There are two very important investment roles played by a financial adviser. The first is understanding and articulating the goals of a client. The second is selecting a suitable asset allocation to achieve the most optimal returns to realize those goals. The emphasis is not on simply maximizing returns without considering the risks. Nor is it trying to beat an index, chosen arbitrarily.
Goals based investing involves identifying client’s goals and the investment returns needed to achieve those goals. In general, the higher the return needed, the higher the risk that needs to be taken. The financial adviser has to ensure that the risk that is taken to generate the return desired, complements the client’s risk profile. This exercise leads to either the client accepting the risk or modifying her goals or achieving the goals with other non-investment methods.
For example, if a client wants to retire early but does not have the level of savings required for it, then the portfolio will have to take relatively high risk in order to generate the returns needed to compound the value of the portfolio. But, if the client does not have the ability to take risk (perhaps because of other obligations, such as Children’s education that would need liquidity) or the willingness to take risk (maybe she has demonstrated skittishness in the face of market volatility in the past) then, the required portfolio risk does not agree with the client’s risk profile. This client will have to postpone her retirement and work longer. If the financial adviser simply focuses on generating high returns, then when the market falls the client may want to liquidate the portfolio at exactly the wrong time.
The second role is asset allocation and portfolio construction. Within a broad allocation that is suitable for the client’s objectives and risk profile, some advisors may make small tactical deviations without veering too much from the desired level of risk. Research has shown that asset allocation contributes the majority (In excess of 90%) of the portfolio volatility. As we show below this also has implication for portfolio returns. Taken together with the need to match portfolio risk with client objectives, an asset allocation based investing is more superior than simply trying to beat any arbitrarily chosen index.
Consider two portfolios. The first one is invested 100% in an equity mutual fund that is down 4% when the index is down 6%. The other portfolio is invested 50% in equities and 50% in bonds through two mutual funds, both of which trail their benchmarks. Assume the equity fund is down 8% (When the equity index is down 8%) and the bond fund is up 10% when the bond index is up 12%. Despite both funds trailing their respective benchmark’s the second portfolio is superior in that it is up 1% (50% * (-8%) + 50%*(+10%)) as compared to the first portfolio that is down 4%. This is only a crude example but it illustrates the point well.