Weekend Reading For Financial Planners (March 9-10)

E&O Insurer Saw 213% Rise In RIA Policy Payouts Last Year

(Christopher Williams | Financial Advisor)

Errors and Omissions (E&O) insurance is often considered an essential component for owning an RIA. Because clients often stake large amounts of money on the advice that advisors give, the result of that advice leading to negative or unforeseen outcomes – even when the advice was given with good intentions – can be a liability judgment against the advisor that could range in the millions of dollars. Consequently, RIAs purchase E&O insurance in order to protect their own assets, while remaining accountable for the quality of advice they give to their clients.

While E&O claims can happen at any time, they often rise following market downturns, as some clients might scrutinize whether their asset allocation was suitable for their needs after experiencing portfolio losses. This trend played out following the 2022 market downturn, as insurance broker Golsan Scruggs recently reported that RIAs holding E&O policies with the firm saw a 213% increase in claims paid in 2023. Within this broader increase, the number of claims related to suitability jumped 500% from the previous year, with the value of all claims paid by insurers against RIAs rising 85%. Notably, wire fraud was the second-biggest factor in the overall spike in E&O claims, with a 400% frequency increase in claims paid by insurers (as advisors can be attractive targets for scammers, given that they often have the ability to send wires worth tens of thousands of dollars for clients).

Altogether, these data points could serve as a stark reminder to RIAs about their potential E&O exposures and possible actions they could take to reduce the possibility of a client lawsuit (as well as to potentially reevaluate whether they have sufficient E&O coverage!). On the suitability side, this could mean reviewing asset allocations with clients on a regular basis (including during periods of strong market performance) to ensure they understand and approve of the advisor’s recommendations. And when it comes to wire fraud, having established policies and procedures (as well as ensuring staff are well trained on them!) and educating clients on how they can protect themselves (e.g., by sending files securely and by using appropriate password protection) can mitigate the potential of being scammed!

Most Prospects Are Open To Working With A Remote Advisor: Survey

(Emile Hallez| InvestmentNews)

In recent years, technological advances in remote communication have allowed all sorts of professionals to expand beyond having clients just in the towns and cities where they live and meeting those clients in just one location. Still, financial advisors who adopted a fully virtual “location-independent” practice were in the minority until the COVID-19 pandemic, when suddenly, those who were fortunate enough to have jobs that lent themselves to remote work† found themselves having to navigate the world of virtual work literally overnight, including financial advisors.

Not only was this shift a major change for advisors (who had to reconfigure their processes and office culture for a remote environment), but also for clients, most of whom were used to face-to-face meetings with their advisor. And while many firms have returned to the office in the subsequent years (and offer in-person meetings again), the remote infrastructure used during the pandemic can remain useful for both advisors and clients alike. From the advisor end, being able to work remotely (at least part time) introduces the possibility of working with clients around the country (or even the world), the ability for location flexibility on their part (e.g., spending an extended period of time working from a different part of the country), and reduced costs from not necessarily needing to rent office space (at least full time).

For clients, the increased number of remote advisors allows them to find a good fit beyond their local area (and even for those who do live near their advisor, remote meetings can be more efficient as they don’t have to spend time driving to and from the advisor’s office!). Notably, according to a survey sponsored by advisor lead generation platform Comparison Adviser, a majority of advisory prospects are open to working with a remote advisor. Openness to remote advisors was highest for the youngest prospects surveyed (with 77% of those in their 30s and 71% of those in their 40s being willing to work with a remote advisor), though a majority (53%) of the oldest age group surveyed (60 and older) also were willing to work with such an advisor (and only 18% of those in this age group said they were not open to doing so, with the remaining 29% being unsure).

Ultimately, the key point is that many clients appear to be open to working with a remote advisor, suggesting that those who offer their services remotely (and are able to make their virtual meetings engaging) could access a broader range of potential clients (which could be particularly helpful for those with a very specific client niche). Nonetheless, at a time when many advisory firms have moved to remote operations, continuing to offer in-person services could become a differentiator in its own right to target clients who prefer to meet face-to-face?

Judge Strikes Down Law Requiring Corporate-Ownership Disclosure

(Mengqi Sun | The Wall Street Journal)

In 2021, Congress passed the Corporate Transparency Act (CTA) which, for the first time, required small business entities such as LLCs and corporations to report identifying information on their "beneficial owners" (i.e., those who own at least 25% of, or who otherwise exercise substantial control over the business). The law's provisions became effective on January 1, 2024, and so under the law many small businesses – including a good number of RIA firms – would be required to submit a Beneficial Ownership Information (BOI) report to the Treasury Department's Financial Crimes Enforcement Network (FinCEN) before the January 1, 2025 deadline for existing businesses (and even sooner for newer companies formed during 2024).

