An Absolute Tale

An Absolute Tale

“The Wealth Inflection Point”

This tale is inspired by an event that made me stop and reflect on what is really important when it comes to managing money.  It changed the way I managed portfolios for most people.  It happened in October of 2002.  This tale primarily provides us with insight on human behavior under financial adversity and also touches on something that isn’t well understood in the financial literature.  I call it The WIP or Wealth Inflection Point.  It is the point where an investor stops looking at their money in terms of rate of return and starts looking at it in terms of dollars.  This is also a Behavioral Tale because once again it shows the difficulty people have dealing with their money while under financial stress.  This difficulty ultimately leads to their inability to make smart decisions under pressure and is where the unfortunately profound phrase most people buy high and sell low comes from.  If I were a sports announcer I would say these people choke under pressure.

As I said earlier, this tale teaches something that I incorporate into my advisory practice on a daily basis.  Specifically, this tale taught me that advisors and individual investors must understand that clients and people will make poor decisions at the most inopportune times.  Since we learn from A Tale of Accountability that all people, whether they self manage or utilize advisors, are ultimately in charge of their own portfolio, it behooves the smart advisor or individual investor to design portfolios that are choke proof.  They have to hold up under pressure.  It behooves the advisor or individual investor to design portfolios that are Behavioral Portfolios as I describe in A Portfolio Tale.  This means that to an advisor, the client’s behavior becomes a variable that must be included in portfolio construction.  Since clients can dismiss their advisor at any time and for any reason, the good advisor anticipates the client’s own self-destructive behavior and plans accordingly.  If you know that people will behave to their detriment under extreme conditions a good advisor must take this into consideration.

In mid-October 2002 I got a call from the brokerage branch that I most often use for my clients informing me that one of our mutual clients was in the office demanding to sell everything in all the accounts and close every one of the accounts.  They indicated that they couldn’t take any more losses.  They were distraught.  It seemed that this particular client felt that they had lost too much money in the 2000-2002 bear market and they were going to salvage what little remained before it was all gone.  I asked to speak with my client, Bob, of the last 15 years.  A few minutes later the brokerage representative came back on the phone and said that Bob wouldn’t speak with me because he knew what I would say.  To quote my client, “I don’t need to speak with him, I know what he is going to say, he is going to tell me I’m making a mistake getting out of the stock market because he’s always bullish.”  Bob proceeded with his plan, his portfolio was liquidated and a few days later he received various checks in the mail.  He wouldn’t even take my phone calls for several months.

I had to reflect on Bob’s statement about my perpetual bullishness.  I think he misinterpreted my belief in concentrated stock ownership with perpetual bullishness.  I’m not a perpetual bull or stock market optimist at all times, I just didn’t know a better way to make money over a long time frame for myself or my wealth building clients at that time.  So I advised clients like Bob that while in the wealth building part of their life if they can stomach the bad times they should stay substantially invested in stocks.  It’s clear to me today that Bob couldn’t stomach the bad times.  I can see how some might consider this approach perpetual bullishness but I don’t.  The approach has its risks and rewards but overall it’s generally accepted as one of the best long-term strategies for wealth building.

Unfortunately, I had overlooked one key component of my wealth building belief and that was the key phrase “if they can stomach the bad times.”  Bob couldn’t.  I had been fired after 15 years and I blamed myself.  It would have been simple to blame Bob for his foolishness but his words kept echoing until I finally understood what had driven Bob to do what he did.  His irrational behavior helped me arrive at a better way to deal with clients when they are in a panic.  It doesn’t make more money in a theoretical sense but it does in practice since it diminishes self-inflicted investment mistakes.  The key is to structure portfolios that lower the chances of clients getting to the panic point.  Current and future clients can thank Bob for the wisdom he bestowed and you can see the results in A Portfolio Tale.

Bob and his wife Linda had been one of my first clients and I had a very fond place in my heart for them. They had been clients since 1987, and were people I genuinely liked.  They were smart, educated and had a very good grasp of the stock market.  At the time they decided to abandon our strategy they were in their late 40s and had a little more than 10 years each before they could retire from their jobs as public school teachers.  The plan was to get each of their IRA portfolios to a yet to be determined level before we reduced their equity exposure to something in the neighborhood of 50%-60% from the almost 100% we had maintained for the last 15 years.  Everyone liked and agreed to the plan.

