How can a financial adviser give good long-term investment advice to a client who is risk averse?

[AJAM]

I am not a professional financial advisor but my career was in financial services.
A couple of years back some ex colleagues of Zurich Life came to me for "advice" on their offer of an enhanced transfer value of their deferred pension. I cobbled together a spreadsheet to allow them play with the possibilities. Not surprisingly they all went for the ETV (money in the hand much more desirable than a pension which was guaranteed to be doubled (3% p.a.) in their 80s).
The next bit was where should they invest the money? They were being offered a choice of Zurich's Prisma funds risk rated from 2 to 7 at subsidised AMC. My first almost subconscious piece of advice was that there was no point in looking at alternative fund managers - the subsidised AMC trumped any spurious alpha differentiation.
Zurich gave an indication of the potential returns and volatility of the various risk rating choices and I accepted them at face value and fitted them to a lognormal model (@Marc ). I let them play with the spreadsheet to get a sense of what the various choices meant in terms of the Quartile distribution of future year by year pay-outs. They had a facility to input a one off fall in equity values which the spreadsheet converted to the impact on the chosen risk rated fund.
So in the round I saw myself as informing not advising and I note the following points:
1) Ex ante differentiation of fund managers is spurious except as regards their charges
2) It was not for me to persuade them to take risks they don't want to take - but merely to let them have a good sense of the risks
3) I carefully avoided conveying my own instinct that markets were in bubble territory - a view that I have had for as long as Colm has been cleaning up! But they are clued in enough themselves to have a broad awareness of stockmarkets and their recent performance and potential for "crash". I let them test their fears (though I admit the spreadsheet as shipped had a 30% one off fall as its input).
4) I didn't bother them at all with the annuity option. I suppose that is advice but considering they had accepted the ETV it would be silly to reverse back into a lesser annuity. I did give a facility to annuitise at older ages.

As a separate point each of my advisees would probably be thinking in terms of leaving the family home to their estate but not much else and they were aware that in switching from pension to ARF the possibility of "windfall" inheritances arose.
This highlights how important personal circumstances are. I suspect that Colm's "good luck" is really good luck for his kids. Does he consult them on his investment strategy? At the other end of the scale someone investing 100% in equities may be risking being unable to keep a car but in the expectation that if equities behave themselves they might be able to trade up from a Ford to a Tesla. Utility considerations are paramount in making these risk reward trade offs.

Great post Duke. I think you're approach is right. Financial advisors should be educating and informing their clients to allow them to make their own decision. The starting point should be "What is your Goal" and "What is your Time horizon"
Most punters will default to the eye roll inducing "I want high returns with low risk"! But if you make them get specific instead of general..... "I want to retire at 60 with 45K per annum income." Now you an put a model together to show them how to reach that goal, and from there you can explain the risks associated with that model.

It's up to them then if they are willing to take the risks. But at least they understand both sets of risk i.e. you need to take on investment risk to have any chance of making your goal vs you can reduce your investment risk, but by doing so you increase the risk of not meeting your goal.

So that's my answer to the Title Post Question. How can a financial adviser give good long-term investment advice to a client who is risk averse?
You have to tie it to goals and explain with models that you need to balance investment risk with outcome risk.

 

[Steven Barrett]

A couple of years back some ex colleagues of Zurich Life came to me for "advice" on their offer of an enhanced transfer value of their deferred pension.

It was a very good offer though, better than any of the others I have seen with an amc that is as low as you can get in the market and something not available through Zurich Life normally.

 

[Duke of Marmalade]

It was a very good offer though, better than any of the others I have seen with an amc that is as low as you can get in the market and something not available through Zurich Life normally.

Yep, it looked a bit of a no-brainer, even though by comparison with annuity rates it was strictly speaking less than the correct "actuarial" value.
They also went through the standard Financial Advice process (with Mercer I think, fees paid by Zurich) involving matching risk appetite to risk rating. While it is easy to criticise this somewhat naive approach I can't actually see how to improve on it. In the end I think they accepted the Mercer advice of 3 and 4. Personally, I am not sure which I would have picked. 2 was definitely out. 7 maybe a bit too aggressive. They were probably well advised.

