collapse within the next month”.

I’m not saying this is wrong. But it’s based on a far too narrow view of what the future might hold. This person is far too certain. Remember when things are bad, we usually think they are really bad and oversell things. Likewise, when we think things are good we think they are really good and we overbuy them. This particular client was looking to buy German bonds. Lending money to the Germans for ten years at less than 2%? There doesn’t appear to be much room for error here.

Stacking the investment odds in your clients’ favour is about the following:

If there is anything we have learned from the past decade, it is that price and valuation matter. The probability of a capital loss is a function of the price at which you buy something. All else being equal, the higher the price you pay, the greater the chance of subsequent loss.

While you can’t ignore volatility, it is incumbent upon you to understand where volatility helps and where it doesn’t. It makes more sense to pay attention to the price you are paying, not the variation in it.

The dividend yield on European equities is in excess of 5%, with a cyclically adjusted PE of c. 11x. The equivalent PE (price) for Cash is about 100*** and German bonds is 55, and investors can’t get enough of it.

There aren’t too many investment experts that would disagree with the standard advice on diversification, yet this is being completely ignored at the moment. The client referred to above is far too certain and is unwittingly taking a very risky stance with his portfolio.

It makes eminent sense, if for no other reason than to placate concerns, to consider investing in non‐euro assets and hedge the potential risks of a euro breakup. But a measured approach is best. Advising clients against taking evasive action (like our client above) is good advice. But remember, if the Euro does break up, this doesn’t make your advice wrong – just a case of good process, bad outcome. You’ll catch a full house by staying in a hand of poker with an off suit 8 and 2 the odd time – but it’s not a good decision long term.

Risk assets come with a price, which sometimes makes them less risky than the supposed low volatile alternative. If I’m buying something at a valuation which is below long term averages, the odds are in my favour that I will earn an above average return over the long term.

The last article in this series was about Investment Philosophy. One of the principles by which you should be offering investment advice is the achievement of better investment returns for a client than he/she would achieve without your help. You should be educating your clients about the acceptability of being wrong in the short term if the odds favour being right eventually. This is an uncomfortable proposition for some. Just as well! Above average investment returns can only be earned by profiting from the mistakes of others.

A disciplined and rational approach to investing should skew the odds in your clients’ favour.

* GMO: is a privately held global investment management firm

** Expected value is outcome times the probability. In this case, (70%x-20%) + (30% x +75%) = 8.5% positive expectation.

*** Based on an interest rate of c. 1%.

Gary Connolly 

Email: gary@icubed.ie.

website: www.icubed.ie

The mention of the term ‘Investment Philosophy’ sometimes meets with resistance from advisers I speak with. Rather than being some highfalutin concoction of a disconnected (from reality) consultant with little relevance to everyday investing, it is actually a very critical part of an investment process. So before your mouse goes on a hunt for the blessed release of an alternative internet page, consider the following:

• What is your firm’s approach to managing investment risk?
• What is your firm’s view on strategic and tactical asset allocation?
• What is your firm’s view with respect to passive investing?
• What is your opinion on diversification?
• Does active fund management have a place?
• Do you recommend market timing?
• What is your firm’s view on market efficiency?

In the last investment education article we looked at putting together an investment policy statement, which is the blueprint for the management of a portfolio. This is a very practical tool in communicating effectively with investment clients and summarises the approach to be used in managing a portfolio. But, before outlining your investment process, it is important to outline the investment principles which guide your thinking and beliefs about investing.

You must give some thought to the questions above before putting an investment process in place. This will form the basis of your firm’s investment philosophy.

All of your investment activities should operate according to a specific, unifying philosophy which you identify up front and which should cover some or all of the areas outlined above. So to be more specific, or practical, here are the steps involved in developing an investment philosophy for your firm.

How do I develop an investment philosophy for my firm?

Step 1:
Your views on market efficiency or inefficiency should be the foundations for your investment philosophy. While capital markets are a complex system involving many moving parts, views on whether markets are efficient at pricing information or not, is largely binary. The degree to which you believe markets are efficient or not can be dealt with separately, but firstly decide on where you stand with respect to this debate.

