by Frazer Rice
As an advisor, my job is to balance those two separate options with the goals my clients have for their current and future lives.
One strategy that marries the two concepts is the use of different pools of money for different goals. If one of your goals is to generate an income stream for this year’s living expenses, you’ll want a certain pool of investments focused on accomplishing that. If another goal is to provide funds for your children in twenty years, you’ll want a different pool of investments that provide future value. It’s against this backdrop of your current and future goals that the various characteristics of investments can be considered and evaluated. This provides the framework to determine whether the investment is suitable for the goals you are trying to achieve.
Create an Investment Policy Statement
After you’ve defined your goals and done your investment analysis, you should create an investment policy statement (IPS) to solidify your investment plan. This document builds guardrails around your investing by clarifying what you’re going to invest in and why. If you don’t put your plan in writing, details can become vague, you can forget your original plan, or you can change your mind too easily or too often. When you write it down, you can stick to it.
An IPS may sound rigid, and it certainly can be. However, you can also build flexibility into the IPS for future opportunities. Its most important attribute is that it embeds discipline into your investment strategy. It reduces the risk of overconcentration and promotes diversification. This gives you a better chance of buying low and selling high within the context of your financial situation and needs.
The IPS helps to create clearer expectations and better communication with your financial advisors and your family. If there’s a baseline understanding from all parties of what the investments can and can’t do, there will be fewer problems when unplanned issues arise and decisions need to be made.
The IPS helps in setting expectations for each asset class. It forces you to determine what you need to invest in for your goals, rather than what you think you want to invest in. It leads to having a beneficial discussion with your advisors about the risks associated with your plan. For example, if you plan to invest all of your money in equities, there would need to be an understanding of the risk of loss (especially if the markets are at an all-time high). It’s the first and most important step in putting a structured framework around your investment decisions.
Creating the IPS can be an educational exercise for both you and your advisors and lead to more informed decisions about the function and direction of the family wealth going forward. People come into the market with different experiences and viewpoints, and many people’s perspectives are distorted by the biases they bring to the table. On many occasions, I’ve asked clients to check their assumptions at the door when it comes to what the different classes of assets can and cannot do. There may be “nothing new under the sun,” but there is also a different level of information in 2018 than there was in 1997 (and before).
By the same token, our shared discussions can also prompt me to reevaluate my assumptions. By having that shared discussion, we both recognize the risks and opportunities involved with the plan. When storms arrive in the future, we’ll be more prepared for them or can even take advantage of situations when the dust settles.
Preventing Bad (and Expensive) Decisions
A large sum of money can quickly become a small sum of money, especially in sudden wealth situations. Let’s look at a few of the common mistakes that can be addressed within your IPS.
Rookie Mistakes
Rookie mistakes are often responsible for big losses, and avoiding these mistakes is one of the major benefits of working with an experienced advisor.
One of the most notable rookie mistakes is overconcentration and lack of diversification. This is especially common among business owners and inheritors whose wealth was tied to one successful stock. People think, Well, this is a great company and everything’s moving forward. That may be true, but unfortunately, the world is littered with great companies such as Kodak, AIG, and Lehman Brothers that turned into nothing in a short time.
When I see clients with a heavy concentration of investments in a company they do not own or run, it reminds me of the old quote, “Don’t bet on boxing unless you know the promoter.” If your portfolio drops by 30 percent, it must achieve returns of nearly 60 percent to return to its starting point. The power of diversification is well documented, and if you’re worried about protecting your portfolio, diversification is the swiftest and straightest arrow in your quiver. Being able to participate in the upside while protecting yourself on the downside is a goal that makes sense for most investors.
Profligate Spending
Profligate spending is another common risk to wealth, and the IPS helps to mitigate that risk. The long-term plan allows you to see how investments work and what you can expect from them. This is a powerful tool in determining whether your spending can be supported. By having your investment information all in one place where you can see it (and where advisors can see it and work from it), you can greatly reduce the risk that you’ll have to draw down your principal with excessive spending. An advisor cannot control your spending. If you’re drinking champagne on a beer budget, it won’t be long before you’re eating into your principal or the bulk of your assets. Once you begin to dip into your principal, your portfolio of investments must work extra hard to achieve the rate of return required to grow your portfolio to its previous state and beyond.
Confusing Consumption with Investment
One final mistake is to confuse consumption with investment. Many people incorrectly classify their consumptions as investments, and personal real estate is a good example of that. Buying real estate to rent to others is an investment, but when you buy a house and live in it yourself, that’s consumption. Your home may end up selling for a higher value than it was purchased for, but you should not view your personal home as an investment in the context of overall asset allocation.
