WEALTH
SOLUTION
Bringing Structure to
Your Financial Life
THE
Steven Atkinson, Joni Clark, Eric Golberg & Alex Potts
Afterword by DR. HARRY M. MARKOWITZ,
Recipient of the Nobel Prize in Economic Sciences
WEALTH
SOLUTION
Bringing Structure to
Your Financial Life
THE
Steven Atkinson, Joni Clark, Eric Golberg & Alex Potts
Afterword by DR. HARRY M. MARKOWITZ,
Recipient of the Nobel Prize in Economic Sciences
Copyright © 2011 Loring Ward
All rights reserved. No part of this publication may be reproduced,
distributed, or transmitted in any form or by any means without the
prior written permission of the publisher, except in the case of brief
quotations embodied in critical reviews and certain noncommercial
uses permitted by copyright law.
IRN: R 10-239
First edition
Printed in the United States of America
Library of Congress Control Number: 2011920405
ISBN: 978-0-615-43722-4
For his friendship, his courage and his passion
for empowering investors through education,
this book is dedicated to the memory of
Gordon Murray.
Foreword
e rst step toward achieving true nancial success is understanding an
important fact: Being rich is not the same as being wealthy. Being rich,
for many, means living an extravagant lifestyle and accumulating all the
latest luxuries that money can buy in the moment. Being wealthy, by
contrast, means setting specic, meaningful goals for yourself and your
family and then making smart nancial decisions to accumulate assets
over time and achieve those key life goals.
is book is about being wealthy.
e authors wrote it to show the steps that many of today’s most successful
families have taken to build, grow and maintain their wealth—and lead
lives that are both highly enjoyable and deeply meaningful. For these
families, the foundation of their success is Structured Wealth Management.
At its core, Structured Wealth Management is an approach to managing
wealth that takes into account the full range of challenges and
opportunities that today’s families face and coordinates their entire
nancial lives so that everything works in concert to solve those challenges
and capture those opportunities. It brings together investment strategies
rooted in proven academic research with methods for addressing the key
investment concerns that today’s families must face.
If you wish to be truly wealthy, Structured Wealth Management is the key
to making that happen. On the pages that follow, you’ll discover the
framework that will empower you to achieve all that is important to you
and your family, along with ways to implement this framework that will
help ensure a lifetime of nancial success.
An entrepreneurial history
How do I know that Structured Wealth Management works? e answer
is simple. Since 2003, I have used it to help clients achieve their most
important goals and dreams. It has become my mission to provide
families the Structured Wealth Management knowledge and tools they
need to determine the very best life that they truly want for themselves
and then help them make it a reality.
My desire to help others make smart decisions about their nances
actually began well before I ever considered becoming a nancial
advisor; it started when I was a young undergraduate student majoring
in engineering. My family never had a lot of money to spare, so to
make ends meet, I took a job at a local pizzeria that I soon learned was
struggling. I helped the owners improve the business substantially—so
much so that they asked me to manage its business model. Once I saw
the economic potential, I realized that I could do much better for myself
by starting up my own pizzeria than I could by continuing down the
engineering path. So, with a trusted partner, that’s exactly what I did.
Our pizzeria venture was a big hit. So big, in fact, that we opened 32
more stores across Ohio during the next six years. As we expanded,
however, I noticed that many of the franchise owners and managers
would approach me with requests to stretch out loan terms, borrow
money, or postpone paying franchise fees. eir need for help always
stemmed from the same thing: a poor nancial decision they had made
that put them in bad shape. Going backward nancially is obviously
bad, but so is spinning your wheels—going to work every day and
failing to increase your net worth isn’t much better. So I began to help
them with their nances to move them and the company in the right
direction. I gured that if I helped them to be proactive with their
money and showed them how to make better decisions, they wouldn’t
end up coming to see me after something had already broken. My help
included everything from business nancials to investing and retirement
planning, funding tax liabilities, securing the correct insurance, and
business succession planning. I didn’t get paid for my advice. I did it
so my people would be protected nancially, be happier, and have good
lives for themselves and their families.