However, the National Small Business Association (many of whose members would likely bear the costs of complying with the CTA) filed a lawsuit against the law in 2022, arguing that it was unconstitutional because it allegedly infringes on protected rights of state sovereignty, privacy, and due process. Last week, a federal judge agreed with the plaintiffs, ruling that the CTA is unconstitutional. The ruling now puts the CTA (and its requirements) in limbo, given that the Treasury Department could appeal the ruling (and ask for a stay pending appeal). For those companies wondering whether they still need to follow the CTA’s provisions, the law firm Holland & Knight noted in a blog post that a FinCEN press release regarding the judge’s ruling indirectly asserts that the government continues to have authority to enforce the law against parties not involved in the lawsuit, suggesting that companies for which the ruling could choose to play it safe by continuing to follow the CTA’s requirements.

Notably, from an advisory firm perspective, SEC-registered RIAs were not required to submit a BOI report (since they're included on a list of entities specifically exempted from the rule) anyway, though many state-registered RIAs are still subject to the BOI reporting requirements – except firms that are dually-registered as insurance producers and/or broker-dealers, which are also included on the list of exemptions. Nonetheless, regardless of whether the CTA applies to a specific firm, given that the beneficial ownership reporting rules have thus far received relatively little publicity in the two-plus years since their enactment, advisors have the opportunity to add value for business owner clients by reminding them about their (possible) reporting obligations!

High RIA Staff Turnover Suggests Extra Care When Hiring, Training

(Lisa Shidler | RIABiz)

As an RIA grows its client base, it will often need to make additional hires to serve these clients, whether in lead advisor or support roles. This is particularly true for rapidly growing firms, which might be tempted to hire quickly to meet a growing demand from interested prospects. However, a recent report suggests that hiring too quickly could end up costing the firm more time and money than would a more deliberate process.

According to research from financial advisor training and consulting firm The Ensemble Practice, RIAs experience an average 36% staff turnover for performances each year, suggesting that many new employees are not meeting the needs of the position they were hired into (or perhaps the expectations of firm leadership). Further, 57% of firms had staff resign in 2023, indicating that many employees either do not see a good fit with their firm or are able to find better opportunities elsewhere.

Given the costs of employee turnover (e.g., time and money spent finding and interviewing candidates, training them on firm systems and practices, and the potential for regular turnover to hinder employee morale), some industry experts suggest that firms might take a more deliberate approach to hiring and consider the types of individuals they recruit. For instance, rather than trying to hire quickly, a firm might assess not only whether a candidate has the desired qualifications, but also is a good cultural fit for the firm and whether the firm will be able to meet their expectations for advancement (e.g., whether they would be on track to become a partner).

Also, while firms often would like to have ‘ready made’ advisor hires who have experience both working with clients and generating business (though these advisors can come at a high price in terms of compensation in order to draw them away from their current firm), an alternate strategy is to consider hiring recent graduates and those early in their careers (and perhaps doing so well before the need for new staff becomes urgent!). Not only does doing so widen the pool of potential hires, it can provide the opportunity for the firm to train these new hires in firm practices and culture, integrating them over time.

Ultimately, the key point is that while firm owners might be tempted to get hiring out of the way quickly so that they can focus on other aspects of the business, doing so could prove costly in the long run. Which suggests that taking the time to find the ‘right’ candidate, ensuring the expectations of both parties match, and providing new hires with the training and career development opportunities they seek could prove to be a worthwhile investment!

How To Develop Team Members Into Great Leaders

(Beverly Flaxington | Advisor Perspectives)

When a firm has an opening for a managerial position, they can choose to hire from the outside or promote from within. While the latter option can be attractive for many reasons (e.g., having first-hand knowledge of the employee’s performance in their current role and whether they are a good cultural fit in the firm), it is not without risks. Because while an individual might be exceptional in their current position as a member of the team, becoming a manager requires a different set of skills.

Nonetheless, employees can make a successful transition to management by focusing on a few key areas. First, it is important for new managers not only to create goals for their new team, but also to communicate them regularly to ensure everyone is moving in the same direction. Next, new managers will need to be ready to provide feedback to their team so that each member knows the areas in which they are performing well and where changes might need to be made (though new managers will want to avoid the appearance of micromanaging, which can leave the team feeling disempowered). In addition, it is important for new managers to recognize that building a team does not come automatically, but rather is a process to manage (e.g., the “Forming, Storming, Norming, and Performing” stages suggested by psychologist Bruce Tuckman). Finally, successful new managers often are continuous learners, both in exploring new management techniques and ways to better support team members.

