Kitces & Carl Ep 147: Preparing An Advisory Firm For The Risk Of A Market (And Revenue) Decline

***Editor's Note: Can't get enough of Kitces & Carl? Neither can we, which is why we've released it as a podcast as well! Check it out on all the usual podcast platforms, including Apple Podcasts (iTunes), Spotify, and Stitcher.

Show Notes

• Your Neglected Stock Market Backup Plan (Parachute Training) by Carl Richards
• Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets (Incerto) by Nassim Nicholas Taleb

Kitces & Carl Transcript

Michael: Good afternoon, Carl.

Carl: Hello, Michael Kitces.

Michael: How are you doing today?

Carl: I am actually fantastic. It's a beautiful day. We've had a bunch of thunderstorms and lightning over the last couple days, now it's blue sky and sunny and everything's green, it's amazing.

Michael: So that part of the late summer as of when we're recording, is that the late summer weather before we head into the fall here?

Carl: Yeah, so we typically get some August monsoon sort of stuff. It's super fun to watch because it's pretty dramatic, so it's been fun, but it makes everything green for a day. It's amazing.

Michael: Yeah, we get a similar effect here in the D.C. area, got these storms that build up on the mountains and then roll off the mountains down out to the ocean. So we'll get these 3:00, 4:00, 5:00 in the afternoon, just thunderstorm torrential downpours that blow through in 20 or 30 minutes as the clouds roll in and out.

Carl: Yeah, so good. So good.

Preparing For The Tough Emotions Marketing Downturns As An Advisor [01:08]

Michael: Well, so ironically, although I don't think you even knew where we were going today, that's actually apropos to a good metaphor for the discussion I wanted to bring today.

Carl: Oh, no, thunder clouds on the horizon.

Michael: Yes. So, had a message come in from, we'll call him Harry. So Harry had asked, "How do we, as advisory firm owners, especially newer advisory firm owners, prepare for the next market downturn, economic downturn?" So as Harry puts it, seems like almost every firm I know, like younger advisors, established firms, everyone seems to be growing well right now, AUM's up, client count's up, prospect funnels doing pretty well, lots of firms hiring. We've been talking more about hiring teams on this podcast. And as Harry puts it, "The longer the bull market goes on, the more nervous I get." So, "I came," I being Harry, "I came into the business after the Great Recession, so my first job is in 2010. And I was entry-level not leadership at that point." So, for those who haven't been through a crash before – I guess Harry's not counting pandemic here since that was the super sharp V, and we came back so quickly – for those who haven't been through a crash before, how do we prepare?

Carl: That's such a great question, and so interesting to me. Let me just set some big context-y things and then you can dive in with where... I think one thing to keep in mind is that risk is an arbitrary concept until you experience it.

Michael: I'll just say, you're saying risk is an arbitrary concept. I'm like, not when you have to make payroll.

Carl: Yeah, yeah, yeah, until you experience it. Rehearsing being punched in the face is completely different than being punched in the face. So there's this tendency, especially as things have gone on a while, as Harry's sort of pointing to, to think of, "Oh, that was quaint or that was...oh, yeah, that was kind of hard." You forget how hard it really was, or how hard it really can be, it doesn't have to be but how hard it really can be. So that's my first step is just to realize men...and I'm thinking more from the advisor's perspective than for the clients. There's lots of things we can talk about with scary markets conversations and how to have those, but I think we're more framing this for the advisor.

Michael: Yeah, I was thinking the same thing. There is a whole, you're doing the proverbial fire drill with clients, talking through markets may get more volatile, what does that mean, how do we think about that in terms of the portfolio. But yes, I think Harry's question is very much in the context of, what do we think about as business owners? Because at the end of the day, particularly for the overwhelming majority of us on the AUM model, our business model is just market volatility amplified. Because we get all the upside of the market rise, all the downside of the market decline magnified by our operating leverage. If my staff costs are lower than my revenue from the markets, I make more and more profits as the markets go up. And oversimplifying the math a little bit, but if you run a 30% profit margin and portfolios are down 30%, your margins just went to 0 because your revenue goes down 30% and your expenses still are what they are. So, we bear the good and bad of the operational leverage that goes with that.

