Financial plans have been the cornerstone of investment portfolios for many years. Recently, planning has re-emerged as investment firms recognize the importance of understanding the risk/reward characteristics of your portfolio. With financial plans being touted as the key to achieving financial success, it is important to gain a better understanding of the role these plans should play in managing your wealth.

Tim Morton-Smith

Tim Morton-Smith

The essence of a financial plan is to create a road map of your financial landscape designed to guide you from Point A to Point B. Traditional plans take into account capital market returns and current economic conditions. The glaring flaw in this process is timing and the assumptions being utilized. For example, if you went through the financial planning process in the 1990s when the S&P 500 averaged roughly 19 percent, you may have been painted a pretty picture, and envisioning a life of luxury on a 60-foot yacht with both of your kids attending Stanford on your dime.

At that time, the economy was firing on all cylinders and optimism was the prevailing sentiment of most plans. However, just one decade later your plan most likely fell off course as the technology bubble burst, and the markets were rattled by the worst financial meltdown on Wall Street since the Great Depression. Now instead of cruising around on a yacht, the only boat you could afford is a kayak, and your kids are lucky if you could pay for their books at SBCC. To add insult to injury, when you had your financial plan reworked based on much more conservative assumptions you now have to work five more years just to achieve your conservative retirement expectations.

Why did these financial plans fail so many people? The reference made above, comparing a financial plan to road map is just one part of a larger process. The most important part of your financial journey is the vehicle you use to get from Point A to B. In financial terms these are the stock and bond investments in your portfolio. Over the last 10 years, the financial industry has experienced an interesting phenomenon, which has been dubbed “group think.” The financial plans being churned out are relatively the same and, for the most part, the investment recommendations are proprietary products or index type of mutual funds designed to keep pace with or slightly outperform a benchmark such as the S&P 500. As a result, what we have found ourselves with is a 20-lane highway with millions of Ford Tauruses all moving in the same direction. Then in 2008 when the market fell off a cliff, so did many of the financial plans that were created based on unrealistic assumptions. The unfortunate outcome is many investors now have a plan that is incapable of meeting their goals.

So what can we do to make sure we don’t fall into this same trap again and future financial plans are successful? First, when developing your financial plan, work with a professional who has significant experience in creating customized plans that takes your entire financial situation into consideration. Second, your plan should consider different scenarios so you are well prepared for down markets similar to what we have experienced over this last decade. Third, make sure the investment strategies you use to implement your plan match your objectives. The majority of the investments that decimated portfolios in 2008 were either misunderstood, or highly correlated to the market, meaning if the market was down big, so was your portfolio.

At Pacific Pointe Advisors, while we dedicate significant resources to the financial planning process, our core focus is on the investment vehicles we use to implement those plans. You can have the greatest plan in the world, but if you don’t have a portfolio of investment managers who are capable of delivering results then your plan is only as good as the paper on which it is written. We believe one of the key components to having the right “vehicle,” is to identify managers focused on achieving absolute returns, not relative performance. Absolute return managers have one overriding goal, to not lose money — no matter in which direction the market is going.

Another interesting characteristic of absolute return-oriented managers is they tend to have low downside-capture ratios, which we believe is one of the most useful and informative financial ratios when evaluating the strength of a portfolio manager. Downside capture measures how a manager performs when the market is declining. For example, if a manager has a downside capture ratio of 30 percent, it means that manager has only participated in a third of the market decline, therefore resulting in significant out performance.

The benefit of utilizing managers with low downside-capture ratios over the long run is profound. If you invested $100,000 with a manager who captures only 85 percent of the market’s upside and 45 percent of the downside from 1974 to 2011, that would have grown to $1,106,190. However, over the same time period if you invested in the S&P 500, which by definition has 100 percent upside and downside participation, it would have grown to merely $485,000 over the same 35-year period. This difference in performance can make or break any financial plan. It is clear that protecting capital on the downside is critical to achieving your financial goals.

So, when revisiting your financial plan, don’t fall prey to the old saying, “Fool me once, shame on you, fool me twice shame on me.” Make sure your portfolio is being managed by managers who have a proven track record of performing well, not only when the markets are rising but also in declining markets as well.

Click here for more information about Pacific Pointe Advisors, or call 805.845.2400.

— Tim Morton-Smith is a principal at Pacific Pointe Advisors.