As mentioned before, some expenditures require a lot of money to maintain, and a house is one of them. A house that you buy for a million dollars could sell ten years later for $1.1 million and give the appearance of a profit. Truthfully, however, you may have spent an additional million dollars over that decade in maintenance and upkeep of the home. Therefore, you would have spent a total of $2.1 million on the asset and sold it for only $1.1 million. If this home were measured as an investment, it would not be considered a good one.
Cars fall into the same category and should be considered consumption. Some people buy a fancy car and believe it will be a great investment, but I feel that’s a fallacy. First, to maintain the value, you can’t really drive the vehicle much, which is both sad and ironic. Second, you incur costs for insurance and maintenance. Third, you’re not generating any income from it, unless you have a museum or something similar. Last, if you’re driving it, it almost certainly depreciates in value from the day you purchase it.
It’s important to understand that some assets are consumption based and depreciate (grow slower than the cost of inflation). Other assets are income generating and appreciate in value. It’s important to understand which type of asset is in front of you before you walk into any investment scenario.
(Over)paying Taxes When You Don’t Have To
Tax inefficiencies are a significant form of risk, and a long-term plan allows you to take advantage of the many vagaries in the tax code. The challenge for the family and their advisors is to navigate the byzantine situations presented by the income tax, capital gains tax, and estate tax systems (among others). They can be different from person to person within the same family and have significant impact.
Most wealthy families have been through discussions with their tax advisors regarding strategies to minimize the income tax bite. Income taxes are vital to all kinds of wealth management decisions, including the relative attract
iveness of various investments. Structuring distributions, aligning appropriate deductions with income, and making judgment calls on the characterization of proceeds can all have a significant impact on the amount a client pays (or overpays) in taxes. While there are times when the tax tail should not wag the investment dog, it’s important that all parts of the advisory team have a sense of a family’s tax situation before making investment or distribution decisions.
For example, on the investment front, there is a difference between tax rates on long-term and short-term capital gains. If you’re anxious to sell an asset you’ve held for eleven-and-a-half months and you’ll realize a big gain on the sale, it can make sense (from a tax standpoint) to wait two more weeks to sell. That short period represents the difference between paying short-term or long-term capital gains taxes, under America’s current tax code. It’s a simple tactic that many advisors use in providing additional value to clients.
Net losses versus net gains are another area where the tax code can make a real impact on your portfolio. In buying mutual funds, you might also wait until after year-end distributions of gains are complete to avoid paying taxes on gains earned by somebody else. An investment advisor can help you evaluate those types of tax considerations in the course of your investing decisions.
There are many other tricks of the trade that can be leveraged. Many of the tricks involve the placement of assets within structures that minimize the bite of income taxes, capital gains taxes, and estate taxes.
For example, placing high-growth assets in an IRA structure could be a boon later on. If you were able to place $100,000 of a hard-charging tech stock in an IRA and able to sell it at $500,000, that $400,000 gain would be shielded from capital gains tax. By the same token, if you purchased life insurance in a properly structured irrevocable life insurance trust, the proceeds of the policy (collected upon the insured’s death, unfortunately) can be collected outside of the beneficiary’s estate tax liabilities, creating a major tax savings. These are two simple examples of many different techniques available to achieve the current and future goals of a wealthy family.
The Client’s Financial Pop Quiz: Analyzing Investments
We’re back to my friend’s impromptu phone call. How do you help friends and clients make intelligent investment decisions in a world of financial television shows, internet news, cocktail parties, and a general level of noise and disorder? First, it’s important to remind them of their plan, hopefully on paper in an IPS. Second, it’s key to equip them with a framework to analyze investment opportunities as they present themselves.
When evaluating investments, I find it best to compare your options using the following measures:
liquidity
transparency
yield
impact
This will help you answer the following questions:
How easily can I get my money out if I need it?
How much access do I have to information about this investment for decision-making purposes?
What is the expected gain in value if the business model works?
Does this investment contribute to a cause or mission I feel is important?
To understand how to look at investments through the prism of liquidity, transparency, yield, and impact, let’s take a closer look at each form of measurement.
Liquidity
Liquidity is essentially a function of how long it takes to trade an asset in exchange for value. Most often, this means you’re diagnosing the asset’s convertibility into cash, because cash is the most liquid of assets and can be traded for many goods in most places.
Stocks and bonds also have value, but they’re less liquid than cash. You can’t walk into a grocery store and trade a couple of McDonald’s stock certificates for thirteen pounds of meat and a two-liter bottle of Diet Coke. You’ve got to sell the stock or bond first and convert it into a usable form of currency.
