- By Mike Fortunato, CIM®, FCSI®

This is the third and final installment dedicated to unrealistic investment expectations. In the last installment, we discussed how misunderstanding financial jargon can be both a cause of an investor’s unrealistic investment expectations, and an obstacle impeding communication between an advisor and their client. Today, I’d like to highlight some common flaws in how many investors use historical information to formulate performance and risk projections, which is another cause of unrealistic investment expectations.

Misinterpreting Historical Data

Most investors look to the past for clues when trying to forecast future performance. Although I agree that historical data can teach us a lot about the future, I want to caution investors about some of the more common mistakes that are made when forecasting. It is important to remember that markets and the economy move in cycles. Generally speaking, all cycles have two things in common: a rising-cycle is followed by a falling-cycle, and, a falling-cycle is followed by a rising cycle. This might seem elementary, however, in my experience, most investors ignore this natural fact, and instead assume that the current trend will last forever. I’ve even had many conversations with investors who claim to be aware of fact that markets move in cycles, but then continue basing their long-term projections as if the market moved in a straight line. Many advisors further complicate this misunderstanding by lazily citing market statistics without highlighting the fact that those statistics are actually averages of cyclical data. 

The key to avoiding this fallacy is to always analyze full cycles when considering past data, and if possible, consider multiple cycles. The past can give us some great clues as to what the future might hold, but we need to make sure we are looking far enough in the past when gathering our data to formulate our projections. A realistic forecast understands that there will be cycles in the future, as there were in the past. And unrealistic forecast presumes that the current phase of the cycle will last forever. Investors need to remind themselves that every bull market eventually leads to a bear market, and vise versa.

Two related miscalculations many investors also make are:

1. Only considering past bull markets when forecasting future return. This will often lead to overly optimistic projections.
2. Only considering past bear markets when forecasting future risk. This will often lead to overly pessimistic projections.

It is important to highlight that I don’t think investors are naive; I would actually argue that they are acting quite logically given how long it can take for a trend to reverse. Market cycles can often take years or decades to reveal their full periodicity. In fact, some slower, cyclical economic phenomenon take so long to unfold that text books on the subject are written, published and taught to finance students only to have the phenomenon reverse or change as those students enter the workforce. Investors are also bombarded daily with news and media that tends to focus on the short-term picture and sensationalize outlier events. In light of all these distractions I can totally understand why many investors formulate unrealistic market expectations. Again, this is where great advisors can really make a difference in helping a client focus on the past data they are ignoring. 

I hope I’ve been able to illuminate what I believe are two major causes of investor’s unrealistic investment expectations: Financial Jargon & Misinterpreting Historical Data. There are many other potential causes of unrealistic expectations beyond these two; I actually plan on devoting future posts to the discipline of Behavioural Finance, which studies cognitive and emotional biases that cultivate irrational behaviour in investors. Advisors need to remember that although investors often have unrealistic investment expectations, there are perfectly logical reasons why those expectation arise. When advisors take the time to educate their clients, they are usually quick to temper and evolve their forecast. Good advisors know that having a solid investment strategy is worthless if their clients are not willing to stick with it for the long haul. Also, clients are not going to stay invested in strategies that are not compatible with their expectations. That is why great advisors understand that the key to long-term success lies in harmonizing their clients’ expectations with their own. As we already mentioned, investors are typically logical, and usually just lack some foundational wealth management principles. By taking the time to educate their clients, advisors can leverage their clients’ logic and encourage a natural alignment in their views towards having more realistic investment expectations.

-  By Mike Fortunato, CIM®, FCSI®

In the last installment, we discussed how many investors have unrealistic investment expectations.
Today we are going to examine what I believe to be the major causes of their outlook.

Financial Jargon

Finance, like any professions, has its own set of jargon that its practitioners employ. The list of
acronyms and other exotic sounding terms is almost endless; however, fancy sounding words &
phrases are rarely the source of confusion for investors. After all, when an advisor uses a word a
client is unfamiliar with, the client can easily ask him/her to explain the meaning of that word. I
believe the majority of confusion comes from the fact that finance jargon also repurposes many
common words & phrases we use in everyday life. This can create a lot of confusion for non-advisors
because words & phrases they use colloquially, might mean something completely different in the
finance world. This is more often than not exacerbated by lazy advisors who neglect to make the
distinction between jargon and colloquial language when conversing with investors. My favourite
example is the word, “risk” or “risky”. We all have a sense of what this means in everyday language,
but in the finance world, there are at least four definitions of risk (and probably a lot more) that impact
investors’ investment plans. They include: probabilistic risk, short-fall risk, absolute risk, and
variability or volatility risk. All of these types of risk are important, but in my experience, investors are
usually referring to the first three types of risk, while advisors are most often referring to the last type
– volatility risk. The end result is that both parties are talking about completely different things while
simultaneously thinking they are on the same page. To an outside observer, the idea of two people
having a full conversation, using different definitions for the same words, may seem funny, but the
situation is much less humorous to the people actually having the discussion, especially for the party
whose retirement account is at risk (pun intended).

