Practical analysis for investment professionals
26 December 2012

The Financial Crisis: Seven Lessons to Incorporate into Client Relationships

The global financial crisis of 2008–2009 exacted a hefty toll on all those who suffered through it: from devastating investment losses to a pervasive loss of trust. The Great Recession, as it is now known, forced many financial advisers to reevaluate long-held investment approaches and to reconsider ways in which they communicated with clients.

We’ve all heard the saying that those who fail to learn from history are doomed to repeat it. So what are some of the key lessons financial advisers can learn from the crisis?

G. Scott Clemons, CFA, chief investment strategist at Brown Brothers Harriman, spoke at the recent High Net Worth and Family Wealth Conference hosted by CFA Society Philadelphia and outlined seven take-aways in his keynote presentation, “Incorporating the Financial Lessons of 2008 into Client Relationships.”

1. Passive investing is not riskless investing.

Clemons declared there “is no such thing as passive investing” and urged advisers to rethink the dichotomy of active versus passive investing.

“An investor in a passive index fund over the past 13 years got roughly 0% return, but the price tag for that was a huge amount of volatility,” he said. “The overwhelming human temptation, even if you are using a passive vehicle, is to sell at the troughs when the pain gets too much to bear and then buy closer in to the peaks.”

Clemons’ point was that, at its root, a passive investment is a price-momentum strategy.

As he explained: “Think about what a passive investment is: Let’s take the S&P 500 index, it’s a capitalization weighted index — shares outstanding times the price of those shares. That determines how big the company is in the index, which determines how much of the company in the index one has to buy. So as the share price goes up, the capitalization goes up, the more the index fund has to buy, which means there is more pressure on the price, which means the capitalization goes up, so, see where I’m going with this? What in reality is happening with a passive investment is a price-momentum strategy. “

While this worked in the 1980s and 1990s, Clemons said, “the reminder of the last decade is that price momentum works on the downside as well.”

He again encouraged advisers to try and break away from the dichotomy of active versus passive. “Passive seems to imply safety, activity seems to imply risk,” he said. “We know that’s not true, but subconsciously when we talk to our clients that connotation of those words is still very much there.”

2. The conventional definition of risk is wrong.

Risk is not volatility. Period,” Clemons told delegates. “I’ve been advising individual clients and families for over 20 years now, and I’ve never met a single individual or family who shared that definition of risk. The wittier of them would say, ‘I like the upside volatility, I liked the volatility from 2009 to date. I’ll take more of that please. I just don’t want the downside volatility.’”

For most investors, he explained, risk is a concept that he or she might do irreparable damage to their capital; that they may lose money and not be able to get it back.

Reflecting on his own conversations with clients, Clemons noted that what is actually taking place is an exercise in asset liability matching.

“So as an investor — as an individual, as a family — you have assets that can be measured financially. You also have liabilities. Some of those liabilities are discrete (mortgage payments, rental payments, tuition payments, healthcare payments). Some of those liabilities, however, are very vague. They are ambiguous, they are lifestyle. ‘I would like to retire to a certain place. I would like to travel in a certain way. I would like to collect art.’ Those aspirational liabilities are still there nonetheless. So you’ve got assets, you’ve got liabilities, and the whole investment exercise is matching those assets and liabilities.”

If you buy into this framework, he added, then risk is the idea that assets and liabilities don’t match. “We [at Brown Brothers Harriman] spend a lot of time with our clients talking about the liability side of the balance sheet, because unless I thoroughly understand the liability side of the balance sheet, how can I possibly put together an asset side of the balance sheet, asset allocation, that has an idea of successfully managing what that liability stream is down the road?”

3. Relative returns are close to meaningless.

Clemons noted the financial services industry has done a very good job training clients to believe that success and failure are defined by how well an investment portfolio (and hence the adviser) performs relative to a benchmark.

“I defy the belief that in a market that is down 50%, when you lose 40% of your client’s money, somehow that’s success,” he scoffed. “It doesn’t work if the ultimate objective is asset liability matching.”

Clemons went on to propose a bifurcated definition of success, one that acknowledges that investment advisers have to compare performance to something. “Ultimately the objective of investment wealth management is preservation and growth of your client’s wealth, and in that order,” he said. “Yes, still use the relevant benchmark, but keep in mind there is a very real absolute measure, an economic measure if you will, that relates back to the idea of asset liability matching.”

4. There is a difference between wealth and money.

The difference is purchasing power. In other words, inflation.

Clemons said that when he talks to clients or industry gatherings, he sometimes gets blank stares when he mentions inflation, given that it is around 2% (a number he disputes).

“If you think about your own bucket of consumption, it just doesn’t seem like a 2% number, it seems higher than that,” he said. “If what I am worried about is that there is inflation on the liability side of my balance sheet, the inflation rate I need to hedge is not CPI, it’s your idiosyncratic rate of inflation, which is probably higher in most cases.”

