Human nature helps guide our investment decisions. Here, we’ll explore a few examples of common thought over time, the value of a financial plan as a central theme in a client relationship and how investment philosophy can help shape the elements of a diversified investment portfolio.

Two conversations with a friend over the last year came full circle. He was a high-risk investment kind of guy and when diversification as a strategy was implemented, he said, “Leonard, it's not diversification; it's diworsification! I could be making more money!”

Flash forward to this year: "You have to go through a crisis to understand the value of what you do."

While everyone's results vary over time and depend upon the adviser or team's investment strategy, many characteristics today are like those in 2000 in terms of market behavior. High-tech stocks were hit hard initially, sector rotation into value and international stocks, and a softening of the interest rates increased the value of bond funds. The outcome: Portfolios with adequate diversification could have been higher than at the start of the year. Again, results vary, and many, as we know, were down.

Investment Management First Step: The Financial Plan

CPAs make the financial plan a central theme of the client experience. Because of the financial planning experience, the reactions to the outcomes around the investment portfolios were fundamentally different than what our client's friends who have other advisers experience when the capital markets shift. Their clients may panic and lose sleep at night. An investment portfolio rooted in risk tolerance and part of the financial planning “experience” becomes a practical foundation in distress.

With the financial plan as the central theme, the quarterly review process is simple:

Step 1: Review the financial plan.

Focus on two pictures of a client's projected retirement life:

• Income needs and the various sources the income comes from over time (such as Social Security and annuities).

• How assets are projected to grow over time: Different assets grow at different rates. It is good to see what an expectation could be for the value of properties that can spin off income, retirement plans, non-qualified assets, tax-deferred assets like annuities or life insurance, commodities personally acquired over time, and much more.

• Review income and expenditure projections line by line: Are there any previously unanticipated cost increases? Homeowner and car insurance are two recent significant changes that may have increased by 50 percent or more over the prior year. We need to check in and recalibrate the plan. Is there a trip or wedding we need to plan for? A desired car or motorhome?

Clients' lives change quarterly based on meetings with other family members. There may be health issues that occur with parents and other family members, new hobbies and many other new or reduced expenses. The more captured and quantified in the next meeting, the more engaged the client becomes in consistent participation in the financial plan. The planning can be instrumental in exploring the impact of strategies like micro-Roth conversions, 1035 exchanges of life insurance for long-term care premiums, evaluation of taking pension income, or a lump sum rollover, to name a few.

Step 2: Review the hypothetical of the client portfolio.

The review of a hypothetical does not convey expected return. Past performance is not indicative of future performance, as well as know. It creates an expectation for volatility and a conversation to ensure that the client's risk tolerance matches the investment portfolio's risk level. When there is a long-term focus on how much can be lost in a market adjustment that is discussed and shared, an expectation is created. When a market crisis occurs, usually, though not always, portfolios move consistent with the risk tolerance discussed.

Because there are statistics involved, we typically speak of 95 percent confidence levels (two standard deviations) that the trading range will fall between two sets of numbers. Sometimes, like in 2008, it is a three-standard-deviation event.

Step 3: Review the portfolio for the period, year to date, and over 1, 3, 5, and cumulatively.

It is human nature to zoom in and look closely. By tying the portfolio to the financial plan and reviewing the risk tolerance with the hypothetical, confidence is established regarding potential outcomes. The portfolio results will usually confirm the risk range in the hypothetical, translating to greater client confidence and peace of mind.

It is important to follow the three key steps because what we hear in the media each day can often drive us to greater fear, concern or stories that may not be entirely accurate.

Like The Beatles' George Harrison's mom wrote to a fan in 1964, "P.S. The US Press only prints rumours to sell the Papers."

Fear drives action, which is why we see so many advertisements for gold for certain types of programs. Gold is a great fear trade, but not where a significant portion of a client's assets should be invested. One key problem I have seen with personally owned gold over the years is that the asset tends to disappear when held in safekeeping or at a client's home. Valuables at home are an invitation to the uninvited. While it may or may not be a good part of a diversified portfolio, it is never good to concentrate too much of a portfolio on one asset. Especially in a home where uninvited guests could take the asset.

American markets can have long periods of bold growth and long periods of no increases. Regarding sector concentration, we saw a more extreme example of what is happening today with the E-Trade tow truck driver who bought a tropical paradise island with his stock market prowess in the 1990s. What happened to the tow truck driver and his island? It was wiped off the map by the hurricane of 2000-2002 and never seen again. Nearly 20 years later, the NASDAQ recovered. The S&P 500 averaged about -1.1 percent before fees and performance through 2009.

A good percentage of mutual funds underperform the index, and people paid for underperforming wisdom. So, it was common to see portfolios down 30 percent during the decade. However, a diversified portfolio with healthy heaps of international and value positions doubled. Something similar happened from 1968 to 1982. The Dow Jones went up 0 percent during that period, whereas a diversified portfolio increased in value.

Missing the Boat

Another reason to diversify is that over the past few years, we have seen very smart minds miss the boat—a huge miss with respect to interest rates.

In 2021, my clients shared price increases in their businesses that I had never heard of in America. Considerable increases in the cost of shipping containers for fluid, lumber costs skyrocketed, catching those I know in construction without clauses in contracts that could pass on the cost to those contracting for buildings (always have clauses, even when life is certain, it's never certain).

I shared my experiences with those who managed bond funds, uniformly were rebuffed that the Federal Reserve and central banks around the world would implement measures that would smooth the tide and keep rates low.

Another surprise market collapse just months before was the curve ball out of left field, the pandemic, a once-in-a-100-year event, was about to occur again, with interest rates. While anecdotal data is often disparaged, it helps with reading the tea leaves. As a result of groupthink, Silicon Valley Bank and other storied financial institutions failed (it was certain interest rates would not rise, the auditors let down their guard), and still today, many financial institutions are still recovering, and the future risks are significant.

Investment Philosophy

Investment philosophy may not be communicated as much as it should be. It may be good to be aware of investment philosophy, which can drive diversification principles. A sample investment philosophy discusses expense ratios, Jensen's Alpha, risk levels, international investing, investing in entrepreneurial companies and much more. Some may include a strategy to mitigate distribution risk in retirement through laddered debt equities that mature corresponding to the year of distribution. There is much to be aware of regarding the professional management of assets.

Conclusion

While we may want specifics of investments and where to turn in difficult times, those specifics need to be delivered by the investment professionals and measured on a fiduciary basis against the related benchmarks and tied to the portfolio's risk tolerance. Different portfolios can have different risk tolerances depending on the job description of the portfolio.

For instance, a 70-year-old still working may have an aggressive stance because the view of the 70-year-old is that the Roth 401(k) being contributed toward will be used for their child's inheritance, hence the aggressive portfolio allocation. In comparison, the 70-year-old's personal assets may be managed to a moderate risk tolerance, as the assets will be spent down during retirement. What is most important is a process that clients can wrap their heads around. The three simple steps to follow to protect the lifetime savings of those we serve in times of trouble with the bedrock of the steps being the financial plan, tying the risk tolerance to the client and re-examining that risk tolerance at every review, and concluding with the performance of the assets relative to the due diligence performed.

And if all three steps are carried out diligently, clients may call and thank you in the middle of a financial hurricane and realize that the benefits of diversification are clearly not “diworsification.”