Diversification as a wealth tool isn't as
easy as it seems.
Early this year, we were referred to a gentleman,
who we'll call "Harry." He and his wife owned an East
Bay business for 15 years, and his life was turned upside down
when his wife died unexpectedly.
Alone for the first time in more than 40 years,
he sold the business and retired.
A friend of Harry's referred us to him to evaluate his financial
affairs and determine if he was on the right track. Harry also
wanted to know what if anything might be improved to ensure he
achieved everything that is important to him.
Harry was more scared now than ever before because
he had never had to manage more than IRA assets and they had taken
a serious hit during the market corrections of 2000-2002. Harry
realized that he needed help. Not only was managing money new
and scary to him, he was in no emotional state to be making these
decisions.
When Harry sold his business, he structured a deal
giving him $200,000 for the next five years as well as $1 million
cash upfront. He also received $1 million from his wife's life
insurance.
Harry was a sharp entrepreneur, but he knew he needed
help reaching his main goals: Income in six years, protection
of the principal, inflation hedging, and legacy planning for his
three children.
When we reviewed Harry's investment statements to
see how the $2 million was handled, we were shocked.
Problem 1 was the lack of diversification. The assets
that were now supposed to be safe were invested 100 percent in
stocks. Most sophisticated investors understand the concept of
not putting all their eggs in one basket. Still, common mistakes
include filling up an investment portfolio with too much company
stock, or buying shares in a sector – let's say shares of
Cisco, Nokia, Yahoo, Microsoft and IBM and thinking that is diversification.
The truth is most lay investors fall into emotional
traps along the way that prevent them from making sound decisions.
Or they rely on professionals who, unbeknownst to them, load up
on stocks.
Next, we pointed out that in 2004 one of his accounts
had so many trades in it that the fees became exorbitant. And
the securities being bought and sold during the year were the
same. To make matters worse, the trades were taking place in his
living trust, which meant they were taxable events. This was going
to keep Harry's CPA busy and cost a lot of money not only in short-term
capital gains taxes, but also in the costs of tracking down the
trades for tax reporting purposes.
When we compared the performance of Harry's investments,
we found the portfolio under performed the S&P 500 Index by
over 55 percent, and his trading costs were well over $40,000.
It was clear his professional money managers fell
into the "noise profile" among investors – the
category of individuals and many financial journalists who believe
that they can both time the market and select superior investments.
The reality is they create excessive taxes and fees and generally
under-perform an unmanaged index.
We lump investor mentalities into three
other broad groups:
The "conventional wisdom profile"
is where we find most financial planners, stock brokers and mutual
fund portfolio managers — those who don't time the market
because it is efficiently priced, but believe they can select
superior securities using research and high tech information systems.
History shows no additional value for assuming these higher costs
for management.
The "Tactical Allocation Profile"
is home to market timers and asset allocation funds. Here there
is a belief the markets are inefficiently priced and value is
created by timing when to get in and out of the market. Again
history shows investors are not rewarded for timing the markets.
The "information group"
is where you'll find 40 percent of institutional investors and
many academics. This is full of investors who recognize that they
cannot time the market, nor can they select superior investments.
In this quadrant are those who research what works and follow
a rational course of action.
For Harry, we recommended he follow the "information
group." This would diversify his portfolio, significantly
lower his trading fees, and reduce portfolio turnover and thus
taxes. These savings would therefore translate into greater returns
on his money. We positioned his risk tolerance in a way that he
can achieve all that is important to him and still sleep at night.
And, we described the concept of the "efficient frontier."
Modern Portfolio Theory – for which University
of Chicago professors Harry Markowitz and Merton Miller and Stanford
professor William Sharpe won the Nobel Prize for economics –
holds that for every level of risk there is an optimum combination
of investments, or portfolio, that yields the highest rate of
return. That ideal combination is the "efficient frontier."
Prudent investors will restrict their choice of portfolios to
those that are on the efficient frontier and that are within their
risk tolerance.
Harry wasn't looking to hit a home run with his
savings. All he wanted was what most of us want: The peace of
mind that no matter what the economy and the markets do, our money
will be there for us and our loved ones to make use of. Through
Harry's new plan he can now enjoy spending his retirement traveling
or with his children and grandchildren. His only regret is that
he didn't retire when Susan was still alive.
Christopher G. Snyder and Haitham "Hutch"
E. Ashoo are principals of Pillar Financial Services in Walnut
Creek. Contact them at 925-356-6780.
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