 

[SGWidow]

I don't think that is entirely correct. Let's say the internal dividend earnings of the fund are 2.5%. These are reinvested. Now a 2.5% withdrawal is simply reversing that reinvestment. There are of course timing and other differences but the broad effect is similar to the dividends having been distributed. As a further thought

Hi Duke,

I don't get this!! ……..that is your point that money withdrawn from an equity fund at a depressed price is similar to dividends being distributed (in the way described elsewhere as a risk sequence support.) Here's why - imagine a fund like....

Equities 970,000 (total shares held by the respective share prices, etc.)
Cash 30,000 (dividends and other money floating around)
Fund Value 1,000.000

Say the fund has 10,000 units in total with a unit price of €100. This unit price is made up by €97 and €3 for the equities and cash, respectively.

If I "need" €10, 000...….I must sell 100 units, meaning that my "need" is satisfied by selling €9,700 in equities and €300 in cash!

What am I missing?

 

[Marc]

Have a look at that thread, and there are well informed people arriving at opposite conclusions.

who is to judge that the opinions are well informed?

 

[Duke of Marmalade]

Hi Duke,

I don't get this!! ……..that is your point that money withdrawn from an equity fund at a depressed price is similar to dividends being distributed (in the way described elsewhere as a risk sequence support.) Here's why - imagine a fund like....

Equities 970,000 (total shares held by the respective share prices, etc.)
Cash 30,000 (dividends and other money floating around)
Fund Value 1,000.000

Say the fund has 10,000 units in total with a unit price of €100. This unit price is made up by €97 and €3 for the equities and cash, respectively.

If I "need" €10, 000...….I must sell 100 units, meaning that my "need" is satisfied by selling €9,700 in equities and €300 in cash!

What am I missing?

Fund is 97% equity, 3% cash from dividends
Fund re-invests 3% cash in equities; now 100% equities
You sell 3% of your units and now hold 97% equities; 3% cash
Exact same position as if fund did not re-invest 3% but distributed directly to you
You have simply reversed the fund’s reinvestment of your dividends

 

[Sarenco]

Or to put it another way, failing to reinvest a dividend in the shares that produced the dividend is the same thing economically as selling those shares.

A statement that proved surprisingly controversial on another thread…

 

[SGWidow]

I was going to reply along those lines but you beat me to it, Sarenco!

Also, the shares get sold at depressed prices so sequence of risk applies in my example.

 

[Duke of Marmalade]

I was going to reply along those lines but you beat me to it, Sarenco!

Also, the shares get sold at depressed prices so sequence of risk applies in my example.

Your example is not what I am talking about. I am talking about selling the amount of the internal dividends that were reinvested in which case the shares were bought and sold at the same depressed prices. The prices are totally irrelevant.
@Sarenco’s comment is total nonsense. Failing to buy a car is not the same as selling it.

 

[SGWidow]

Hi Duke,

I'm going to be busy for the next day or so but will try find the time to explain my position better. Hopefully, this evening.

 

[Duke of Marmalade]

Hi Duke,

I'm going to be busy for the next day or so but will try find the time to explain my position better. Hopefully, this evening.

I am really making an almost trivial point, so it must be my faulty explanations. I'll try another illustration.
Fund consists of 2 shares; the look through make-up of my units in the fund is as follows:
Share A valued at 100; Share B valued at 110; Total value of units 210
Share B pays a 10 dividend leaving the Fund with 100 A, 100 B and 10 Cash
The fund reinvests the 10 equally in A and B and now consists of 105 A, 105 B
I sell 10 of the units and now hold 200 in units plus 10 cash which on look through is 100 in A, 100 in B and 10 in cash
This is the exact same as if the fund had distributed the 10 to me and not bothered with re-investing. The price at which the re-investment and subsequent reversal of that re-investment by encashing units took place is irrelevant (on the approximate assumption that it is the same price).

I hope this is blindingly obvious. The more significant point is whether receiving dividends is less vulnerable to sequence risk than selling shares/units, which I addressed in the other thread. This little rabbit hole is about whether direct investment has an edge over collective investment with re-investment of dividends. At first blush I thought it had and actually made the argument against collective re-invested funds but on reflection the "advantage" is a bit of an illusion.

