Harold Evensky: Is This Time Different?
Geopolitical upheaval and rapid inflation have driven volatility and, with that, questions from clients about whether to reposition portfolios defensively. In my wide-ranging conversation with Harold Evensky, he explained how he responds to fears that this time is different.
If you’ve been reading Advisor Perspectives articles over the past three or four months, you know that there are a lot of informed opinions about what the markets are doing and where they’re going – and, of course, their conclusions are highly divergent. The situation reminds me a lot of the early stages of the tech meltdown two-plus decades ago, when the markets had become chaotic, and the speculation ranged all the way from buy the dips to flee to cash.
But the interesting thing is that we are always in this situation: in the dark, hearing informed, persuasive opinions about what the markets are doing and what they’re going to do next. I talked with Evensky, the co-founder of Evensky & Katz/Foldes Financial Wealth Management, author of The New Wealth Management, about his thoughts on what to tell clients about today’s choppy markets. He has consistently been one of the leading investment thinkers in the financial planning profession, and he offered some interesting perspectives that are very different from the prognostications you may be accustomed to reading.
We might as well start with his opinions on the actual idea of prognostications – or, at least, listening to them. Evensky notes that, particularly when markets are turbulent, people with above-average intelligence (a category that fits many financial planning clients) will assume that they are smarter than the average, and they perceive 'the average' to be the index market returns. The smart people develop opinions about whether this is a good time to reduce or increase their exposure to risk assets, often with the generous help of some confident predictions written by someone who ought to be (in the interests of full disclosure) wearing a wizard’s hat and staring intently into a crystal ball.
Naturally they are asking their advisors to make changes accordingly.
“The idea that someone with above-average intelligence or a lot of research can anticipate the markets is a very attractive story,” Evensky concedes. “It certainly sells books, and it generates lots of commissions. But the fallacy is that it has never been successful.”
Never? Can an advisor say that to clients?
“One of the things I say to the people we work with,” Evensky counters, “is: can you name for me the top 10 greatest market timers of all time?”
The most common response, he says, is a long silence, while the clients struggle to name even one. Then Evensky will point out that if there were people who had a long track record of successfully predicting future market movements and trading accordingly, they would certainly be quite famous by now. And incidentally, they would also own most of the world’s assets. “Alternatively, if they were that smart,” he says, “why would they tell anyone else?”
The elegance of this argument is that it refutes any prognostications that the client may bring to the advisor’s attention, and (bigger picture) takes the advisor off the hook for making any market timing recommendations him/herself. Not only do you, the advisor, not know what’s coming next (Markets up? Markets down?), but nobody knows. Or, at least, there isn’t any track record to suggest that anybody does. And the client’s own reflection about famous market timers makes the point.
But of course, tugging on the sleeve about repositioning assets based on future assumptions is not the only client communication issue that advisors are facing. Evensky notes that many clients will take rebalancing their portfolios back to their target allocations in stride when the markets are going up.
When the markets are going down, as they have been lately, rebalancing can lead to more complicated conversations. That, in turn, can lead advisors to put off rebalancing into equities during a downturn – which avoids the protests of their clients, but also undermines future returns.
“If you’re not consistent about your rebalancing discipline in both types of markets,” says Evensky, “it’s the equivalent of systematically buying high and selling low. It’s a guaranteed drain on the health of the portfolio.”
You and I understand that, but what about clients? “Back in the great recession, we rebalanced three times,” says Evensky. “The first time, clients were saying, Okay, we understand. You told us that. The second time was: Are you really sure about this? The third time,” he adds, “it was really difficult. But in hindsight, that last rebalance worked out pretty well.”
Evensky says that the third rebalance in 2009 was, in retrospect, the most painful of his long career. “We were rebalancing into a bear market three times while it was going down,” he says. “Everybody thought we were crazy.” How did he handle this conversation with clients during a period when it seemed like the global financial ecosystem was tottering on the brink of failure? “We said that we have all the faith in the world that the global economy will eventually recover,” Evensky says. “And when that happens, these decisions are going to look really smart.”
Then he added: “If it doesn’t, who gives a damn? We’ll be dead anyway.”
