I’m especially not amused if a client fires me because their diversified portfolio is underperforming the US stock market and they abandon the strategy. The result is often a financial travesty.
The February issue of “Inside Information,” Bob Veres’ financial newsletter, puts a name to this phenomenon: “frame-of-reference risk.” The term is used by Roger Gibson, Chief Investment Officer, and Christopher Sidoni, Director of Investment Research, of Gibson Capital in Wexford, PA. Veres reported on a presentation they gave at the American Institute of CPAs (AICPA) Personal Financial Planning conference in Las Vegas in January.
Gibson describes “frame-of-reference risk” as clients’ tendency to compare the performance of their diversified portfolios with current returns in the US stock market. He points out, “If the discrepancy gets too painful, they will fire you and abandon a diversified approach at the wrong time.”
Based on the emphasis the media gives the US stock market, one could easily conclude US stocks must be the largest, most important asset class in the world. Not at all. US stocks represent less than 10% of the world’s wealth and make up 10% to 20% of most diversified portfolios.
Neither do US stocks consistently produce the best returns. In the 1970’s, commodities dwarfed US stock returns. In the 1980’s, international stocks led the way. In the 1990’s, US stocks were the stars. In the 2000’s, the leader was real estate.
Yet most investors judge the performance of their portfolios by US stocks. They may compare the returns of a diversified portfolio with news reports about the S&P 500 and the Dow, which together include only 530 companies.
Between 1994 and 1999, Gibson’s multi-asset class strategy delivered a 13.05% return, which paled in comparison to the US market’s 23.55% return. He lost one-third of the assets he managed in 1999, as clients fired him. They abandoned their diversified investment strategy at just the wrong time to save themselves from the 2000-2002 US stock market downturn, when real estate and commodities soared. Gibson’s multi-asset class portfolios did 9.96% from 2000 to 2005, when US stocks rang up losses.
This pattern, familiar to many financial planners, is the sad consequence of frame-of-reference risk.
Another aspect of that risk is our human tendency to stay in a comfort zone where most of our neighbors are doing pretty much what we’re doing. One client even told Gibson, “I would rather follow an inferior strategy that wins when my friends are winning and loses when my friends are losing, than follow a superior strategy that at times causes me to lose when they’re winning.”
Unfortunately, this tendency can lead us into disasters. Diversified portfolios are once again underperforming the US stock market. Predictably, an increasing number of investors are abandoning diversification, right in time to get nailed.
Gibson and Sidoni’s conclusion seems to be that educating clients to stay the course is a no-win game. In their view, advisors need to craft a less efficient, lower-return long-term strategy that clients will consistently follow rather than a more efficient strategy that clients may abandon in mid-stream.
While that view seems pragmatic, it really misses the mark. Instead of dumbing down portfolios to match client’s dysfunctional money scripts, it would be a better outcome if advisors concentrated on helping their clients uncover and modify the money scripts that are driving their self-sabotaging behaviors. This approach can help keep clients from saying “You’re fired!” at the wrong time for the wrong reasons.
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