Carl: Yeah, I'd love for you to talk a bit about that and what I would like to talk about mainly is just the emotional and psychological side of it because I think that's really important. Because on top of that, you keep in mind that your job is to show up every day and give people advice with incomplete information in conditions of uncertainty, irreducible uncertainty, like, you're not going to be able to get rid of it. And there are going to be times, 2007, 2008, I still remember closing the conference room door. People have heard me tell the story, I'm sure, but I can remember the handle on the door. Rather than going into the whole story because I've told it before but I can still remember closing that door, the conference room, after meeting with Dan and Barbara, and looking them in the eye and saying, "You got to stay the course, you got to stay the course," because that was the best advice I could give at the time. But I remember closing the door, I remember the feel of it and everything. And thinking to myself, “Gosh, I hope I'm right” for the first time in my career.

Michael: A lot of that, for those of us who went through financial crisis '07, '08. I started in 2000s, I got the tech crash out of the gate. But the tech crash was weirdly concentrated because the technology stocks got decimated. Large-cap growth got hit horribly. Small-cap value finally got its love and was this amazing diversifier. And the bonds held up decently well as a diversifier, the Fed cut rates, the "normal market response" happened. And for better or worse, it was a slow-motion train wreck. So the bad news is, it was 2-plus years from top to bottom, but the good news is, it was 2-plus years from top to bottom. We bled out very slowly in a way that was a little bit more manageable whereas the financial crisis, the world is melting down, the markets lurching down 11 up 13, double-digit days, multiple days in a row. And you're on with clients telling them to stay the course. It's like, "I really hope it doesn't turn out that the financial system actually is melting down," because that would be unfortunate.

Carl: Yeah, I just don't think you can underplay or overplay the significance of the toll that that takes or can take on you especially if you're under-resourced, if you think coffee and doughnuts is a good breakfast, you aren't getting sleep, all those things, because, and you see this in military doctrine sometimes, there's times when overconfidence is a strategy. And you don't want your EMT...

Michael: Because reality would not actually be helpful.

Carl: Yeah, you don't want your paramedic to show up and go, "You know what, I don't think you're going to make it." You want the paramedic to say, even if they already know, you want them to be saying, "Stick with me, come on." So there are times when you might need to be overconfident even in the face of irreducible uncertainty and the physical toll that takes on your body when you feel like fight or flight yourself, but it's your job to sit in the seat and be steady, be the... What's the old poem? “The mountain in the hurricane.” And so I think that's one thing I would be doing is being, like, look, how do I deal with uncertainty? What are the sorts of things I could do to get my nervous system in a place where I feel confident? And that we all know those things, get a little bit better sleep. And these are things we should be doing anyway. That's the good news here, exercise, eating a little better, getting better sleep. Those things all make us more resilient because the thing, and if I could draw this for people, how things are going, if you just had a normal stock market chart going up, up into the right, and you just label that, "what I could handle." And underneath it, you had a really spiky line chart going up into the right, and it's like, what was happening. Well, the gap between what I can handle and what's happening is my resilience gap. Well, if that thing crosses, and we can move those lines up just by getting better sleep, thinking through things. And then that to me is the emotional-psychological thing we could do to be preparing for it. Because I just don't think we talk about that enough. I know that's what knocked me out, that's why I ended up in New Zealand was, I just was a broken human. The business survived, it was okay, but I was a broke... I wasn't sure. I remember for 2 or 3 years after '08... I remember every day feeling like when's this going to happen again and thinking, I don't know if I could handle it. So I think that's important to understand and I don't think we talk about it enough, but what... First of all, comment on that, but second, what are you thinking, what comes to mind when you get this email from Harry?

Michael: So, no, I parted my head, it does go very much to where you went as well, just, yes, it is. It is psychologically traumatic to have to be, what was it you said, the mountain in the hurricane. Because we're bearing all, or taking the venting and the brunt of all of our clients trying to emotionally unload the fear and everything that's going on, and to some extent, if you're trying to help them vent and work through it, it's basically like, "Come on, just get it all out. I'm through it. Let's lay it all out there, what's going on, what's scaring you, let's talk through this." And then you have to carry all that after they leave, after they leave all...

Carl: In addition to looking at your own balance sheet, and your own income statement, and your own, both personally, for your own investments, and for the business. So it's like this giant... This is why I think it's a tough job, this exact topic, because the very thing, you're so concentrated.