 

[Sarenco]

I sell 10 of the units and now hold 200 in units plus 10 cash which on look through is 100 in A, 100 in B and 10 in cash
This is the exact same as if the fund had distributed the 10 to me and not bothered with re-investing

You may not like my phrasing, but that's the exact point I have been trying to make all along.

At first blush I thought it had and actually made the argument against collective re-invested funds but on reflection the "advantage" is a bit of an illusion

I hadn't appreciated that you had shifted your position in this regard.

It seems that we are in violent agreement.

 

[Duke of Marmalade]

It seems that we are in violent agreement.

I hope so

 

[Colm Fagan]

Once you explain to them that this doesn't really happen ... and that what the industry calls risky is investing in the likes of Apple, Microsoft etc they are more comfortable. But that does not mean that your money is safe, indexes have fallen by -45% in the past, even with the big companies in it. It's just they have come back.,

Steven, I like your approach, which is similar to my own. The knowledge that I am investing in real, solid businesses allows me to sleep at night. It would be great if there were more financial advisers like you who could give that sort of reassurance to clients.
People think I am taking massive risks by putting nearly all my money in equities. I see it differently. For example, my biggest ARF holding pays a dividend of 7% a year (at the current market price). The dividend hasn't fallen once in the last ten years (at least). In fact, it has increased by 50% in the period. The board of directors believes that the dividend is safe for the next 20 years. I've done a thorough analysis of its finances. I agree with that assessment. In the circumstances, why would I sell part of that holding and put my money instead in a bond that will pay almost zero over the same period? I would be mad. I see that particular share as a type of 'bond' . It just so happens that it pays almost 7% a year more than I could get from a 'real' bond.
OK, there are circumstances where the dividend could fall (although I find them hard to envisage ). Even if the dividend were to fall, the company would still be solvent. I accept too that its market value could fall. For example, its market value fell to about two-thirds of its current value in March last, but I wasn't particularly worried, because the dividend wasn't affected. At the time, the dividend yield was almost 10%. I'm sorry now I didn't put more into it at that time. Some of my ARF is invested in companies which are in completely different businesses and which will be affected by different risks. It's very unlikely that all of them will experience difficulties at the same time.
I believe firmly that, if financial advisers could persuade their clients to focus more on the fact that, by buying equities, they are investing in real businesses, placing less emphasis on fancy graphs of the type that @Marc produces, their clients would sleep easier at night and would be considerably better off.
So the bottom line when advising people on the merits of equities v bonds is to forget the graphs and focus instead on the fact that an equity investment means investing in real businesses like the ones Steven mentioned in his post.

 

[Marc]

There are some posters on here who believe that my posts are directed at them personally and seek to engage in constant mud slinging simply because whatever they did worked for the them. When I am more concerned with providing professional analysis based on statistically significant evidence which has ideally been peer reviewed.

Often these, lets call them facts shall we, don’t fit the narrative of the, often, annoying anonymous troll wishing to pick a fight.

I frequently report posts which are wrong, misleading, irresponsible or reckless and I am frequently told not to report posts I “disagree” with. It’s like reporting someone breaking into someone’s home and being told “leave them alone they probably just want a new TV”

So I now simply block the more offensive posters and don’t engage directly in debate since there are none so deaf as will not hear.

For the avoidance of doubt I’m not against people investing in equities when it is done prudently and sensibly through a suitable, globally diversified collective investment fund.

I am however firmly against poor “advice” being touted to lay investors who might not realise just how flagrantly irresponsible it is.

There is a very substantial difference between being able to identify the winning stocks over the last decade and avoiding the vast majority of stocks which are likely to underperform cash over the next decade - see link at the end of this post.

So there is a very significant difference between investing in a global equity index and buying a collection of companies most of which won’t make more than a bank account.

It is well documented in behavioural finance literature that investors frequently fall into the trap of thinking that because past winners have been so successful that trying to identify the next winning company has to be the right way to invest.

