Important questions for your Investment Advisor
Select an item below to explore the questions and answers.
1. Does your advisor have a 'get out' strategy to take you to the sidelines when markets are risky?
How do you manage risk?
Risk management is the most important function that an Advisor adds to the wealth management process. In constructive markets traditional risk management tools like diversification work to limit the daily swings in portfolio values. However, when markets turn risky, traditional tools don't work. The simplest way to manage risk is to simply get out of risky markets and wait for the tone of the market to turn positive again. Don't let your Advisor tell you this isn't possible. There is plenty of evidence that it is possible for simple timing systems to help investors avoid major bear markets.
What system does your Advisor use to identify when markets are risky? Is this identification process systematic? If so, what is the system, and how well has it worked in the past? Ask for specific evidence that supports the efficacy of his or her risk management process.
2. Can your Advisor clearly articulate his/her buy and sell rules, and can he/she demonstrate their effectiveness?
How do you make investment decisions?
There are many different styles of investing, but successful investors have a few things in common: independence, vigilance, consistency, conviction (in process), and humility. High-value Advisors should be able to articulate in detail the process they use to choose investments, and then demonstrate the efficacy of their process over time, especially during bear markets.
Be wary of Advisors who say their investment process consists of choosing investment ideas from their own firm's research. There is a mountain of evidence indicating that no single analyst or economist, at any firm, is able to consistently forecast individual stock returns. That's not to say that analyst opinions have no value, however. In fact, if taken in aggregate analyst estimates can be a superb indicator of stock direction. If the average of all analyst estimates for an individual stock is rising, the stock has a high probability of outperforming the market over the next 12 months. Leading Advisors will use tools to aggregate data from a wide variety of sources, and combine this data with other indicators to choose winning investments. This process should be consistent and systematic — ad hoc is rarely a recipe for success.
Ask your Advisor to clearly articulate his or her buy and sell rules, and then ask for evidence that this process works over time.
3. Is your Advisor a Portfolio Manager? If not, how does he/she manage portfolios with ad-hoc positions?
How do you manage portfolios and keep track of all positions?
Many Advisors, especially those who charge commission for trades instead of managing portfolios for a fee, do not have homogeneous portfolios for all clients. These Advisors must often track the prospects for dozens of different investments on behalf of hundreds of clients, sometimes across thousands of accounts. Investments are necessarily made ad-hoc, and based on whatever their firm is recommending at the time of a client phone call.
This may be a dangerous proposition for clients, as it is difficult to effectively track dozens of various positions at once. As a result, clients end up with many 'orphan' positions, which have not been re-evaluated by their Advisor in many months or even years. Often, these positions have dropped substantially in value, and Advisors are not inclined to draw attention to them, so they sit there as a drag on client portfolios.
Professional money managers run model portfolios so that every client is invested in a similar basket of investments that the manager watches closely. In this way, managers can be intimately familiar with each position in portfolios, and when the position should be sold. If done properly, these portfolios have characteristics to manage risk and optimize returns.
Ask your Advisor how he manages to remain current on all the positions in each client portfolio, and whether there are any current positions which have not been addressed in a while.
4. Does your Advisor have a process for taking advantage of global opportunities, or does he/she stay close to home?
How do you decide which markets hold the most promise? How do you avoid the 'Canada bias'?
Many clients have a Canadian Advisor who practices at a Canadian firm. This Canadian firm concentrates its research efforts on Canadian companies, because they are most likely to attract investment banking revenues from Canadian firms. Clients at these firms tend to own investments that are covered by their firm, so they hold mostly Canadian companies in their portfolios. Canadians have benefitted from this over-exposure to Canadian companies over the past decade, at least relative to investments in the U.S. and Europe. This is largely because the strong Canadian dollar amplified the poor performance of US and European investments. However, even accounting for the Canadian dollar's strength, there were areas of the world that delivered much better performance than Canadian stocks.
Small investors should be taking advantage of their two main advantages over large funds: portfolio agility, and mandate flexibility. Stock picking should be a secondary or tertiary task within a broader investment process, not the primary one. The first step in the investment process should be identifying whether the primary trend of markets is up - or down. Sometimes it is better to remain in cash on the sidelines. If the trend is up, one should then find the most promising opportunities among all available investments, and geographies. Canada may look more promising than US markets (or not), but that should not cap your set of choices. With ETFs, investors can access the strongest markets in the world, be they Canadian, US, Japan, emerging Asia, Latin America, Africa, or emerging Europe. Why should investors limit themselves to Canadian stocks if Indonesian, Turkish or Swedish stocks represent better opportunities?
Ask your Advisor how she chooses to enter the markets, and how she finds the best opportunities around the world? Does she default to Canada because of the limitations of her firm's research, or can she articulate her process for making Canada earn its way into your portfolio?
5. Is your Advisor aware of opportunities in commodities and international REITs via Exchange Traded Funds?
Do you have a process for investing in commodities and REITs in addition to stocks and bonds?
It is a statistical fact that risk-adjusted performance is directly related to the diversity of one's investment opportunity set. This means that investors can improve the performance of their portfolios by including allocations to unrelated asset classes like commodities and global REITs. Faber et. al. demonstrated how adding a fixed allocation to these asset classes improved investment results substantially from 1970 through 2010, while also reducing portfolio risk. ETFs enable investors to access commodities as diverse as livestock, gold, grains, and palladium, and let investors participate in the growth in international real estate.
Ask your Advisor whether she has a mechanism for investing in these alternative asset classes. Of course, these asset classes should also be subject to independent exit rules when risk is high.
