September 28, 2022
Robin Powell

What a Financial Planner can and can’t control

It’s hard to think of a profession that’s as misunderstood by the public as financial planning.

If you ask people, “What does a financial planner do?”, the answer is likely to have something to do with investing or the markets. It might be “They advise which stocks or funds to buy”; “They warn you when a crash is coming”; or perhaps even, “Their job is to make you rich”.

All these descriptions are inaccurate. Sadly, though, there are some advisers who are only too happy for their clients to think like that. There are even some advisers who genuinely believe that they can predict the future, and identify, ahead of time, which investments are going to perform better than others.

The truth is that nobody — that’s right, nobody — knows what the future holds for the financial markets. Economic forecasting is extremely difficult, and so is predicting the outcomes of wars and elections. And even if you do correctly predict, say, a key decision on interest rates or the result of an important referendum, using that foresight to profit as an investor is an entirely different matter.

Howard Marks, founder and chair of Oaktree Capital explained this particularly well in a recent memo, “The Illusion of Knowledge”

“I imagine that for most money managers, the process goes like this: “I predict the economy will do A. If A happens, interest rates should do B. With interest rates of B, the stock market should do C. Under that environment, the best performing sector should be D, and stock E should rise the most.” The portfolio expected to do best under that scenario is then assembled.

But how likely is E anyway? Remember that E is conditioned on A, B, C and D. Being right two-thirds of the time would be a great accomplishment in the world of forecasting. But if each of the five predictions has a 67% chance of being right, then there is a 13% probability that all five will be correct and that the stock will perform as expected.”

All is obvious in hindsight

Of course, everything looks inevitable with the benefit of hindsight. It may feel like it was obvious Putin would invade Ukraine; or that it was obvious we’d see the rapid onset of inflation. But in truth, nothing is obvious in real time. So, for example, berating your adviser for failing to predict the soaring inflation we’ve seen around the world in recent months, or the impact it’s had on the bond markets, is completely unreasonable.

No doubt there are some financial advisers who say they did see those events coming. But do they know when stock markets are going to start to climb again after the falls we’ve witnessed since January? And will they spot the catalyst for the next market downturn? Making correct calls, and getting in and out of the market at just the right time, on a consistent basis, is practically impossible.

The same applies to which stocks and funds to invest in. Most stocks deliver mediocre returns in the long run. The “mega success stocks” like Apple or Amazon that have driven much of the market’s returns in the past decade are few and far between. Highlighting their successes in hindsight is easy but picking them ahead of time is infinitely harder.

Putting your time and energy into trying to pick the next “big stock” is an endeavor that mathematically has a very low probability of adding value. Likewise, paying somebody else to do this for you, will likely yield little return.

It follows, most active managed funds will underperform the broader market on a properly cost- and risk-adjusted basis. So, for financial advisers to know, in advance, who the winners are going to be is a very tall order.

The best financial advisers know what they can and can’t control. They acknowledge that despite their deeper knowledge and closer proximity, they have no greater insight than anyone else of where the market is headed in the short-term. They won’t tell you which will be the top performing stocks over the next 12 months, what the central banks will do with interest rates or how long the war in Ukraine will last.

A plan without forecasts

Of course, everyone will have an opinion on the economy or the efficacy of government policy or what the market might do next. But a good adviser knows that that is the sort of conversation best held in the pub, not in the context of planning a client’s future.

In any case, a financial plan should not be shaped in terms of a forecast for the market, but according to the needs, goals, risk appetites and life circumstances of each individual client. In this sense, the adviser is not an expert in prophecy but in possibility.

He or she starts by spending time with the client or prospect to learn about them — not just about their assets, liabilities, income and expenditure, but also about their aspirations and expectations. Often times, the client may not have a completely clear set of objectives, and in this case the adviser is there to help facilitate the formulation of goals for the short, medium and long term.

The adviser then connects those goals to investment strategies that give the client the best chance of both succeeding with and sticking to. A forecast is not required. If the goal is long-term, the planner knows the client will experience ‘capital market rates of return’, and in most cases, that should be satisfactory if the investment strategy was well thought out.

The keys to earning those returns are not market timing or stock selection but employing diversification, discipline and other empirically tested systematic strategies. The equity market will have more good years than bad, we know that. But there will be bad years, so the plan needs to accommodate for those years by including bonds and other defensive assets.

Not every sector of the market will perform well at the same time, so the plan will diversify across and within asset classes and across different types of stocks — large and small, value and growth, Australian and international.

Cost is another determinant. The fees paid to fund managers can be a drag on the returns delivered to the client. So, the plan will consider the most efficient solutions. Taxes, too, can make a difference between the advertised returns of various strategies and what ends up in your pocket. A good financial plan takes account of that.

Finally, no plan is ever set in concrete and forgotten about. That’s for two reasons: First, markets are always changing. This can move a client’s portfolio beyond the bounds of their risk appetites. Second, people are always changing. We change careers, relationships, build families, move house and face periodic challenges with our health and external circumstances. Plans need to be reassessed, portfolios rebalanced, and goals reset, if necessary, to accommodate all of that.

A plan for all possibilities

The point is that none of this requires making bets on the future. It requires a financial plan that accommodates a wide range of possible developments and builds strategies to deal with whatever arises — an economic recession, an industry restructuring, a marriage breakdown, a health crisis — just life really.

A good planner knows that the investments, once structured and set, will largely look after themselves. They must be monitored and measured, of course. But the most important element is the clients themselves and their lives.

The many variables that make the nightly TV news — geopolitics, rising markets, falling markets, currencies, interest rates, commodities — are all very interesting and we can debate them till the cows come home. But none of any of that is within our control.

What a financial plan does is start from what we can control — understanding each client’s goals and preferences, building strategies that maximise the chance of meeting those goals, managing risk through diversification, controlling costs and taxes, exercising discipline, and regularly rebalancing.

The controllable stuff may not be as interesting as the big political or market story of the day, but it’s here where your adviser can make a real difference.

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One story has dominated the economic news in 2022 — inflation. Around the world, prices have risen faster than forecasters were expecting, because of knock-on effects from the Covid-19 pandemic, the war in Ukraine and strong consumer demand. According to the Australian Bureau of Statistics, the annual inflation rate reached 6.8% in [Read More]

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