“Risk”, isn’t the only regular English word with a unique definition in finance jargon. Here are a few
more words that are commonly used (that mean different things) by both advisors and investors: “risk-
free”, “consensus”, “annual return”, and “price”. Even the concept of “loss” and “gain”, are often
miscommunicated/misunderstood when advisors fail to elaborate on what they actually mean or
truncate the more appropriate phrases of “paper-loss” & “paper-gain”.

Words are just sounds we make with our mouths - what really matters is the definitions we all agree
correspond to those sounds. A sentence can have a radically different meaning if you change the
definition of just one word. Those differences matter a lot when the discussion is about formulating a
strategy. Finance jargon is designed to pack a lot of information into a short word or phrase, so the
onus is on the advisor to ensure their client is comprehending their message.

In light of the fact that some of the most commonly used phrases in finance have both multiple
meanings and different usages (normal and jargon), it isn’t a surprise that many clients have an
unrealistic view of potential risk and reward. My advice to advisors is to always remain cognizant of
the fact that clients are unfamiliar with finance jargon: especially when the particular jargon is a
homograph for more commonly used words. Great advisors should strive to empower their clients
with knowledge, and the tools to think critically in a financial context. It will always be much easier to
have a client temper their own unrealistic expectations than it is to debate them into changing their
mind about concepts they don’t fully understand.

There is so much to say about finance jargon, that I plan to dedicate an entire future post to common
phrases I mentioned above. In the next installment of this article, I plan to illuminate another factor
that has contributed to investors’ unrealistic investment expectations: flaws in how we analyze past
performance & risk. Until then, I’d like to end with a quote. A wise man once said, “Lorem ipsum
dolor sit amet, consectetur adipiscing elit, sed do eiusmod tempor incididunt ut labore et dolore
magna aliqua.”, and I still don’t know what he was talking about!

-  By Mike Fortunato, CIM®, FCSI®

Everyone intuitively understands that investing for the future is a good idea, but when it comes to setting realistic investment expectations, people’s intuitions vary wildly. An investor’s expectations are key axioms which form the foundation for a solid financial plan. When expectations are overly optimistic, the stage is set for a future disappointment, and conversely, when expectations are overly pessimistic a goal may appear out of reach, and not worth pursuing. A good advisor should know what is realistic when it comes to potential future risks & rewards. And a great advisor is able to explain why certain expectations are or are not realistic rather than simply telling the investor to trust them. Only when both the advisor’s and investor’s expectations are aligned are they able to move forward with a strong financial plan. That is why one of the most important jobs an advisor has is setting realistic investment expectations for their client. Although this sounds simple and straight forward, in practice, this is one of the most challenging role an advisor has.

Every week I help investors formulate and execute financial plans to reach their goals, and in my experience, the majority of clients I work with come to me with unrealistic investment expectations. More often than not, clients are not willing to change their expectations without some debate. Here are some examples of unrealistic investment expectations:

• “I want my investments to grow a lot, but I don’t want to risk losing anything.”
• “I want a safe investment, but it has to return over 10%.”
• “I want to see 10% return every year, year after year.”
• “I’m willing to invest for aggressive growth, but if it doesn’t materialize in a short amount of time I will pull the plug.”

It is obvious why investors cling to these expectations, after all, if they actually believe these scenarios are possible, why would they want to settle for less. Here are some examples to illustrate my point - which would you choose:

Scenario 1) Eating magic ice cream, that gives you rock-hard, six-pack abs, or eating broccoli and exercising for two hours each day?
And
Scenario 2) Driving to work each morning in a magic car at 200 Km/h on the 401 Highway, at rush hour, or sitting in traffic on the 401 Highway at rush hour?

If it were possible, I think most people would pick the first choice in both scenarios; the problem is that magic ice cream and magic cars don’t exist in the real world. Most people can easily see how unrealistic these scenarios are, however, most investors I work with have trouble seeing the same flaws in the examples of unrealistic investment expectations I mentioned above. This can be a real challenge for advisors as they are essentially trying to convince their clients to choose between what appears to be a riskier and inferior investment plan, over a safer and superior investment plan. Simply telling the client one choice isn’t real often doesn’t settle the debate, in fact, in my experience it can make things worse. After all, these clients already believe the magic low-risk, high-reward investment exists, so when you tell them it doesn’t exist, they actually question your expertise as an advisor. This is why you can’t simply tell the client they are wrong, instead, great advisors take time to educate their clients about the concepts of risk and reward. Once a client is empowered with this knowledge, they often revise their own expectations to be more realistic.

