The Seven Dumbest Mistakes I Made as an Advisor

by Robert J. Martorana, 6/16/15

After 30 years in the advisory business, I’ve made plenty of mistakes. It is my hope that this article will help others avoid following in my errant footsteps.

I put together a list of cautionary tales for the interns at my firm. It starts with the big picture and works its way down to more granular issues, and it includes references to best practices I have observed as a consultant.

1. Clinging to a poor value proposition

The dumbest mistake an advisor can make is having a value proposition that is vague, uncompetitive or, at worst, nonexistent. I learned this the hard way, when a high-net-worth client complained that the firm where I worked charged a high fee, bought expensive mutual funds and kept the same asset allocation year after year. “I have an account with your firm and an account at Charles Schwab. Your firm offers a diversified mix of funds and so does Schwab. Your asset allocation never changes and neither does theirs. You charge a high fee and they don’t. Why am I here?”

Ouch.

The client nailed all of the key weaknesses in my value proposition: Premium prices, the lack of low-cost funds and an asset allocation process that did not respond to major changes in capital markets. The critique stung because it was true. (In all fairness, this firm did offer a full suite of wealth management services, but the client did not perceive value in them.)

Addressing these flaws eventually led me to start my own firm, and my value proposition was and still is based on four principles:

Maintaining a fiduciary mindset: This requires a fee-based compensation and fiduciary business model in every arena. Otherwise, conflicts of interest and vested interests arise, and the best interests of clients fall to the wayside.

The worst mistake is to have a value proposition that is not based on a fiduciary model. (It may be dumb to have a flawed value proposition, but dumb is fixable; dishonesty is not.) A fiduciary mindset requires:
- Intellectual honesty: Only you can know if you have a fiduciary mindset. After all, even fee-based advisors can be lazy, misguided, stubborn or selfish. We all have our limitations as investment advisors. Honest advisors admit their flaws, learn from their mistakes and do their best to minimize the impact on clients.
- Practicality: If an ethical appeal doesn’t matter to you, consider the practical consequences: Commissions are going the way of the dodo, and fee-based fiduciaries are the future. When you deviate from the fiduciary standard you will spend your time and energy hiding your limitations and covering up your mistakes, rather than honing your skills and improving client relationships. Either way, intellectual dishonesty takes its toll.
Using a goals-based and holistic approach to advice: Investment advice that is goals-based and holistic requires an ongoing process of assessing and reassessing client needs and the market structure. This is a continual challenge for a variety of reasons:
- Client resistance: The client doesn’t always want to talk about goals or share information about their entire life. This is frustrating for advisors; you can’t help if you don’t know.
- Aggregation of assets: Holistic advice is problematic if the assets are held at other institutions. You may be able to gather information and give advice on all of the client’s accounts, but if your firm does not aggregate assets your recommendations may not get implemented.
- Economic viability: A holistic model is time consuming and may not be economically viable for small accounts. Your business model should never make a client feel small. (There are small accounts, but there are no small clients.) Some clients may be best served by target-date funds, a discount broker or automated solutions such as Betterment and WealthFront.
Being cost-effective: Solutions should be as cost-effective as possible and keep the all-in fee to the client as low as possible. Being a full-service advisor is very challenging for small accounts, so if the client wants a do-it-yourself approach, I’m glad to show them how. In that respect, I agree with Fair Advisors, that clients do not necessarily need an advisor, assuming they have the “time and temperament.” (Although that is a big “if.”)
Staying focused: You cannot serve everyone. The needs of clients vary and so do the value propositions of advisors. I have no problem referring a client to an advisor with a different philosophy, as long as the advisor is honest and a good fit for the client.

My value proposition leads me to use model portfolios with low-cost funds, plus selective use of liquid alternatives. I focus on clients with less than $500,000 and I charge 1% or less. I create model portfolios myself, and I use the Envestnet platform, which helps me customize while still providing scalable solutions. I spend a lot of time consulting, and this keeps me up to date on best practices.

