Executive Summary
Enjoy the current installment of "weekend reading for financial planners" - this week's edition kicks off with a great exploration of why, in these times of market volatility, investors continue to give such credence to pessimists and view them as sages.
Continuing the theme of recent market volatility, other articles this week include: a reminder of the ways to talk with clients about market volatility and reassure them; the latest investment commentary from Howard Marks of Oaktree about the dynamics of investor psychology; a caution from John Hussman that while market volatility has picked up the leading economic indicators are also turning down (and the combination of both can be especially concerning); and a reminder of tax planning opportunities that emerge in a down market, from tax loss harvesting to Roth conversions of IRAs while they're down to Roth recharacterizations of last year's conversions that have declined in value since the original conversion.
We also have a couple of practice management articles this week, from a look at why more clients don't provide referrals (hint: it's not that they don't want to, but that they're not sure how to describe you or to whom), to a look at the ongoing rise of salary-based advisor compensation models and whether they can be successful without fewer business development incentives, a discussion of the importance of engaging both members of a couple (as most advisory firms are at more risk to lose assets when a widow leaves than when the money flows to the next generation), and an important reminder that the SEC is scrutinizing the Chief Compliance Officer role in advisory firms (and warning that it should not be fully outsourced)!
We wrap up with three interesting articles: the first is a review of a recent SEC report on the credit rating agencies, which finds that they are still engaging in many of the questionable practices that led up to the 2008 financial crisis; the second is a discussion of Bitcoin, which appears to be in the midst of a systematic collapse as it reaches capacity limits (and is controlled by a small number of influences who are preventing the capacity from expanding, for their own financial gain); and the last is a great reminder that we all need to say "no" more often, not just to avoid over-committing ourselves in general, but because saying "no" more often ensures that you'll have the time and capacity to say "yes" when it really matters.
Enjoy the "light" reading!
Weekend reading for January 23rd/24th:
Why Does Pessimism Sound So Smart? (Morgan Housel, Motley Fool) - As humans, it appears we are hard wired to be interested in people with pessimistic views. In investing, being bullish just sounds like reckless cheerleading, but bears are often perceived as having a "sharp mind" and being someone who dug past the headlines. And notably, the phenomenon is not unique to investing or the modern era; as Housel notes, 150 years ago John Stuart Mill wrote "I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage." One study even found that those who publish negative book reviews are seen as smarter and more competent than those giving positive reviews of the same book! On the other hand, our attraction to pessimism may actually be logical - evolutionarily speaking, those who treat all threats as urgent will have a better chance of surviving in the long run (even if they over-react to some non-threats along the way). Housel also offers up some additional reasons why we seem attracted to pessimism, including: optimists often act oblivious to risks, which by default makes pessimism seem more aware and intelligent; pessimism requires action and speaks to our own desire to "do something"; and optimism can sound like a sales pitch, while pessimism sounds like someone trying to help you. Which means in the end, pessimistic forecasters aren't likely to go away any time soon, given our hard-wired desire to listen to them. But as Housel points out at the end, the irony is that a focus on pessimism is usually wrong precisely because it fails to account for how as human beings we can and do adapt over time... which means the recent negative trend extrapolated into the indefinite future never actually turns out as bad as the pessimistic forecast implied.
Three Ways RIAs Can Reassure Clients (Brooke Southall, RIABiz) - For most human beings, our ability to adapt means that we adjust remarkably well to negative events; the greatest pain is often not the bad event itself, but the uncertainty leading up to it. Southall notes that our distaste for uncertainty spans a wide range of domains - even when it comes to the cable guy, our greatest objection is usually not the service or the bill, it's the uncertainty when we're told he'll only show up sometime in a ridiculously wide 8-hour time window! In this context, Southall suggests that when we get to times of market volatility and potential investment losses, the same holds true: our primary challenge is not actually the losses themselves (to which we can adapt), but the uncertainty in not knowing how severe the event will be, nor how long it will last. Accordingly, some strategies to cope with the situation include: 1) try to help clients narrow down how long the pain me be (if the typical market decline plays out over 2 years, then remind clients that if volatility just continues for another two years, that's normal, not something to worry about); 2) frame the potential decline by talking through a "worst-case scenario", such as helping the client think through "if your whole portfolio really does decline 40%, what would you have to change to get back on track?" (thereby eliminating the uncertainty of "what will happen" because the scenario has been considered); and 3) set goals tied to market misery, such as making a wish list of investments to buy if prices fall far enough to become even more appealing (i.e., provide a reason to actually root for markets to go down).
