Marc Cuniberti: How is your advisor doing and how are they doing it?
Take the case of two advisors, A and B. Both advisors start out with a $100K portfolio. At the end of 12 months, advisor A has grown the portfolio to $106K while advisor B ends with a $103K balance.
Which is the better advisor?
Asked at multiple seminars I have given, the answer is usually the same. Advisor A is superior.
But much like a young man taking your daughter out to the prom who arrives at the dance safely and on time, while another teen suitor arrives late, the end result does not necessarily mean the correct answer was the obvious one. In fact, it could be just the opposite.
In the case of the first young suitor who arrived on time, perhaps he drove a little too fast, ran some red lights and failed to come to a complete stop while transporting your precious little jewel — while suitor two took his time driving more carefully.
The same could be said of the two advisors.
Much like the teen driver, in the two advisor comparison, the important question is how did they get there?
It’s true the end result from advisor A bested advisor B by a 100% margin (3K return versus 6K), but just how he did it is the real concern.
The word “risk” would be a key factor in this equation as well as the symptom of that risk which I call drawdown and take up.
I’ve talked to many investors and money professionals alike, and more often than not, the end result is the main consideration surrounding how one advisor did compared to another.
The underlying problem in this thinking will only be known when it’s usually too late.
The level of risk each advisor subjects his client to should be one of the main considerations when evaluating performance. When evaluating security risk, analysts look at a figure called “beta.”
Beta is the degree of comparative movement a security historically exhibits compared to the overall market.
A beta of 1.0 means the security has an historical tendency (but not a guaranteed predictor of) to move in lockstep with the overall market.
For instance, if stock A has a beta of 1.0, if the market drops by a certain percentage, stock A will be forecasted to drop a similar amount. Note I said “forecasted” and “similar.” Beta is a historical value, based on the past, and therefore is no guarantee of anything. It just represents what it has done.
If stock B on the other hand has a beta of 2.0, it has moved twice the degree of the overall market in the past. Conversely a number below 1.0 (such as .5) means the security may move half the amount of the overall market. A lower beta is assumed to less volatile and therefore more “conservative.”
One can surmise the beta of a portfolio overall by adding the beta values of each security and its percentage of the portfolio make-up then divide by the number of securities in total. This would give you the beta of the portfolio.
Continuing on, in our example of advisor A and B, “drawdown” means how much under 100K did the portfolio move at its lowest level, and “take-up” (my term) means what is the highest level it reached. The ending value (103K and 106K) in our example is the “end result” that is being evaluated.
If advisor A had a higher beta in the portfolio than advisor B, one would expect the drawdown of advisor A portfolio would be a greater number. An example might be the advisor A portfolio may have seen the 100K drop to 93k sometimes during the course of the investment time period while the advisor B portfolio may have only dropped to 97K. Fictional values here of course but it illustrates the point: the end result means little if you don’t know how it got there. In simple terms, what risk was the client exposed to using either advisor A or B, was it what the client expected, and was it the appropriate level of risk the client should be exposed to given his particular situation?
In an up market, advisor A would likely yield better results, but much like our teen driver rushing to the prom, all is well until it isn’t. In a down market, the advisor A portfolio would probably mean bigger losses.
If a crash in the market were to occur, advisor B would likely be the driver of choice.
And much like a vehicle crash, you wouldn’t know just how bad the outcome might be until after the fact. And at that point you may had wished you had picked the slower driver.
This article expresses the opinions of Marc Cuniberti and should not be construed or acted upon as individual investment advice. No one can predict market movements. Investing involves risk. You can lose money. The example is a fictional illustration only. Cuniberti is an Investment Advisor Representative through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Marc can be contacted at SMC Wealth Management, 164 Maple St #1, Auburn, CA 95603 (530) 559-1214. SMC and Cambridge are not affiliated. His website is http://www.moneymanagementradio.com. California Insurance License # OL34249
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