The business of financial planning is about people. It isn’t percentages or performance, it’s simply “people”. And at the core of our existence – what we humans really care all about – is relationships. Beyond relationships we care about security. And in financial planning you have to manage, discuss and deliver both. That is an enormous responsibility that, in an age of slumping economic growth and events like Brexit, is seemingly impossible to do consistently.
Happily, there is completely different approach to investing that delivers not only sound long-term returns, but delivers your clients’ restful nights, while positioning you as a trusted and steady hand, a responsible steward of your clients’ lifetime of work.
So if you have built your advisory practice on percentages and ignored the personal, or if you have built your business by promising performance, you are on shaky ground.
Not long ago the UK voted to leave the European Union. Shortly after the move, some Britons riding the tube (London Underground) were heard telling Eastern Europeans, “Time to pack your bags”. Then, the Dow Jones fell more than 5 per cent, Spain fell 12 per cent and some individual company shares fell by more than 25 per cent.
And yet today, it all seems like a bit of storm in a tea cup.
World already ‘awash with debt’
Around the world today government bonds are paying paltry returns to their investors. In some countries, such as Germany and Switzerland, rates are negative. In Germany, the 30-year rate is just 0.4 per cent, which means that over 30 years an investor will receive a total of 12.7 per cent.
The world over, pension and super funds are investing in these bonds and locking their investors into very low returns for extremely long periods. With the passing of time, investors will look back with astonishment.
Investors need to accept the argument that returns will be lower for longer. From property, to shares, to private equity transactions – such as the purchase of the UFC (Ultimate Fighting Championship), which earned US$600 million in revenue last year and was reportedly sold for US$4B – asset prices are elevated.
Yet, in Australia, aggregate earnings per share growth have been negligible since 2010 and despite this, or perhaps because of it, company payout ratios have increased from 55 per cent to 80 per cent over the same period. What that means is less of each year’s profit is being retained to grow the business and it future earnings.
Of course a company can also borrow money to grow but the world is awash with debt, much of which has been borrowed to fund “financial engineering”, buybacks and mergers and acquisitions, rather than productive capacity increases.
High asset prices and low growth has everyone jumping at shadows and events like Brexit add fuel to the fire, causing investors to stampede towards security, driving bond prices even higher and yields lower. In their hunt for security and yield, investors are laying the groundwork for the next collapse in the value of their retirement savings.
In past 66 years a “crash” every 1.15 years
Jumping at shadows is the stockmarket’s specialty and for an industry that is paid a percentage of activity, it relishes such events. But ancient philosophers had it right when they said: “This too shall pass.”
And pass it does.
Did you know that in the 66 years since 1950, there have been 57 market moves downward of 20 per cent or more in either of the US S&P 500, the UK’s FTSE, Germany’s DAX, and Japan’s Nikkei?
In other words, on average, there has been a “crash” in a major market every 1.15 years.
It is the tendency for investors to panic. For more than 20 years, Dalbar has been comparing the returns of investors to the investment returns of the funds and markets they invest in. Without exception investors produce returns worse than those of the products they invest in. Why? Because they panic and sell at the lows, or panic that they are going to miss out and buy at the highs.
In fact the most recent Dalbar Report revealed that over rolling 20 year periods, in almost any asset class, the average investor earns less than 60 per cent of what the product has produced.
The lessons of Charlie and Warren
And this is where the aphorisms and allegories of the famed investment duo, Warren Buffett and Charlie Munger might help.
When asked about whether he was worried about a big drop in the market, Warren Buffet’s colleague Charlie Munger replied:
“In fact you can argue that if you’re not willing to react with equanimity to a market price decline of 50 per cent, two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get. Compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.”
Munger’s comments beg the question, why would an investor be willing to invest in any market that could halve? The answer is that the stockmarket is the greatest concentration of financially irrational people in any one place. And those irrational and emotional people concentrate not on values and worth, but on prices.
While prices move around greatly and frequently, the underlying values and worth of a business change much more slowly. Over the long-run, prices will always follow the underlying values.
Think about a farmer in rural Australia, who has inherited a farm from a generous ancestor, and on which no debt is owed. The farmer is under no pressure to sell the farm. Clearly there will be a few very bad years, but there will also be a few very good years to even things out, and overall returns will be ok.
The unhinged neighbor
Buffett suggests you think of events like Brexit, and news of inflation, deflation, unemployment and GDP growth or collapses, as the emotionally immature farm neighbour who:
“[yells] out a price every day to me at which he would either buy my farm or sell me his — and those prices varied widely over short periods of time depending on his mental state … If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.”
It is true that prices may indeed fall but should we care? Is the value of a portfolio of pieces of extraordinary businesses determined by daily gyrating prices? We know that a company increases in worth by adding retained earnings to its equity capital and maintaining its return on the now larger equity. A bank account with $100 million deposited, earning 20 per cent per year would achieve a much higher price at auction than a $10 million bank account earning the same 20 per cent. As the bank balance grows from $10 million to $100 million, so does its value to other investors.
Don’t worry, buy value
If I can find a business that is able to grow its equity tenfold, while maintaining its return on the growing equity, I know that I will be able to sell it for far more in the future than I paid for it today. I don’t need to worry about China, the US Federal Reserve or Brexit.
Stockmarket investors forget the valuation mechanics of compounding returns and allow the price-impacting emotional behaviour of their fellow investors to infect their decision-making, causing them to respond emotionally too. If you didn’t rush to sell your home, your hobby farm, your holiday house or your caravan during the tech wreck or the GFC (global financial crisis), then there is no reason you should behave differently when it comes to your share portfolio. The only difference is that one is priced daily and the other assets are not.
Despite their apparent significance, events like Brexit represent little more than the noisy neighbour panicking that his farm might fall further in price. The constant stream of discussion, prediction and introspection about interest rates, unemployment, inflation and the economy is nothing more than a distraction from the main game of investing.
Share this allegory with your investors, practice its learnings yourself and you’ll be free to focus on the relationship and building a more enduring business.