Step 2:
All investment philosophies revolve around a view about how markets work or fail to work and the types of investment behaviour that underlie that activity. Success in investment must arise at the expense of someone else’s mistakes. So identifying where it is that investors make mistakes is a critical step.

Step 3:
You take your views about the principles guiding investment markets and role investor activity plays in this and try to devise strategies that reflect your beliefs.

By way of example, a belief that stock markets are inefficient, would translate into an investment philosophy which would, in the main, be dismissive of passive management. The investment strategies, reflecting this guiding principle would be to use active funds for the majority of a portfolio. This is a little simplistic and investment strategy would have many more aspects to it, but this is just to make a point.

Just to be clear, this is not my own belief. It is not for me to dictate what a firm’s investment philosophy is. I am merely trying to promote the idea of conceiving of a set of principles which will guide your firm’s investment strategy.

Why should you have an Investment Philosophy?

It is a rudder which guides you in the direction of particular investment strategies and funds. An investment philosophy promotes consistency of investment advice. Particularly where there is more than one adviser at a firm, this is extremely important.

In the absence of a core set of beliefs or guiding principles, an adviser is much more susceptible to the following:

1. Fad investing and product selling.
2. Having an investment strategy that is influenced by what others are doing.
3. Switching from strategy to strategy will inevitably promote buying high and selling low.

Being influenced by what others are doing may not seem to be that problematic. There aren’t many professions where it pays to think differently to the consensus, but investment is one of them. If you are building a bridge and solicit the opinion of fifteen different engineers as to the best approach, you would be very mistaken to ignore the consensus opinion. Investing is quite different. While not as simple as taking the complete opposite view, it pays to think independently.

Summary on Investment Philosophy

There is no ‘correct’ investment philosophy. Yes, there are certain views I would have about how markets work and this would influence the investment strategy that I would recommend.

It is not the purpose of this article to foist my views upon you, but rather to get you thinking about an investment philosophy and how important it is as a guiding principle within an investment process.

In an effort to steer you in the right direction, as opposed to offering you something to plagiarise, I have included below as an appendix some suggested headings under which you might begin to develop your own firm’s investment philosophy. I have taken some of these principles from various investment websites and adapted the language and context for use by financial advisers.

Finally, a search on the internet for investment philosophy directs you mainly to sites concerned with managing discretionary assets on behalf of clients. Clearly, this is not the case for the vast majority of financial advisers. So be careful in how you interpret and use information from these sites. There are a lot of good ideas to be harnessed but they need to be placed in the right context.

Gary Connolly

Email: gary@icubed.ie.

website: www.icubed.ie

Appendix – Headings for considering an investment philosophy

The primacy of risk control
Superior investment performance is not our primary goal, but rather superior performance with less than commensurate risk. The emphasis at our firm is on consistency and protection and less on one off high returns.

Focus on process not on outcomes
Investing successfully is difficult, and so it should be. If there were an easy path to riches it would be soon exploited and cease to work. Our job as your adviser is to coach you in making decisions which we believe to be to your long term benefit. We are not influenced by short term results, be they good or bad. Ultimately we desire positive outcomes, but it is only through a focus on a robust process by which we can be confident in delivering on this aim.

The importance of market inefficiency
Between  two thirds and three quarters of money managers fail to beat their benchmark over the long run. This is not a result of market efficiency however. It is a result of misaligned incentive structures. The job of identifying the genuinely skillful is made easier by having a rigourous process for selecting funds which extends well beyond mere performance analysis. We believe less efficient markets exist in which dispassionate application of skill and effort should pay off for our clients. As such we recommend both a passive and active approach for a portfolio.

Market timing, re‐balancing and cost averaging
Because we do not believe in the predictive ability required to correctly time markets, we structure portfolios with a long term time horizon in mind. That is not to say that the benefits of timing are illusive. Through a disciplined approach to re-balancing and through a commitment to invest on a regular basis, the benefits of market timing can accrue to an investor.

