CPD: Financial adviser investment philosophies – the why, what and how

02 Aug 2023

From AdviserVoice - this Best Practice CPD series is proudly brought to you by Bennelong Funds Management

Financial advisers are increasingly realising the need for their own investment philosophy to manage and guide client expectations.

Experts should have opinions

As investment markets continue their rollercoaster ride, and with many developed countries on the cusp of recession, discussions around investment philosophies have ramped up in many circles. This is understandable because, while the current economic climate may not be entirely without precedent, making sense of the way forward has certainly become more complex, and the relative merits of many common philosophies – such as active, passive, value, growth, and contrarian – are now being hotly debated.

Importantly, these discussions and debates are no longer the exclusive domain of fund managers.

Increasingly, financial advisers are recognising that they too should have an investment philosophy, not just because their clients are paying them to have an opinion on such matters, but because a well thought out adviser investment philosophy can drive business efficiencies, deeper client relationships, more effective marketing and referral activities, and more rational investment decision making. Ultimately, a robust, well-articulated investment philosophy can drive better client outcomes.

This article will act as a practical guide for advisers seeking to develop their own investment philosophy, examining:

the essential components of an investment philosophy
the benefits
steps to create a robust investment philosophy, and
client communication considerations.

What is an investment philosophy?

According to Investopedia, an investment philosophy is:

“A set of beliefs and principles that guide an investor’s decision-making process. It is not a narrow set of rules or laws, but more a set of guidelines and strategies that take into account one’s goals, risk tolerance, time horizon, and expectations”.^[1]

An investment philosophy can be based on many different approaches, including:

the type of stocks you may invest in (e.g., value v growth)
actively or passively managed investments
the outcomes sought (growth, income, tax efficiency)
the approach to analysis (technical v fundamental)
the importance of factors
the importance of sustainable/responsible investing
portfolio construction approaches, and
your approach to advice (is it, for example, goals based?).

A fund manager’s investment philosophy is the set of guardrails within which investment decisions are made, now, and into the future.

Ultimately, the investment philosophy is how every fund manager ‘nails their colours to the mast’, signalling to the potential investors what they believe in and what to expect.

As an adviser, you wouldn’t dream of investing with a manager who didn’t have a clear investment philosophy, it would be too much of a risk, a leap into the unknown. A manager’s philosophy gives you clues about how likely they are to deliver on their goals, and how they may react during turbulent market times. It’s the difference between chaos and calm.

So why would a client be any different? Why would they choose an adviser without an investment philosophy?

In the words of Australian financial adviser, Justin Brand:

“An adviser without an investment philosophy is like a boat without a rudder. If your adviser doesn’t have a convincing, evidence-based set of beliefs about the markets and how to invest in them, then you risk drifting from one idea to another.”^[2]

An investment philosophy can deliver many benefits to advisers and clients

There are many important ways an investment philosophy can enhance your offering:

Provide confidence and clarity to your clients
Regardless of the type of clients you deal with, recommendations around the investment of assets is likely to be a central part of your advice. A documented investment philosophy, that you can keep referring to, is a distillation of your experience and specialist knowledge, and helps reinforce client trust in your expertise.
Helps ensure consistent, emotion free decision making in volatile times
Investing is complex and risky by virtue of the uncertainty. Volatile markets can be stressful for clients – whose real tolerance of risk is often lower than they have stated – and this stress can in turn be directed towards the adviser. Referring back to your investment philosophy can remind you and your client why you have pursued a particular strategy, and how that strategy is likely be impacted by different economic conditions, helping you ease the pressure and encouraging them to stay the course rather than make knee jerk, emotional decisions.
Referral partners
Having a clear investment philosophy can give your referral partners more confidence in your expertise, and can improve the success rate of referrals by providing more clarity about the type of clients they should – and shouldn’t – refer to you.
Marketing
As with referral partners, your investment philosophy can be an effective marketing tool, both in helping position and differentiate you with potential clients and referrers, and in more efficiently aligning you and your practice with the right type of clients. It goes without saying that your investment philosophy should be easily found on your website.
Selecting investment partners
Regardless of the extent to which your investment management is insourced or outsourced, and regardless of how much you play a part in selecting your APL, you are still likely to have considerable discretion in which investment solutions and managers you recommend to your clients. Having absolute clarity about your investment philosophy helps narrow your focus when researching and selecting managers
Focused client communication
As an adviser you will typically have access to mountains of data and research, which can be valuable in informing your different channels of client engagement, including face to face meetings and regular newsletters. Your investment philosophy helps narrow down which of this research you should pay attention to, and pass onto your client, meaning more efficient use of your scarce time and less ‘noise’ for your clients.
More appropriate pricing
Your investment philosophy will drive your investment style, which in turn will determine your resource requirements and pricing. A philosophy built on low-cost passive investing will be cheaper to implement, which can be reflected in your fees. On the other hand, more active management will likely be more differentiating, but also resource intensive, requiring higher fees and different processes to be sustainable.
A more consistent client experience across a practice
A documented investment philosophy is akin to having a ‘house view’, making it easier to ensure everyone in a practice is aligned and able to deliver a consistent client experience.

Steps to developing your own investment philosophy

The starting point to developing your own investment philosophy is to reflect on your own beliefs about the way investment markets behave.