This value proposition works for me, mainly because my clients like to speak with an advisor who has their “hands on the wheel.” Clients like the fact that I am willing and able to make changes in asset allocation when necessary. Many investors are uncomfortable with static asset allocations during retirement. They want active management of distributions and they are not satisfied with mathematical models that merely extrapolate the past. They are happy to pay a modest fee for strategic changes to asset allocation.

Advisors who are just starting in the business may be limited in their options, but they should be realistic about their bandwidth, their strengths and weaknesses and where their value proposition fits in the spectrum of wealth management solutions.

2. Putting my asset allocation on autopilot

Prior to 2010, most wealth management firms had a long-term approach to asset allocation that did not make tactical changes to asset allocation. During the crashes of 2001 and 2008 the firms I worked for remained bullish, and this led to awkward conversations when clients asked me what I was doing with my own money (indeed, I was raising cash).

A static allocation was a mistake in my asset-allocation process, and this mistake is common in wealth management:

Firms do not want to get sued, so they default to the standard regulatory assumptions about Modern Portfolio Theory and how it should be implemented for clients.
Firms do not want to underperform their peers, so they cluster around the same asset-allocation process and asset-allocation targets.
Many firms avoid cash because it “looks bad” in the portfolio and clients might move their money to a more aggressive firm. Thus, cash is not considered a bona fide asset class, despite its liquidity and its risk/return characteristics during crashes.
Many firms have a “see no evil” approach to bubbles, saying that they cannot be predicted with any consistency. Therefore, raising cash is a form of “market timing” that is impossible in principle.

It was my mistake to buy into these assumptions, which are prevalent among institutional investors. Part of the problem, though, is that the institutional world of money management acts in its own self-interest, which is not necessarily aligned with that of its clients. But it reflects also the fact that wealth managers are often tempted to impose an approach on individuals who have different goals, time frames, expertise, liquidity needs and risk capacity than institutional clients.

Protecting clients requires a view on bubbles, recessions, correlations, tail risk and risk premia. One should not have to say to the client: “Sorry, my model failed and you ran out of money during retirement.”

I have modest expectations about my ability to add value via active asset allocation, and I stick close to the baseline allocation in most market environments. I make no claims to the client about future performance, and I do not charge a premium fee based on my crystal ball. But a 100% passive process toward asset allocation is inappropriate for most individuals, especially when designing lifetime income solutions for retirees. Static asset allocation is as an abdication of my responsibility to protect the client.

3. Being presumptuous in my portfolio construction

When I managed money at Schroders and Barclays, we built portfolios from individual securities, which was incredibly time consuming and largely unproductive. The key problem is that you needed to have forecasts for every asset class, sector and security. And you needed to have ideas all the time, even when there were no obvious opportunities. We had to justify our fee on the entire fund, and it was not acceptable to merely own the benchmark when we did not see attractive opportunities.

This portfolio construction process was presumptuous and overly ambitious; it assumed superhuman abilities. Today I use a passive core and an opportunistic satellite, and I own the benchmark if I do not have conviction in an asset class or a position. (This process is a lot easier when accompanied by a low-cost approach, a fiduciary mindset and a strong backbone when speaking to clients.)

A benefit of a passive core and an opportunistic satellite approach is that it allows a high proportion of low-cost funds, and one can adapt as opportunities arise, so this approach may help generate alpha.

In the recent AP Viewpoint webinar debate and follow-up discussion on active versus passive management, C. Thomas Howard, PhD noted certain characteristics that are desirable for active equity managers: a focused strategy, limited AUM, high active share, low R-squared, limited number of positions, etc. An advisor is more likely to identify and benefit from these characteristics when using a low-cost approach that combines a passive core and an active satellite since this compensation structure takes the pressure off the advisor to have a hot idea in all asset classes at all times.

4. Succumbing to confirmation bias in security selection

I started out as a stock analyst at Value Line in 1985, and I still enjoy equity analysis. Many clients still prefer individual positions despite evidence that it rarely leads to better results.

I have made virtually every behavioral mistake, from performance chasing to recency bias (overemphasizing recent information). I am still susceptible to all of these biases, just as a dieter is susceptible to the charms of a hot fudge sundae. Knowing your weaknesses does not eliminate them.