In sum, while the leap from team member to manager can be a tricky one (for both the new manager and their new team), focusing on goal-setting, feedback, and continuous learning can help smooth the transition. Further, firm management can play an important role in this process as well by selecting the ‘right’ individual for the job; for instance, because the skillsets required to be a good employee and a good manager are often different, carefully choosing an individual with the talent (and interest!) to become a manager (rather than just the highest performer on the team) could contribute to a more successful transition and help the firm avoid having to hire a new manager in the near future!

Best Practices When Terminating An Underperforming Employee

(Richard Chen | Advisor Perspectives)

When a firm makes a new hire, they typically do so with the hope that the individual will stay on with the firm for years to come. Nevertheless, a firm might eventually decide that the best course of action is to terminate an underperforming employee. Because being fired can by psychologically and financially damaging to the (former) employee (who could decide to file a wrongful termination suit against the firm), firms can take steps to increase the chances that the process will go as smoothly as possible for both sides.

Well before a decision to terminate an employee is made, firms can protect themselves by drafting employment agreements that clearly lay out the employee’s role and responsibilities, as well as reasons the employee may be terminated and what the employee will be entitled to receive if they are eventually let go for reasons beyond their control (i.e., without cause) or because of underperformance or bad conduct (i.e., with cause). In addition, firms can use an employee handbook to outline its expectations with respect to performance standards, workplace behavior, and disciplinary procedures (and, preferably, ensure that employees understand these policies and have the opportunity to ask questions about them). Also, conducting regular performance evaluations can ensure that employees are aware of performance areas where they are expected to improve (and the firm can offer to provide additional coaching or training in these areas if necessary).

When the firm does makes the decision to terminate an employee, a valuable first step is to review the firm’s policies addressing employee terminations so that they are followed (in addition, a firm could consider consulting an attorney experienced in employment law to create a termination plan designed to mitigate the risk of a lawsuit). Firms can also consider offering the employee a severance package (that could include salary and/or certain benefits) to smooth relations and reduce the risk of a suit (to claim these benefits, the firm can also require the employee to sign a release of claims that waives their right to sue the firm for wrongful termination). During the termination meeting itself, those participating should engage with clarity and respect to try to avoid an emotional confrontation. In addition, firms can protect themselves by having more than one individual represent the firm in the meeting (to help prevent false accusations about what happened during the meeting) and to clearly document the steps it took during the termination process.

In the end, terminations can be uncomfortable for both the employer and the employee. Which suggests that firms might proactively consider ways to avoid these conversations in the first place (e.g., by hiring carefully and by offering ongoing support to employees) and, if a termination is necessary, take steps to provide the employee with a sense of dignity, not only because doing so could prevent a wrongful termination lawsuit (or poor reviews on employer rating sites), but also because it also shows current employees that the firm will show them respect even if they are let go down the line.

A Short History Of The 60/40 Portfolio

(Ben Carlson | A Wealth Of Common Sense)

While there are practically infinite possibilities when it comes to building a diversified investment portfolio, one common starting point for many investors is a “60/40 portfolio”, consisting of 60% stocks and 40% bonds. The premise behind this portfolio is that the stock portion will help the portfolio grow during periods of strong equity market performance, while the bond portion will provide a steadier (if potentially lower) return and serve as a ballast during stock market downturns. However, 2022 was a rare year that saw poor performance in stocks and bonds, leading to a -17.9% return for a 60/40 portfolio tracking the S&P 500 and 10-year treasuries.

While this weak performance led to some calls that the 60/40 portfolio was officially ‘dead’ (given that the bond portion did not provide significant cushion against losses from the stock portion), 2022 appears to be an outlier for the strategy. In fact, the 2022 performance represents the 3rd-worst calendar year for the strategy since 1928, trailing only 1937 (-20.7%) and 1931 (-27.3%). Given that the S&P 500 has experienced multiple 20%+ drawdowns during the period (including a nearly 40% decline in 2008, a year in which a 60/40 strategy returned -13.9%), the 60/40 portfolio appears to do a good job dampening volatility over multiple decades compared to an all-equity portfolio.

Another criticism of the 60/40 portfolio is that it has only been successful recently because of the falling interest rate and inflationary environments experienced during the past 4 decades (as the 60/40 portfolio returning an average of 10.5% annually between 1981 and 2021). Nevertheless, looking back to the period between 1940 and 1980, which saw interest rates and inflation mostly rising, the 60/40 portfolio still returned an average annual return of 7.9%. Which suggests that if an investor expects inflation and interest rates to be elevated in the coming years that they might reduce their expectations for returns from a 60/40 portfolio, though historical data suggest it could still provide the desired volatility-dampening benefits (as the portfolio only experienced 1 double-digit negative (nominal) calendar year return during the 1940-1980 period).

