Question Everything

Master the art of critical thinking to help your clients.  

By Frank Smith

The persistent quest by investment professionals for accurate and well-considered information is necessary to elevate the quality of advice we provide our clients. To reach that goal, it is imperative that we maintain a skeptical but open mind as we critically analyze recommendations and ideas offered to us.  Call it due diligence, call it research, but whatever you call it … ask questions!

Let’s learn from an investor in the now shuttered blood testing company Theranos Inc., who was quoted as saying “ … I only have myself to blame for not asking a lot more questions.”

This article looks at several common situations you may face when reviewing investment advice and how to apply critical thinking to separate facts and useful insights from opinions and fiction.

Source of the message

Understand who it is that is providing the information. Advice from inexperienced, untrained sources can be useless. Therefore, I want to know if they have excellent experience and training in the topic they are discussing, how long they’ve been in business, and determine their reputation in the industry. And don’t be afraid to ask for references. It’s also important to recognize that expertise in one discipline does not necessarily transfer to another one.  For example, someone who specializes in fixed income markets does not necessarily have expertise in equity markets.

Facts vs. opinions

In critically analyzing conclusions being presented to me, I’ve found that many are based on poor analysis. Consider the following hypothetical pattern regularly seen in the investment arena. Mr. Market Strategist notes that the stock market rose significantly four of the five times after the Federal Reserve raised its target rates.  Therefore, he concludes that stocks will move up in the future because the Fed just raised rates again.  This type of analysis is problematic.

First, a sample size of five events, or even 20, is statistically insignificant and would result in a low degree of confidence in any forecast on which it is based. Second, that type of historical analysis assumes current macro and micro conditions are similar to those in the historical periods being studies, which in reality never exists.  Finally, some analysts attempt to link unrelated events — such as presidential cycles, Super Bowl winners, or even dress hemlines and Santa Claus rallies — to financial market price movement.

As a critical thinker, question whether there is a real connection between events that are cited and the movement of markets or are they simply coincidental. Recommendations that are not supported by concrete evidence and sound analysis should probably be ignored.

Purpose of message

What is the motive or goal of the entity presenting the message? They may be attempting to sell you a service or product and are therefore selectively presenting partial information that supports their goal. For example, an insurance broker might list the benefits of using his annuity contract in order to gain a commission or a mutual fund salesman could highlight the most recent performance of funds he represents to meet a sales quota. As the above examples illustrate, money is a great motivator so don’t hesitate to ask how the provider of the information is paid.

I’m always intrigued by financial shows on television that offer views on a myriad of topics including the direction of the economy, financial markets and individual securities.  It may be entertaining to watch the speakers press buttons and bang on horns, argue with other guests, and provide obscure charts, but I remind myself that the shows want to attract and entertain viewers so they can generate profits by selling advertising. The networks are in the entertainment field, not in the investment business, and the opinions they offer should be ignored.

Track record

Track records matter!  We’ve all seen sales material from market strategists and analysts who boast how they predicted events such as the 2008 financial crisis, the Dot-Com bubble, the last economic turn or market tops and bottoms.  Look past those occasional accurate forecasts and critically assess the aggregate success rate of those strategists over a long time horizon before you act on the advice.

It is not unusual for investment advisory services to make several market and stock forecasts each day. Because of their sheer volume, some of those predictions are bound to be right. Other services may maintain the same positive or negative outlook over many years regardless of changes in relevant factors. They are also likely to be right occasionally, just as a stopped clock is correct twice a day.

I saw a headline recently that boasted an 87% success rate.  That sound impressive, so let’s apply the figures in an example.  Assume this analyst recommended equal investments of $1,000 in 100 securities and that 87 of them went up by 1% while the other went down by 100%, to zero. The net result would have been a portfolio that declined by 12.13%. [(-$13,000 + $870)/$100,000 = 12.13%]. The seemingly impressive headline is meaningless without knowing more complete information including the number of investments, size of each position, return of each one, holding period, and amount of risk involved.

If an impressive call on the economy, market or security peaks your interest, request the full track record of the provider. If they will not or cannot provide you with their record, consider that to be a major warning sign. However, if you are still interested in the service, seek confirmation of their track record from an independent third party.

Obtaining track records of in-house strategists and analysts can be difficult. In those cases, prepare your own critical analysis by running a paper portfolio based on the recommendations of the analysts in which you have an interest over several months, years, or various market conditions.

Quantify risk

We regularly see investment fund marketing material in which return statistics are listed in bold headlines to catch your attention. But, how much risk is involved in achieving those returns and is the level of risk consistent with that of your clients? Sadly, risk measures are usually relegated to the small print or may not be presented at all. A critical thinker will quantify the risk of every investment being considered for clients — it is half of the risk vs. return analysis we should regularly perform.

For example, suppose you are a financial advisor who plans to outsource the management of your client’s assets and are considering two portfolio managers (PMs).  As a test, you give each $1,000 and tell them to manage it for one year. After a year, the first PM reports that his $1,000 rose by 10%, to $1,100, and the second PM announces that his $1,000 doubled to $2,000. Based on returns alone, the decision to hire the second PM might seem clear.

However, you then ask each PM to describe how he managed the money. The first PM explains that he invested in a diversified group of equities, while the second PM explains that he went to Las Vegas, bet all of the money on red, and the wheel came up red.  After learning how much risk was involved in achieving those returns, you would likely switch your choice to the first PM.

Additional Reading: Constructing Investment Portfolios for Retirees 

For equity investments, risk and volatility may be measured by statistics that include beta, standard deviation, movement in up or down markets, and worst quarter returns. I suggest focusing on the Sharpe ratio because it calculates a risk-adjusted return factor by combines the historic risk of a security and its historic return. In the fixed income market, consider using one of several independent agencies, such as Moody’s and S&P, who provide quality ratings of bond issuers and use the duration of individual bonds and funds to assess their relative volatility.

Gut check

Finally, compare the recommendations being offered to what makes sense to you.  Before accepting advice, ask what information and analytical methodology were used in the analysis. Is the information accurate and can it be verified? Is the analysis logical and consistent with your experiences? If you uncover inconsistencies or something that doesn’t make sense to you, and especially if an offer seems too good to be true, trust your gut and reject the advice.

A word of caution

By asking critical questions, you are applying a healthy level of skepticism to uncover accurate information that will enhance the financial guidance you provide to your clients.  However, not everyone will understand your objective. For example, some managers might say they want employees to be independent thinkers but will actually practice confirmation bias and may marginalize or punish anyone who offers an opinion different than their own. For them, it’s “my way or the highway.”

On the other hand, there are leaders like Ray Dalio, founder of the successful investment firm Bridgewater Associates. He advises, “The greatest tragedy of mankind comes from the inability of people to have thoughtful disagreement to find out what’s true.” Reflecting that belief, the guiding principles of Bridgewater include, “Knowing what is true is essential for making good decisions.” I suspect critical thinkers thrive in that work environment.

Before engaging in critical analysis with others, consider whether your probing questions will be welcomed or frowned upon in your organization. It could mean the difference between a raise and a pink slip!

Frank Smith, CFA, RICP, MBA, is fiercely proud of the personal and award-winning investment advisory services he provides to clients who are retired, near retirement or building their wealth. He draws on 40 years of quality experience and continuous training as an analyst and portfolio manager. Among his many accolades, Frank was named “Best Investment Advisory Service Provider – Northeast USA.”” Five Star Wealth Manager.” and “Best Investment Firm in Bucks County.”


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