Does your advisor’s personality expose you to risk? In the new book Quiet, Susan Cain suggests it may.
In 2008, in the wake of the credit crisis and the collapse of Lehman Brothers, the S&P/TSX Composite Index declined by over 30%. Many Canadian investors were shocked to find that the values of their portfolios had shrunk by significantly more. This shock was compounded by the fact that many investors believed that their advisors had put them in conservative investments. Their expectation was that high quality, conservative investments would be less volatile—i.e. that in a downturn, they would go down less than the market.
How could this happen? There is a growing body of evidence suggesting that the sort of people most likely to go into the lucrative financial service sales roles are precisely those least suited to judging risk. In the recently published book Quiet, author Susan Cain cites a series of studies that suggest that extroverts tend to be attracted to the high-reward environments of investment deals and trading. More importantly, the studies conclude that these outgoing people also tend to be less effective at balancing opportunity and risk than some of their more introverted peers.
In their defence, investment advisors would likely explain that that their clients expect and even demand that they earn their keep by out-performing market indices. However, in order to do that, they are forced to take on more risk. If a fund out-performs in a rising market, it will likely under-perform in a declining market. Again, that is exactly what many Canadian investors experienced in 2008: while the TSX Composite Index declined by 33%, many supposedly ‘conservative’ large-cap equity funds declined by 40% or more.
Part of the problem is using the S&P/TSX Composite Index as a benchmark to judge the performance of your investments. The TSX is not an ideal investment yardstick. It simply reflects the nature of business in Canada. And for better or worse, we are still ‘hewers of wood and drawers of water.’ Resource companies (combining the energy and materials sectors,) comprise about 50% for the market capitalization of the TSX Composite Index. That concentration in the resource sector means that the S&P/TSX Composite Index is highly volatile. For example, as commodity prices rose in 2009, the TSX moved up sharply. When they declined in 2011, the TSX dropped sharply.
“The essence of investment management is the management of risks, not the management of returns.” – Ben Graham
So what should investors do to reduce risk and volatility in their portfolios? Firstly, one should set reasonable expectations for investment returns. Rather than demanding that your investments outperform the market, it is more reasonable to ask that they generate a modest real rate of return, after inflation and management fees. We also believe your best protection is to find an investment manager who meets a ‘fiduciary duty.’ A fiduciary duty is a legal requirement that a manager avoids all conflicts of interest and put the client’s interests first. Investment advisors employed by the big bank-owned brokerages only responsibility is to suggest investments that are ‘suitable’ for their clients—a much lower threshold than a fiduciary duty. In addition, they are not required to disclose any fees or commissions that they will receive if you buy what they are recommending.
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