How A Firm's Profit Margins Can Brace Against Downturns [11:38]

Michael: Yep. Well, and look, in that vein, you're shifting maybe a little bit to the business end. I know there's a lot of people that question how profitable advisory firms are, question how profitable AUM firms are in particular. Is there still a lot of industry debate about business models and AUM firms running 25%, 30% margins? And I look at that and I say, having been through multiple of these bear market cycles over my career, I'm like, "Well, yeah, I sure hope you're running at least 25% or 30% margins because that's the pad, that is your first round of defense when the market gets crushed for a year or two and keeps you from going upside down where you got to put money in to make payroll, if you've got any level of staff team." If you're literally just running solo for yourself you get a little bit more flexibility and just need to put food on your own table as it were. But when you've got team on board, it oversimplifies the business a little, but if I run 25% profit margins and my portfolios are down 25%, my profits just went to 0. The problem is not that your profits go to 0, that's part of the deal, you get your 25% to 30% profit margins because 1 or 2 years every 10 your profits go to near 0 when the bear market comes through, that's part of how it averages out. The problem is, if you're not running healthier margins then you go negative when the bear market comes through. And that's when things get really, really bad, very quick, because now suddenly you're in the realm of, I have to put in money I may not have to make payroll, or I have to cut expenses...

Carl: Yeah, at a time when nobody wants to give me any money too.

Michael: Correct. Or I have to cut expenses which means cutting people. So at the exact time that my clients are having peak needs for service and support, I'm going to downsize my staff, which is where really bad downward spirals can start to happen for advisory businesses.

Carl: So what do you do about that on the business side? How do you think about preparing for that or just being thoughtful? And I want to be clear, I don't feel like this is doomsday-preparing.

Michael: No, I mean this is...

Carl: This is the business model you chose.

Michael: Yeah, markets get 40%-plus declines from top to bottom with some regularity of bit of bear markets, give or take a few points. Granted, most of us are not 100% in equities, but if you got a good old-fashioned 60/40 portfolio, you're going to be off somewhere in the neighborhood of 20 to 30 depending on quite how steep that market decline is and quite how much your diversifiers end up diversifying you in helpful ways. And again, I don't think it's coincidence that you see a lot of advisory firms run 20% to 30% profit margins when balanced portfolios can have 20-something percent top to bottom drawdowns. That is your line of defense. So the first thing I would emphasize overwhelmingly before anything else is, this is why having a healthy profit margin matters, this is why I get really concerned anytime I see an advisory firm that particularly has a profit margin below 20%. It's not because I'm trying to say you should be greedier and leech more money off your clients in excessive economic rents. It's, this is the margin that you need to be able to withstand the hurricane as the mountain. This is what you need to be able to withstand the volatility. It matters, your margins are your first line of defense. And then the good news is when you've got healthy enough margins, for a lot of firms that is the entire sufficient defense for the business with an asterisk on the personal, and I'll come back to in a moment, but your margins are your first defense.

Your second to me, shortly thereafter, is any level of flexibility that you have in your expenses. So, most of us don't exactly hire a team that we don't need. And most of our other costs are just the software I use to run my business, which is not very flexible. I need it to run my business. My office space, if you do have a physical office space, it's hard to just ditch out of the rent. When markets get tough, your landlords don't tend to like that. So, for most of us, I see the biggest flexibility that you get in expenses to be able to manage just a little bit further is having some layer of variable compensation or bonus structures tied to your team. And the bonuses are tied to some combination of revenue and profits.

Carl: Interesting.

Michael: If you want to do it from the profitable firm or firm owner, and the bad news is that it means you pay people a little bit more when markets are good. And the good news is that means the structure is built for your team to share with you a little bit when times are difficult. We didn't have growth this year, the bonuses aren't getting paid. Now, your team did not sign up to be a business owner and take all the volatility that comes with being a business owner, so that doesn't mean you can give them the compensation volatility that you get as a business owner, but having even just 5% or 10% of compensation be some kind of bonus structure that probably is not getting paid out when profits are near-0 and revenues are down in a market helps a lot. For a lot of advisory firms, 70% to 80% of our costs are staff comp. So if 5% to 10% of those costs are variable compensation that comes off your shoulders, that's another 5% in margins that you have as a buffer in a downturn. That goes a long way, if you're running 20-something in the market and the portfolios are down 20-something, that bonus that doesn't get paid can be the difference between being able to get through or needing to either put money in to make payroll, or needing to cut someone because there's not enough dollars going around.

Carl: Yeah, that's really smart.

Michael: So just the financial management of the business. Once you've got team, it's a little bit different. If you're solo you just got to feed yourself. And we usually have better margins as you know, or EBOC, or some kind of earning owner take home. But once you've got team and responsibility for other mouths to feed, to me, just this is where the financials and the financial management of the business and its margins matters. It's not just your profits, it's your ability to withstand external shocks to the business, the most straightforward of which is markets tend to do crazy things every 1 or 2 of 10 years.

