“‘Why’ – Investor Protection Made Simple”

=One of the most rewarding aspects of writing this blog and my books is when someone contacts you and thanks you for the information and advice that you provide. I recently had someone write and tell me that they have enjoyed my metric, the Active Management Value RatioTM 3.0, so much so that is has become a hobby to do AMVR analyses for their friends. The most commonly used word in emails and conversations has been a feeling of “empowerment..

I enjoy working with both investors, financial advisers and investment fiduciaries, such as plan sponsors. Many people ask me how I can work with groups that have inherent conflicts of interests. My answer is simple. In my practice, I always try to identify and address quality of advice issues and then provide suggestions and solutions that promote a common goal, a win-win situation for all parties.

For over thirty years, I have been involved in quality of financial/investment advice issues in some form or another. I have been a compliance director for both general securities and Registered Investment Adviser divisions, director of financial planning quality assurance for a major international insurance company, and the initial director of the peer review department at the CFP Board of Standards. And now I offer quality of advice services in the form of fiduciary audits for pension plans, trusts and other investment fiduciaries, as well as ERISA litigation support services.

So, I feel qualified to offer advice on my two blogs, this blog and my blog oriented toward ERISA professionals and investment fiduciaries, “The Prudent Investment Fiduciary Rules” (iainsight.wordpress.com). I truly believe in this blog’s byline – “The Power of the Informed Investor.” As Thomas Jefferson once said, “knowledge is power, knowledge is protection, knowledge is happiness.”

I am a firm believer that the best investor protection strategies are proactive and simple. As Steve Jobs once said, “simple is the new sophisticated.”

Once of my favorite examples of the power of “why” involves a widow who dared to question an asset allocation prepared by a financial adviser. The widow’s husband had carefully created a portfolio that would provide his wife with a portfolio that provided her with the upside potential of capital gains, while at the same time providing her with the incom she would need when he was gone.

When the adviser started to explain the pretty multi-color asset allocation pie charts and calculations, the widow cut the adviser off and simply asked “why.” Unsatisfied with the adviser’s explanation, the widow thanked the adviser for their time and left. The widow left her husband’s work intact and enjoyed a comfortable life thereafter.

In this blog, I want to address three wealth management/asset allocation quality of advice situations that I commonly encounter:

  • quality of advice issues regarding asset allocation recommendations due to the instability of the asset allocation software itself;
  • quality of advice issues due to inconsistency between a financial plan’s recommendations and actual implementation of the advice, what I call recommendation-implementation gaps; and lastly,
  • quality of advice issues due to the recommendation of cost-inefficent investments during implementation of the asset allocation recommendations..

My goal is to help the reader understand and recognize the issues so that they can hopefully avoid the risk management and financial issues involved in each scenario.

Asset Allocation Software Issues
Various financial planning firms offer asset allocation recommendations to the public. The price typically ranges from a couple of hundred dollars to thousands of dollars. What the public is not told and does not realize is that such recommendations may have serious flaws, rendering them virtually worthless.

Many of these asset allocation recommendations are created by asset allocation software programs. Most of such programs are, unfortunately, highly unstable. Like any computer program, the data generated is subject to the the quality of such results depends on the accuracy of the assumptions and other data entered into the software program, the “garbage in, garbage out” syndrome.. Slight errors in the input data can produce significant errors in the recommendations generated.

Asset allocation programs typically suffer from two common problems. First, most of these programs are based upon programs are based upon Microsoft Excel, which, according to software engineers I have worked with, was never intended to handle the numerous interrelated calculations used by most financial planning software.

Secondly, most asset allocation software programs are based on a concept known as “means-variance optimization (MVO). MVO favors investments with high returns relative to volatility/standard deviation. This bias, and the quality of advice issues it creates, has led one expert to characterize MVO-based programs as “estimization-error maximizers.”1

When I am asked to review asset allocation recommendations , the first thing I do is review the data and assumptions that were used in preparing the plan. Any software program is always vulnerable to the “garbage in, garbage out” syndrome. The second thing I do is to reverse engineer the recommendations to see where errors may have been made in the calculations and/or advice provided by the recommendations. After thirty years of dealing with financial/investment quality of advice issues, most errors that investors would miss are readily apparent and easy for me to spot.

