how you as the personal cfo can help.
by anthony glomski
let’s examine in detail some key drivers of investment success:
- diversification can provide a smoother investment journey – and greater
wealth. - global exposure adds value.
- diversity with fixed income.
- control what you can control.
more: when clients don’t listen | what clients need to know | what level of advice do entrepreneurs need? | three components of collaborative wealth management
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andrew carnegie’s advice for growing assets – put all your eggs in one basket and watch the basket – is sage wisdom when it comes to building a great enterprise. that strategy has worked for you as an entrepreneur, and it’s likely why your clients are successful, too
successful investing is an entirely different story, however – one in which diversification is the key to growing (and more important, keeping) your money. contrary to andrew carnegie’s advice, we all know the basic, almost cliché idea behind diversification: don’t put all your eggs in one basket.
and yet, too many investors – especially entrepreneurs – invest too much of their wealth in any number of non-diversified ways. some of the most common, and potentially wealth-threatening, include:
- owning too much of any one single stock (i.e., overly concentrated)
- owning too much of any one single asset class, such as stocks or alternatives
- owning too many stocks from one single industry, sector or country
sound familiar?
so-called concentrated stock positions are particularly common among business owners after they’ve had a liquidity event. that’s often when they have received a large amount of stock of the company (or companies) that acquired their enterprise. in such situations, there are two main tasks for the successful entrepreneur:
a plan should be developed to diversify into other asset classes as well as into other categories of equities. often, the best approach for dealing with an oversized position in one stock is one or a combination of the following strategies:
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in all the above scenarios, the investors are taking on far more risk than is prudent. it is simply unnecessary to incur the full volatility of a single asset class, like stocks. the marginal benefit from doing so (in the form of higher return) is not commensurate with the amount of risk taken – risk that can threaten the preservation of your client’s wealth.
no one can say what will happen today, tomorrow or next month with absolute certainty. unexpected developments such as sept. 11, the global financial crisis and the covid-19 pandemic will always occur that can affect your investments in ways you might never anticipate.
therefore, it’s impossible to know precisely when a stock, asset class or industry will outrun all the others – and when it will find itself languishing at the back of the pack. in fact, financial science tells us that an asset class that soars in one year rarely finds itself at the top of the pack the following year. likewise, a “loser” asset class one year often catapults to the winner’s circle the next year.
the lesson that financial science teaches us is clear: if you want to own winning investments consistently over time, you can’t just invest in one or two stocks, sectors or even broad asset classes. you need to own many of them at all times – regardless of how they perform in any single year. that way, you will always be invested in enough areas of the market that are doing relatively well at any given moment.
diversifying your portfolio will also ensure that you don’t put too much of your money in the wrong areas of the market and end up watching your net worth plummet. with diversification, your portfolio is far less likely to experience wild swings in value the way a highly focused or highly concentrated portfolio does.
global exposure adds value
during the so-called “lost decade” of 2000-2009, the s&p 500 delivered a cumulative total return of minus 9.1 percent. add in the volatility of two sizable bear markets during that time, and nobody remembers that period too fondly.
interestingly, however, other asset classes fared much better than large-cap u.s. stocks over the same dark period:
- msci world ex-us index + 17.5 percent
- msci emerging markets index + 154.3 percent
- citigroup world gov’t bond index + 57.7 percent
while past performance is not indicative of future results, a properly balanced portfolio diversified across the globe and asset classes had a much better chance of not losing an entire decade. looking outside the united states can feel uncertain and be intimidating for many. headlines can be frightening, and foreign governments can be unpredictable. in an agnostic investment portfolio, however, it is exactly in these environments that value is found. if one doesn’t make the mistake of having too many opinions and diversifying improperly, history shows, a global portfolio will tend to weather any storm quite well. through our strategic partnerships, our firm has the ability to own 12,000 stocks in 44 countries through a select number of low-cost institutional asset class funds for our clients. the bond market exposure via these funds is equally broad. this way the investor can feel like the house, rather than an individual gambler. when clients participate in all markets, the odds are more likely to be in their favor. they don’t need to decide when to walk away from the ace or the jack or when to turn off the “let the gamblers gamble” sign. over the long term, the house always wins.