Do you believe that markets are efficient or inefficient?
Do you believe in the long run all outperformance is fleeting and not worth the cost and stress?
Do you believe that performance is driven more by investment factors than the stock picking skills of an individual manager?

From there you need to consider a range of other factors, including your own skills and resourcing, your philosophy on advice, your beliefs about your own role as an adviser, and your ideal clients.

The following questions can be useful thought starters when developing your own investment philosophy:

What is your view about how markets behave?
What research have you read and agree with? What investment manager philosophies resonate with you and shape your approach? Do you believe markets are efficient or inefficient?
What are your own convictions and how have your experiences shaped them?
Drawing on your own observations and experiences, personally, and on behalf of your clients, do you have a view on the ability of fund managers to add value? This entails forming a view on the different schools of thought – active versus passive, for example.
What restrictions do you have in place?
You may have licensee imposed (APLs) or technology (chosen platform) or license driven restrictions (for example, MDA licensing) which will shape your philosophy.
Can your philosophy be flexible enough to cater to your different client segments?
Or do you need a different philosophy for different client groups?
Do you insource or outsource investment implementation?
Do you have the skills, knowledge and resourcing to maintain your approach?
If your philosophy entails portfolios that require constant monitoring and adjusting, do you have the capability and interest?
What are the cost and scalability ramifications?
A more active and/or bespoke approach can add value, but will likely come at a higher cost, which needs to be reflected in your fees.

Different foundations on which to build an investment philosophy
As previously mentioned, there are a number of different approaches you can adopt when infusing your beliefs into an investment philosophy. The best approach will depend on you and your answers to the questions above.

The nexus between your investment philosophy and your advice philosophy

Your investment philosophy and your advice philosophy need to work hand in hand, and can lead you down quite different paths.

A conventional, risk profiling approach to client investing is consistent with a philosophy based on strategic asset allocation. Followers of such an approach might believe:

Psychometric risk profiling, to determine the clients appetite for gain and loss, is the best way to determine an investment strategy.
Risk means volatility of capital.
Markets are efficient and repeatable, so optimal portfolios can be built using historical data.
Over the long term, clients are always adequately rewarded for risk.
Eventually all markets and managers are mean reverting, so the true value add in a more dynamic approach is likely to be minimal and not justify the extra risk and cost.

On the other hand, if you provide goals based advice, an aligned investment approach will likely be a dynamic one, likely reflecting your beliefs that:

Investors’ actual needs and goals are the most important building block of an investment strategy.
Risk is the likelihood of not meeting an investor’s goals.
Investors will have numerous different goals – so a one strategy fits all is not possible.
Markets are not always efficient – risk-reward opportunities arise from time-to-time.
Forward-looking estimates and projections are more relevant than historical data – as markets will not always perform as they have historically.
The world is continuously changing – a more flexible, and dynamic approach can do more to drive growth or minimise losses.

Your advice and investment philosophies are your ‘north stars’ – reference points you can refer back to help guide your decisions. They are intensely personal, reflecting your own inner ‘why’. But while there are countless different approaches you could adopt; they need to work hand in hand. Bespoke, premium, strategic advice and a philosophy based entirely on low-cost passive ETFs are unlikely to support each other.

The importance of simplicity in your investment philosophy

The most powerful investment philosophies, and the most easily understood by clients, are generally the simplest. This means articulating your philosophy in a way that is short, and jargon free.

Warren Buffet, regarded as the world’s greatest investor, has a simple approach to investing, summed up in many ‘quotable quotes’. Three of his best-known utterances are:

“It is far better to buy a wonderful company at a fair price, than a fair company at a wonderful price”^[3]

“If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.”^[4]

“Our favourite holding period is forever”^[5]

Distilling these beliefs down might result in an investment philosophy which looked like this:

“Buy wonderful businesses at fair prices, with the intention of holding them forever”.

Now that’s powerful!

Stress testing your investment philosophy

Once you have developed your investment philosophy, it’s important to see how it stands up in the real world. There are two ways you can ‘stress test’ your investment philosophy.

The first is to run it by others, including your peers, researchers, fund managers, asset consultants, and even clients. Does it make sense, and is it understood?

The second, more scientific approach is to actually simulate the performance of your philosophy across a range of market scenarios.

Many fund managers and researchers offer tools that allow you to ‘back test’ constructed portfolios based on historic market events (and we have a few to choose from!). Along the same lines, there are portfolio x-ray tools which can simulate the impact of potential stress scenarios, and quantify the ‘value at risk’ (VaR)^[6]. These findings can help you see how your philosophy might perform in certain circumstances, allowing you to decide whether it is consistent with the expectations you have set with clients.

Conclusion

A documented investment philosophy is an essential tool for financial advisers, regardless of their advice philosophy and regardless of the extent to which they insource or outsource investment implementation.

By providing guidance on how you invest, a well-articulated and understood investment philosophy will help build trust and confidence among clients, by demonstrating your expertise, setting expectations, and ensuring philosophical alignment.

An investment philosophy can also provide advisers with powerful efficiency and marketing benefits, and help ensure a more consistent client experience across a practice and across client segments.

After developing an investment philosophy which is aligned to their own beliefs and their own advice philosophy, advisers should stress test their philosophy, by seeking the views of their peers, and using the various quantitative tools widely available from asset consultants and research houses.