From Wall Street to independence
In the late 1990s, after a short stint in the dot-com world, I decided it
was time to move on and sell my company. Helping people as a nancial
advisor seemed an obvious next step. After going back to school and
earning nancial degrees, I became certied as a nancial planner, got a
job as a stockbroker at a big Wall Street rm and prepared to help people
achieve their nancial dreams.
I was in for a very rude awakening. I learned that Wall Street’s priorities
were not aligned to work in the clients’ best interests. Instead, I was
supposed to sell the clients those products that made the most money
for my employer. It was all about the rm—not the client. It didn’t
matter if it was a 70-year-old trying to preserve wealth or a 40-year-old
trying to aggressively grow wealth—the investment options given to me
by the corporate oce were the same. Why? Because those were the
investments that were most protable for the rm, I remember thinking,
“is is crazy. It’s a hoax!” I couldn’t imagine not doing the right thing
for clients all day long and then coming home to my wife and children
and feeling good. ese clients put their trust in me to be able to provide
what was right for them.
I started looking for another approach—as an independent advisor. I
immediately saw that the independent advisor’s alignment was the
complete opposite of Wall Street’s. As an independent, I would focus
on the client’s needs—the client would be the boss, not the big parent
company with an agenda. My job would be to listen and nd all the best
solutions for each client. Not the best solutions for a parent company,
but the best for the client who is trying to achieve his or her biggest
dreams. I realized that was exactly what I was looking for—and I made
the switch.
Today, I combine an independent approach with the Structured Wealth
Management process to help guide clients with not just their investments,
but also wealth enhancement, wealth protection, tax mitigation, estate
planning, retirement planning and charitable giving. In short, I help
them make smart decisions in all areas of their nancial lives. e need
for this comprehensive approach is vital today. e decisions we make
about our money aect not just ourselves, but also our families, our
communities and the world around us. We all have to be good stewards
of our wealth so that it can do the most good for the people we care
about most. We cannot aord to let these assets wither away due to bad
decision making.
is book will show you how to be that good steward and use your
wealth to build the life you want, which is why I’m extremely honored
to have been asked to write this foreword. I encourage you to read on so
you can learn how I help clients every day to achieve their true nancial
well-being. I wish you success in all your endeavors as you journey down
the road to nancial success.
— J G, CFP®
Acorn Financial Services
Table of Contents
Chapter 1
A Framework for Financial Success ................................................1
Chapter 2
e Key Challenges Facing Today’s Investors ................................7
Chapter 3
e Structured Wealth Management Solution ............................. 15
Chapter 4
e Investment Planning Process: An Overview .........................25
Chapter 5
Markets Work ................................................................................29
Chapter 6
Risk & Return Are Related ...........................................................51
Chapter 7
Diversify with Structure ................................................................ 65
Chapter 8
Building and Implementing Your Investment Portfolio ..............83
Chapter 9
Invest for the Long Term ...............................................................93
Chapter 10
Advanced Planning and Trusted Advisory Relationships..........107
Chapter 11
Putting It All Together ................................................................121
Chapter 12
Selecting the Right Advisor .........................................................129
Afterword .....................................................................................141
About the Authors ........................................................................143
Acknowledgements ...................................................................... 147
Chapter 1
A Framework for Financial Success
“Being rich is having money; being wealthy is having time.”
— H W B
A few years ago, a friend who worked as an executive at a huge
technology rm in Silicon Valley found herself in a dismal nancial
situation — facing an enormous tax bill on stock option gains that,
for a variety of reasons, never found their way to her bottom line.
Suddenly, instead of enjoying a well-earned retirement, replete with
sunny vacations to exotic places and free time to spend with friends
and family — she was forced to continue working for many more
years in order to help rebuild the wealth that she never should have
lost in the rst place.