Disciplined and structured approach
The basis for our philosophy is that investors overreact in the short run due to emotional stress or excessive optimism. If investors follow a structured and disciplined approach to investing they will avoid many of the biases which cause them to act in irrational ways. Our job as financial advisers is to guide you through this process.

Cognitively we get smarter through the generations, but not emotionally. Investment decision making is inevitably an emotional process. Learning to master emotions is one of the most valuable things that investors can learn to do. As an adviser, you can assist in this process by crafting a suitable Investment Policy Statement (IPS) for your clients.

What is an IPS?

Investment Policy Statements have been used in the pensions market for a long time. An IPS codifies broad guidelines for the investment portfolio along with clear restrictions. To use the cliché, an IPS is the road map essentially in terms of the investment journey.

An IPS places clear limits on the allocation to different assets, documenting of investment goals and clarifying the source and time of the information. This is an important aspect, as people’s memories about investment decisions become distorted with the unfolding of new information (see next section).

Why should you use an IPS?

Our memories are shaped to a great extent by the present and we frame the past using this knowledge. The results of this when we apply it to our experiences of investing in markets is fascinating. A fascinating report by Wellershoff & Partners Ltd, highlights flaws of memory which impair our ability to learn from the past and contribute to poor financial decisions.

Bad memories tend to be blocked by good ones. For those of you partial to a bet on horses, do you find it easier to remember the names of the horses you have won money on, or those that didn’t come in? If you are like the vast majority, the chances are, you can remember your winners, but not those of the losers which probably number a lot more.

In much the same way, we block the memories of some poor financial decisions with other more pleasant memories. While it is unlikely many of us will forget the disastrous equity experience in Irish financials for some time, we are still conditioned to gloss over with the more favourable decisions we have made. This conditions us to be overconfident in our abilities by blocking adverse information about our financial expertise with positive information.

A carefully designed IPS can be a versatile tool in the investment process. It functions on several levels, not least of which is as a document that protects you (the adviser) in the event of a complaint. Importantly, it is a tool to help both you and your client understand the advice that is been given and why.

How do you construct an IPS?

Each client will have unique investment considerations, but this should be covered by a standardised process to develop your recommendations.

You should design a basic template for your IPS that you can customise for each new client based upon their needs.

Firstly, most clients will never have heard of an Investment Policy Statement, so you must give a brief explanation of why you created it in the first place.

This is your opportunity to highlight that they are not being sold a product. You are a professional who uses a disciplined, effective process to design an appropriate strategy just for them.

First, you must have clear personal sense of your own investment philosophy. What is important to you as an investment adviser and what do you believe are appropriate rules to follow when investing? What is your philosophy with respect to risk, diversification, timing, buy and hold, costs/ fees, etc. These must be clearly set out before an appropriate plan can be put in place.

There are a number of steps involved in the crafting of an IPS. I have tried to break them down as much as possible here. I have provided a sample IPS separately and while, not as comprehensive as the finished article should be, it will provide a guide. It may be best to start with a blank sheet and develop it over time. You will never settle on your first attempt.

Step 1

Decide on goals, objectives and strategies.
The individual’s specific investment-performance goals should be established with appropriate benchmarks identified to monitor results.

• What is the target rate of return?
• How long is this money going to be invested?
• How much income needs to be driven from the portfolio?
• When to commence income drawdown?

These questions should be answered before an action plan is established.

Step 2

Decide on strategy for managing risk
Maximising return without regard for volatility and risk is a major contributor to the failure of most individual investors.

All investors want the most return for the least amount of risk – how one manages the risk will determine success.

Determine what the client’s tolerance and attitude to risk is. There may be a conflict with a client’s preference (i.e. attitude to taking risk) and their capacity for bearing it. This needs to be teased out with the client first by getting them to fill out a risk profiling questionnaire and then having a broader discussion around risk and return. Risk is not a single number. It is a complex concept and can only be properly addressed through informed dialogue with a client.