On The Couch (Howard Marks, Oaktree Insights) - There has been a growing recognition in most social sciences that behavioral psychology plays a significant role, a phenomenon long observed (and now increasingly studied) in the realm of economics and investing as well. In recent years, the "psychological" effects seem to have driven investments and asset prices higher - at least, higher than what Marks thinks was justified by the underlying fundamentals alone, especially given the significant macroeconomic crosswinds underway (from the ongoing impact of globalization to the challenges of entitlement programs and rising geopolitical instability). That trend finally seemed to give way in the second half of 2015, as complacency subsided and the looming risks became more real. Yet as Marks notes, the significance of that psychological shift in 2015 is not merely that investment bullishness slows, but that upon reaching the "tipping point" the negatives turn market psychology bearish and at that point bearish thinking and results just beget more bearish thinking and results. In other words, the investment pendulum appears to now be shifting to swing the other direction, as even though the world is not dramatically different than it was a few months ago, we now give significantly different weightings to the positive and negative news, as investors become disillusioned about the some of the underlying fundamental issues previously ignored and start to recognize the second-order consequences now emerging. Ultimately, though, Marks notes that he doesn't anticipate a 2008-style market and economic crash; while the forceful market shift that results from changing market psychology can lead to a significant decline, and there are concerns with market fundamentals, the recent years didn't have the kind of boom and leverage that led to the explosion of sub-prime in 2008 and thus the bear market shouldn't be that severe.
Complex Systems, Feedback Loops, and the Bubble-Crash Cycle (John Hussman, Hussman Funds) - While markets themselves have been in recent turmoil, the U.S. and global economy do not appear to be in recession... at least, not yet. But Hussman notes that a number of leading economic indicators are turning negative now as well, as declining order activity across industries (and falling regional and national purchasing manager surveys) may lead to inventory reductions that tip the U.S. into a recession. And while market declines can actually happen independent of recessions, equity market weakness combined with declining economic data is drastically more likely to foreshadow a recession, which in turn tends to make the market decline more severe, with Hussman forecasting a top-to-bottom decline as severe as 40% to 55% (in equities). Notably, the declining economic indicators coincide directly with the Fed's recent decision to raise interest rates in December, but Hussman suggests that the real "policy mistake" of the Fed was not raising rates in December, but keeping them so low in the first place, which may have triggered a "self-reinforced feedback loop" of speculation that in turn will exacerbate the market decline when it unwinds. Of course, once feedback loops are underway, they are very difficult to derail and turn in the other direction, but Hussman points out that declining market internals suggest that investors really are losing their speculative energy, implying that the turn really may be underway.
Tax Tips for a Down Market (Laura Saunders, Wall Street Journal) - While losing money is never pleasant, the tax code does offer many direct and indirect opportunities to partially mitigate the adverse impact of a market decline. The starting point is just to recognize that if/when/as investments are sold and changed in the shifting market environment, capital losses can be offset against capital gains, with up to $3,000 of losses applied against ordinary income. In addition, with market declines, there's also an economic benefit for doing tax loss harvesting as well (though remember to comply with the 30-day wash sale rule, including for mutual funds and ETFs!). Other strategies include: getting new contribution dollars into an IRA or Roth to be invested in a decline leaves the money well positioned for a future rebound; the "temporarily" depressed value of retirement accounts due to a market decline is also a nice opportunity for a (partial) Roth conversion; if you convert and markets fall further, you can recharacterize and try to convert again at an even lower price next year (and if you converted last year and find your account down from the original conversion value, it may be appealing to recharacterize now); and if you're looking to do family gifting for estate planning purposes, transfers while prices are down allow more shares to be shifted for the same gift tax cost or use of the same gift tax exclusions.
The Real Reason Clients Don’t Refer (Julie Littlechild, Absolute Engagement) - As someone who's worked with advisors for a decade or two, Littlechild notes that she's met many coaches who work with financial advisors... yet when advisors talk to her about their struggles, she rarely refers most of the coaches she's met. The reason is that most advisor coaches say they help with broad-based issues like "practice management" or "growth" but most advisors don't describe their problems that way; instead, most advisors have specific problems. Which means those who solve specific problems can get referred, while ironically those who say they can solve any problem don't get referred at all. And Littlechild notes that the problem isn't unique to advisors and referring advisor coaches; her ongoing research with the clients of advisors find that clients go through the same dynamic. For instance, while their data finds that 78% of clients are "somewhat or very comfortable" referring their advisor, actual referrals are far rarer, and 2/3rds of clients who don't refer state it's because they "haven't met anyone who needed a financial advisor." Of course, the reality is that our clients meet people who need an advisor all the time, but they don't know how to identify those people because the generalist advisors don't solve specific problems that clients can identify and refer. For instance, someone who recently went through a divorce, or had a birth or death in the family, is likely in need of some financial advice around those issues - so if you help everyone (including those who went through a divorce) you may not get any referrals at all, but if you explain to your clients how you help people going through divorce, you're likely to be top of mind and referred every time they talk to someone going through a divorce! The bottom line: the referral gap (clients willing to refer who don't) isn't a matter of clients not wanting to refer, but because most advisors aren't referrable in the first place because they lack the specificity necessary for clients to know what to refer, how to refer, and in which situations a referral would be appropriate!
