Taking a Comprehensive Approach to Your Financial Life

May 22, 2023- Money means different things to different people. Each of us has different dreams. You may want to achieve financial freedom so that you never have to work again—even if you plan on working the rest of your life. You may want to make a top-flight college education possible for your children or grandchildren. You might want to provide the seed capital that will give your children or grandchildren a great start in life, whether that’s with a home or a business. You may dream of a vacation home on the beach or in the mountains. Or you may have achieved tremendous success throughout your career and want to leave behind an enduring legacy that will enable your favorite charity to continue its work.

Whatever your dreams are, you need a framework for making wise decisions about your money that will help enable you to achieve all that is important to you. Chances are good that you have a wide range of financial goals, as well as diverse financial challenges.

Common sense tells us that such a broad range of possibilities requires a full, well-considered, comprehensive outlook. It’s for this reason that most affluent clients want their financial advisors to help them with more than just investments. They want real wealth management—a complete approach to addressing their entire financial lives.

Rising Above the Noise

Investing is actually not that complicated. It can be broken down into two major beliefs:

• You believe in the ability to make superior security selections, or you don’t.

• You believe in the ability to time markets, or you don’t.

Let’s explore which investors have which belief systems and which belief position is best to guide you in your investment decisions.

This exhibit classifies people according to how they make investing decisions. Quadrant one is the noise quadrant. It’s composed of investors who believe in both market timing and superior investment selection. They think that they (or their favorite financial guru) can consistently uncover mispriced investments that will deliver market-beating returns. In addition, they believe it’s possible to identify the mispricing of entire market segments and predict when they will turn up or down. The reality is that the vast majority of these methods fail to even match the market, let alone beat it.

Unfortunately, most of the public is in this quadrant because the media play into this thinking as they try to attract readers and viewers. For the media, it’s all about getting you to return to them time and time again.

Quadrant two is the conventional wisdom quadrant. It includes most of the financial services industry, which has the experience to know they can’t predict broad market swings with any degree of accuracy. They know that making incorrect predictions usually means losing clients. However, they believe there are financial professionals who can find undervalued securities and add value for their clients. Of course, it’s the American dream to believe that if you’re bright enough and work hard enough, you will be successful in a competitive environment.

As un-American as it seems, in an efficient capital market we believe this methodology adds no value, on average. While there are ongoing debates about the efficiency of markets, we believe that, fundamentally, capital markets work.

Quadrant three is the tactical asset allocation quadrant. Investors in this quadrant believe that, even though individual securities are priced efficiently, they can see broad mispricing in entire market sectors. They think they can add value by buying when a market is undervalued, waiting until other investors finally recognize their mistake, and selling when the market is fairly valued once again. We believe that it’s inconsistent to think that individual securities are priced fairly but that the overall market, which is an aggregate of the fairly priced individual securities, is not.

Quadrant four is the information quadrant. This is where much of the academic community resides, along with many institutional investors. Investors in this quadrant dispassionately research what works and then follow a rational course of action based on empirical evidence. Academic studies indicate that investments in the other three quadrants, on average, do no better than the market after fees, transactions costs, and taxes. Because of their lower costs, passive investments—those in quadrant four—have higher returns on average than the other types of investments.(1)

Our goal is to help investors make smart decisions about their money so that they are firmly in place in quadrant four. To accomplish this, we help investors move from the noise quadrant to the information quadrant. We believe this is your best posture to maximize the probability of achieving your financial goals.

Five Key Concepts for Financial Success

While investing can, at times, seem overwhelming, academic research can be broken down into what we call the Five Key Concepts to Financial Success. If you examine your own life, you’ll find that it is often the simpler things that consistently work. Successful investing is no different. However, it is easy to have your attention drawn to the wrong issues. These wrong distractions—the noise—can derail your journey.

In this section, we’ll walk through these five concepts and then explain how successful institutional investors incorporate each of these concepts into their investment plans. These plans both meet their fiduciary responsibilities and achieve their financial goals. Your own investment plan could work for you just as well as what the institutional investors have.

It’s important to note here that while these concepts are designed to maximize return, no strategy can eliminate risk, which is inherent in all investments. Whenever you invest, you have to accept some risk. It’s also important to remember that you’re responsible for reviewing your portfolio and risk tolerance and for keeping your financial advisor current on any changes in either your risk tolerance or your life that might affect your investment objectives.

Concept One: Leverage Diversification to Reduce Risk

Most people understand the basic concept of diversification: Don’t put all your eggs in one basket. That’s a very simplistic view of diversification, however. It can also get you caught in a dangerous trap—one that you may already have fallen into.

For example, many investors have a large part of their investment capital in their employers’ stocks. Even though they understand that they are probably taking too much risk, they don’t do anything about it. They justify holding the position because of the large capital gains tax they would have to pay if they sold, or they imagine that the stocks are just about ready to take off. Often, investors are so loyal to particular stocks that they develop a false sense of comfort.