Step 3

Set guidelines for asset classes
The IPS should provide guidelines for the asset classes to be considered. The more specific you are within each class, the better. The allocation must take into account the need for cash flow, growth and safety. It’s best if you have 4 or 5 model portfolios which you consistently use.

Step 4

Monitor and rebalance schedule
The most important step. Retail investor success is not based on choosing the “best” investment but rather on decisions regarding timing and diversification. Investors’ have a long track record in obsessing over fund performance (usually short term) and joining the performance derby of selling the losers, very often moments before they work, in order to chase ‘successful’ Managers just as they are about to run their course.

The ability to harvest gains as investments are going up, and at the same time invest in asset classes as they are out of favour is the greatest help that the IPS can offer. The very act of writing one, will help your clients avoid the tendency for irrational decisions.

Investors need to have a written plan for how often they are going to monitor performance and when they are going to rebalance. This is the discipline that most retail investors lack. This is easily executed on a platform, but may be difficult/ expensive to implement where the policy is spread over more than one provider. Apply a sense test.

Summary on Investment Policy Statements

Earlier we referred to some flaws with our memory. Another well documented flaw in our memory processes gives rise to what is termed “hindsight bias“. This is the tendancy to look back and see events as more predictable than they in fact were before they took place.

Take the recent credit crisis, which can be traced back to a property bubble in the US. It’s difficult to disentangle ourselves from the position that it was obvious when viewing the incident through the lens of knowing all we do now. To some it was so obvious, it’s almost as if uncertainty and chance didn’t exist three years ago.

I’m sure you have come up against this scenario several times – investors being ‘wise’ after the fact. It promotes overconfidence in investors, by fostering the illusion that the world is a far more predictable place than it is in reality.

The IPS is invaluable in terms of a documentation of events at a point in time. It functions as a very comprehensive ‘reasons-why’, but it is a sales aid, not a compliance exercise completed after the fact. When the going gets tough, an IPS is a very helpful reminder of the long term goal.

Investing is emotionally challenging. This impediment to investment success is greater than any other. The temptation to abandon well thought-out but disappointing strategies moments before they work, in order to chase successful strategies just as they are about to run their course, can be overwhelming.

Help your clients to avoid this peril by crafting an IPS.

Gary Connolly. 

Email: gary@icubed.ie.

website:  www.icubed.ie

The slightly provocative title reflects what we have all experienced as investment market practitioners in recent months.  The latter part of 2011 has seen a dramatic flight to safety by many investors.  The historical reasons to invest in cash (liquidity, security, uncertainty) are as prevalent today as at any other time.  However, one significant change is that “real return” has been added to this list.  This short note sets out some thoughts on the deposit account options available to the risk averse investor, the considerations required before any investment decision is made and questions whether logic is the casualty of slick marketing in certain cases.

Deposit Accounts – the silver bullet?  

Deposit accounts serve a very important purpose and most if not all mature investors operate at least one such account.  In recent years, deposit accounts have been wrapped in pension and life structures to widen their accessibility and this option has proven particularly popular. 

The extreme (self-inflicted) trauma experienced by Irish banks in the past 4 years has prompted new and aggressive interest rate pricing practices.  The understandable fear of many investors has led to many deposit options being embraced.  However, it is worth considering some of the factors that mean not all deposit accounts are the same and that, in certain instances, deposit accounts may not be the answer.  Historically, depositors had no real need to pay any regard to esoteric concepts such as financial strength ratings as most banks held strong ratings and any memories of a significant bank run were over 100 years old.  The world has changed.  Not all banks are the same any more.  Some banks have to bid a very high price (interest rate) to secure depositors’ hard earned cash and “mainstream” Irish banks now have financial strength ratings as low as BB+.  However, it is very questionable whether the depositor is being rewarded in many instances for the extra risk that they take (see later in this note) when they place their deposits with certain banks.