Ultimately, the key point is that while few advisors might use a ‘pure’ 60/40 portfolio with their clients (given that a client’s age, risk tolerance, or other factors might call for a stronger tilt in one direction of the other, or the inclusion of additional asset classes), the long performance history of this strategy demonstrates the potential benefits of holding a diversified portfolio (even though there almost certainly be years where it underperforms expectations!).

The Downsides Of Diversification

(Nick Maggiulli | Of Dollars And Data)

The benefits of diversification are well-known in the investment community, as properly diversified portfolios can provide better risk-adjusted returns than a portfolio invested in a single asset class and/or only a few concentrated investments (as the chances that the value of an individual stock goes to 0 is significantly higher than the odds that all of the stocks in the S&P 500 will do so!).

Nevertheless, while diversification has sometimes been called a “free lunch” because of these benefits, maintaining a diversified portfolio over time can be challenging for many investors given that it will naturally underperform (in terms of returns) a portfolio investing in the best-performing asset class or investments within it, particularly in the shorter term. For instance, given the outperformance of stocks compared to bonds during the past 15 years, those with a portfolio consisting of both asset classes might question their fixed income allocation. Further, within equities, large cap U.S. stocks offered much greater returns during this period compared to their international counterparts, perhaps leading some investors to wonder whether they should invest their entire portfolio in a large-cap index fund going forward.

Altogether, while investors might recognize the benefits of diversification in theory, inevitable underperformance of certain parts of the portfolio, or the portfolio as a whole compared to a more concentrated strategy, can make it challenging to stick with a diversified approach. Which suggests that financial advisors can add value for their clients not only by explaining the benefits of diversification, but also making them aware that periods of underperformance are bound to happen, even if the asset allocation selected is the optimal choice based on the client’s goals and risk tolerance (while also being ready to field the worried phone call when underperformance eventually occurs!).

U.S. Equities Have Outperformed Global Indexes For 10 Years. Will It Last?

(Holly Deaton | RIAIntel)

Portfolio diversification can involve both a mix of asset classes (e.g., stocks, bonds, and real estate) and a variety of investment types within these asset classes (e.g., Treasury bonds and corporate bonds). Within equities, a common source of diversification is to invest in a mix of U.S. stocks and international stocks to gain exposure to a broader spectrum of companies (and not just those based in the U.S.). But while international stocks have outperformed their U.S. counterparts at times in the past (e.g., during the mid-1980s and from the late 1990s into the mid 2000s), their recent relative underperformance has led some investors to question whether an all-U.S. portfolio might lead to better returns going forward.

Notably, U.S. stocks not only have offered better returns than international stocks in recent years (e.g., the Morningstar U.S. Market Index gained an annualized 12% between 2010 and 2022, compared to the Morningstar Global ex-U.S. Index’s 4.4% return during this period), it has done so with less volatility than foreign stocks (defying assumptions that higher expected returns are linked with greater risk taken, though these results could change in the longer run). Interestingly, while there is no shortage of high-performing international companies (as non-U.S. stocks represent more than half of the best-performing 500 individual stocks during this period, according to Morningstar); the fact that more than 80% of the worst-performing 500 stocks were outside of the U.S. hindered the performance of international indexes. According to a Morningstar report, an additional reason for U.S. outperformance is increased exposure to technology companies, which have outperformed during this period (with the Morningstar Global Technology Index gaining an annualized 12.7% between 2010 and 2022), while the highest weights in international indexes belong to financial services (which only grew 6.1% a year during this period) and industrials.

While U.S. stock indexes have clearly outperformed their international counterparts during the past decade, the key questions are whether such outperformance will continue and whether including international exposure in an asset allocation remains prudent. On the former question, potential catalysts for improved international performance could include better earnings growth and changes to corporate governance, or perhaps simple mean reversion, according to Morningstar (in addition, valuations of international stocks appear to be more attractive than their U.S. counterparts at the moment), though the timing of a future regime change is hard to predict.

In the end, while international stocks might continue to underperform their U.S. counterparts in the near term, historical data suggest that foreign stocks have an important role to play in a portfolio designed for the long run, including their ability to boost portfolios as stocks recover from global downturns and the likelihood that they will outperform U.S. stocks again at some point in the future. Which suggests that advisors can support clients with international stock exposure by providing this context and keeping them client focused on the long-term goals for which their asset allocation was designed!

