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More Talking Points for Clients and Investment Advisers

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I'm Grove O'Rourke, big-swinging stockbroker and the hero of Top Producer. This post continues my series on conversations between financial advisers and their clients.

In two more weeks, I'll appear in Australia when Murdoch Books publishes Norb Vonnegut's debut novel. There's a special treat for Acrimoney's readers, who live in Sydney. You will find at least one highly venomous funnel web spider lurking deep inside the pages. Figuratively speaking, that is.

Okay, enough with the commercial. I'm about to make the most outrageous statement ever in the history of private wealth management. Some or you will regard my words as heresy.

Asset allocation is a joke.

A quick primer. Asset allocation is a process for combining stocks, bonds and other investment classes. The goal is to find the mix that maximizes portfolio returns given an individual's risk profile. Financial advisers often use mathematical tools, like Monte Carlo simulations, to ferret out how much risk an individual can tolerate.

But my head is already swimming. I don't know a single client who defines investment objectives as a percentage allocation to stocks, bonds, or other assets. I've never met anyone who insisted, for example, on a "thirty-two percent allocation to alternative investments."

I've never called any of my "guys," which is broker lingo for "clients," and said, "Congratulations. You are now on the efficient frontier."

Huh?

The efficient frontier is not just "inscruta-speak" from Wall Street. It's the holy grail of Modern Portfolio Theory. It's a mathematical curve that charts the optimal returns from a portfolio -- stocks, bonds, alternatives -- given the level of risk. And an investor's risk tolerance is shown as standard deviation.

Standard deviation sounds serious. Can I catch it? If so, do I need to see a doctor?

Herein lies the problem. It's virtually impossible to quantify how people feel about risk. All the Monte Carlo simulations and J-shaped efficient frontier curves are forgotten during a year like 2008. I think the structure of every portfolio should start with the answer to one question:

How much cash do I need?

I invest my clients' portfolios by focusing on their cash needs first: renovations to a house, capital calls from other investments, and tuition for example. These discussions are tangible, unlike the concepts of efficient frontiers and standard deviation. I buy securities, usually bonds, to ensure cash is available as necessary.

Cash is something we all understand, even works of fiction like me.


Grove O'Rourke