Will Advisors Work Without Incentive Pay? (Dave Lindorff, Financial Planning) - An emerging trend in the compensation of financial advisors, particularly given the rise of "employee [fiduciary] advisors" in channels from independent RIAs to banks, is the shift from the historically popular commission or revenue-sharing based compensation to salary-based compensation instead. Notably, some firms have been using salary compensation models for advisors for many years now, but with the Department of Labor's fiduciary rule looming, there is an increasing expectation that the resultant decline in commissions and fiduciary shift could lead to an explosion in the use of salary to compensate advisors. On the other hand, many remain concerned about whether salaries, which lack the kind of incentive-pay structure of revenue sharing or commissions, will still be effective to attract and retain the best advisors necessary to grow the business. Yet a look at firms that have used salary for years finds that it doesn't seem to be significantly inhibiting growth of the firm and that turnover hasn't been an issue (though it is necessary to screen for the 'right' people who will be comfortable working in a salaried environment). Notably, the shift to salary usually isn't devoid of any incentive pay; overall bonuses based on the revenue or profitability of the overall firm (or division) are still common, but without the individual-level "get clients and implement products to get paid more" approach. For firms that have adopted a salaried approach, other ancillary benefits have become evident as well, including that advisors are more team-oriented and less competitive with each other (since they're not competing for clients and bonus incentives), and transitioning retiring advisors is easier, because there's no fight for taking over clients to get access to the associated revenue-sharing.
Couples Therapy: Working With Widows (Angie Herbers, Investment Advisor) - While Herbers notes that in general she believes that professions (including financial planning) should be gender neutral, there is a growing body of evidence to suggest that independent advisory firms are sorely lacking in female advisors. Herbers suggests its this lack of female advisors, and their related ability to related to female clients, that is leading to female clients feeling alienated... which it turn helps to explain why 70% of women leave their [typically male] financial advisors within a year of being widowed (and given that women tend to live longer than men, this implies the greatest risk to AUM-based firms is not losing assets to the next generation but simply upon the death of the first member of a couple!). Beyond just attracting more female advisors to related to female clients, though, Herbers offers several other suggestions to help advisory firms improve their relationships with couples (and future widows), including: if the firm really serves couples as a target market, be certain to craft a client service model relevant for both members of the couple (i.e., make sure that there are services and benefits relevant for both spouses!); work hard to engage both members of the couple in the process, even if they usually delegate financial decisions to just one of them; work with couples using advisor teams, to help ensure that at least one member of the advisory team can relate to each member of the couple (which Herbers suggests is better than the 'unnatural' approach of telling advisors comfortable with one communication style to adapt a different communication style for the other spouse, which may come across as uncomfortable or insincere).
Advisors, Own Your Compliance (Tom Giachetti, Investment Advisor) - The SEC has been increasingly scrutinizing not just the compliance of registered investment advisers, but the role and activity of the Chief Compliance Officer (CCO) themselves. The issue was highlighted in a recent SEC Risk Alert about chief compliance officers, which noted that the SEC is looking for CCOs to have an active role in the organization, to ensure that the CCO is on site and capable of actually intervening if there is a compliance issue. In practice, the significance of this focus on the CCO is that RIAs must be cautious when outsourcing compliance tasks to a third-party consultant, and that blaming compliance failures on a consultant during an SEC exam will likely fall on deaf ears. The SEC expects the RIA itself to own - through its CCO - responsibility for compliance within the firm. Notably, this doesn't mean it's wrong to outsource any compliance activity at all - one study found that 38% of investment advisers are currently outsourcing some aspect of compliance functions - but that a fully outsourced compliance solution isn't viable. Someone has to be the CCO in an advisory firm, and really take on that responsibility; outsourced assistance (particularly for implementing some administrative functions) can help, but doesn't eliminate the underlying compliance responsibility.
Ratings Agencies Still Coming Up Short, Years After Crisis (Gretchen Morgenson, NY Times) - The SEC recently issued a report studying the behaviors of rating agencies like Moody's Investors Service and Standard & Poor's since the financial crisis, and finds that some of the dubious practices which led to the companies to put profits ahead of principle are sadly still in place. For instance, while the SEC report didn't specifically name names amongst the 10 primary credit rating agencies it reviews, the report did note that amongst "large" credit agencies (which basically means Fitch, Moody's, and S&P) there are still "numerous occasions" where ratings are being issued in a manner that isn't even consistent with the companies' own policies, procedures, and models. In other cases, outright mistakes are being made, with limited accountability, from one structured finance deal that took a hit to its price after a coding mistake revealed its original rating was in error (which just produced a loss for the original investors, not the ratings agency), to another situation where the ratings agency caught its own mistake after the fact but then failed to even disclose the discovery. And the SEC even (still) found one instance of an agency giving an unsolicited rating to an issuer motivated "at least in part by market-share considerations" (i.e., trying to gain an issuer's business by offering it better ratings than competitors, not necessarily in the interests of consumers). Notably, rules changes in 2007 and 2010 and the aftermath of Dodd-Frank generally prohibit these practices, but Morgenson emphasizes that until and unless the SEC gets serious about enforcement to drive cultural change at ratings agencies, it's not clear that any real change is going to come.