The Exact Age When You Make Your Best Financial Decisions

(Clare Ansberry | The Wall Street Journal)

Financial decision-making is a fact of life, but the skill with which make these decisions can change over time. For instance, research has found that younger individuals tend to have more “fluid intelligence” (i.e., the ability to quickly solve problems or complete tasks), while older individuals have more “crystallized intelligence” (i.e., the ability to synthesize ideas and recognize patterns). Which suggests that those in the middle might best be able to take advantage of both types of intelligence when making financial decisions.

According to 2 research studies, this is in fact the case, with one study finding that 53 is the “age of reason” where financial mistakes are minimized and another finding that financial literacy typically peaks at age 54 before declining. Though notably, those in this age demographic do have some blind spots, including the tendency for some to underestimate their life expectancy, with a 2020 study finding that 28% of Americans age 50 and older underestimated their life expectancy by at least 5 years.

Altogether, this research indicates that individuals who are able to avoid financial mistakes are those with a combination of financial literacy (perhaps hard-won from firsthand experiences) and the ability to apply this knowledge to their problems. Which suggests that financial advisors have the opportunity to add value to individuals in every age bracket, from younger clients who might not know the technical details involved in certain financial decisions, to middle-age clients who might be underestimating their longevity (and the implications for how much they need to save for retirement), to older clients who might have lost some of their financial knowledge and could use an advisor’s support in absorbing and processing new information and ongoing changes to their financial situation!

There Is No Secret Option C

(Emily Oster | ParentData)

Life is filled with difficult choices, both in the personal and professional realms. Some of the hardest are those where there are 2 options, both of which seem ‘bad’. For instance, an individual with significant debt might have to choose between trying to pay the debt off (which limits their cash flow for other expenses) or declaring bankruptcy (which will negatively impact their credit score for years to come, potentially restricting their future financial options).

When faced with a tough decision with 2 distinct options, there is sometimes the temptation to avoid making a decision in the hopes that a third, clearly superior, option might emerge that will make the choice easier. However, this “Secret Option C” almost never comes about and the time spent avoiding the decision can lead an individual to make a decision at the last minute or having the decision being made for them. Instead, confronting the decision head-on can allow for time to weigh the pros and cons of each option and to potentially consider ways to make one of the options less bad (e.g., in the example above, the individual might contact their creditors to negotiate a repayment plan with lower monthly payments).

Given that many difficult decisions in life revolve around finances (some of which come with major tradeoffs), financial advisors can play an important role in helping clients confront a challenging choice (whereas the client might be tempted to put it off) and in providing information that could make the decision easier (e.g., running financial planning scenarios based on the two options might demonstrate to the client that one is superior to the other)!

How The Science Of Choice Can Boost Innovation

(Sheena Iyengar | Harvard Business Review)

While individuals tend to prefer to be able to choose from a variety of options in their (from what type of cereal to eat to the investment options in their 401(k)), research suggests that in reality, too many choices may make a person so fearful of choosing poorly that it leads them to not choose at all (the so-called “Paradox of Choice”). Notably, this challenge can extend from consumer decisions to the ability to innovate in a professional setting.

For instance, a financial advisor might decide to engage in content marketing to attract prospective clients. However, this choice requires a wide range of follow-on decisions, from which medium (or media) to use (e.g., blog, podcast, and/or video) to what topics to discuss within the content the advisor produces (as within the specific world of finance, there are still thousands of potential topics to discuss!). To combat this challenge (and to prevent regret from making the ‘wrong’ choice), Iyengar suggests creating a “Choice Map” to explore and narrow down options. After identifying the key problem (e.g., what topics should be discussed), an advisor would then break the decision down into sub-problems that could be easier to answer (e.g., What issues does my target client face regularly? What questions do I encounter regularly from prospects?). Next, the advisor could look for precedents that might make the decision easier. Notably, these can come from both “in-domain” areas (e.g., looking a range of popular blogs written by other advisors and seeing what they’re discussing) and from “out-of-domain” areas (e.g., what successful professionals in related fields (e.g., law or accounting) discuss in their content marketing and how do they disseminate it). Together, these sections of the “Choice Map” can break down a problem with unlimited choices down into easier to solve components and provide for potential ideas and solutions based on what others have already created (so that the advisor doesn’t have to completely reinvent the wheel, but rather put their own spin on the content).

Ultimately, the key point is that while decisions with many potential options might seem challenging on the surface, taking a structured approach to finding a solution could make them easier to solve and minimize the chances of feeling regret. Which means that whether an advisor is deciding on a content marketing strategy or is choosing a client niche, narrowing the scope of the decision using a “Choice Map” to break down the problem could be a valuable first step!

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