But a recent change in my process helped address the behavioral flaws in my security selection process. Beginning in 2014, I organized periodic conference calls with a network of advisors to evaluate ideas, and this has been particularly helpful in addressing confirmation bias. Like any investor, I tend to interpret information in a way that confirms my existing beliefs, ideas and investment positions. I have found it helpful to bounce ideas off other advisors, particularly since they have no stake in the outcome and they have completely different approaches to investing. This identifies risks I have overlooked and weak points in my thinking. My process still has room for improvement, but a sounding board certainly helps.

(For additional reading, a good collection on institutional biases is in Folklore of Finance, published by the Center for Applied Research in December of 2014.)

5. Confusing regulatory compliance with investment suitability

My initial experience with client suitability was purely defensive: The firm where I worked required an Investment Policy Statement so that it did not get sued. The emphasis on regulatory compliance was necessary but incomplete since it ignored the investment implications of a suitability mismatch.

When clients do not understand their investment portfolio, or when they lack confidence in their advisor’s recommendations, they are vulnerable to “bail-out risk,” selling a position at the bottom of the cycle. This is especially problematic with alternative investments that are complex and which are designed to be uncorrelated with the market. If a client is unwilling or unable to understand an investment, it is clearly unsuitable. But there are degrees of suitability. The greater the suitability, the greater the client conviction and the lower the likelihood that the client will lose money because they bail out at the bottom.

One way I address bail-out risk is to keep investment solutions as simple as possible, and to link them directly to the goals of the client. If the client does not get it, I try something else.

6. Using jargon with clients

I love investment research, and it is easy for me to slip into CFA-speak. I made this mistake recently when I started using the Barclays VEQTOR ETN (VQT), which provides hedged exposure to the S&P 500. But concepts like contango and volatility drag, which I used to explain VQT, were meaningless to clients. So I started to explain how managing volatility is like putting shock absorbers on a car. You still get to your destination, but the ride is not as bumpy. This describes the function of the product in the portfolio and how it helps achieve client goals. (The metaphor is not perfect, but it is better than “an implied volatility hedge via dynamic reallocation of stocks, VIX and cash.”)

A related issue is the use of jargon to avoid accountability. I have not fallen prey to this, but I understand the temptation to hide under the desk when performance is poor. Investor surveys show that clients hate it when advisors and investment managers dodge accountability, and the tactics to do this include vague language, incomprehensible mathematics and obscure references to ancient Greek philosophers.

Fortunately I got good guidance early in my career when I was managing small-cap stocks at Schroders. The firm announced that it was going to review our results against fixed benchmarks, and I was afraid that my results wouldn’t pass muster. Alan Gilston, a senior portfolio manager and a friend of mine, gave me a healthy perspective: “Benchmarking is the key to improving your process. If you know what you’re doing wrong, you fix it. And if you are doing something right, you do more of it. But without benchmarks, you’re just guessing.” It was good advice then and now.

7. Trying to fix the unfixable

I have often made the mistake of trying to fix problems with the investment process that simply do not have solutions. Some organizations have a dysfunctional culture that is deeply embedded and resistant to change, whether it is due to bureaucracy, office politics or intellectual arrogance. (Large asset management firms are particularly susceptible to becoming job-preservation machines, with unwritten rules that preserve the status quo.) Clients can also be stubborn and dysfunctional, or act in ways that are irrational, capricious or relentlessly demanding. If you are not careful, vampire clients can drain time and energy from your business.

Trying to fix an unfixable situation is one of the dumbest mistakes I have made. I have since learned that the best response to a futile situation is to cut your losses and move on. Sometimes the only winning move is not to play.

My thanks to Varun Amesur, Owen Zukovich and Jessica Rabe for putting up with me during their internships.

Robert J. Martorana, CFA has been an investment professional since 1985. He owns Right Blend Investing, LLC, which focuses on the institutional research of liquid alternatives. He is the co-author of Alts Democratized.