by Frazer Rice
Impact
From individual investors to pension fund managers, impact investing is a popular and growing trend. In addition to generating a yield or investment return, impact investments are structured to accomplish political or social objectives that surmount traditional investment criteria. Measuring impact often involves a qualitative goal with intangible results.
An example might be investing in a real estate project in a blighted area. Of course you would make the investment because you might make a reasonable return on it. The concept of impact investing contemplates that another valid reason for the investment is that you think there is tangible civic value in doing so. The investment itself may have a positive impact on many people’s lives and it might lead to a multiplier effect, attracting other impact investments and social good. Other examples may include investing in companies with female or minority board members or charitable organizations providing clean water in Africa. Impact investments create value in your life beyond your portfolio, as they provide “psychological income” and can intersect with your philanthropic goals.
These impact investments may carry different investment expectations for you. The criteria of liquidity, transparency, and yield may take on less importance in the context of an investment that has significant social impact. Many people are willing to make sacrifices in these criteria in support of an impact investment that provides outsized social good.
With any investment, the balance of the various factors and how they fit within the asset allocation of your IPS should be analyzed before a commitment is made. Advisors can help frame the issues, risks, and opportunities, but ultimately, those decisions are up to you.
How Should Assets Be Allocated?
Most people build their wealth by making a concentrated bet in something, whether it’s the company they work for, a business they build, or the investment they make. They concentrate on one thing or a small number of things, and they win big. Lloyd Blankfein made a commitment to his career at Goldman. Wayne Gretzky devoted his life to hockey. Mark Zuckerberg bet his career on Facebook. The intersection of their talent, determination, and luck—combined with the concentration of their efforts and resources toward a singular goal—made them fabulously wealthy.
When a client comes into wealth, we discuss the need to shift from the concentration that made them rich to the diversification that will keep them wealthy. When you invest in only one thing—whether it’s your brother-in-law’s app, your own business, or a stock you like—your risk of loss is significant. Diversification is the strategy of making several smaller bets (many of which will be winners over time and generate cash flow), while simultaneously avoiding or mitigating massive losses.
My clients have already taken a high level of concentrated risk to reach their level of wealth. To avoid losing their wealth in their next stage of life, most of my clients choose diversification as the better strategy for them going forward.
Focus on “After-Tax, After-Fee, After-Inflation” Returns
When looking at your portfolio, you should not just focus on the overall growth of your investments. Instead, you should look at how your investments performed after taxes and fees, and whether the return is keeping up with inflation.
For example, if you have a million dollars tied up in a mutual fund you bought for twenty dollars a share, and now it’s at twenty-five dollars a share, you don’t truly have a million dollars because you’ll have to pay income taxes on distributions and capital gains taxes on the sale. Taxes can weigh down investment performance significantly.
If there’s an investment manager handling the mutual fund, you also have a management fee. Fees are a significant drag on investment performance, and if one’s investments cannot match the fees charged for management, they should be reconsidered.
Inflation should also be factored into the performance of your investments. A dollar will buy much less in forty years than it will today. For the long-term investor who has many years to go before retirement or for the wealthy family looking to invest for a future legacy, investments that don’t keep up with inflation may not preserve the spending power needed to accomplish their long-term goals.
A good wealth advisor can address tax-efficient ways to manage a portfolio, beat inflation, and minimize management fees.
An Example of Allocating Assets
Hypothetically, let’s say you have $10 million in assets, no other sources of income, and wanted your investments to provide you with $400,000 per year. You could probably invest in a diversified bond portfolio to provide that income, with the goal of generating a 4 percent return on $10 million. Over time, however, the taxes, fees, and inflation would slowly whittle down the amount of money you have and how far it goes.
Inflation is a significant force and a drag on your spending power. What you bought last year now costs more, and taxes (particularly property taxes) also go up. Some expenses such as healthcare and education grow faster than inflation. If you stick your money in the mattress or become too yield-oriented to get the cash flow you need today, you compromise on investing for future growth that addresses the portfolio challenges of inflation. This can lead either to a reduction in lifestyle (which no one ever wants to do) or to attempts to “grow your way” out of a problem by taking on imprudent risk to make up for earlier bad decisions regarding asset allocation. That can send the proverbial car off the cliff, especially if unforeseen expenses rear their heads.