If you’re like most investors, you don’t buy the stock right away. You’ve probably had the experience of losing money on an investment—and did not enjoy the experience—so you’re not going to race out and buy that stock right away based on a hot tip from a friend or business associate. You’re going to follow it awhile to see how it does. Let’s assume, for example, that it starts trending upward. You follow it for a while as it rises. What’s your emotion? Confidence. You hope that this might be the one investment that helps you make a lot of money.

Let’s say it continues its upward trend. You start feeling a new emotion as you begin to consider that this just might be the one. What is the new emotion? It’s greed. You decide to buy the stock that day.

You know what happens next. Of course, soon after you buy it, the stock starts to go down, and you feel a new combination of emotions—fear and regret. You’re afraid you made a terrible mistake. You promise yourself that if the stock just goes back up to where you bought it, you will never do it again. You don’t want to have to tell your spouse or partner about it. You don’t care about making money anymore.

Now let’s say the stock continues to go down. You find yourself with a new emotion. What is it? It’s panic. You sell the stock. And what happens next? New information comes out and the stock races to an all-time high.

We’re all poorly wired for investing. Emotions are powerful forces that cause you to do exactly the opposite of what you should do. That is, your emotions lead you to buy high and sell low. If you do that over a long period of time, you’ll cause serious damage not just to your portfolio, but more important, also to your financial dreams.

If you are a truly diversified investor across a number of different asset classes, you can lower your risk without necessarily sacrificing return. Because they recognize that it’s impossible to know with certainty which asset classes will perform best in coming years, diversified investors take a balanced approach and stick with it despite volatility in the markets.

Concept Two: Seek Lower Volatility to Enhance Returns

If you have two investment portfolios with the same average or arithmetic return, the portfolio with less volatility will have a greater compound rate of return.

For example, let’s assume you are considering two mutual funds. Each of them has had an average arithmetic rate of return of 8 percent over five years. How would you determine which fund is better? You would probably expect to have the same ending wealth value. 

However, this is true only if the two funds have the same degree of volatility. If one fund is more volatile than the other, the compound returns and ending values will be different. It is a mathematical fact that the one with less volatility will have a higher compound return.

Concept Three: Use Global Diversification to Enhance Returns and Reduce Risk

Investors here in the U.S. tend to favor stocks and bonds of U.S.-based companies. For many, it’s much more comfortable emotionally to invest in businesses that they know and whose products they use than in companies located on another continent.

Unfortunately, these investors’ emotional reactions are causing them to miss out on one of the most effective ways to increase their returns. That’s because the U.S. financial market, while the largest in the world, still represents less than half of the total investable capital market worldwide.(2) By looking to overseas investments, you greatly increase your opportunity to invest in superior global firms that can help you grow your wealth faster.

Global diversification in your portfolio also reduces its overall risk. American equity markets and international markets generally do not move together. Individual stocks of companies around the world with similar risk have the same expected rate of return. However, they don’t get there in the same manner or at the same time. The price movements between international and U.S. asset classes are often dissimilar, so investing in both can increase your portfolio’s diversification.

Concept Four: Employ Asset Class Investing

It is not unusual for investors to think that they could achieve better investment returns, if they only knew a better way to invest. Unfortunately, many investors are using the wrong tools and put themselves at a significant disadvantage to institutional investors. You need the right tools, and we believe that asset class investing is an important tool for helping you to reach your financial goals.

An asset class is a group of investments whose risk factors and expected returns are similar. Originally, institutional asset class funds were not available to the great majority of investors. Often the minimum investment for these mutual funds was in the millions of dollars, effectively keeping them beyond the reach of all but large pension plans and the wealthiest individual investors. Fortunately, these institutional asset class funds are now accessible to all investors. You can gain the same advantages previously enjoyed only by large institutional investors.

Four major attributes of asset class funds make them attractive:

1. Lower operating expenses

2. Lower turnover resulting in lower costs

3. Lower turnover resulting in lower taxes

4. Consistently maintained market segments

We’ll look at each factor in turn.

Lower Operating Expenses

All mutual funds and separately managed accounts have expenses that include management fees, administrative charges, and custody fees. These are expressed as a percentage of assets. According to the Investment Company Institute, the average annual expense ratio for all stock funds is 1.54 percent.(3) In comparison, the same ratio for institutional asset class funds is typically only about one-third of all retail equity mutual funds. All other factors being equal, lower costs lead to higher rates of return.

Lower Turnover Resulting in Lower Costs

Many investment managers do a lot of trading, thinking that it adds value. This is costly to shareholders because each time a trade is made there are transaction costs, including commissions, spreads, and market impact costs. These hidden costs may amount to more than a fund’s total operating expenses, if the fund trades heavily or if it invests in small-company stocks for which trading costs are relatively high. Institutional asset class funds generally have significantly lower turnover rates because their institutional investors want them to deliver a specific asset class return with as low a cost as possible.

Lower Turnover Resulting in Lower Taxes

If a mutual fund sells a security for a gain, it must make a capital gains distribution to share-holders because mutual funds are required to distribute 98 percent of their taxable income each year, including realized gains, to remain tax-exempt at the corporate level.(4) They distribute all their income annually because no mutual fund manager wants to have his or her performance reduced by paying corporate income taxes.

