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Fire Your Index


Too many investment advisors and their partners rely on market indexes as the way to judge performance for clients. The shift to a scenario approach may be the best thing you can do.

Like most "learning" experiences, the bear market that held us in its grip from late 2000 through early 2003 was painful. Investors learned that indicators of stock value like P/E ratios still mean something and that diversification is not an obsolete concept.

And financial advisers learned that finding new clients, or even retaining the clients they already have, calls for an approach to client service that far exceeds order-taking. Many advisers who came into the industry during the long, strong bull market have left, and the survivors' perspective on their profession is now tempered by their experience of a truly difficult arc of the market cycle.

Now that we seem to have turned the corner, let's not forget the hard lessons we learned (or relearned) during the bad times. One area that remains ripe for an educational campaign is the tendency to focus on indexes, especially on the widely reported Dow Jones Industrial Average, S&P 500 and Nasdaq figures. Matching or beating an index is still considered a portfolio manager's as well as an adviser's performance bogey.

Bad Benchmark

I've said it before, and I'll say it again. Indexes are a bad benchmark for individual investors looking to build, protect and distribute wealth over a lifetime plan.

Why is this so? Because indexes are an abstract concept, and individuals deal in reality. Comparing an index return to a real portfolio return is like calculating the disposable income of two couples who are alike in every way except one. They have the same income, same living costs, same debt, but Couple A is childless, while Couple B has two children. How hard is it to calculate which couple will have more money to spend on life's luxuries? In a head-to-head comparison between an index and a real portfolio, the real portfolio starts out in the hole every time.

From peak to trough of the market downdraft, the Nasdaq lost nearly 80% of its value on paper, but some investors' technology portfolios were down 50%, while others lost as much as 90%. What these individuals, these people, cared about was how many dollars they lost, not what the percentage of the index actually went south.

Your job as the trusted investment manager, through your sales partners, is to work with your clients to define their personal benchmarks in dollars and to keep them focused on that goal. Affluent clients are usually affluent because they've been successful in their lives. Successful people are usually smart. Don't force your clients to fall into your own lingo trap of expressing themselves in terms like, "I want to beat the index by 3% every year for the next 12 years," or "I want to have a 12% average annual return over the next 10 years."

Instead, ask them, "What kind of lifestyle do you want, both now and in retirement? What are your big expenditure obligations? What are your educational commitments to your family? Are you planning to buy a business? Travel? Purchase a second home? Are expensive healthcare costs looming?" Finally, last but not least, ask your clients, "What kind of financial legacy do you want to leave to your family?"

The answers to all of these questions can and should be expressed in dollars, not in return percentages. Then, moving from that raw dollar goal, you can calculate how likely it is that your client will be able to get there from here. There are many programs available that extrapolate from historical norms of capital markets. Some third-party asset management programs (TAMPS), like those offered by Lockwood Advisors, provide this software as part of their service. Most TAMPS are based on Monte Carlo simulations or Brownian motion (random walk) models.

The best programs consider standard factors (funds invested, time horizon, risk posture, probable inflation) while also allowing you to factor in asset flows.

With the dollars and time frame in place, you can then identify the level of risk the client must assume and calculate whether there is a reasonable probability of achieving their goals. Going from there, you can recommend a variety of investment scenarios. And all the while, you can keep educating your client about the validity of the dollar benchmark as opposed to the indexes they hear about every day.

Len Reinhart is president of The Bank of New York Separate Account Services. He pioneered separate accounts at Lockwood Advisors, now a BONY subsidiary. This column originally ran in sister publication Financial Planning. Reinhart can be reached at lreinhart@bankofny.com.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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