While deposit accounts carry a degree of security of the capital sum, there remain other risks with using deposit accounts in addition to the fundamental risk of default:

• Liquidity risk – premature access to funds may only come with payment of an interest penalty or may not be possible at all.
• Inflation risk – quantitative easing (printing of money) has yet to begin in Europe but there is a strong belief that 2012 will herald the rolling of the printing presses by the ECB.  This will inevitably create upward pressure on inflation.  Deposit accounts are an awful hedge against this risk.
• Currency risk – Will the euro exist in 12 months? If Ireland were to leave the euro, will a new Irish currency be devalued? Almost certainly, yes.  All of this spells a dire outcome for a depositor stuck in an inflexible Irish domiciled (old) euro account if Ireland were to leave the euro.

Do I get paid for the risk?  

Banks borrow from depositors at a certain rate and aim to lend out those deposits at a higher rate; the difference being their margin.  The Irish deposit environment has seen aggressive competition between banks as they compete for depositor funds. Their main weapon is the interest rate.   With any return, there is some element of risk. Identifying the risks and assessing whether or not the investor is being compensated for these risks is vital. Firstly, the risks associated with tying up money in a fixed term account are straight forward. They include inflation risk, currency risk and liquidity risk. 

The other important risk is default risk. To illustrate, a German Government bond is currently rated AAA and an equivalent Irish Government bond is rated BBB+.  Currently, the 5 year German bond will yield you 0.77%, while the Irish bond will yield 7.3%[1].  Many Irish banks are currently rated at less than the Irish Government, yet they do not offer a higher return. Therefore, the investor is not being compensated for the risk assumed. 

If you don’t know what is going to happen, diversify. If you do know what is going to happen, diversify.

“Don’t put all your eggs in one basket” – a well worn mantra but one that contains more than a grain of truth when it comes to using deposit accounts.  .  It is not unusual for investors to hold a number of deposit accounts across a number of institutions. This type of strategy can make sense as it helps to decrease the impact of default and, very importantly, provides a method to manage the inherent risks mentioned above.

Some readers may know someone that was directly affected by the failure of the Icesave deposit provider in the United Kingdom in 2008.  The Icelandic parent Landsbanki failed and all deposits were lost, at least until the UK Chancellor of the Exchequer stepped in on an ex gratia basis to cover the losses.  A dispute rages on between the United Kingdom and Iceland to recover the cost of this bailout.  Notwithstanding the eventual positive outcome, all investors and advisors that were caught up in this crisis learned a very painful lesson about the benefits of diversification.  Unsurprisingly, Icesave offered one of the highest deposit rates of interest on the “High Street” just prior to its collapse.

The real cost of fixed term rates

Fixed term deposit accounts typically offer a return that is higher than a standard demand account.  Banks can do this because they have created certainty around their liability, i.e. the investor has agreed not to come looking for their cash until the end of the agreed timeframe (if they do, they will be subject to penalties).  This uplift in rate is often referred to as the “liquidity premium”.  If a customer cannot access their investment or easily convert their investment into accessible cash, they demand a higher return for the deposit.

In the current economic environment, liquidity risk has become more significant than ever before.  The current market uncertainty has threatened a number of possible scenarios for the euro from total break-up to partial break-up to significant devaluation.  It is difficult to imagine that the euro zone can overcome its debt problems without some element of currency devaluation.  If this is the case, being positioned within a fixed term account is not the optimal location.  Accessibility and speed to effect change are critical.

This too will end….

The rates on offer in the Irish market are not sustainable due to the high costs associated with providing them. They will reduce once the banks have sufficient capital and/or the ECB begins quantitative easing ala the US Federal Reserve. In light of these risks, sensible positioning for the future is critical. 

AXA Financial

[1] Source: Bloomberg.com closing price as at 9/01/2012

The idea behind any investment is straight forward – it should grow. While the idea might be straight forward, the implementation and outcome is not. Choosing an investment strategy is difficult – there are many issues to consider and a wealth of products that claim to help.

The Consensus Concept

The Consensus approach is one of the many strategies that are designed to help investors achieve their financial goals.

