An investor has an appointment with a financial advisor. They discuss plans for the next 5, 10, 20 years: buying a house, kids going to college, starting a business, etc. They have a conversation about investment options and the advisor recommends a portfolio that fits them best. Then, the following conversation ensues:
Investor: What kind of performance can I expect out of my portfolio?
Advisor: Well, given your age and your time horizon to retirement, I believe this is the kind of portfolio that should help you toward your goals.
Investor: Sure—I figured that would be the case...I guess I’m just wondering how I’ll know if we’re on track. Where do you think we’ll be at a year from now?
Advisor: Well, I’m no prophet or shaman; I don’t have a crystal ball. I can’t predict where the market is going to be a year from now. That said, if we’re thinking long term, I do think this portfolio is the right fit for you.
Investor: Wait a minute—I can’t just sit back for thirty years in order to find out if we were right! I’m at least going to need an idea about what is considered “normal” year-over-year for this portfolio.
Advisor: I completely understand. I can’t make any promises, but given our long-term perspective, this portfolio might make something like 8% year-over-year.
The advisor’s statement was technically accurate. Here’s the problem: when the client looks back on this conversation, they won’t remember much of it. In fact, there’s only one thing they'll selectively remember: 8%.
Just like that, bad expectations have been seeded and the advisor/client relationship is set up for failure. Sure, the market average might be 8%, but do you know how many times the market has hit its average in 25+ years? ONCE.
If returns are below the advisor’s narrow target, investors aren’t happy. When returns are above the target, they still might not be happy. Why? Because they ask questions like, “why is the market beating my portfolio?” It’s enough to drive great advisors insane.
If the portfolio didn’t meet expectations, the investor assumes there must be something wrong and the portfolio needs to change. Hanging success or failure on a razor-thin margin is unfair, considering the standard fluctuation of the markets. Was an advisor wrong to capitulate and discuss returns? Not necessarily. Is there a better way? Absolutely.
Next up, Part 4: "The Short Term Gets Ignored"