Luck of the Index? How to Talk to Clients About Diversification
Assuming too much portfolio risk through overweighting indexed mutual funds and ETFs is a lot like relying on luck to reach long-term financial goals.
Recommending more actively managed mutual funds and ETFs might make perfect sense to you, a professional financial advisor, but it’s likely going to come with pushback from some of your clients:
- Why am I pay for these higher fees when the market is only going up?
- Active management doesn’t consistently beat the market.
- The S&P 500 always wins in the long run.
But the reality is most investors consistently underperform the market.
Why do investors underperform the market? Because they are human, and humans have a natural tendency to let emotions influence the decision-making process. This fatal flaw leads to the buy high, sell low pattern that destroys long-term return on investment.
How can you help investors avoid getting in their own way? Through diversification.
How to talk to clients about diversification
Proper diversification doesn’t just provide the potential to protect client portfolios from large losses in a drawdown. It can also help provide a smoother ride in the market. Why is that significant? Because it reduces the emotional influences – like anxiety, fear, and doubt – that lead to subjective decision making. It helps investors stay invested when the market experiences a downturn.
Here are a few easy ways to help clients understand the need for diversification:
Help them understand the dangers of emotions in the investment process
Refer to Dalbar’s research on investor underperformance (above). Use these sobering facts to discuss the importance of remaining objective and disciplined in the investment process. Talk about the cyclical nature of our market, and the emotions that often accompany volatility. In comparison to substantial long-term underperformance, the costs associated with diversification become more reasonable.
Help them understand their need for diversification
The key to making diversification relevant to each client is by framing it in a way that makes sense to them. You can do so by asking three simple questions that you already know the answer to.
- Global markets, though volatile, have historically been great engines for long-term wealth creation. Should a portion of your portfolio be exposed to the returns and volatility associated with these markets?
- Would you expect a portion of your portfolio to be actively managed during periods of market volatility?
- Should a portion of your portfolio be excluded from market movement during periods of market decline?
The answer to all three of these will almost always be yes. This helps make the connection between strategies that are designed to provide diversification in a portfolio and their real-world applicability to the client’s portfolio.
Tie diversification to available investment strategies
After answering the above questions, clients should realize their need for allocations to three distinct strategy types – strategic beta, tactical beta (actively managed), and liquid alternative (or diversifier) strategies.
Strategic beta strategies seek to position part of the client’s portfolio to capture growth. However, these strategies are also vulnerable decline in a market downturn (Question 1).
Tactical beta strategies seek to capitalize on short-term growth opportunities while avoiding short-term decline (Question 2).
Diversifier strategies are designed to disengage from market movement and provide new sources of return and risk. They tend to exhibit low correlation to the other strategies (Question 3).
Some say they would rather be lucky than good. We disagree. A good investment process that is objective, repeatable, and easy to understand is a more reliable way to help clients reach their financial goals.
FTJ FundChoice helps advisors easily discuss diversification with clients and build portfolios that are designed to align with expectations, regardless of market scenario, through a unique, three-mandate diversification process.
Click here to learn more about the three-mandate diversification process, today.