The erosion of returns from taxes happens so gradually over the years, that it escapes the notice of many investors. However, the impact is there all the same, and it can be significant—even for those investors who are not in the top tax bracket.
The Process 61
5
C H A P T E R
5
The Investment Management Consulting Process
I
n Part I, you got a glimpse of the industry, how it relates to you, and how fast it’s growing. Before getting down to the nuts and bolts of separate account structure, however, we’d better take a general look at how some of the top financial advisors work—or ought to work.They start by gathering pertinent financial information about their clients using a specially designed questionnaire that, unlike those typically in use in the industry today, is detailed but not cumbersome. The questionnaire asks clients to describe their future real-dollar needs, retirement plans, and any major financial transactions such as the sale of a home or business.
The advisor works with the client to identify all known variables (e.g., the time period until retirement, required cash flows, investment saving pools [401(k)s, IRAs, taxable accounts, applicable tax rates, social security bene- fits, etc.]).
The goal of the consultant at this point is to uncover what the client truly wants. Some advisors set a targetgoal and a fallbackgoal. A target goal is what the client would liketo have (if everything goes right), and a fallback goal is what the client musthave. Next, the advisor converts the client’s financial goals into future liabilities—viewing them as money the client owes to himself/her- self at some point in the future. By setting these dollar goals and understanding
63
the risks that are inherent with various investments, the consultant can deter- mine the probability of reaching those specific goals (Figure 5.1).
If this sounds to you like financial planning, that’s because it is. This doesn’t mean that you have to be a financial planner, but you may want to consider forming a partnership or strategic alliance with one.
After all data are gathered, the consultant looks at the absolute dollars required to satisfactorily meet the client’s financial objectives at specific peri- ods of time in the future. Only after this information is laid out does the advi- sor attempt to solve for unknown variables such as the combination of assets that will provide the best future capital market returns. As the advisor works with the client, he/she uses the information gathered to determine the proba- bility of achieving financial goals using various investment allocations. The advisor is continually adjusting all known variables to approach as close to 100 percent probability of success as possible. The goal of the advisor/con- sultant at this point is to focus on the investment strategy that has the highest probability of achieving the stated result.
In most cases, this evaluation will indicate a shortfall. If it does, you will have to explain to your client that he/she will need to take more risk, the larger the size of that shortfall. Can you see why this step has nothing to do with any risk tolerance questionnaire you had your client fill out? What if you discover that your client has no tolerance for risk? Your job is to explain that realrisk is not having enough money at retirement, and there is no way to make enough money unless he/she takes more risk. It may be an uncomfortable con- versation, but it may be one of the most important in your client’s life.
64 THE PROCESS
FIGURE5.1 The Investment Consulting Process.
This also takes the responsibility out of the realm of how good your man- ager selection was and puts it back squarely on the client’s shoulders. You just show the client the facts.
Once the client understands that he/she will have a money shortfall, you can look at optimal asset allocation and recommend a strategy. (Do you see why we are including financial planning in the next chapter?)
You should have a series of market charts that you can show at this point to help your client see what the market has done over different time periods.
Show him/her how, by adjusting the asset allocation percentages, he/she can meet his/her future financial goals and stay within his/her risk tolerances.
Include your client in this step of the process. Together you may discover that optimizing his/her asset allocation is still not enough to bring the probabili- ties of success to acceptable levels. Now what?
Work with your client to adjust more of the knownvariables (e.g., savings rate, expenditures rate, and/or time allocated to achieve his/her goal). The client may need to extend his/her retirement date by 5 or even 10 years to make things come into line. This makes him/her think. He/she may also bring in more assets. At this step you are building trust.
This is the most important step of the process because it establishes realis- tic expectations and begins the educational process. Including this step will impact the probability of your client reaching his/her target financial goals.
Explain that the ultimate decision between the downside volatility versus the promise of a higher probability of success is based on the fine-tuning of all known variables, such as time horizon, savings, and expenditures. Keep put- ting responsibility back in the client’s court. Help your client fine-tune these variables, and he/she will see where you are going.
Once your client understands and accepts the risks, it’s time to create a detailed asset allocation within the major asset classes. This becomes the long-term strategic investment plan with the highest statistical degree of probability of reaching your client’s goals.