On the other hand, if you start taking riskier bets by investing all of your money in growth stocks, hoping that your $10 million turns into $20 million, that’s an ugly place to be in if there’s a market correction and your $10 million turns into $5 million instead. Now you’re working from an even smaller base of assets. This is a frequent problem for people who retire too early, who have a chunk of money they believe will last indefinitely if it remains in the same successful (but risky) stocks they’ve always had. They forget about the years when the stock market plummeted. Diversification is important toward building a portfolio that addresses the risks of inflation while providing for and protecting the income stream you need.
In the wealth-creation “concentration” mode, people invest in their business, make blockbuster movies, shoot a basketball, or do whatever they do to take advantage of their edge and maximize their income streams. Before retirement, most people aren’t generating their income through the investment of their assets—they’re relying on the incomes from their jobs or the increase in their balance sheets with the growth of their business. For the advisor, the dance between managing a client’s wealth and dealing with the drags of spending, taxation, and inflation involves looking at how the wealth was built and incorporating the strategies and advantages that informed the client’s concentrated bet. It also involves marrying the concentrated bet attributes that the client understands with a more diversified approach that allows future life objectives to be met when the income stream the client was accustomed to (a yield generated by diverse portfolio of stocks and bonds, for instance) begins to recede or take a different form. Diversification reduces the risk of market drawdown and seeks to avoid the prospect of having to downsize a client’s lifestyle if the assets can’t financially support it.
Everyone has a unique set of goals and obstacles in allocating their assets. A person may have passive income streams from real estate and needs to decide how much to take now as cash flow and how much to invest for the grandkids. That’s far different from the person with a big balance sheet full of illiquid collectibles that aren’t throwing off any income. They’re not out on the street, but they’re not living as comfortably as they’d like, given the wealth they possess. Their decisions will focus on how to reallocate their assets to provide sufficient cash flow.
Every case is unique, but there is one commonality: tension between current income needs and investing for the future. Different investments tend to favor one approach or the other, so we help
clients work through that tension and put a plan in place to take care of current income while investing sufficiently for future growth.
A Quick Note on Overseas Investment
International investment is a useful component of diversification. For the same reason you wouldn’t necessarily invest in just a couple different stocks, it’s not prudent to invest in only one particular country or region. If your heavy investment in one region drops 25 percent, you’ll need a 50 percent gain to restore it to its previous level. Of course, there are risks and opportunities in every region and nation, but it’s good to have exposure to more than one place. The United States may currently be the major driver of the world economy, but the United States is not immune from risk. It’s foolish to think it’s the only country with good investment opportunities. On the other hand, diversification just for diversification’s sake can be risky as well. An investment in a banana republic may promise huge returns, but it’s just as likely to fall into revolution, and your money may not come back. I’m supportive of diversified investments in foreign countries that emphasize economic growth and countries with a culture of governance, predictability, and safety.
When investing directly in overseas opportunities, you may be challenged by different laws, customs, and regulatory environments. Many times, there will be differences in the language spoken and the manner of doing business. If you’re inexperienced with overseas business or the culture of the country you’re investing in, you may want local experts nearby to help you learn the ropes. If there is a time that a management fee is worth the cost, this may be it. The expertise to deal with cross-border issues and the costs of having actual presence in foreign countries can be expensive. I would rather have expertise in these specialized areas than managers who engage in guesswork.
Additionally, if you are a US citizen overseas, you sometimes leave the comfort zone of the US tax system. Overseas taxes and regulations are normally governed by tax treaties between the United States and other countries. American citizens are typically taxed on their worldwide income, which means if you have an asset in Belgium that generates income, you may have tax obligations in both Belgium and the United States. However, in many situations, you may not face double taxation. Often, there are treaties to indicate whether one country gets the money or whether there is a sharing arrangement.
The day-to-day administration of your foreign investments will most likely require more attention than domestic investments. It can be as simple as understanding what your investment is worth in local currency and making sure taxes are categorized correctly and filed in the proper place. It’s useful to lean on local experts with boots on the ground, who have experience dealing with local governance, language, business practices, and financial reporting requirements.
As a safeguard against money laundering, owners of foreign investments may face greater compliance and visibility requirements. The documentation you receive to track or memorialize your investment may need to be formatted and filed differently to comply with local requirements. You hope your information also conforms to your own records and accounting requirements. You’re only as good as the information you receive from the people on the ground.
