diversify and function as a fiduciary.
by anthony glomski
your $5 million high-net-worth practice
the first thing you and your clients should understand as investors looking to make smart financial decisions is this: the broad asset classes you choose to own (such as stocks, bonds, alternatives, real estate, private equity and so on) and the percentage of your household wealth that you allocate to each of those asset classes will have a greater impact on your future investment returns than any other decision you make – including which individual stocks you buy.
more: preserving wealth is a different mindset | do you know your client’s total picture? | what level of advice do entrepreneurs need? | three approaches to investment consulting | the role of the personal cfo | three components of collaborative wealth management | cashing out: your business clients’ five big issues
exclusively for pro members. log in here or 2022世界杯足球排名 today.
this means your first question as intelligent investors must be: how should i allocate my assets among the major asset categories?
“ninety-seven percent of performance variation is due to asset class structure.”
– eugene fama, economist and nobel laureate in economics
this is the single most important investment decision to be made. if it is done correctly, you should know the approximate return to expect from a given portfolio over the long run, and what a 2008-style scenario would look like in terms of drawdown and the amount of time needed to get back to even. it is this knowledge that enables you to help clients tune out all the noise that surrounds them and remain consistent in their approach without succumbing to emotion.
vanguard’s john bogle famously said, “buy right and hold tight. once you set your asset allocation, stick to it no matter how greedy or scared you become.”
indeed, clients sometimes ask us what our plan is for dealing with the latest troubling headlines or a downturn in the stock market. our answer is always the same: the plan – driven by our investment philosophy statement (ours is about 42 pages long) – was established up front when we determined the appropriate asset allocation for you and your family.
“the most important thing about an investment philosophy is that you have one you can stick with.”
– david booth, founder, dimensional fund advisors (dfa)
ask your clients to think of their household as a new business. their “main office” is now their family office.
therefore, it makes sense to examine how other successful families tend to manage their wealth. one broad survey of single-family offices reveals that high-net-worth families allocate their investable assets as shown in the table below. this data can be a good starting point from which you and your clients can make their own family office asset allocation decisions. again, no two families have exactly the same needs and goals.
| target allocation | |
| stocks | 44% |
| bonds | 15% |
| hedge funds | 14% |
| private equity | 9% |
| real estate | 9% |
| other tangible assets | 4% |
| principal company investments | 4% |
| other stores of value | 1% |
data from the wharton global family alliance
note that the allocation to stocks for the typical family office remains relatively high, at 44%. we believe that this allocation to equities may be unnecessarily risky for many successful families, who might very well be able to achieve the full range of their financial goals and preserve their wealth better by owning fewer equities (for example, around 30%).
take this example of an entrepreneur – we’ll call him dan – who had recently experienced a liquidity event and sold his firm. dan’s deal was largely based on equity in the acquiring company. this left him not only with a large allocation to stocks, but also with a highly concentrated position in a single holding. we began working toward an overall portfolio allocation for dan that resembled the typical family office allocation, customized to his family’s unique needs and goals. as homes and other assets were acquired, dan was able to use the targeted household allocation to stay on track over a planned number of years.
asset class returns are ample for preserving and growing wealth
if our asset allocation choices are responsible for nearly all of our investment results, then clearly it makes sense to build portfolios consisting of entire asset classes – be they stocks, bonds or other categories.
this was exactly the thinking that turned wall street upside down when john bogle founded vanguard. as he once said, “don’t look for the needle in the haystack. just buy the haystack.”
my experience is that some people like stocks. they like the stories attached to products and companies and growth. as a result, the act of stock picking receives a tremendous amount of focus from investors and their advisors.
however, when you purchase the stock of one or even several companies, you essentially place a bet that has two possible outcomes:
(1) lose a lot, or
(2) make a lot.
but when you buy “the whole market” – that is, the hundreds of stocks that make up a particular asset class – you vastly narrow the range of possible outcomes. it may not provide the same adrenaline rush as holding a single hot individual stock, but it certainly protects your downside while still providing plenty of upside.
further, it is incredibly difficult to pick only the winners over time consistently. consider these findings from the spiva® u.s. scorecard:
- 6% of large-cap stock fund managers underperformed their benchmark (the s&p 500, aka the “haystack”) during the five years through 2019.
- 99% failed to deliver incremental returns over the benchmark over the past 10 years.
- 37% of small-cap stock fund managers lagged their benchmark (s&p smallcap 600) during the past five years.
- 61% underperformed over the 10-year period.
what’s more, the few active stock pickers who do manage to beat their benchmarks in a given year are more likely to have been lucky than skillful. according to research by nobel laureate eugene fama and his frequent co-author ken french, “an investor doesn’t have a prayer of picking a manager that can deliver alpha. even over a 20-year period, the past performance of an actively managed fund has a ton of random noise that makes it difficult, if not impossible, to distinguish luck from skill.”
add in the drag on returns from trading costs, tax inefficiency and fees paid to managers to do the stock picking, and it’s no wonder that active stock pickers lag the indices that represent various asset classes. professional money managers or otherwise, the odds of consistently outperforming the broader market are extraordinarily slim.
is there a better way? we believe so. suppose the market consists of thousands of different marbles – each one a different color, and each with a different value that can grow or diminish. the active manager has a choice: choose 20 or so marbles of different colors that seem to look best, or fill the jar of marbles with many different types – i.e., to diversify.
we embrace the approach that starts with the full jar and then weeds out the undesirable ones. this is based on decades of academic research that teaches us there are different dimensions of risk that lead to different dimensions of expected returns. the focus is not on which select stocks to own, but rather on which stocks not to own. added bonus: the active manager who starts with the empty jar typically also comes with high fees and a higher tax bill. diversifying can help you avoid both of those potholes.
for the average retail investor, a vanguard or classic index fund is optimal. even when i was trading full time, i kept my retirement funds (and my father’s) invested in index funds. think of the more evolved version described above as an institutional (as opposed to retail) solution. having developed a partnership with dfa, our firm is able to offer our clients the same investment sources that pension funds and endowments have utilized for decades. we believe this is the best institutional solution for our clients. as fiduciaries, we are required to act first in our clients’ best interest – not our own. that means we are not allowed to receive commissions, kickbacks or other incentives for steering our clients into dfa funds. we can’t just recommend “suitable investments” for our clients – we have to make investments that are absolutely in our clients’ best interests.
i strongly recommend that you function as a fiduciary.
dimensional works exclusively with fiduciaries – which is why its funds aren’t accessible by brokers at firms such as ubs, j.p. morgan and merrill lynch. dfa has a strict vetting process for advisory firms that want to partner with it. as of this writing, we are one of only a dozen or so firms in the los angeles area that dfa works with.
we aren’t necessarily recommending that you work with dfa, but we do suggest you act in a fiduciary role with your clients and champion investment philosophies of people and organizations that are not in the business of selling headlines. vanguard’s john bogle was one of the best and his lessons are timeless.