In one study, Stanford University economists John B. Shoven and Joel M. Dickson found that taxable distributions have a negative effect on the rate of return of many well-known retail equity mutual funds. They found that a high-tax-bracket investor who reinvested the after-tax distribution ended up with an accumulated wealth per dollar invested of only 45 percent of the fund’s published performance. An investor in the middle tax bracket realized just 55 percent of the published performance.

Because institutional asset class funds have lower turnover, the result is lower taxes for their investors.

Consistently Maintained Market Segments

Most investment advisors agree that the greatest determining factor of performance is asset allocation—how your money is divided among different asset categories. However, you can accomplish effective asset allocation only if the investments in your portfolio maintain a consistent asset allocation. That means your investments need to stay within their target asset classes.

Unfortunately, most actively managed funds effectively have you relinquish control of your asset allocation. On the other hand, because of their investment mandates, institutional asset class funds must stay fully invested in the specific asset class they represent.

Concept Five: Design Efficient Portfolios

How do you decide which investments to use and in what combinations? Since 1972, major institutions have been using a money management concept known as Modern Portfolio Theory. It was developed at the University of Chicago by Harry Markowitz and Merton Miller and later expanded by Stanford professor William Sharpe. Markowitz, Miller, and Sharpe subsequently won the Nobel Prize in Economic Sciences for their contribution to investment methodology.

The process of developing a strategic portfolio using Modern Portfolio Theory is mathematical in nature and can appear daunting. It’s important to remember that math is nothing more than an expression of logic, so as you examine the process, you can readily see the common sense approach that it takes—which is counter-intuitive to conventional and over-commercialized investment thinking. Markowitz stated that for every level of risk, there is some optimum combination of investments that will give the highest rate of return. The combinations of investments exhibiting this optimal risk/reward trade-off form the efficient frontier line. The efficient frontier is determined by calculating the expected rate of return, standard deviation, and correlation coefficient for each asset class and using this information to identify the portfolio with the highest expected return at each incremental level of risk. By plotting each investment combination, or portfolio, representing a given level of risk and expected return, we are able to describe mathematically a series of points, or “efficient portfolios.” This line forms the efficient frontier.

Most investor portfolios fall significantly below the efficient frontier. Portfolios such as the S&P 500, which is often used as a proxy for the market, fall below the line when several asset classes are compared. Investors can have the same rates of return with an asset class portfolio with much less risk, or higher rates of return for the same level of risk. 

This exhibit illustrates the efficient frontier relative to the “market.” Rational and prudent investors will restrict their choice of portfolios to those that appear on the efficient frontier and to the specific portfolios that represent their own risk tolerance level. Our job is to make sure that, for whatever risk level you choose, you have the highest possible return on the efficient frontier so that we can maximize the probability of achieving your financial goals.

Your Next Steps

As we discussed at the beginning of this article, taking a comprehensive approach to achieving your financial objectives requires wealth management. This means more than just taking care of your investments. It also means addressing your advanced planning needs, including wealth enhancement, wealth transfer, wealth protection, and charitable giving.

Such a wide range of financial considerations requires a wide range of financial expertise. Because no one person can be an expert in all these subjects, the best wealth managers work with networks of experts—financial professionals with deep experience and knowledge in specific areas.

Effective wealth managers, then, are experts at relationship management—first building relationships with their clients in order to fully understand their unique needs and challenges and then coordinating the efforts of their professional networks in order to meet those needs and challenges. Wealth managers must also work with their clients’ other advisors—such as attorneys and accountants—to ensure optimal outcomes.

Many in the financial services industry today call themselves wealth managers but offer little more than investment management. How then will you know whether you are dealing with a true wealth manager?

First, the financial advisor should offer a full range of financial services, including the four areas of advanced planning that we mentioned above. As we’ve said, a network of professionals to provide these services should back up the wealth manager.

Second, the wealth manager should work with you on a consultative basis. This allows the wealth manager to uncover your true financial needs and goals, to craft a long-range wealth management plan that will meet those needs and goals, and to build an ongoing relationship with you that ensures that your needs continue to be met as they change over time.

(1) Michael C. Jensen, “The Performance of Mutual Funds in the Period 1945–1964,” Journal of Finance, May 1968.

Mark M. Carhart, Jennifer N. Carpenter, Anthony W. Lynch and David K. Musto, “Mutual Fund Survivorship,” unpublished manuscript, September 12, 2000.

Christopher R. Blake, Edwin J. Elton and Martin J. Gruber, “The Performance of Bond Mutual Funds,” The Journal of Business, 1993: 66, 371–403.

Edwin J. Elton, Martin J. Gruber, Sanjiv Das and Matt Hlavka, “Efficiency with Costly Information: A Reinterpretation of Evidence from Managed Portfolios,” The Review of Financial Studies, 1993: 6, 1–22.

(2) McKinsey Global Institute, Mapping the Global Capital Market 2006.

(3) 2006 Investment Company Fact Book.

(4)  Subchapter M, Internal Revenue Code.