diversify with fixed income
“rule no. 1: never lose money. rule no. 2: never forget rule no. 1.” – warren buffett
there are many definitions of risk. too many, actually. we concern ourselves with two types:
- fluctuations in the value of a portfolio
- actual realized losses in a portfolio
the latter type of risk results from owning single stocks of companies that experience major financial issues (like bear stearns, lehman brothers, countrywide, enron, etoys, etc.) and has no place in our process. the former can be tolerated differently by different investors, and it is the type of risk we can do something about.
for this type of risk, we allocate to bonds. that’s because bond prices typically do not fluctuate as much as stock prices do, and because bond prices often rise when stocks fall. that makes bonds an excellent tool for diversification and for smoothing out overall portfolio returns. in the 2007-2008 bear market, for example, stocks lost more than 50 percent of their value. in sharp contrast, the barclays us aggregate bond index delivered a 6.1 percent annualized gain during that time, while the highest-quality long-term u.s. government bonds returned 17.6 percent annualized.
overall, bonds historically generate lower returns than stocks do over the long term. and with interest rates near historic lows right now, you may wonder how bonds could do anything but hurt the overall return of your client’s portfolio going forward. but that question doesn’t account for the uncertainty of time. the long-term return expectations for stocks and bonds are not valid for each and every starting point in history. plus, we never know how far – or for how long – any asset class will trend up or down.
remember from above that investment returns are “lumpy” and unpredictable? it’s entirely possible that even a low annual return from bonds of, say, 3 percent over the next few years could end up giving your client’s portfolio a boost and help them better preserve wealth if stocks experience multiple years of flat or negative returns.
that’s exactly what happened during the decade-long period from 1965 through 1975. during that time, u.s. government bonds returned 2.2 percent annually. hardly impressive – but still better than the 1.2 percent annualized return from stocks over the period. ancient history? maybe. but there’s no way to be sure history won’t repeat.
the message: by owning bonds at all times – even when they appear unattractive – your client could at any time own the best-performing asset class available, and therefore preserve their wealth better while increasing the probability of generating the target return they seek from their portfolio.
control what you can control
you may not be able to control the direction of the market, but (as shown throughout this post) you can control the level of risk that you and your clients bear and how you help them position their wealth to best take advantage of the market to compensate them for that risk. other key determinants of investment success that you can – and should – seek to control include:
- focus on the total cost structure of your investments with the goal of minimizing all components as much as possible – such as portfolio expense ratios, trading costs, fund turnover and tax-related costs. asset class funds that maintain consistent exposure to various segments of the financial markets have cost-advantageous features such as low expenses and low turnover that enable more of your client’s investment capital to be put to work.
- tax efficiency offers a tremendous opportunity to add value by minimizing drag on a portfolio. one way to boost overall tax efficiency is to use tax-sensitive and tax-optimized investments that keep trades to a minimum and keep taxable gains low through advanced trading strategies. because your clients are likely in high tax brackets, this focus on after-tax returns becomes especially important. to that end, municipal bonds might be more heavily weighted within the fixed-income portion of the portfolio, while “yield plays” such as bank loans and high-yield corporate debt may be de-emphasized.
there are some one-size-fits-all “tax efficiency” models that rarely serve entrepreneurs well. instead, entrepreneurs require specialized customization to their unique situation, which is often complex with a lot of moving parts. we have an arsenal of tools that help to minimize taxes, but many require customization to the individual or family.
coordinate and oversee – the personal cfo
many affluent families work with multiple financial advisors and/or money managers. for example, 78 percent of families with more than $10 million in investable assets have more than three advisors simultaneously, according to research from aes nation. this “advisor diversification” approach may make good sense in some situations.
that said, the key to working with multiple financial professionals simultaneously is to ensure that each professional’s efforts are coordinated. that way, an investment strategy implemented by one advisor doesn’t conflict with or harm an investment solution used by another. a personal cfo is needed here – someone who is capable of organizing, overseeing and coordinating the work that each professional do on behalf of your client and their family. the real value in your investment experience comes from this coordination, which helps ensure that every investment strategy works as it should, and nothing falls between the cracks. without a trusted personal cfo at the top, the good work of all the other professionals can be quickly negated.
the next steps
the investment consulting process is just the first step in a collaborative wealth management process. once the investment foundation is built and solidified, it’s time to turn our attention to the key non-investment financial areas of importance in one’s life.
these areas might include advanced tax planning, transferring assets to family members or others, protecting assets from those who would seek to take it from your clients, and developing planning strategies to help causes and organizations that they care about.