The problem here is just because the past is easily observable doesn’t mean that the future is predictable. The reality is that most companies individually make horrendous investments. Only by purchasing all possible companies are you sure to own the winners of the future. This is the empirical basis of index investing and why the vast majority of investors fail to “beat the market”

The pattern repeated over the whole of my career goes something like this.

“Why do you have all of your money in cash?”
Client ; “I’ve never been lucky with investing. I bought some bank shares and lost my shirt.”

Advisers then have to explain the difference between speculation, gambling and investing. Nursing the battered and bruised clients emotions of regret and loss which are very strong and hard to overcome.

Just imagine how much easier it would be to convince everyone to invest more in risky assets if their experience initially had been a good one?

This is the crux of the issue. A lucky investor pursuing a flawed strategy believes that they are correct because it has worked for them. The danger for society is when they try to recruit followers.

It can’t be said often enough. When you buy the market you can’t lose everything. When you buy an individual company or a small collection of pet stocks, you absolutely could.


Two very plausible scenarios for anyone pursuing the reckless strategy being touted here.

1) the client loses mental capacity and an enduring power of attorney is triggered. The attorney approaches a financial adviser for advice.
The recommendation is always going to be sell the collection of pet shares and buy a globally diversified portfolio.

2) the client dies and the widow approaches a financial adviser. Same outcome.

Even Warren Buffett has this in his will. Sell 90% of Berkshire Hathaway and put it in an index fund.

This is why you should also avoid Stockbrokers. As Woody Allen said;”a stockbroker is someone who invests other people’s money until it is all gone”

By way of an example here are the fortunes of a sample of real businesses as at May 2020

PG&E
Market value: $7.6 billion

• 11-year change: -59.8%

First Solar

• Market value: $4.6 billion
• 11-year change: -60%
  
  Murphy Oil
• Market value: $2.4 billion
• 11-year change: -60.5%

Mosaic

• Market value: $5.4 billion
• 11-year change: -64.6%

Devon Energy
Market value: $5.1 billion

• 11-year change: -65.6%

Marathon Oil

• Market value: $5.4 billion
• 11-year change: -67.8%

Fluor

• Market value: $1.2 billion
• 11-year change: -73.6%

EQT Corp

• Market value: $1.6 billion
• 11-year change: -77.8%

Range resources

• Market value: $667.4 million
• 11-year change: -92.7%

Transocean

• Market value: $1.5 billion
• 11-year change: -95.1%

Chesapeake Energy

• Market value: $424.3 million
• 11-year change: -98.5%

And that’s just in the USA!

Atari, Woolworths, Pan Am, Polaroid; Kodak, Lehman Brothers, Royal Bank of Scotland, Anglo Irish Bank, Bank Of Ireland, AIB all worthless or virtually worthless

BUYING INDIVIDUAL COMPANIES IS NOT INVESTING ITS SPECULATING.

when investing in equities you absolutely must buy a globally diversified index

[broken link removed]

The irony of a feckin Actuary complaining about “fancy graphs”

“Ignorance more frequently begets confidence than does knowledge: it is those who know little, and not those who know much, who so positively assert that this or that problem will never be solved by science.” Charles Darwin

 

[Colm Fagan]

And your point is?
Tell me the story of any of those companies. You just gave numbers showing market values and changes over a period. You didn't tell us a blessed thing about any of them. They are all complete mysteries to me - and I'm sure they're also a mystery to others who'll read the post. Was the purpose just to scare people off investing in equities? I do know the story of the companies Steven mentioned in his post.

 

[Steven Barrett]

And your point is?
Tell me the story of any of those companies. You just gave numbers showing market values and changes over a period. You didn't tell us a blessed thing about any of them. They are all complete mysteries to me - and I'm sure they're also a mystery to others who'll read the post. Was the purpose just to scare people off investing in equities? I do know the story of the companies Steven mentioned in his post.

Let's be clear Colm, I am not qualified to pick stocks and don't try to. I outsource that responsibility to the likes of MSCI and S&P who do a great job for me and they don't even bother to invoice me. There may be losers in the 1,600 companies that MSCI have but if they don't fit their criteria, they are gone (I tried reading the [broken link removed] but couldn't understand it The S&P 500 is a lot easier to understand.)