Carl: Yeah. I'm loathe to use the term stress test, but have you seen that be helpful for people like, "Hey, let's just put..." And I mentioned earlier pretending to be punched in the face is different than actually being punched in the face, but it still could be helpful to run through real examples. So what would you do there?

Michael: Yeah, ironically now I was saying all the discussions we have about stress testing and portfolios, I haven't heard referred to as a stress test before, but I have a few advisory firm friends that run basically what...they call it rehearsals. All right, things go crazy, markets down 30%-plus next year, balance portfolios down 20-plus. Let's just literally take a couple hours and run through how this shows up in our P&L. Let's just project out... we usually don't have a ton of line items in our business, right? Markets don't go down in a month, so, they do it over a couple of quarters. So, model your revenue going down over several quarters as your profits get chewed up. What is my payroll? What are my other expenses? If I do have something like a little bit of variable comp or bonuses that don't get paid, how does that play out? Just run it on a spreadsheet to see how does this actually work, how does this play out.

And again, and in general, I find if you've got healthy margins, it works okay. If you don't have healthy margins, it gets pretty squeezy. But then even in the context of a rehearsal, you can start going through, like, "Cool." So if the math is starting to turn upside down, what would we do? Let's rehearse this and play it out. Am I going to cut bonuses? Is there someone I could lay off that maybe sort of needed to go anyways and this will just end up being the excuse? Can I not afford to let go of anyone? And my response would be, I'm just going to have to go to the team and say, "Look, I've got to dial everyone's comp down by 10%. The good news is I don't have to lay anyone off. The bad news is we just all have to take a little bit of pain. Hey, my profits are going to 0, so I'm taking the most of it, but I've got to take everybody's comp down a little." I know a few advisors that did that in the financial crisis as a way to keep from needing to let anybody go. Would you borrow if you could? Would you run up any credit card debt? Would you take out a HELOC? I'm not saying whether you should or shouldn't. You know your business and your risk better than I do, but it doesn't hurt to just think through in your head, would you do that in preparing. "I would totally do this as a HELOC." "Cool. Do you actually have a home equity loan open now? Because in the middle of the markets, that probably won't be the best time to set that up if you don't have it now. Maybe we should put that buffer in place."

Carl: I love the idea of identifying because obviously, these are very similar to what we do with clients, but the idea of identifying the levers you'd pull beforehand even in the priority order that you'd pull them all representing guesses as just a model, but at least then you have something to go to when you're not the exact... You might be feeling a little stressed, a little worried. It's just so helpful to have a plan that you can refer to beforehand. When you're thinking about doing something silly, it's cool to be able to revert back to a plan. So I love the idea of identifying the levers especially.

Buffering One's Lifestyle Against Downturns As An Advisory Firm Owner [23:36]

Michael: Now the piece I will note on the other hand, the place where I see... For advisory firms, I've seen that had some kind of space, you got a blow-up in a market downturn. I've seen a handful that just ran really thin margins, said, "I run a 12% margin. My business is big enough that 12% margins on the amount of revenue I bring in is more than enough to pay my bills and live my lifestyle. So I don't need to run higher margins." And then they got very punished when the market downturn came and they couldn't make payroll. The other version that I've seen, probably even more often, is what blew up the firm was not the market downturn. It had 20-something percent margins, they basically went to 0 when the market decline came. The problem was the business owner had a lifestyle that was not capable of sustaining a year without profits from the business because they basically spent all the profits of the business every year. So the business was totally healthy. It ran a good margin. Their lifestyle was to live basically all of that profitability, and they had no capability to manage their personal household expenses and their lifestyle when the profits went to 0. And so the weird effect was that the business was fine. But it imploded because they had to get enough money out for their own really nice house and the really nice second house that they did not want to sell in the middle of the financial crisis, and a couple of cars and a couple of other nice things. And I'm not trying to be judge-y about lifestyle, but many things with fixed payments that they could not sustain when the profitability went to 0. And just at a more generalized note, where I see a lot of advisory firms struggle at the end of their, or advisory firm owner struggle at the end of the day, the problem is not actually whether the business is okay, the problem is whether they can pay their own bills in the year that the business has no profits.

Carl: Fascinating.

