Lesson Learned: Start With a Plan
For those that don’t know, I began my career as an attorney. I worked at a law firm in Denver as a litigation associate. My cases spanned the gamut from contract disputes to regulatory compliance to criminal investigations. The most interesting cases, for me, were a string of portfolio mismanagement cases. This was in the late 90s and early 2000s, around the swell and pop of the Internet bubble. The cases typically involved what happens with something goes wrong – an advisor allegedly recommends a portfolio unsuitable for the client.
The very short story to my legal career: I enjoyed the finance aspects, but not the “lawyering.” I wanted to help people before something went wrong, rather than argue about it afterward.
After changing industries, my first job was in a Charles Schwab branch office, offering advice to Schwab clients. At Schwab, the first step in the process was to find an appropriate asset allocation for each client.
At the time, I felt very comfortable allocating assets from an academic perspective. In graduate school, I studied economics and statistics. I had managed my own portfolio for a decade. I read countless books, articles, and papers on asset allocation and portfolio construction. I spent time corresponding with seasoned advisors about how they put together portfolios. What I didn’t yet know is how to put all of this in place with actual people.
Allocation by Vibes
Schwab directed me to help clients gauge their risk tolerance by showing them historical returns over the previous 50 years or so. There was a single-spaced page full of data showing the yearly returns of different portfolio allocations (e.g., 80/20, 60/40, 40/60). The paper also showed the previous maximum yearly loss for each allocation. My job was to engage the client in a conversation, something to the effect of “How much pain do you think you can take before you abandon the strategy?” Clients would assess how much they could take and decide on an allocation.
This approach has several big problems. First, the strategy assumes investors can easily assess their risk tolerance. But most can’t. It’s just not something people are good at. It’s hard for someone to imagine how they might feel with a 10% or 20% loss of capital if they’ve never experienced it. Moreover, the framing is basically asking “how tough are you?” Investors may feel pressure to overstate their risk tolerance to avoid looking weak or unserious.
Second, yearly returns are different than rolling returns. Annual returns smooth over intra-year volatility. The classic example is 1987. At that time, the Dow Jones Industrial Average (the “Dow”) was the most widely followed market index. The Dow ended calendar year 1987 up a little over 2%.1 Certainly a below-average return, but presumably nothing to worry about for diversified investors. At least not according to the Schwab data sheet.
For those who don’t know, 1987 included (probably) the single-most famous crash in market history. Dubbed “Black Monday,” the Dow dropped over 22% in one day. Even a moderate investor with a 60/40 portfolio of stocks and bonds likely experienced a double-digit loss of capital. If you ask investors “of a certain age” about their worst investment memory, many will say 1987 and Black Monday. By showing annual returns, the Schwab approach glossed over a generationally terrible investment experience.
Third, and most technical, is the downside of using a statistical technique called “standard deviation.” I’m simplifying, but analysts take historical data and get a mean (average) return. From that mean, an analyst (or advisor) might say “you have less than a 5% chance of your yearly return going below X.” But the numbers assume investment returns follow what’s called a “normal distribution.” It’s technical to explain, but most investors have seen something like this chart of a normal distribution:2
Again, simplifying: investment-return plots look like the chart above, but not exactly. There are more outlier data points, i.e., more extreme events than a normal distribution would suggest. Investors are more likely to experience very bad (or good) outcomes than the above curve shows. Unfortunately, it’s the very bad outcomes that most rattle investors, and the normal distribution undercounts them.
Taken together, the “how much can you stomach” approach forces investors to make tough decisions, ignores important intra-year volatility, and may understate the number of painful moments investors are likely to experience.
A Lesson Learned
Less than one year after I began working with clients, the Global Financial Crisis (“GFC”) arrived. The GFC would test Schwab’s pain-avoidance approach and each of its weaknesses. Spoiler alert: it did not go well.
In fact, it was a disaster. Clients who claimed to be able to weather a 20% drop in capital sold everything after losing half that. Ostensibly long-term investors started checking their balances each day, saying something to the effect of “I’ve lost $15K today. When is the market going up?” As the GFC dragged on into 2008 and early 2009, many clients insisted on making drastic changes to their portfolio, some doing so at or near the very bottom of the market.