 

[Colm Fagan]

@Steven Barrett I realise that. My point was that, based on what you wrote earlier, you tell clients the names of some of the companies in which their money will be invested if they choose an equity fund, so that they're not just numbers on a page for them. They know that their money won't disappear down the tube. You don't bamboozle them with guff about lognormal distributions, volatility drags, arithmetic versus geometric means, etc. Even bamboozling themselves.

Yes, I'm different in that I want to relate directly to the companies in which my money is invested, not indirectly through a mutual or unit-linked fund. I realise that others won't need that comfort to invest in equities. My ARF is invested in 12 companies. I have made three transactions in 2021 so far. My longest-standing investment has been in my portfolio for over 22 years. I have attended that company's investor days and AGM's and have asked questions of the Board. I have also written to the Senior Independent Director when I have had governance concerns.
To call that speculating rather than investing is rubbish.

 

[Colm Fagan]

it would be great if some real life financial advisers could share (anonymously, of course) some of the (good and bad) experiences of their clients, so that we could learn from them. For example, I don't think there is anything available at market level, setting out what ARF investors have actually earned (after fees and commissions) over the last (say) 3, 5, 10 years. I've given the figures for my ARF. It would be lovely to hear from advisers the range of returns (net of all fees) earned by their clients.

Does anyone know if there is reliable data available on what returns people are actually earning on ARF's (and other retail investment products) - after commission and charges, of course? There should be a central source of such information. From my own limited experience of friends and acquaintances telling me of their investment travails, some buyers of ARF's and other pension products haven't seen any growth whatsoever in their investments over a five-year period, some longer. They were all "advised" by brokers/ financial advisers. What does that tell us about the quality of advice being dispensed?

 

[Steven Barrett]

@Steven Barrett I realise that. My point was that, based on what you wrote earlier, you tell clients the names of some of the companies in which their money will be invested if they choose an equity fund, so that they're not just numbers on a page for them. They know that their money won't disappear down the tube.

That is it exactly. Most people have very limited knowledge of investing and so many people in this country either had or know someone who suffered massive losses with the "blue chip" Irish banks. And then there's Eircom as well. When they know the size of the companies they are investing in (Microsoft are almost as big as Ireland!), it puts their mind as rest a bit.

Yes, I'm different in that I want to relate directly to the companies in which my money is invested, not indirectly through a mutual or unit-linked fund. I realise that others won't need that comfort to invest in equities. My ARF is invested in 12 companies. I have made three transactions in 2021 so far. My longest-standing investment has been in my portfolio for over 22 years. I have attended that company's investor days and AGM's and have asked questions of the Board. I have also written to the Senior Independent Director when I have had governance concerns.
To call that speculating rather than investing is rubbish.

Speculating/ gambling - the longer you stay invested, the greater the chance of losing your money.
Investing - the longer you stay invested, the greater the chance of making money

Does anyone know if there is reliable data available on what returns people are actually earning on ARF's (and other retail investment products) - after commission and charges, of course? There should be a central source of such information. From my own limited experience of friends and acquaintances telling me of their investment travails, some buyers of ARF's and other pension products haven't seen any growth whatsoever in their investments over a five-year period, some longer. They were all "advised" by brokers/ financial advisers. What does that tell us about the quality of advice being dispensed?

Most of my ARF clients are up on their initial investments. The vast majority are prudent in their withdrawals, keeping it at 4% or 5%. Those who are down are only slightly down after years of making withdrawals and have no fear of running out of money. These would have a more conservative approach to investing and they are happy with it.

I did a review last week for a client who invested €1.5m in his ARF in 2008. His ARF just creeped over €2m when we reviewed it and he has taken €900k from the ARF. He had a decent chunk in Tech funds from the off so has benefited hugely. And as I said to him, the returns are not down to me as I told him to take a more conservative approach based on him continuously telling me he was a low risk taker (he's not really, he just says he is). Now, this client had a large slice of luck with timinig and has other assets as a safety net, so he would have been alright.

It's a lot different doing tricks on the trapeze when they take the net away!


Steven
www.bluewaterfp.ie