Her story is troubling and all too common, even for sophisticated,
educated investors. We’ve seen too many similar nancial missteps
over the years. Too many investors never reach their most important
goals — not because they aren’t smart or don’t make the eort, but
because they don’t use a successful plan to help them get there. As a
result, they end up compromising not just their own futures, but the
futures of their families.
Our goal is to give you the tools you need to make smarter nancial
decisions — and avoid the mistakes that too often trip up investors.
We are committed to making sure that investors have everything
they need to achieve all that is important to them and their
loved ones.
Chapter 1: A Framework for Financial Success — 3
If you’re like the vast majority of investors today, you could use such
tools and guidance. Saving and investing to reach your nancial
goals can often seem like a huge challenge. And chances are, you’re
at least a little uncertain about whether the decisions you’re making
with your money in a variety of key areas — from investing for
retirement to minimizing taxes to paying for a child’s college tuition
— are the right decisions.
You are the reason why we’ve written this book. It will give you an
actionable framework to help you make better, wiser, more informed
decisions in all areas of your nancial life.
To get started, we need to acknowledge an important fact. It’s become
harder than ever to navigate through the increasing complexity of our
nancial lives and ensure that we are making consistently smart moves
with our money. Achieving major nancial goals was challenging
enough even before the so-called “Great Recession” and the tremendous
upheaval in the nancial markets in recent years. In the wake of those
historic events, many investors feel more confused and uncertain about
their futures and how to get back on the right track.
When we rst sat down together to discuss the idea of writing a
book to help investors, it was in late December 2009 — the tail
end of a decade that saw the worst 10-year return for the Dow
Jones Industrial Average since the 1930s. During that time, many
investors watched their hard-earned savings plummet in value.
Many questioned their approach to saving, spending and investing,
and worried that they would have to delay or forgo some of their key
life objectives such as a comfortable retirement, or leaving a legacy
to their children. is fear that many investors experienced during
the worst of the recent downturn is not easily forgotten — and has
left many wondering how to get back on track and stay there over
the long run.
2 — The Wealth Solution
But if that’s the reality today, it’s important to recognize another
fact: ere is a process that can enable you to cut through all the
confusion and noise, simplify your nancial life and help ensure
that you’re making the smartest possible decisions about your
money consistently — day in and day out. What’s more, it’s a
prudent, time-tested process based on empirical evidence about how
the nancial markets operate, a process used by some of the most
successful families in America to manage their wealth.
is process — called Structured Wealth Management — is what this
book is all about. As you’ll discover, Structured Wealth Management
is a fundamentally dierent method for managing your nancial life
from those used by other investors (including most nancial advisors
and investment professionals). It is designed to help you solve
your biggest nancial issues — including investments, taxes, estate
planning, wealth preservation and protection, and charitable giving.
Structured Wealth Management: An Overview
Structured Wealth Management is a dened and disciplined process
that consists of a number of closely connected steps. We’ll explore
this process in greater detail in the following chapters. For now, it’s
helpful to understand three main characteristics:
• Structured Wealth Management is consultative. Structured Wealth
Management helps you identify and clarify the specic nancial
goals that are truly important to you — those that hold the most
meaning and will have the greatest impact for you and your
loved ones. By beginning with this step, all your future nancial
decisions can be made “with a purpose” — that is, within the
context of your key objectives. is method is distinctly dierent
from other approaches, in that it steers you to make decisions based
not on events in the markets or the economy but on the steps you
should take to further your progress toward your unique goals.
Chapter 1: A Framework for Financial Success — 3
2 — The Wealth Solution
Chapter 1: A Framework for Financial Success — 5
Wealth management should not be concerned with picking
hot stocks or trying to beat the overall market. Instead, wealth
management blocks out the “noise” by encouraging investors to
answer an extremely powerful question: What should I be doing
with my money to provide the life I want most?
is approach to wealth management tangibly puts tremendous purpose
behind your nancial decisions. Your timeframe and perspective are
immeasurably broadened, and you no longer have to worry about what
the stock market is doing today or this month or even this year. You are
no longer thinking tactically, but strategically. Your plan is based around
a desired long-term outcome — not on beating the market or simply
guarding your wealth from short-term losses.