The Resolution Of The Bitcoin Experiment (Mike Hearn, Medium) - Hearn has spent more than 5 years as a Bitcoin developer, written software used by millions of Bitcoin investors and hundreds of developers and startups, and become a recognized expert on Bitcoin, but in this article he proclaims that the Bitcoin experiment has failed (and that he has liquidated his own Bitcoins and will no longer be developing the platform). Ironically, Hearn notes the primary problem is that the system intended to be a new, decentralised form of money that wouldn't rely upon "systemically important institutions" has instead become entirely reliant on just a handful of people that have led the network straight to the brink of a technical collapse. Part of the challenge is simply a technological limit; a system constraint added long ago to the size of the blockchain has now reached its maximum limit, which is resulting in a maximum capacity of about 3 transactions per second (which means Bitcoin could never possibly handle the volume of transactions it would take to be viable amongst the general public). This limitation, given the growth of Bitcoin overall, is leading to regular events where the network runs out of capacity, leading to a backlog where an attempt to move money could take 60 minutes or 14 hours, and seems to even be tempting more online attacks seeking to overload the already-nearly-at-capacity network. Bitcoin's response has been to charge fees for transactions - to try to limit the false and inappropriate volume - yet that's now making Bitcoin transactions more expensive than traditional credit card charges. The situation could be resolved by expanding the capacity of the blockchain, yet just two Chinese participants own more than 50% of all the Bitcoin computing power, and appear to be preventing the expansion for their own benefits. In turn, this shift - and objections about it - has led to major Bitcoin participants being banned from the community, limited information flow to investors and users, and a general breakdown of the community. Ultimately, Hearn suggests that the Bitcoin fundamentals are broken beyond repair, and that regardless of what happens to the price in the short term, ultimately the value of Bitcoin will trend down as the system inexorably fails.
Saying No, So You Can Say Yes When It Matters (Carl Richards, NY Times) - For many advisors who are entrepreneurs and business owners, it's incredibly difficult to say "no" to new, exciting projects. Social media has opened our eyes to a wide range of amazing ideas and opportunities out there, and for business owners the more successful you are, the more opportunities that tend to come along. Yet in a world of abundance and opportunity, perhaps the greatest scarcity of all is simply being capable of saying "no" to the opportunities that abundance brings. As Richards notes, saying "no" can stress us so much, it takes days just to formulate a "no" response. Yet ultimately, the inability to say no means eventually we will be saying "no" anyway, as we run out of time in the day; it's just that the inability to say "no" in the business world may lead us to saying "no" outside of work, to the family, friends, and self-care that we no longer have time for. Accordingly, the real key is that saying "no" isn't just about saying no to something, but about saying "yes" to having the time and opportunity to do something else; no is not "doing nothing" but, as Greg McKeown of "Essentialism" notes, is simply a trade-off to do "something else" instead. And if you're still having trouble saying no, Richards suggests as a starting point to create an index card, write "NO!" on it, and carry it around as a practice reminder!
I hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of any articles you think I should highlight in a future column!
In the meantime, if you're interested in more news and information regarding advisor technology I'd highly recommend checking out Bill Winterberg's "FPPad" blog on technology for advisors as well.
The mental gymnastics someone has to perform in order to proclaim that there is some kind of virtue in salary based compensation for an employee at a firm that lives and dies by actual revenue. Then try to create some convoluted bonus structure that tries to elicit the same behaviors that tying comp to revenue would. And top of all that an owner who thinks that by paying salary to their employee advisors that he’s some pure unconflicted soul.
Here’s a few tidbits:
1) Team structure was invented by the wirehouses so they could bring on fresh advisors, burn them out in prospecting, give them the boot, and all the assets would stay with the senior advisor and the firm.
2) Only about 10 years ago the smart financial advise to the public was to *avoid* unnecessary company partnerships and to carefully enter into them when you did because of their tendency to produce large and frequent disagreements over money, effort, labor, direction, etc. Now feel good crazies have apparently thrown those years of sage advice out.
What a load of BS. If young advisors new better they would tell these faux feel gooders where to shove these ridiculous “team” offers.