Even worse, some clients blamed me personally. A few even claimed that I had misled them. For months, my days were filled with conversations that included “You told me I wouldn’t lose more than $X,” “You told me this wouldn’t happen,” or “You lied to me!”
Admittedly, as a former attorney, my first instinct was to correct them. I was actually very careful to explain to them that expected returns aren’t actual returns. We discussed, in detail, the potential risks of investing.
But I didn’t – couldn’t – correct them. I felt terrible. Real people were losing real money. They didn’t care that, a year earlier, I told them investing is a long-term process and, in the short term, markets can go up or down a lot. Because what I said wasn’t what they heard.
That’s the crux. I didn’t appreciate it at the time, but the “pain vs. gain” approach carries an implicit promise than the future will look like the past. That nothing unexpected will happen. That they won’t have to worry about large capital losses. But there are no promises. Eventually something will happen we don’t expect. What do you do then? For those without a plan, the answer is often: panic.
My Schwab experience is a big reason why, in these essays, we continually stress the importance of a plan.
Benefits of a Plan
We believe a financial-life plan is the key to successful investing. First, and most important, a plan “gives the why” to the investor. Industry secret: investing is hard! Investing feels easy when markets go up. But what happens when they go down? “Why am I doing this?” is a legitimate question. If there isn’t a reason to endure the pain of a bear market, there’s no reason to stay invested. It’s easy to fall into a vicious cycle of investing after the market has gone up and selling after the market drops.
Investors with a plan, however, have an answer to that question. Perhaps many. “I’m doing this because I want to retire early.” “I’m doing this so my children have opportunities I didn’t.” “I’m doing this to care for my spouse.” “I’m doing this to create a charitable legacy.” With a plan, market volatility becomes short-term pain as a means to an end. The volatility is what allows us to reach our goals.
Second, a plan provides guidance as we go along. At Wealth Architects, we seek to simplify the complex. Thus, we sometimes boil a financial plan down to a “confidence” number: how confident we are that we’ll meet our financial goals. That simplicity, however, can mask how much data goes into the financial plan. Our plans can include a range of investment returns, inflation rates, interest rates, taxes, and many other market factors.
For example, inflation spiked in 2022, driven largely by pent-up post-COVID spending and the start of the war in Ukraine. At the time, some clients asked us, “I hear inflation is coming back, should we do something different with our investments?” Most clients were relieved to hear that their plan and portfolio already accounted for high-inflation environments. Our plans can, thus, simplify our response to market conditions. Rather than asking, “Should I do something different?” we can ask, “Has my plan changed?” If our long-term plans haven’t changed, then we can more easily resist the urge to tinker.
Finally, a financial-life plan helps us focus on what we can control: our own actions. If market returns aren’t what we hope, what can we do? We can control the risk we take. We can control how much we spend, save, or share. We can work longer or differently. The financial media focus on the unknown: what may or may not happen in the future. A plan helps us ignore the noise and focus on what we can do today to make our future better.
Sometimes, people will ask me to give them “one piece of advice” to help them become better investors. I typically say: “Start with a plan.” A financial-life plan gives meaning to investors, helps us make better decisions, and empowers us as we seek to build wealthier lives.
[1] See, e.g., Berndhardt and Eckblad, Stock Market Crash of 1987, www.federalreservehistory.org.
[2] Source: Corporate Finance Institute
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The information provided in this commentary is intended to be informative and not intended to be advice relative to any investment or portfolio offered through Wealth Architects. The views expressed in this commentary reflect the opinion of the author based on data available as of the date this article [essay] was written and is subject to change without notice. This commentary is not a complete analysis of any sector, industry or security. Individual investors should consult with their financial advisor before implementing changes in their portfolio based on opinions expressed. The information provided in this commentary is not a solicitation for the investment management or other services offered by Wealth Architects. References incorporated into the report [essay] from third party sources are as of the date specified and are believed to be reliable. Wealth Architects is not responsible for errors in the third party data.
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