That conversation has relevance today, since many clients are asking a third question of their advisors. With the war in Ukraine going badly for Russia, and a mentally unstable dictator controlling the deployment of some 5,000 nuclear warheads, suddenly there is a nontrivial chance of a truly catastrophic World War III scenario. Clients are asking Evensky (and surely many other advisors): How do we position our portfolios for the possibility of a nuclear war?
How does he respond?
“My answer is that if we go into a worst-case scenario, we’re going to have a lot more significant things to worry about than whether our portfolios have lost value,” he says. “If Putin pushes the button, that aspect of things really won’t matter.”
If his clients persist, then Evensky will acknowledge that there actually is a portfolio that is best positioned to withstand a global nuclear holocaust. It consists of a deep bunker, canned food and water, a bag full of Krugerrands, guns and plenty of ammo. But he also notes that, historically, this has not been the best performing mix of assets – even through global wars, the Cuban missile crisis or the global economy teetering on the brink. “After all those scary historical events, the markets have subsequently achieved record highs,” Evensky says. “And some of those scary events were pretty significant.”
The best thing to tell clients is to buy and forget. Right?
Wrong. “I think ‘buy and forget’ is entirely the wrong message,” says Evensky; “in fact, that’s one of my criticisms about what advisors tell their clients. It is not ‘buy and forget,” he adds; “it’s ‘buy and manage.’”
How is ‘managing’ different from market timing?
“You need to consistently update your forward-looking expectations, revise your assumptions about returns, correlations and standard deviations, and revisit your hypothetical efficient frontier – and adjust your portfolios accordingly,” says Evensky. “Not, of course, on a daily basis,” he quickly adds. “As you know, I provide the assumptions and models for MoneyGuidePro, and I update them maybe once every year or two. To the extent there are changes, they tend to be very modest.”
Most advisors assess their clients’ risk tolerance and recommend a portfolio on the corresponding point of the efficient frontier. But the interesting thing about efficient frontiers is that, in any 10-year time frame, we never get the same curve as the long-term averages. How does Evensky manage that disparity?
“When you’re developing your efficient frontier, one of the inputs is risk, measured by the standard deviation,” he says. “Most advisors are using the five-year standard deviation for asset classes, and they show that to their clients,” he adds. “But over time, we learned that five years is not a time horizon most people can relate to, especially in a bear market.”
His solution is to use one-year standard deviations in the efficient frontier graph. “There is no mathematical logic behind it, and it does tend to overstate the risk a bit,” Evensky concedes. “But it’s something that most people can relate to.” For the expected return input, he uses real (after tax, after inflation, after expenses) returns rather than the higher nominal figures, which also tempers expectations.
The result is that many clients, based on their risk tolerance, are offered a somewhat more conservative place on the efficient frontier, and given what might be a slightly exaggerated view of the potential volatility they could conceivably experience. “So much of portfolio management is managing client expectations,” Evensky says. “We can’t manage the market. All we can do is help our clients understand what they can realistically expect from the markets.”
But what if clients’ risk tolerance framework is not sufficient for them to meet their financial goals? “Then we have a different conversation,” says Evensky. “We tell clients, do you want to eat less well or sleep less well? They have to decide what’s controlling,” he adds. “As a financial planner, I believe that risk should be the controlling factor. It’s easy for a client to say, I’ll take a little more risk. But if you don’t think they can handle that, then you’re exposing them to the possibility that they’ll make a dangerous decision when the [you know what] hits the fan.”
Which raises a question that is coming up more frequently as the markets get choppy: How does one best define client risk tolerance?
“There have been all kinds of papers written,” says Evensky, “and I finally concluded that there is only one definition, from a financial planning standpoint, that makes any sense. And that’s: where is the threshold of pain, where the client is going to call me up and say: Harold, I can’t stand it anymore. Take me to cash. That is my definition of risk tolerance,” he adds. “All the other ones are academically very interesting, but ultimately nonsensical.”