The objective is to produce a return in line with the average fund manager performance over three years. This is designed to eliminate the risks of poor fund manager selection and poor asset or individual equity allocation.

In a seven horse race, the consensus runner should finish 4th – always! It will never win the race, but equally, it should never finish last – thus reducing an element of relative performance risk.

The strategy achieves this result by mirroring the average asset and country allocation of all the investment managers included in a “league table”.  A typical consensus fund will work off the average asset allocation for the funds in the relevant managed fund sector to arrive at its asset mix. Once it does this, it will then take a “passive” management approach to selecting stocks. Going back to the racing analogy, it consistently finishes in midfield .

Does the Consensus approach have merit?

If the field of horses are very fast and consistently fast, then yes there is merit in having a degree of exposure. However, that is not the case inIreland. The intention may be good, but the execution and outcome is disappointing.

There are two issues here 1. Adopting the collective wisdom, and 2. Using a Passive approach

Collective Wisdom

The sorry performance experience of the past decade confirms that the managed fund is dead. So why rely on it for your investment strategy? The old “one size fits all” approach is outdated and contradicts the two basic investment fundamentals of appropriate risk assessment and asset allocation. The typical Irish managed fund has a local fund management arm that decides on asset allocation and is tasked with managing all the components in an active manner. It is not realistic to expect that a local fund management team can emulate the research, expertise and resources in every asset class of the cream of the international fund management community. Pooling these local fund managers into a collective mix does not improve your odds of outperformance.

Consensus funds argue that asset allocation risk is removed because they use the collective wisdom of all the managed funds in their sector to determine asset allocation. To quote one leading provider: “There is no asset allocation risk within the Consensus Fund as it mirrors the collective wisdom in the industry”.  This is flawed logic. Firstly, asset allocation risk can never be removed, it can only be managed. Secondly, and more importantly, by using the average of the available managed funds, the consensus fund is relying on the collective wisdom of the other fund managers. One must bear in mind that the historical asset allocation of these funds is strong evidence that these managers closely watch each other and compare their performance against each other. As a consequence, the performance difference between each manager is minimal.

Passive Approach

The debate between active and passive managers has been raging for years. Both sides have merits and it is not necessarily an either/or option. Many of the most successful investment portfolios blend elements of both approaches to arrive at a portfolio that suits the client’s needs in terms of risk/reward and, of course, cost.

The issue here is not so much the passive approach, but rather the cost of this passive approach. Many consensus funds come with a 1% annual management charge. The consensus fund is a passive fund in disguise. A good quality passive fund from an international/global provider with the required scale can be accessed for 0.5% – half the cost of the average Consensus fund. Therefore, before you start, the cost is twice the industry average for passive funds. To highlight the importance of this point, that difference in cost alone will save the investor €2,717* on a €100,000 investment over a 5 year period! (*Assumes 6% growth and a 0.5% annual charge)

What can you do?

Go back to basics:

• Manage your risk and pick the best funds.
• Diversify – do not rely on one local life company.
• Use funds that benchmark themselves against international competition, not local.

Take the table below as an example. It compares the Irish Balanced Managed Sector average, the Irish Life Consensus Fund and the AXA Financial Model Portfolio 3 (suitable for the Balanced Investor[1]). The power of real diversification and access to the strongest international fund managers is self evident. There is a 21% out-performance over a 5 year period.

Questions you should ask your financial adviser?

1. Are Consensus funds right for the current market?

Global markets have undergone a roller coaster ride in response to the Euro crisis and fears over slow global growth. Are consensus funds the appropriate vehicle to cope with market volatility? Active managers can place investors in winning stocks or attractive bonds, but in a stall speed economy where market returns are suffering big weekly swings, positive market returns can take longer to materialize. Blending both passive and active gives the investor the best of both worlds.

2. Can you respond to changing market conditions?

When you buy a consensus fund you effectively give up control and flexibility. You are no longer able to increase or reduce exposure to an asset class as you see fit. 