To make it easier for people to invest overseas without the burden of local management, most investment groups hold their foreign investments in mutual funds and exchange-traded funds (ETFs), hiring managers with in-depth, in-country experience to oversee and manage those investments. This provides a vehicle for investors to gain exposure to other countries without needing to navigate foreign jurisdictions and institutions.
Responding to My Friend on the Phone
After I explained the concepts of this chapter to my friend on the phone, I hoped my phone pal had paid attention well enough to remember the concepts of concentration and diversification. These are concepts that will help him remain wealthy and stay on target to achieve his goals.
“Okay,” he said. “This has been helpful in understanding what I should be thinking about as I consider investing in my brother-in-law’s app. But the question still stands: should I do it?”
“We’re not quite there yet,” I replied. “You need to do a little more thinking on this. We have to see how you should classify this investment and see where it fits in your asset allocation. Another way of thinking about it is to ask the questions:
Can I afford to make this investment if it tanks and goes to zero?
Will my long-term goals be affected by a total loss?
Is the potential upside worth the risk?
Is there a positive impact beyond investment return that I will get by investing in my brother-in-law’s venture?
Maybe most importantly, do I want to get into business with my brother-in-law?
Chapter Five
5. Types of Assets and Where They Fit
Helping our caller make sense of his goals and his long-term plan are the important first steps in untangling the prospect of a new investment. To analyze the appropriateness of the new investment, the next step is to classify and contextualize the investment within his targeted asset allocation. As you consider different types of assets and investments, there are several common and alternative asset classes you’ll want to understand. Let’s begin with two of the most common assets: stocks and bonds.
Stocks
Publicly traded stocks are equity ownership positions in businesses. They can be bought and sold within brokerage accounts. The stocks may be based in the United States, or they may be foreign stocks based in other countries. In the United States, publicly traded stocks are linked to companies that must register with the SEC and provide ongoing information about the company’s financial results.
Stocks have a variable value, and the ability to buy and sell stock is linked to the price being asked by the seller and the amount the buyer is willing to pay. The risk is whether you can find someone willing to buy your stock at the price you’re asking. When the seller’s asking price and buyer’s bidding price meet, the trade is executed and the equity position changes hands. When stocks don’t move, it’s because those two numbers are too far apart.
Stocks can provide the most upside and can also carry the most risk. When you look at stocks, you need to analyze whether the company’s cash flow and growth prospects will increase over time and whether the market will recognize these characteristics.
Publicly traded stocks are fairly liquid, and traditional stockbrokers can usually sell them within a day. Smaller stocks with lower market capitalization may take longer to sell, because there is a smaller pool of owners and buyers. If you really need to liquidate a stock, you can usually find a willing buyer if your selling price is low enough. You may not be happy with the price, however, and that presents a different type of liquidity issue. You’ll likely be able to sell it but not always for the price you’d like to get.
From a transparency standpoint, stock is freely traded, registered with the SEC, and linked to public reports. Along with several Wall Street firms, the financial press—publications such as Barron’s, Wall Street Journal, Investor’s Business Daily, and Kiplinger’s—prepare research reports about large stocks. Other companies provide further intelligence about stocks, both in the traditional media and online. Nevertheless, stocks are much less transparent than cash, because you must rely on the information that is publicly available without knowing what may be happening behind the scenes. There may be strategic shifts under way that have not been shared with the public. Even though there may be many sources of information about stocks, they are not a perfectly transparent investment.
The sudden collapse of Lehman Brothers is a good example of the lack of transparency that can occur. When markets were moving chaotically in 2008, the condition of Lehman’s capital and loan portfolios were conveyed to be much different than they actually were. Even if you are watching CNBC or reading the newspapers to track an investment, you may not hear what is t
ruly going on behind the scenes. There can be a lag in the reporting, and in some cases, there can be outright fraud. With the failure of Enron, for example, faith was placed in management’s reporting while something quite different was transpiring behind the scenes.
How Stocks Return Value
Stocks have two different ways of providing value. Investors can receive a cash flow (through a dividend or stock buyback), or the company can keep the cash and pump it back into the company to help it grow (and increase the value of the stock, ideally). Investors seeking current income will be more interested in the yield scenarios that generate a cash flow through dividends or buybacks.
Google generates a lot of cash, but instead of issuing a dividend, the executive team and board pour the cash back into the business. At the same time, they are pursuing different initiatives they think will spark better sources of return for the shareholders.