As I said earlier, this tale teaches something that I incorporate into my advisory practice on a daily basis. Specifically, this tale taught me that advisors and individual investors must understand that clients and people will make poor decisions at the most inopportune times. Since we’ve learned that all people, whether they self-manage or utilize advisors, are ultimately in charge of their own portfolio, it behooves the smart advisor or individual investor to design portfolios that are choke proof. They have to hold up under pressure. It behooves the advisor or individual investor to design portfolios that are behavioral portfolios as well. This means that to an advisor, and you may be your own advisor, the client’s behavior becomes a variable that must be included in portfolio construction. Client behavior is not yet part of modern portfolio theory, but we are working on it. Because clients can dismiss their advisor at any time and for any reason, the good advisor anticipates the client’s own self-destructive behavior and designs and plans accordingly. Again, modern portfolio theory assumes the client behaves rationally. They assume people are just as happy going from poverty to wealth as they are from wealth to poverty. We know that’s just a crazy way to look at life.
In mid-October 2002, I got a call from the Schwab branch that I most often use, informing me that one of our mutual clients was in the office demanding to “sell everything” in all the accounts and close everyone of the accounts. They indicated that they couldn’t take any more losses. They were distraught. This particular client felt they had lost too much money in the 2000–2002 bear market, and they were going to salvage what little remained before it was all gone. I asked to speak with my client, Bob. He had been a client for 15 years. A few minutes later, the brokerage representative came back on the phone and said Bob wouldn’t speak with me because he knew what I would say. To quote my client, “I don’t need to speak with him. I know what he is going to say. He is going to tell me I’m making a mistake getting out of the stock market because he’s always bullish.” Bob proceeded with his plan. He liquidated, and a few days later, he received various checks in the mail. He wouldn’t even take my phone calls for several months.
I had to reflect on Bob’s statement about my perpetual bullishness. I think he misinterpreted my belief in a high stock allocation with perpetual bullishness. I’m not a perpetual bull or stock market optimist at all times. I just didn’t know a better way to make money for my wealth-building clients at that time. I would advise clients like Bob that while in the wealth building part of their life, if they can stomach the bad times, they should stay substantially invested in stocks and all my research tells me I’m correct. It’s clear to me today that Bob couldn’t stomach the bad times. I can see how some might consider this approach perpetual bullishness, but I don’t. The approach has its risks and rewards, but overall it’s one of the best long-term strategies for wealth building.Unfortunately, I had overlooked one key component of my wealth-building belief, and that was the key phrase “if they can stomach the bad times.” Bob couldn’t. He fired me after 15 years, and I blamed myself. When something goes wrong, I always blame myself. It would have been simple to blame Bob for his foolishness, but his words kept echoing until I finally understood what had driven Bob to do what he did. His irrational behavior helped me arrive at a better method to deal with clients when they are in a panic. The method doesn’t make more money in a theoretical sense, but it does in practice since it diminishes self-inflicted investment mistakes. The key is to structure portfolios that lower the chances of clients getting to the panic point. Current and future clients can thank Bob for the wisdom he bestowed.
Bob and his wife Linda had been two of my first clients, and I had a very fond place in my heart for them. They had been clients since 1987, and were people I genuinely liked. They were smart, educated and had a very good grasp of the stock market. When they decided to abandon our strategy, they were in their late 40s and had a little more than 10 years each before they could retire from their jobs as public school teachers. The plan was to get each of their IRA portfolios to a yet-to-be-determined level before we reduced their equity exposure to something in the neighborhood of 50–60% from the almost 100% we had maintained for the past 15 years. Everyone liked and agreed to the plan.
Their plan was simple. Bob and Linda would own quality equity investments and would stay fully invested until they had saved enough money to be able to reduce some of the risk or volatility from their portfolio. They would do this by selling a portion of their equity holdings at some future date and moving or converting that money to bonds under the assumption bonds are safer, which is a fair assumption.
The couple had started, in 1987, with less than $40,000 in each of their IRAs and had added $2,000/year when they could. They had never taken a withdrawal from the account. The IRA accounts had peaked at almost $450,000 in the year 2000. On that fateful day in October 2002, each of their IRA accounts was worth a little over $300,000. The couple also contributed to their retirement plans at work, which were also almost 100% invested in stock mutual funds, but for purposes of this tale, the IRA target is the appropriate measure.