In a nutshell their plan was simple. Bob and Linda would own quality equity investments, stay fully invested until they had saved enough money to be able to reduce some of the risk or volatility from their portfolio.  They would do this by selling a portion of their equity holdings at some future date and moving or converting that money to bonds.

The couple had started with less than $40,000 in each of their IRAs in 1987 and had added $2,000/year when they could.  They had never taken a withdrawal from the account.  The IRA accounts had peaked at almost $450,000 in the year 2000.  On that fateful day in October of 2002, each of their IRA accounts was worth a little over $300,000.  The couple also contributed to their retirement plans at work, which were also almost 100% invested in stock mutual funds, but for purposes of this tale the IRA target is the appropriate measure.

What went wrong?  In my opinion, nothing went wrong other than I underestimated their Wealth Inflection Point.  It is my belief that everyone either individually or as a couple has what I call a Wealth Inflection Point or WIP.  Everyone’s WIP is different and people’s WIP changes over time as they get more comfortable with wealth.  But in Bob and Linda’s case, the WIP is the point where they looked at their assets and said that’s a lot of money.  It’s the point when people ask themselves the question “Is this enough money to live on the rest of my life?”  It’s also at this point that many people stop looking at their portfolios from a rate of return perspective but from an absolute return perspective.  This moving target of wealth is difficult to determine and is the art of the relationship between the client and the advisor.  The portfolio composition or asset allocation is a reflection of this moving target.  I suspect that Bob and Linda stopped seeing gains or losses as percentage gains or losses and start seeing them as absolute dollar gains or losses, thus the title of this tale is An Absolute Tale.  Losing close to $300,000 over a two and a half year period was significant to them.  Forget percentages, what about the dollars is all they could think about.

The market had dropped for almost 30 months and the portfolios were down.  From a planning perspective, Bob and Linda had never reached their stated goal at any time, they still had more than 10 years until the early retirement age of 59 and if they stayed on track the next upswing in the market would get them to their target or at least very close.  Why couldn’t they follow the plan?  Why didn’t I know that they couldn’t follow the plan?  They assured me that they could in conversations and they were well versed and educated in stock market history.  These are smart people.  I had to dig deeper.  I went back and analyzed the couple’s portfolio on a monthly basis from 1987 through 2002 and was surprised with what I found.

I found that even though the accounts had dropped in value by a little more than 30% from the 2000 peak that this had happened on 3 other occasions over the 15-year period.  Why couldn’t they stay with the program this time?  I suspect they lost confidence in the stock market’s ability or my ability to provide them with future returns because the losses associated with the first three 30% declines were never amounts in excess of $75,000 but that the last one was.  If you asked them if it was a well thought out decision they would say no but they did it anyway.  Why?  I can only speculate that people, and I suspect most people, have ingrained mechanisms that prevent them from thinking in terms of percentage losses and gains and they turn to thinking in terms of dollar losses and gains when the numbers get large.  Again, I suspect that most people can stay with an aggressive investment program as long as it doesn’t exceed their threshold of pain but when it does, they panic, and it’s not enough for them to have a trusted advisor at the helm for 15 years.  As is invariably the case, Bob and Linda sold their stocks at just the wrong time since October 2002 marked the end of the bear market.  They missed a significant run up in their portfolio had they just stayed with the plan.  Then again, who didn’t see this coming?

Out of curiosity, I developed a hypothetical portfolio over the same 15 years that Bob and Linda were clients to determine if I could have done something to make them more at ease.  I developed a model portfolio that was invested 60% in stocks and 40% in bonds to see what would have happened.  This process led me to some insights I didn’t have before this episode.  I found that using the 60/40 model we never had a decline of 30% over the 15-year period.   So it was less volatile, but it didn’t capture the great gains in the stock market over what at the time was one of the greatest bull runs in history.  As a result, the theoretical equity never exceeded $300,000 and would have been worth slightly less than $250,000 in October of 2002.  Bob and Linda would have had less in October of 2002 with the theoretical 60/40 model but they would have had more confidence in the probability of achieving their goal I suspect.  I also suspect that had I employed the 60/40 standard for the 15 years that they would still be clients today and they would have reached their retirement goals even if it took them a longer period of time.  This was one of the most valuable lessons of my life and taught me that people define wealth according to their perspective, they behave irrationally and that advisors that act as portfolio managers should be aware of a client’s WIP.

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