Michael: And true to our recommendations as financial advisors, that's basically a discussion around emergency fund, emergency reserves with the caveat that we can bear the full brunt of market cycles that can be down for a year or 2 if you want to go all the way back to 2000 to 2002. So, if your business has 25% margins and may be fine, but do you have 2 years of personal living expenses in cash or easily convertible to cash if you want to use some alternatives, cash or easily convertible to cash if you got to withstand a 2-year market cycle downturn? And to me, particularly as firms get bigger and have some healthy margins, that's actually the place that I find most advisors have the real stress. So, run healthy margins, and 3 to 6 months of emergency reserves is just not enough when you're the owner of an advisory firm unless you run really big margins. I suppose, if you're running 40%-plus margins you'll probably still be able to draw some money out anyways.

Carl: Yeah, that's... It's interesting how... I don't know what the right word is. I want to use the word heavy, but it's not heavy. It's just interesting how real that could get really fast. And I think it's just so smart to be thinking it's... I'm glad that Harry asked the question because the time to... I had a sketch in the column in "The New York Times" once. It was a Venn diagram that the Venn diagram police got so mad at me for because it wasn't really a Venn diagram, but it was something like learning how to use a parachute after you've jumped out of the plane or something, It was a little too late. It was the overlap was labeled. And I think to your point of home equity line, nobody gives you that when you need it. So, super smart.

Looking To Cash Reserves And Other Alternatives To Work Through Market Downturns [27:40]

Michael: But again, the distinctions, it's one thing to manage the downturn in the business. You do that with margins as buffer and some flexibility of expenses. And if you're running margins that these businesses are capable of, that tends to be enough. Your upkeep is your downfall for most advisors. So, what are their personal cash reserves? If you have to go 6 months, or 12 months, or 2 years without any material profits out of the business, while you're making payroll and keeping clients on board, you can run break even and the business is fine and we'll eventually get whatever the rebound comes. Can you handle that yourself?

The one other thing I have to note in here is ways to do this that just... I know one advisor that did this. I do not, in any way, support or endorse this strategy, you can do your own math. But, so for those who remember, Nassim Taleb's Fooled By Randomness came out in the early 2000s. And one of his whole things was because markets are so asymmetric, you buy, you're deep out of the money. Puts or calls, particularly puts, and you just wait for the inevitable market crash that will, you know, be completely useless 9 out of every 10 years, and then the 10th year it may pay off. So I had known an advisor who upon reading that book, had a deliberate strategy. Every year, he took 1% of his revenue and he bought deep out of the money puts.

Carl: I was going to ask you about that. Just basically Southwest buying hedges on fuel costs. Our fuel cost is the market.

Michael: Yeah, his revenue was tied to the market. And so he hedged against the market.

Carl: What do you think of that?

Michael: He would never share with me how the math played out, but he was doing this straight up to and through 2008, and he definitely did not look financially stressed when the market fell out and the VIX went to 40, or 60, or 100, or whatever, I don't even remember what crazy number it got to in the peak. And I have to presume his puts gave him a bajillion percent return even though he'd lost money for the past 7 or 8 years that the market hadn't gone volatile. And basically, because he bought himself a little portion of portfolio insurance, but his model is just, "Look, I'm going to do 1% of my revenue. Just means my margins are 1% lower." As a percentage of profit it was higher because 1% margins when you run 25% margins is 4% of your total dollars. So, it was a non-trivial portion of his profits. And he ran it every year, and many years it was a complete waste of money, and the year that it mattered it definitely wasn't. So, to each their own about how they like to do deep put options that will probably go to 0 most years, but it is another way to do it and approach the problem. And you're notably, assuming you're buying longer-term puts, you don't actually need them to go into the money if the markets get anywhere close to the level you buy at the strike price. They're going to not be highly vested, highly valuable because there's still value left in the remainder of the term of the option. So...

Carl: Plus the volatility kick, normally.

Michael: Yes, yes, plus you get a boost. You know, Black-Scholes model looks a whole lot better when volatility goes through the roof. So...

Carl: Yeah, that's so interesting especially when you know, well, you don't know, but the odds are that thing is going to show up.

Michael: At some point.

Carl: Yeah, yeah, it would be silly not to think that that's going to show up. So, that's super interesting.

Michael: Margins, reserves, and maybe deep out of the money put options if you're so involved.

Carl: That's purely it. And I think another way to think about it is just an insurance policy.

Michael: Yeah, oh, very much. He viewed it as business insurance against markets.

Carl: Again, no different, I remember when Southwest had that year where they had hedged their fuel costs. I think it was Southwest, one of the airlines had that year where they hedged their fuel costs and it ended up being a huge contribution to their profit for that year. So, super interesting. Well, that's enough of that, Michael. That's enough of that. Super, super helpful.

Michael: Awesome. Thank you, Carl. Appreciate it.

Carl: Yeah, cheers.