Asset allocation recommendations typically assume a constant rate of growth for investments. This simply does not portray reality. Historically, the stock market suffers one down year for every two positive years. Losses suffered during bear markets such as the 2000-2002 and 2008 definitely one’s financial  situation. Financial/asset allocation recommendations typically use either past performance or projected performance, or “guesstimates,” of investments to prepare the financial plan.

The problem with past performance data is that, as the required disclosure for investments states, “past performance is no guarantee or future returns.”  The problem with projected performance, or “guesstimates,” is that they are just that, guesstimates, which can be easily manipulated to convince investors to make decisions that benefit the party that prepared the financial plan.

An investor should always ask the adviser who prepared the asset allocation recommendations to provide the investor with all the data and assumptions that were used in preparing the plan. One common scenario we see is manipulation of the assumptions to ensure that certain investment product are recommended..

One common example of this involves small cap investments. Most people have portfolios that are heavily invested in large cap, blue chip stocks. One reason for this scenario is that blue chip stocks are often stocks that people are familiar with (e.g., AT&T, Coke, McDonald’s). Since most financial planning software favors investments with certain characteristics (e.g., high returns and low risk/standard deviation), a planner can ensure that the plan recommends such products by using assumptions meeting such criteria.  So, if a planner wants to ensure that purchases of small cap products are recommended to produce commissions for the planner, they can manipulate the data to ensure such results without the investor suspecting anything.

Another common scenario I encounter is where the adviser blindly relies purely on the asset allocation software’s output and lacks the knowledge and or experience to identify software mistakes or poor advice, a situation commonly referred to as “black box” advising. As Harold Evensky, one of the nation’s most skilled and respected financial planners has opined,

One of the most frequent criticism of wealth manager optimization is the use of a complex computer program, frequently referred to as a black box. This pejorative description suggests that the wealth manager is implementing an asset allocation policy without understanding how the allocations were determined. The presumption is that the black box, not the wealth manager, is making the decision. Unfortunately, this is often a valid criticism.2

As usual, Mr. Evensky is right on point. Whenever I question advisers about the quality of their recommendations and the advice provided, more often than not the first response is the “deer in the headlights” look, followed with an admission of simply following whatever the software produced and/or a meritless, legally insufficient explanation based on inaccurate interpretations of financial theories such as Modern Portfolio Theory. The quality of advice issues with regard to investment recommendations is so bad that Nobel laureate Dr. William F. Sharpe has deemed the situation to be “fantasyland.”3

If you are an investor who has already had a financial plan prepared, I issue the same challenge to you that I make in my wealth preservation challenges. Review the various spreadsheets and check the accuracy of the calculations of the first ten rows on the spreadsheet. Unfortunately, the other forms of deception used in connection with financial plans are often subtle and difficult for the public to detect without the help of someone experienced in such matters.

For what it’s worth, whenever I point out the calculation errors in a financial plan, the planner and his company often respond by saying that they were simply calculating future value, so the last line of the spreadsheet only needs to be correct. When I ask if the customer, who paid for the plan, was informed that the planner knew that most of the numbers were wrong and were simply to fool the customer into thinking a lot of work went into the plan, I usually get more blank stares

Likewise, when I ask whether the customer was informed of whether past performance or “guesstimates” were used in making the asset allocation recommendations, as well as the inherent issues with either approach, I often get more blank stares or a defense that the asset allocation document disclaimed liability for the asset allocation recommendations. So the adviser asked the customer to pay for the asset allocation recommendations, then basically added a disclaimer to the effect that the adviser and/or his firm were not liable if the recommendations were worthless. So much for developing a relationship of trust.