Is there a tool that defines this elusive threshold of pain? Evensky uses FinaMetrica (now part of the Morningstar Risk Profiling tool), but he also realized that the process of assessing a client’s risk tolerance could become a valuable teaching tool – even before a portfolio recommendation has been made. “We added a scaling, that shows stock/bond returns, the real return spectrum out to two standard deviations,” he says. “And we show what would have happened with each portfolio mix during the great recession, which was a lot worse than two standard deviations.”
Then he asks clients where, on that spectrum, they would feel comfortable. “It’s very much an educational tool,” says Evensky. “We’re showing clients what they might expect right up-front, so when it happens in real time, they’re more prepared for it.”
Of course, some clients might object and ask for a portfolio with low risk and high returns. “I tell them, I have a buddy who is a broker down the street who will promise exactly what you want,” says Evensky. “We don’t deal in fantasy.”
Evensky once told me that his investment process went something like this: We research, we research some more, and then we do a lot more research. And then we guess.
What does that mean, exactly?
“You have to focus on the academics,” Evensky explains, “and we use all the intellectual capital that we can apply. But of necessity, we have to overlay that with a combination of common sense and wisdom – with our experience and judgment.”
That takes Evensky to another investment-related topic that he says many people are overlooking. “You can’t just focus on the investment aspect of things,” he says. “Investments are only a part of what we do to help guide our clients.”
The larger part, of course, is financial planning, which includes quantifying client goals and objectives. “You have objectives that are short-, intermediate-, and long-term, and some are variable,” he says. “You have to know those things going in before you can make customized recommendations.”
Why? “We help clients understand that not everyone has to maximize their returns, that the returns compared with an index or the market, especially for many of their shorter term goals, are irrelevant,” Evensky explains. And this is an area where advisory firms who worship the god ‘efficiency’ may be short-changing their clients – in a variety of ways.
One way is to gloss over some important inputs into the investment decisions. “We know from our relationship with MoneyGuidePro that the average advisor is only inputting two client goals into the software,” says Evensky. “We think that’s crazy. Our typical client will have a dozen or more, all with different time frames that we have to plan for.”
Another is a focus on managing the portfolio rather than the client – which is certainly more efficient until it threatens the client relationship. The downside of this business strategy shows up most strongly when the market returns are colored red instead of black on the performance statement or have a minus sign in front of them.
“I go back all the way to 1987,” says Evensky. “We had that big scary downturn. I was amazed at how many brokers and advisors retreated under their desks instead of calling their clients,” he says. “I recently met with a prospective client at lunch, and he said, Harold, I have about $10 million with one of the major trust companies. The markets went down, and I was down about half a million dollars, and nobody called me. I figured that should have been worth at least one phone call.”
It is efficient (and easy) to create client portfolios and collect quarterly fees without doing the hard work of financial planning. It’s efficient (and easy) during a bull market to overpromise your ability to deliver positive returns. When the markets go down, and suddenly you’re underdelivering on that promise, and returns are your value proposition, you know that the conversation with clients are going to be awkward at best, furious at worst. Better to not ‘disturb’ the client with a phone call and trigger that awkward discussion.
Better still, Evensky says, is to spread out many awkward conversations throughout the bull market run. “With the diversification that we recommend,” he explains, “when the markets are going up, we’re going to look stupid. The returns won’t be as good as what they read in the headlines, and there are always some elements in the portfolio that look like crappy investments.” The benefits come in the bear market, when the conversations, while not always happy, are about how the diversified portfolio is holding up against the downturn.
Every bull market creates a complacency among consumers and advisors. In the professional space, there is a tendency to lean more heavily on the portfolio returns as the value proposition. There is a tendency to let the portfolio overweight the assets that have been offering the highest returns and underweight the ‘crappy’ investments that seem to be weighting down the performance.
Then comes the bear, and those incrementally growing bad habits undermine client relationships. We may be in that unhappy teaching environment today; most of us know that it will come someday. Evensky says that the message about the markets should not be different today than it was a year ago, or five years, or 25 years.
“There are never new stories; we just have to relearn them over and over again,” he adds. “There’s no reason to think this time is any different.”
Bob Veres' Inside Information service is the best practice management, marketing, client service resource for financial services professionals. Check out his blog at: www.bobveres.com.