Financial advice today has evolved. It goes far beyond the traditional bounds of managing investments. It is more holistic, more personal, and more effective for more Australians. You could be forgiven for thinking investment conversations should be demoted in favour of other areas of the advice process, but that would be a mistake.
Investing remains a core part of the guidance clients seek, and for good reason. Investing is hard. It involves uncertainty. And people generally don’t like uncertainty, they like guarantees.
It is challenging enough to guide people in making investment decisions for their future, when there are no guarantees, but the predicament advisers face is far worse than that. There is an ocean of investment ideas, opinions, insights, and speculation that clients and advisers need to wade through.
So how can advisers better bridge the gap between certainty-seeking clients and the uncertain ocean of the investment world? We believe a lot of ground can be gained by developing an investment philosophy.
A neutral playing field does not exist
An investment philosophy is best described as a set of beliefs and principles that guides your thinking, decision-making and actions. A well-developed investment philosophy can help financial advisers make informed decisions, avoid emotional pitfalls, and have better conversations with their clients.
For many advisers, developing an investment philosophy can be something that easily falls to the bottom of the to-do list. It’s easy to imagine your own investment ideas are based on the best estimation of the facts, that your choices are mostly rational and balanced. Like it or not, aware of it or not, all advisers are choosing their own set of ideas from the ocean of information that bombards them every day. There is no such thing as a neutral playing field where you can avoid taking a position when making investment decisions. Everyone is taking a position. Even investing in a MSCI global index implicitly takes the position that capital is best deployed in public markets in the same proportions that are already there. Avoiding an examination of which ideas you rely on and to what extent, can be very dangerous – just as anyone who has been for a ride through the crypto markets from 2021 to now would know.
Putting an investment philosophy to the test
To illustrate, let’s take an idea most advisers agree with – equity markets provide growth in your investment capital over the long-term. However, we all know there are many historical examples where long periods of time invested in equities have not provided better returns than cash. For example, in the U.S. 14.9% of all rolling 10-year periods cash did better than equities between 1926-2020. No doubt these are still good odds to invest, but the question is why do you allocate to equities to provide growth without guarantees? For argument’s sake let’s explore two possible views.
We’ll call the first one the ‘statistical view’. It holds that long term historical returns provide the best guidance about future returns. Historical outperformance of equity markets is simply an observed trait of market behaviour – the transfer of wealth from the impatient to the patient, as Warren Buffet would say. Therefore, historical returns should be mined as sources of information about the future returns and should be used to design investment strategies. There’s certainly a reasonable basis for that.
For the second one, let’s take an ‘economic view’. It holds that equity markets tend to rise over the long term, because the companies that make up the markets are driven by innovation, productivity growth and the profit motive. Since economic activity is captured and expanded by companies, ownership of their capital is a driver of returns. There is a sound logic to this as well.
A good investment philosophy should help you identify areas of disagreement or uncertainty, and explore alternative viewpoints and perspectives. It should draw the borders around the spaces where the ideas will work and where they will fail. This is far more useful than it sounds.
To extend the previous example, taking the statistical view, you would logically change your strategy of investing for growth in equities when the data suggests there is a lower probability that shares would outperform cash. So, when a client is concerned about the effect a major global conflict might have on share market returns, you could confidently say that the historical period includes many conflict periods and that they should stay the course. Alternatively, if you held the economic view, you could argue that a global conflict would be very bad for productivity growth due to the ensuing retraction in globalisation and a poor period of investment returns should be taken seriously. Both perspectives have their merits, but their logical outcomes are different, because they ultimately reflect different beliefs about the fundamental nature of equity returns.
Benefits of a clear investment philosophy
Having an investment philosophy is not supposed to answer every question about investing. It should however describe the drivers that matter to your decision making. It’s like having Google Maps when traveling on a long road trip. Just as Google Maps helps you navigate and stay on track, a well-defined investment philosophy provides clear direction for your investment decisions and helps you avoid detours that can lead to poor outcomes. It won’t describe every blade of grass on the drive or guarantee you won’t encounter roadblocks or unexpected events along the way. An investor will face market challenges and uncertainty, but having a guiding investment philosophy helps you stay focused on the decisions that matter.
Advisers often avoid setting out a clear investment philosophy, perhaps for fear it will box them in. But the reality is that all investment choices reflect an overarching philosophy, whether you like it or not. The benefits clearly outweigh the costs.
- It results in better communication with clients. There is virtually no larger area of expectation misalignment with a client than investments. Having a clear philosophy should describe how you allocate your client’s capital and the reasons why. It removes some of the mystery around decisions and makes allowances for the things you can’t control.
- It constructively narrows the investment selection process for advisers. If you believe that following short term trends is a waste of time, then you can avoid investigating whether a currency trading fund is a good idea to include in client portfolios.
- It attracts more of the right kind of clients. Being able to articulate what you believe about markets is likely to attract people who agree with you and deter those who don’t. If you believe ‘buy and hold’ is the best approach to investing, those who want advisers to call up like a broker and trade the portfolio are unlikely to engage.
When thinking about your investment philosophy, start by exploring your own view on the big ideas in investing, such as how should an investor think about risk? Is it volatility, the chance of failing to meet objectives, or something else? How efficient (or not) are markets at pricing securities? Does that change depending on the market in question, and if so, what evidence are you relying upon for that view? What drives investment returns and what is the best way to capture them?
Ultimately, developing an investment philosophy can provide you with a framework for understanding and engaging with the world around you. You’ll be better for it and so will your clients.
Schroders has launched an investment education space on the Ensombl platform to give advisors a safe space to expand their investment knowledge to have more influential conversations with clients. Join the space here
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