One of the challenges in long- term business planning is anticipating changes in the environment in which you’ll be operating. It’s hard enough to plan 12 months out, much less five or 10 years. Although there’s no way to predict changes with certainty, there is a simple rule of thumb that is helpful. Known as Stein’s Law, this method comes from the late Herbert Stein, who was chairman of the U.S. Council of Economic Advisors under presidents Nixon and Ford. That rule of thumb, which applies to politics, economics and business, is: if something can’t continue, it will stop.
If you step back and look at the status quo in the financial advisory business and ask yourself what things simply don’t make sense and are unsustainable, you will come up with a surprisingly long list.
Stein made a deceptively simple case: the moment you identify the status quo as unsustainable, whether it is interest rates, house prices or deficit spending, you should assume that it will change. It’s not a question of if but of when.
History teaches us that it’s impossible to predict the timing of that change, in large part because the status quo can persist for longer than the skeptics believe possible. (Just remember how long tech stocks continued their rise in the late 1990s, and the way that housing prices defied the skeptics in the mid-2000s.) Once change starts to kick in, however, it can assume a life of its own and move much faster than so-called “experts” believe possible.
Recognizing that things are always clearer after the fact, it’s easy to find recent examples of Stein’s Law at work.
Some observers in the West argued that the Iron Curtain’s inefficiency made its status quo in the 1980s unsustainable. But even for the doubters, no one foresaw the collapse of the entire Eastern European bloc over only two months in 1989.
The Arab Spring revolts of 2011 saw power shifts in Egypt and other Arab countries. These revolts arrived seemingly overnight with virtually no warning.
There’s a long list of once dominant market leaders that have fallen on hard times: the Big Three auto companies and names such as U.S. Steel, Kodak, Polaroid, Sears, Montgomery Ward and Xerox come to mind.
In all of these cases, growing customer dissatisfaction, new competitors and a sclerotic resistance to change made those companies vulnerable. Inertia and historical dominance masked that vulnerability until – all of a sudden – it didn’t. And once the market share of these companies started to slide, the decline accelerated rapidly.
So, if you’re making plans for your business, the critical question becomes: what are the things today that are unsustainable and that have to change as a result?
Just to be clear, we’re not necessarily talking about change in the next year or two; rather, about things that a rational observer would say make little sense and are unsustainable in the mid- to long term.
When I look at inevitable changes in the retail investing arena, I’m not referring to short-term bubbles in social media valuations or Bitcoin. Rather, I’m talking about fundamental, structural shifts in things that make little or no sense today. Here are my nominations for four aspects of investment advice today that are unsustainable and to which Stein’s Law applies as a result:
– Shift 1: Closing the gulf between “smart” and “dumb” money
The portfolios of most institutions and family offices bear little resemblance to the way most retail investors operate, with many sophisticated investors referring to retail investors as “dumb money.” Recognizing that there are big differences in liquidity considerations, time frame and risk tolerance, a yawning gap between more informed and less informed clients isn’t sustainable in any business.
Some of the shifts that will inevitably make future retail portfolios look more like those of institutions include:
We will see a broader range of asset classes in diversified portfolios, with greater focus on alternative investments within long-term holdings. (In a recent Barrons interview, the CEO of Harvard University’s endowment talked about the rationale for just 11% in U.S. stocks compared with a 55% allocation to alternatives, including private equity, hedge funds, venture capital, real estate and direct ownership of natural resources.)
There will be more use of low-cost indexing in efficient sectors such as U.S. large-caps, adopting the “core and explore” approach of many sophisticated investors.
Tools such as “active share” (a measure of the difference between an investment fund’s portfolio weighting and that of the index) will be used to ensure that investors are indeed receiving the active portfolio management they are paying for. Some firms already offer retail solutions to help close this gap; but in the period ahead, these solutions will increasingly enter the mainstream.
– Shift 2: More annuities in retirement portfolios
Academics have written extensively about the annuity puzzle – why immediate annuities are so dramatically underrepresented in retirement portfolios, even in the face of clear-cut evidence of their ability to enhance risk-adjusted returns.
This situation will change, in part because the financial media will respond to advice from respected voices such as Harold Evensky, arguably America’s best known and most credible financial advisor and author. In recent interviews, Evensky has said that single-premium, immediate annuities and longevity insurance will be among the most important investment vehicles over the next decade.
As a result, we will almost certainly see a substantial increase in both the awareness of annuities and their use by retail investors within five to 10 years.
– Shift 3: Less home-market bias
Academic researchers scratch their heads over the home-market bias that is common to investors around the world. One of the first research studies on this, in 1991, indicated that Japanese investors had 98% of their equities portfolios invested domestically, while the proportion for American investors was 94%.
This bias exists in the face of clear evidence of the positive impact of international diversification in increasing returns and reducing risk over time, and has resulted in a corresponding shift by institutional investors overseas. In an article published in 2000, Ken Rogoff of Harvard University and Maurice Obsfeldt of University of California – Berkeley identified home-market bias as one of the six major puzzles in international macroeconomics. Recent research from Investor Economics Inc. in Toronto indicates that this bias is still significant in Canada, where long-term mutual funds have an average home bias of 68% (as of February 2014).
– shift 4: incorporating principles of behavioural finance
A fourth inevitable shift will entail the broader use behavioral finance to help investors make better decisions. Two Nobel prizes in economics have been awarded for work in this area (Princeton University psychologist Daniel Kahneman in 2002 and, last year, Yale economist Robert Shiller) and rising profiles for other well-known names such as Richard Thaler and Dan Ariely.
As one example, Cass Sunstein’s recent book, Why Nudge?, explains how “nudges” lead to better decisions. In particular, default options, in which the “correct” decision is made automatically unless the consumer chooses to make a change, have been shown to have a dramatic increase in rational outcomes.
Today, few advisors fully incorporate the principles of behavioral finance into their advice to clients. But in light of the growing body of research in this area, it will become commonplace.
Dan Richards is CEO of Clientinsights (www.clientinsights.ca) in Toronto. For more of Dan’s columns and informative videos, visit www.investmentexecutive.com.
Next month: How Stein’s Law applies to the way advisors run their businesses, including ways of adding value, charging for services and interacting with clients.
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