What Went Wrong?
In my opinion, nothing went wrong other than I underestimated their WIP. It is my belief that everyone, either individually or as a couple, has a WIP. Everyone’s WIP is different, and a person’s WIP changes as they get more comfortable with wealth. However, in Bob and Linda’s case, the WIP was the point at which they looked at their assets and said, “That’s a lot of money.” It’s the point at which people ask themselves the question “Is this enough money to live on the rest of my life?” It’s also at this point that many people stop looking at their portfolios from a rate-of-return perspective, but from an absolute return perspective. This moving target of wealth is difficult to determine and is the art of the relationship between the client and the advisor. The portfolio composition or asset allocation is a reflection of this moving target. I suspect that Bob and Linda stopped seeing gains or losses as percentage gains or losses and started seeing them as absolute dollar gains or losses, thus the title of this tale, An Absolute Tale. Losing close to $300,000 over a two-and-a-half-year period was significant to them. Forget percentages, their sole focus was dollars.
The market had dropped for almost 30 months, and the portfolios were down. From a planning perspective, Bob and Linda had never reached their stated goal at any time. They still had more than 10 years until the early retirement age of 59, and if they stayed on track, the next upswing in the market would get them to their target, or at least very close. Why couldn’t they follow the plan? More importantly, why didn’t I know they couldn’t follow the plan? They assured me they could, and had in the past. They were smart people with an understanding of the history of stock market movements. What went wrong? I had to dig deeper. I analyzed the couple’s portfolio on a monthly basis from 1987 through 2002 and was surprised with what I found.
I found that even though the accounts had dropped in value by a little more than 30% from the 2000 peak, this had happened on several other occasions over the prior 15-year period. Why couldn’t they stay with the program this time? I suspect they lost confidence in the stock market’s ability—or my ability—to provide them with future returns because the losses associated with the first three 30% declines were never amounts in excess of $75,000, but the last one was. If you asked them if it was a well-thought-out decision, they might say no. But they did it anyway. Why? I can only speculate that people, and I suspect most people, have ingrained mechanisms that prevent them from thinking in terms of percentage losses and gain, and they turn to thinking in terms of dollar losses and gains when the numbers get large. Again, I suspect that most people can stay with an aggressive investment program as long as it doesn’t exceed their threshold of pain, but when it does, they panic. When they do, it’s not enough for them to have had a trusted advisor at the helm for 15 years.
As an experiment, imagine you had $100,000 and lost 30% of it. It is a $30,000 loss. Can you stand it? Now imagine you had $1 million and lost 30% of it. It is a $300,000 loss. Can you stand it? Lastly, imagine you had $10 million and lost 30% of it. It is a $3 million loss. All are 30% losses, but the amounts vary. When the dollar amount matters more than the percentage amount, you have reached your WIP. When you consider that most people don’t come from wealth and had to build it themselves, you can see why this is so important and why good advisors know the larger the portfolio, the more conservative the allocation.
As is invariably the case, Bob and Linda sold their stocks at just the wrong time since October 2002 marked the end of the bear market. If they had just stayed with the plan, they wouldn’t have missed a significant run up in their portfolio. Then again, who didn’t see this coming?
Out of curiosity, I developed a hypothetical portfolio over the same 15-year period that Bob and Linda were clients to determine if I could have done something to make them more at ease. I developed a model portfolio that was invested 60% in stocks and 40% in bonds to see what would have happened. This process led me to some insights I didn’t have before this episode. I found that using the 60/40 model, we never had a decline of 30% over the 15-year period. This means it was less volatile, but at a cost. It didn’t capture the great gains in the stock market over what, at the time, was one of the greatest bull runs in history. As a result, the theoretical equity never exceeded $300,000 and would have been worth slightly less than $250,000 in October 2002. Bob and Linda would have had less in October 2002 with the theoretical 60/40 model. However, I suspect they would have had more confidence in the probability of achieving their goal. I also suspect that had I employed the 60/40 standard for the 15 years that they would still be clients today, and they would have reached their retirement goals even if it took them a little longer.
This was one of the most valuable lessons of my life and taught me that people define wealth according to their perspective, they behave irrationally and that advisors should be aware of a client’s WIP.