3. What am I paying a manager for?

The deal with investing in an investment fund is simple. You loan your money to a fund manager or to a group of fund managers and you pay them a fee to grow your money in a predefined manner. If they have an active approach, you pay a little more but you are entitled to expect better than market performance over the long run. If they have a passive approach, you pay a little less but expect a performance broadly matching the market. With a consensus fund, you pay a higher price but don’t get the enhanced performance. A good deal for the company but not good for the investor.

4. What can I do about it?

Get advice from an independent financial adviser.

Go back to basics, assess your attitude to risk, build an asset allocation to match and then select international investment funds to populate that asset allocation. Ensure that these funds have been selected using a robust and truly independent investment fund selection process. 

Diversifying your investment across a number of asset classes and top performing funds to match your investment and risk objective is good advice. For the reasons above, a consensus fund is unlikely to be the way to achieve this.

Alan McCarthy, Senior Investment Associate
AXA Financial: 01 471 1317 or Alan.McCarthy@axa.ie

A work colleague and I have just completed the Graduate Diploma in Financial Planning. This is one of the necessary steps towards completing the relatively new industry qualification – the Certified Financial Planner or CFP.  As many will be aware of the course and its objectives and may be considering enrolling, I thought it would be useful to share my perspectives having just completed the final two modules.

However, rather than discuss the course in a diarised micro manner, I think it is more relevant, and possibly more important to discuss why this qualification is relevant at the macro level and how it might help change and shape the industry’s future.

Suffice to say that each module was interesting and valuable – while there were certain modules where I expected not to learn much, I found that I learned something from all modules. Interestingly, speaking to other members of my class, this seemed to be the popular view. It is not until you sit down and prepare for the final exam that you realise how much you have covered – no matter how much experience you have in the subject area.

One key learning for me was the interaction with other members – specifically listening to their opinions and approaches. There was a diverse mix of individuals on my course, all of which brought something to the table. This adds to your personal learning and also to the atmosphere of group projects and class discussions.

The concept behind the Certified Financial Planner (CFP) course is clear – to raise the standard of personal financial planning advice provided to clients by our industry. If this is achieved, there are many benefits to be gained by the industry; increased respect from clients, greater integration across other professions, improved sustainability and higher revenue potential for the financial planning professional. The industry is not the only beneficiary – and one would argue, not even the primary beneficiary – the end client will also gain from a more integrated, deeper and holistic planning service to aid them in achieving their goals.

All good ideas are simple – it is the implementation that creates the real challenge.

We are all aware that our industry has suffered over the last 3 years largely due to the macro economic conditions that currently prevail. This problem has been compounded by clients decreasing level of trust in financial services and the real financial losses that many suffered. The human reaction, during and after a crisis, is to look for somewhere to apportion blame. We all have a tendency to polarise discussions and turn the outcome into a “black or white”, “yes or no” scenario. Rightly or wrongly, our industry is under this spotlight.

The industry is not blameless either.  With hindsight, product selling overtook financial planning as the main income stream and priority with areas such as risk and diversification not getting the due attention that they deserved.  The consequence of this practice is well documented.

Our industry needs to evolve and improve – the competition for scarce resources is ever growing. This, I would argue is a positive and necessary development. It raises the bar for everyone. This is what the CFP course delivers on.

I decided to complete the Graduate Diploma in Financial Planning (CFP) course for this very reason.  18 months later, the lectures are finished and the final exams completed. The last stop is the official CFP exam in February 2012.

To get to this position, 6 modules covering various aspects of financial planning were completed. When I look back on the experience the obvious questions spring to mind;

• Was it worth it?
• What have I gained from the experience?
• Does this type of qualification help the industry (and me)?

My situation may be slightly different to the average CFP student profile. I work in the investment area, but rather than give direct financial planning advice to retail clients, I work alongside financial advisers hopefully adding value by guiding them towards good international investment funds and aiding portfolio construction. I see an alignment of interest here between the investor, the adviser and my company.