In the next instalment of this article I will examine what I believe are some of the major causes of unrealistic investment expectations…

As expected, the sudden drop in both the Canadian & American stock market has caused investors to scramble to find answers to the following questions:

1. What is causing the market drop?
2. Is this a correction or the beginning of a prolonged bear market?
3. Is my retirement secure?
4. Should I alter my strategy and sell all my investments?

Fear is clearly on the rise and although these questions are simple and straight forward, there are a few reasons why I don’t think they are the best ones investors should be asking:

• I’m not sure anyone could honestly answer questions 1 & 2. If they could, I doubt they would have time to write market commentary blogs, as they would be too busy making billions of dollars timing the worlds markets.
• Questions 3 & 4 are better than the first two because they are concerned about strategy vs. market prognosticating, but the best time to ask these questions isn’t while the market is dropping. Instead, investors should be thinking about strategy for the long term.
• These questions reveal a lot about the mindset of the person asking them: and that mindset is clearly reactionary and in a state of panic.
• These questions also reveal a deeper truth about how many investors seem to focus on the things they can’t control (markets) rather than focus on the things they can control (investor best practices).

I’d like to help investors cut through all this panic, and show them what I feel is a better way to think about market corrections and investing.

There is an old saying, “corrections are healthy for the market”. This phrase is often touted as a powerful piece of wisdom coded into the fabric of the universe. I think this phrase represents everything that this wrong with how many investors think about markets and investing. Let’s break down this phrase: it claims that corrections are healthy, but what it is really saying is that from time to time the market is wrong about valuation, and a sudden change in prices, brings the market back to a more reasonable “correct” valuation. This is a terrible way to think of health. Here is a simple analogy to illustrate my point: eating junk food until you get so sick you aren’t able to eat anymore, and then calling that healthy. When it comes to food, we all understand that that junk food isn’t healthy, and true healthy behaviour would be to not eat it in the first place. Health isn’t about having visceral reactions to bad habits, but rather, health is more about having good habits that make your stronger over time. There is, however, one piece of wisdom that I feel most investors are missing here: A correction is usually defined as the market moving opposite to its prevailing trend by more than 10%. And statistically, these corrections happen about once per year. So, it is fair to say that when it comes to valuation, most of the time, the market is wrong.

Before we talk about strategy, let’s bring some perspective to the last few days of market action. Everyone saw the headlines that Friday February 2 had the 6th largest point drop in the Dow Jones Industrial Average in history. What this headline failed to mention is that this day didn’t even make the top 500th for single day declines when measured in percentage terms. As we know, the news tends to sensationalize everything, and this is exacerbated by the fact that for the last 5-6 years investors have become accustomed to low-volatility.

Let’s summarize some of the key points we’ve discussed so far:

• The statistical frequency of market corrections means that there is always the potential that the market is mispriced at any point in time.
• Some investors are focusing more on markets and less on long-term strategy.
• The last week’s market action is far from sensational, historically speaking.

With all this in mind, I’d like to give investors some other questions that I think are better to focus on.

1. Is my strategy appropriate for my time horizon?
   This question goes right to the heart of what is panicking many investors: reconciling the unknown future value of the market, with the known future liability of retirement (or some other investment objective). When it comes to markets, it is impossible to predict what will happen in the short-term future, but it is easy to analyze what has already happened in the past. And although, many investors look to the past for guidance, they are often looking in the wrong places by focusing on potential future return, when they should be focusing on potential future risk. Investors should try to understand the many different types of risks and how they impact different assets over different time horizons. Nothing can guarantee success, but this the best way to ensure you are using the best strategy to complement your time horizon.
   
   
2. What things can be done to enhance my chances of success?
   This comes back to the idea of focusing on what is controllable vs. what isn’t controllable. If an investor’s strategy is already well matched to their time horizon, then their own behaviours might have a greater impact on their success than the markets. Investors can enhance their chances of success by focusing on things they have control over:

• Contributing more to their strategy than they initially planned.
• Having a large enough emergency fund that is separate from their investment funds.
• Using insurance to protect against certain types of risks.

Investors should be asking more questions like these two above, rather than the four at the beginning of this article. Our goal shouldn’t be to predicting where the market will be tomorrow; our goal should be to meet our investment objectives. We have very little control over the direction of the market, but we have total control of our strategy and the ‘healthy’ habits that will help us get there.