Real estate can be an illiquid investment due to the length of time it can take to convert property value into cash. Anyone who had a house for sale during the recession of 2008 can describe the liquidity problems of real estate when there are more sellers than buyers.
Additionally, some people borrow against property in the form of a home equity loan if they require liquidity for other cash flow needs.
Hedge fund investments can also be slow to convert into cash. Whether the hedge fund is invested in public securities, derivatives, or other illiquid securities, they tend to have redemption features that are triggered when you want to turn your hedge fund assets into something liquid. You often have to put the asset into redemption, and it can take a quarter or even a year to get your money out. Occasionally, these illiquid investments can put up “gates” if a situation arises where everyone wants to take out their money at the same time. The market correction in 2008 was an eye-opener to many people who did not notice these features in their illiquid investments.
Private equity funds also have long redemption periods, because they are long-term investments in companies and often have longer lockup periods. This lack of liquidity can be frustrating to people who are trying to build wealth for the long term but need access to cash in the short term. Some people borrow money to solve the problem of liquidity in this case. They put up their less-liquid securities (a private equity fund, for example) as collateral and then get a loan against that collateral to generate the cash they need in the short term.
Why would anyone invest in something that’s not liquid? There is an expectation that illiquid investments generate a higher return than liquid investments. Cash, for instance, is very liquid but doesn’t typically generate any return on investment. Treasury investments are among the safest and most liquid securities out there but also don’t generate much of a return.
As you move along the spectrum from low-risk investments to high-risk investments, the assets become progressively less liquid. At the high-risk, low liquidity end of the spectrum are assets such as a private equity fund or a private business. Those investment vehicles carry a deep and involved selling process: a buyer must be found, and the sales process can take years, if it is able to occur at all.
Analyzing an investment’s liquidity helps you understand your level of access to the value of that asset, so you can determine if it’s appropriate for your goals and portfolio. It’s also important to assess the liquidity of your entire portfolio to ensure you’ve got the balance and flexibility needed to achieve your goals.
If your portfolio were to remain fully liquid at all times, you would likely not be taking enough risk to generate the returns you need. On the other hand, if your investments are all completely illiquid, you’re taking on a different risk with your cash flow. You could end up extremely wealthy on paper, but that wealth could be in danger if there were shortfalls in cash.
Diversification through a mixture of liquid and illiquid assets will provide more options to protect against cash shortfalls. Additionally, creating lines of credit with private banks can also provide liquidity solutions for the continual growth of your wealth.
Transparency
Transparency is the amount of information you have about your investments and assets. Cash, once again, provides the greatest transparency, because you know exactly what it is, how it works, and how much of it you have.
Publicly traded stocks and bonds offer less transparency than cash, but they are required to be registered with the Securities and Exchange Commission (SEC), which gives them a certain level of transparency. Foreign stocks and bonds have less transparency due to the different levels of regulation and communication in other countries. Transparency can become a bit dodgy on the international front.
The levels of transparency begin to diminish as you move into hedge funds. Hedge funds’ ability to make money depends on their ability to control and act on information, so they tend to provide as little transparency as the
y can get away with, as it relates to their investment positions. You have to take it on faith that the reports you receive from hedge fund managers accurately reflect the value of your investments with them.
Private equity works in a similar way, because you are dealing with private companies that do not have to register publicly. You’re relying on the expertise of the private equity managers in determining the value of the enterprise, assuming you can even get access to that information.
It’s no different for the owner of a small business. The value of the company is the amount a buyer will pay for it. There’s an entire industry of experts who provide business appraisals and fairness opinions, but they’re only as reliable as the information that’s fed to them. You don’t have to look too deeply in the Wall Street Journal to spot inaccuracies or valid differences of opinion that can skew valuations.
Transparency is the issue that drives the aforementioned warning that you shouldn’t bet on boxing if you don’t know the promoter. You only need to look back as far as Bernie Madoff to understand how people can be duped into believing they knew the promoter and had full transparency. They clearly didn’t.
Yield
Yield is the amount of cash or income generated by an asset. There are investments made to generate current income and yield cash dividends immediately, which carries pluses and minuses. Then there are other types of investments (especially stocks in disruptive companies) that will soak up as much cash as they can and reinvest in their business for faster growth. If a company is developing new technologies, for example, you wouldn’t expect them to throw off much of a yield in the short term. Some investments can focus on yield, like bonds; others can focus on future return without generating yield or income, like the stocks of tech companies who use their cash to fuel further growth. Some investments can provide both yield and growth, like dividend-paying stocks. For the savvy family, it’s smart to balance the usage of yield-friendly investments for current cash needs with the usage of non-yielding investments for future growth and goals.