As a financial advisor, you’ve likely had endless discussions with your clients about how your investing approach can maximize their returns. But how many times have you discussed the efficiency in which you are managing their portfolio?
Identifying and eliminating common investment frictions is what will pay off handsomely over time—far more so than most clients, and even advisors, truly appreciate. By our calculations, they can increase an investor’s wealth by more than 15 percent over a 10-year period.
The idea of mitigating losses is more than avoiding leaving money on the table. It’s about safely managing your client’s assets and actively reducing the overall risk level of their portfolios without sacrificing the intended goals.
So, what are the frictions that can and need to be mindfully managed?
- Extreme Losses
We cannot avoid losses when investing. But we can seek to avoid, or at least mitigate, extreme loss events. Investors often assume that buying a basket of many different securities, or “diversifying” their investment portfolio, addresses concentration risk.
What they often neglect is that true diversification requires attention to more than just the number of stocks or bonds that they hold. If all the securities have a similar exposure, concentration risk is not lowered. For example, buying dozens of energy stocks does not reduce risk relative to owning just Exxon. In fact, it may even increase the risk depending on the selected names.
That’s why, in the face of ever-changing market conditions, you should constantly rebalance your client’s portfolio and seek to lower the overall risk of a portfolio when returns are likely to be high. The obvious benefit is that this should minimize the chances of extreme losses, resulting in higher compounding of returns.
This is even more likely to be the case for clients nearing or in retirement who seek to generate a steady stream of income from their portfolios. Indeed, simulations show that the wealth enhancement can be as high $2.8 million for a $10 million investor who withdraws at a rate equal to their annual expected return.
What’s more, this strategy also prevents clients from making knee-jerk, trading decisions that hurt their ability to achieve long-term success.
- Taxes
Most investors are so focused on driving higher returns that they eschew one of the most effective solutions to achieve better results: exploring ways to significantly reduce their tax burden. All too often, advisors ignore tax management in rebalancing and loss harvesting.
Yet, the impact can be significant. If tax savings from simple passive strategies result in a 1% increase in investment returns per year, that translates into an extra $1.3 million for client who holds a $10 million portfolio for 10 years. And the benefits can be even higher amid volatile markets.
Just as there is a difference in the performance of a high-quality “Lexus” and a standard “Honda” vehicle, the same applies to tax strategies. That’s why it is important to keep up to date with the latest rules and research – and seek outside expertise to make sure that you are deploying them effectively.
- High Fees
Most investors can rattle off the returns of their best-performing investments. But ask them to tally up the cost of all the fees that they are paying for those results – and you are likely to get a blank stare. Between advisor fees, SMA manager fees, and the underlying product fees, the tab can quickly add up.
For example, a 100-basis-point, or 1%, reduction in fees can translate into $1.32 million in savings for a client with $10 million to invest over 10 years. That is 13.2% of the investment amount.
This savings is real money that otherwise would eat away at their returns. Indeed, just as the savviest supermarket shoppers look for private-label options of their favorite brands, smart investors look for ways to replicate popular investment strategies using lower-cost funds, like ETFs and other relatively inexpensive securities.
The Ultimate Friction: Time
Addressing any of the common frictions above requires constant attention and focus, and time is any financial advisor’s most valuable asset. Even if they have the right expertise, it is challenging enough for most advisors to continuously monitor the portfolios of the dozens, if not hundreds, of clients they are privileged to work with.
And trying to rebalance their holdings to reflect the vagaries of market conditions or their clients’ unique tax needs is practically impossible.
That’s where automation from technology can play a powerful role. By relying on sophisticated algorithms and other technologies to constantly assess your clients’ portfolios and then automatically rebalance their positions based on a set of pre-determined criteria, you can better service your clients – and, in turn, more effectively remove the frictions and imperfections that exist in wealth management today.
In other words, technology can help you deliver better outcomes to your existing clients and free you up to grow your business.
Dr. Vinay Nair is the founder and chairman of 55ip, a leading investment science and technology company. He brings nearly two decades of experience working with investment management professionals and academics. Dr. Nair is a visiting professor at The Wharton School and the MIT Sloan School of Management and serves as an advisor or board member to several companies that aim to utilize modern science and technology to solve real-world problems. Dr. Nair holds a PhD in Financial Economics from the Stern School of Business at New York University.