How the principles of active management, behavioral finance, and planning—combined with sound money management—can work together to help clients achieve their long-term financial goals.

The National Association of Active Investment Managers (NAAIM) is an enthusiastic proponent of active management strategies for advisors and their clients, providing educational and networking resources. Through the use of active management strategies, money managers can employ investment approaches that moderate the volatility of the market, helping investors stay the course and benefit from the long-term gains of the market. This approach seeks to produce more favorable risk-adjusted returns as an alternative to passive, buy-and-hold strategies. The following article touches upon some fundamental themes important to advisors as they consider active management strategies on behalf of their clients.

Active or passive: Is that the question?

Much of the active versus passive argument has centered on “beating the market,” with active investment strategists making the case that staying out of the market during downturns—and jumping in at the bottom to ride the upturns—enables them to beat the market, while the buy-and-hold, passive-investment pundits insist that “if you missed the 10 best days in the last 10 years” you would have small or even negative returns—basically arguing that timing the market is impossible.

This whole line of reasoning misses the point. It’s not about beating the market. Simple arithmetic tells us that most investors will not consistently beat the market. It’s fundamentally about enabling your client to meet their financial objectives, which involves allowing them to stay comfortably invested in all market environments. We contend that active management is an important tool in meeting that goal and provides additional diversification—enabling you the opportunity to improve performance and smooth market volatility.

The real question

So what is active management? Fundamentally, it is simply making adjustments to a portfolio to take advantage of mispriced securities. On the other hand, passive investing makes the assumption that the market is efficient and securities are always fairly priced.

The real question involves understanding the individual and his or her specific needs, which is where a skilled advisor provides value. It only makes sense to use all the tools at your disposal, including active management.

The answer: Three fundamentals

If only the answer could be as simple as “if a client needs a 5% return each year over a 10-year period, then pick fund X,” but obviously it’s not. The challenge we face as advisors is educating the client and ourselves, as well as setting appropriate goals and managing expectations—which require a fundamental understanding not only of the markets but also human behavior.

1. Beating the market: Not the goal

It’s about keeping clients on track so they can stay the course and reach their financial goals. Clearly, helping clients set realistic goals reduces uncertainty and improves their chance of success.

Each investor is unique, and each will almost certainly have unique life circumstances. Keeping them on track to reach long-term financial objectives requires you to be part savvy investment advisor and part psychologist.

2. Behavioral finance: Its role

Most clients need to have a certain amount of money at a certain time, and they can afford to contribute a certain amount toward that goal. Clearly, managing clients to reach their goals requires understanding the individual and how they will react to volatility, uncertainty, or the latest news story.

Within the behavioral finance discipline, investor biases have been defined, along with possible solutions to solve for them, to help you keep your client from making costly mistakes. This field is becoming a regular part of the curriculum for investment advisors and is critical to understanding clients’ needs. Simply put, two basic behaviors that put clients at risk of not meeting their financial objectives are fear and greed.

In managing these behavioral biases, as well as your clients’ aversion to losses, selective memory, or regret, management professionals have two core tools—moderating the client or adjusting the portfolio. In many cases, a combination of the two approaches may be the most appropriate strategy. In many cases, even with good education to help clients curb faulty reasoning, you cannot undo emotional biases. Active management techniques are a key weapon in creating portfolios that can help clients stay invested and reach their objectives despite their inherent biases.

3. Money management: More than diversification of asset classes

Money management, when implemented with discipline, is an excellent tool to get an investor to their investment objectives. As evidenced by the last 13 years of market behavior, using traditional asset classes—stocks, bonds, and cash—just is not enough. So we add commodities, real estate, and other alternative investments. The point is that there are choices—lots of choices. To narrow those choices, clients hire advisors and professional managers to sift through them and choose the best combination at any point in time.

Now more than ever, the dynamic global economy demands that we must not only decide what to buy but when to buy it, as well as what to sell and when to sell it. That’s active management. One core attribute these managers have in common is using processes or rules to remove emotion when making buy and sell decisions. Not every decision will be correct, but management systems that employ a disciplined decision process give advisors critical tools to manage clients—to reduce reactive behaviors and help clients reach their financial goals.

The combination of diversification across asset classes using a mix of investment strategies and diversifying across holding time frames smooths volatility and provides a more robust investment portfolio.

Conclusion: Keep learning

For the advisor to create that lifelong relationship, it is imperative to continue to learn, know the client, understand their behavioral biases, and, based on that knowledge, know what portfolio adjustments to make. A process-driven discipline supports diversification, using a variety of asset classes and holding time frames.

NAAIM is an excellent resource to meet and network with professionals that use active management to generate a well-rounded suite of investment offerings and active strategies that support uniquely diversified portfolio management systems.

This article provides a condensed version of a white paper published by NAAIM with permission. Read the full white paper here.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.