Recommendation-Implementation Gaps
A serious flaw in asset allocation software is the fact that most asset allocation software is only designed to produce recommendations based on broad, generic asset, not the actual investments eventually chosen during the implementation of the asset allocation recommendations. The performance data and cost data between the generic asset categories and actual investment products is usually very significant, essentially invalidating both the asset allocation program’s input data and the recommendations themselves, “garbage in, garbage out.” This concern is rarely disclosed or discusses with investors.

That is another reason why investors should always ask the adviser for a list of the assumptions used in preparing the asset allocation recommendations. The investor can then use one of the various asset allocation programs online to verify the adviser’s work. Some of the online asset allocation programs may even allow you to perform a limited number of asset allocation calculations based on actual investment products.

Advisers usually have access to advanced asset allocation software programs that allow them to go back and perform an revised asset allocation analysis based on the actual investments recommended during implementation. I know I can. I can even call Vanguard and they will do the analysis for me. Yet, for some reason, advisers do not offer to perform this valuable value-added service for clients. Have to wonder why.

Implementation Cost Concerns
While the recommendation-implementation gaps issue looks at general consistency issues in the transition from recommendations to implementation, an investor should always look at the cost-efficiency of the specific investment products recommended by an adviser. A cost-efficiency analysis is simply a cost-benefit analysis comparing the costs and returns of an actively managed mutual funds to those of a comparable low-cost index funds.

I have written extensively on a simple metric that I created, the Active Management Value RatioTM (AMVR) The AMVR is based on the research and concepts of investment icons such as Charles D. Ellis, Dr. William Sharpe and Burton L. Malkiel. Since studies show that people are more visually oriented, I simply created a visual version of their work.

The AMVR slide below shows how profound the impact of cost-inefficient investments can be on an investor’s end-return. The slide represents the retail class shares of a popular actively managed fund.

A couple of things immediately stand out. First, the impact of a fund’s charging a front-end load to purchase their mutual fund. Most actively managed fund’s charge a front-end load; index funds do not. Secondly, the actively managed fund failed to provide a positive incremental return, or outperform the index fund. And finally, the actively managed fund is clearly cost-inefficient, as its incremental costs (0.47) exceeded it incremental return (-1.12).

So, if an adviser were to this fund during the implementation of their asset allocation recommendations, a prudent investor should immediately ask the adviser to perform an AMVR analysis, or do one themselves. Once the analysis shows results such as those shown above, the investor should immediately ask…”Why?” For more information about the AMVR and the calculation process., click here.

Going Forward
Unfortunately, investors cannot, and should not, blindly accept investment advice from anyone. Yet, the evidence shows that most people do because someone is a “broker” or an “adviser,” a professional trained in such matters. Consider the following:

  • A study by CEG Worldwide concluded trhat 94 percent of those holding themselves out as “wealth managers” were actually nothing more than product salesmen.4
  • A study by Schwab Institutional reported that 75 percent of the transferred investor portfolios inspected were unsuitable given the customer’s financial situation or goals.5

President Ronald Reagan might have expressed it best – “Trust, but verify.” Use the “CommonSense InvestSense” blog and other online resources to educate yourself on common investment concerns, strategies and techniques. Always practice proactive InvestSense and never be afraid to ask “why.”

1. Richard O. Michaud, Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation (Boston, MA: Harvard Business School Press, 1998), 36.
2. Harold Evensky, Stephen M. Horan, and Thomas R. Robinson, “The New Wealth Management: The Financial Advisor’s Guide to Managing and Investing Client Assets,” John Wiley and Sons, (Hoboken, NJ: John Wiley and Sons, 2011),187.
3. William F. Sharpe, “Financial Planning in Fantasyland,” available online at http://www.stanford.edu/~wfsharpe/art/fantasy/fantasy.htm.
4.Brooke Southall, “Wirehouse accounts don’t match client goals,” InvestmentNews, March 12, 2007, 12.
5. Charles Paikert, “Poll: Few advisers are ‘real’ wealth managers,” https://www.investmentnews.com/article/20071029/FREE/710290324?template=printart; the John Bowen post upon which the article is based is available at http://www.cegworldwide.com/resource/expert-team/003-bp-john-bowen.

© 2021 InvestSense, LLC. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

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