But what if the number is right, and 2% is right rate of inflation? Is this still something advisers and clients should worry about? The answer is yes.

“We’re all familiar with the miracle of compound interest,” Clemons explained. “Inflation is simply that dynamic shifted into reverse. It’s the evil twin. It is how a great fortune at even a modest inflation rate can diminish in purchasing power over time. Graphically, $1 million at a 2% inflation rate, if that were to remain the case over 25 years, you would lose close to 40% of the purchasing power. The higher the rate of inflation goes, the more damaging it is. So when we talk to our clients about matching assets and liabilities, and we look at the liability side of the balance sheet, and we talk about the inflation on that side of the balance sheet, inflation is front and center. And when we think about the kind of money that they may need down the road to support a future lifestyle, retirement, philanthropy, whatever it is, I try very hard, I don’t always succeed, to not even use the word money, but to use the word wealth because there is a difference between the two, and that difference is inflation.”

5. The role of cash as a call option is under appreciated.

There is a debate, Clemons noted, about whether or not cash plays a role in a portfolio. Most asset allocation policies and most asset allocation approaches look at cash and say, ‘This is an asset in today’s market that has a rate of return that is pretty much zero, and when you take into account inflation, the return is actually negative so it really doesn’t play a role in a portfolio. Why would you hold cash in a portfolio?’”

He believes, however, that there is another role that cash plays. “I’ve begun thinking about it in terms of an optionality value, and cash is a call option on future downside volatility in, if you will, riskier asset classes,” Clemons said.

He thinks of cash as “dry powder on the sidelines” that can be deployed when needed but noted that this approach requires contrarian investment thinking, patience, and an ability to look long-term for an extended period.

6. Strategic versus tactical asset allocation is a false dichotomy.

Strategic allocation, Clemons said, is generally defined as “long term, patient, thoughtful, conservative, value based most of the time,” while tactical allocation “is more price-driven, more momentum-driven, more technical.” The issue is that those two approaches tend to be on opposite sides of the spectrum — and yet sometimes strategic decisions appear to be tactical decisions.

He related the firm’s experience during 2008–2010, when there were a lot of strategic changes, or what the firm thought of as strategic changes. Clemons said he started to hear from clients who wanted to know if something had changed, because they were not used to seeing this many changes in a portfolio. This prompted some introspection. “We said, ‘We’re not doing anything different, we are still very long-term, patient, value-based investors.’ But of course you know how to solve that paradox: being, long-term, patient, value-based investors in a period of heightened price volatility gives you more opportunities to act strategically. Just it looks tactical.”

Clemons noted that Brown Brothers Harriman is trying to break the dichotomy by using a different word: replacing strategic and tactical with “dynamic.”

“You may say that’s just semantics, and you’re probably right, but there is such a connotation, and in some cases even negative baggage to tactical asset allocation, of trying to dance between the rain drops. The strategy we employ is still very much a value-based strategy, but when the market gives us more frequent opportunities to employ that strategy we will dynamically do so.”

7. Modern portfolio theory requires a generalization.

Clemons believes the limitations of modern portfolio theory have been laid bare and offered a real-world analog by way of explanation: Albert Einstin, a grantee of the Research Corporation for Science Advancement, which funds innovative scientific research. (Clemons is on the board.)

As Clemons told the story, “In 1905 Einstein developed a special, or specific, theory of relativity, it had severe constraints wrapped around it, and it didn’t really cause a ripple in the scientific community. He continued to work on it, and by 1916 published a general theory of relativity, and since that day we have seen the world through different eyes. And the difference was he generalized away the constraints. I think that what we have in modern portfolio theory is a specific theory, a theory that is severely constrained by some constraints that work on paper and work in theory but don’t necessarily work in the real world. It is a theory that begs to be generalized.”

Modern portfolio theory, he said, posits certain assumptions that the experience of the past decade have called into serious question. Namely, that:

  • Risk is equivalent to volatility;
  • Correlations between asset classes are static;
  • A risk-free asset exists, is readily identifiable, and is agreed upon by investors;
  • Markets are frictionless;
  • Markets are efficient (to some degree);
  • Investors act rationally; and
  • The future will resemble or echo the past.

Clemons noted that while this final point is not necessarily part of the theory itself, he sees a lot of it in practice. And, if the financial crisis has taught us anything, it is that there needs to be a more thorough assessment of both theory and practice — and how the two intersect.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

About the Author(s)
Lauren Foster

Lauren Foster was a content director on the professional learning team at CFA Institute and host of the Take 15 Podcast. She is the former managing editor of Enterprising Investor and co-lead of CFA Institute’s Women in Investment Management initiative. Lauren spent nearly a decade on staff at the Financial Times as a reporter and editor based in the New York bureau, followed by freelance writing for Barron’s and the FT. Lauren holds a BA in political science from the University of Cape Town, and an MS in journalism from Columbia University.

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