This is a key part of the CFP – alignment of interests. The CFP helps to change the dynamic in which one views the industry. Financial advisers are to a degree, reliant on the product providers for revenue. Many need to sell a product to generate revenue. Therefore, the commission rates that the product provider offers will determine the revenue generated and therefore reduce an element of the control that the adviser has over their own bottom line.

The CFP focuses on placing this control in the adviser’s hands.  While revenue can still be generated via traditional commissions, it opens up a world of delivering value to a client in a manner that can justify payment regardless of the method. The client becomes the centre of the adviser’s focus with their interests being aligned with the adviser.

The Grad Diploma in Financial Planning is completed over 6 modules;

1. Principles & Ethics in Financial Planning.
2. Asset Management.
3. Retirement.
4. Tax & Estate Planning.
5. Financial & Risk Management.
6. Integrated Financial Planning.

Each of these modules aims to educate and enhance the students’ knowledge of the subject from a technical and financial planning aspect. This is where the value can really be seen in completing the course.

Financial plans or strategies can be complicated by their very nature. They seek to match financial goals and objectives with often limited or scarce resources. Financial plans are not a panacea. In fact, very often, they will lay bare the harsh reality of a financial situation, or highlight the sacrifice that must be made for a financial plan to come to fruition.

We all strive to best match and respect our client’s goals. However, given the nature of our role, there may be recommendations, options or suggestions that clients were not anticipating or do not favour.

Financial plans do not necessarily need to mention or promote products. If products are needed or required, they can be discussed at the appropriate time. Deciding and advising how best to achieve the clients’ stated goals is the priority of CFPs at all times.

Our industry suffers from complexity and reliance on product selling. Independent financial advice is the classic bundled service. Advice is bundled up with product and product is bundled up with remuneration.  This is the standard model.  While the CFP does not suggest it should necessarily change,  it does challenge the student to question and seeks to clarify and improve the model.

How many times has work been carried out for a “prospective” client only to see this work not bear any fruit? Whether we like it or not, in this situation, clients who engage pay for the clients who don’t.  This is not sustainable.

You might ask yourself, what this has got to do with the CFP.  In my opinion, this is the most valuable aspect of the CFP. It has helped to create focus on the bigger and longer term picture rather than short term benefits. It helps to create focus on the value that the client is receiving. It helps to align interests of all parties. It moves the adviser away from being a product seller to a financial planner. This is a necessary step to move the industry towards the future.

Planning is the long-term process of wisely managing a client’s finances so they can achieve their goals, while at the same time negotiating the financial barriers that inevitably arise in every stage of life.  The CFP delivers on this.

Going back to those questions earlier on;

Was it worth it for me? Yes -There were frustrations and challenges along the way. This is part of taking any qualification. Everyone’s experience will be different to a degree. It depends on personal circumstances (I have a day job, a wife and two small boys so attending two lectures a week, group work, assignments, study, etc. was challenging). The specific learning’s will also differ (I work in the investment area, am a QFA and have Masters in Economics).

What have I gained from the experience? – Although there were topics covered that I have a good knowledge in, I still took something new from these topics. Of course, there were new topics and concepts that I had not been exposed to. This will be different for everyone taking the course. Interaction and debates during the classes were both educational and entertaining.  Thankfully, these debates were facilitated by all the lecturers as it is often the best way to understand new concepts.

Does this type of qualification help the industry? – That remains to be seen but the industry is changing.  One only needs to look across the water to see the future of how financial advice may be regulated inIreland. The only debate is when, not if. Competition is tougher, margins are tighter, surviving and prospering in the changing financial planning world takes hard work and innovation. While the CFP does not provide you with a silver bullet, it provides a strong foundation towards raising the standard of financial planning advice available to clients.

I started this piece with a quote. It seems only right to finish with a quote from a well-known orator and student of life;

“Every time I learn something new, it pushes some old stuff out of my brain”
– Homer Simpson.

Maybe it is time for our industry to push some old ideas out and bring in some new ones.

Alan McCarthy, Senior Investment Associate

AXA Financial