• Structured Wealth Management is comprehensive. Many
investors focus only on one aspect of their nancial lives — often
their investment portfolios or 401(k) accounts. Of course, smart
investment choices are crucial to achieving long-term nancial
goals such as a secure retirement. But for nearly all of us, there are
other vital issues that need to be addressed to make our goals come
to fruition. Depending on your circumstances, these needs could
range from saving for future college tuition costs to helping aging
parents meet health care needs to providing for children and heirs
to supporting your favorite non-prot organizations and causes.
Unlike many approaches to nancial planning, wealth management
addresses the full range of nancial-related issues that investors and
their families face. What’s more, it ties all those various pieces and
moving parts together seamlessly, so that the components of your
nancial life — investments, insurance, wills and trusts and so on
— always work together as eectively as possible to achieve the
meaningful goals you’ve set.
4 — The Wealth Solution
• Structured Wealth Management is rooted in facts, data and analysis.
Based on decades of nancial data and research, this rational and
practical approach helps investors avoid making rash, emotional
decisions that could derail their plans and make it harder for them
to reach their goals. For example, many investors in the wake of
the nancial crisis of 2008 and 2009 became fearful of investing in
the nancial markets. But we know from history that markets have
tended to work in the long run — despite the occasional crisis.
In order to fully take advantage of Structured Wealth Management
and make the most of its benets, we encourage you to work in
partnership with a nancial advisor who uses the type of approach
we outline in this book.
e reason is simple: Successfully managing all the key aspects of your
nancial life is a complex process — one that can require a great deal
of time and attention to detail to get right. In our experience, we’ve
seen that most investors lack the time, knowledge or desire needed
to manage their wealth. As a result, we have found that investors
tend to end up in much stronger nancial shape when they enlist
a professional whose job is to stay acutely focused on their clients’
nancial lives and the Structured Wealth Management process at all
times. is is not to say that it is impossible to implement Structured
Wealth Management on your own and have a better nancial life.
But this process will be so time consuming and requires such extensive
knowledge and specialization, it is not very practical for the majority
of investors. We believe it makes sense for your wealth management
eorts to be as successful as they possibly can — and that working
in partnership with the right kind of nancial advisor oers a much
surer and smoother path to achieving your nancial goals.
Chapter 1: A Framework for Financial Success — 5
4 — The Wealth Solution
Why You Need Structured Wealth Management
e term “wealth management” may seem a little o-putting if you
don’t think of yourself as particularly wealthy. e truth is, you don’t
have to be among the super-rich to make the wealth management
process a successful and important part of your nancial life. Quite
the contrary. We all face numerous nancial goals, challenges and
choices, from paying for today’s bills to funding goals that might be
decades away to leaving a lasting legacy. ese concerns won’t solve
themselves or go away if you ignore them. Indeed, by disregarding
them, you’re simply asking for someone else to make the decisions
about how and where your money is used.
If you don’t want to be dependent on or beholden to others,
you need to eectively manage the money you do have. Wealth
management’s aim is to help you make smart, rational choices about
your nances so that you can control your own destiny and build
the life you want for yourself and your family. is approach makes
wealth management entirely applicable to your life — regardless of
whether you have $100,000 or $20 million. It is designed to help
address issues that almost all of us will have to face at some point in
our lives. So ask yourself: Do you want to create a plan to address
those issues structurally, or do you want to leave it all to chance?
We think the answer is obvious. You have an obligation to make
wise choices about your wealth and do all you can to avoid frittering
it away. e reason: Your wealth can create a world of good — for
yourself, your spouse, your children, grandchildren, and beyond. So
whether or not you “feel” wealthy isn’t the point. In the end, your
assets can be a tremendously positive force in many, many lives. But
you have to take proper care of them to make all that happen.
We’d like to show you how.
6 — The Wealth Solution
Chapter 2
e Key Challenges Facing
Today’s Investors
To understand how Structured Wealth Management may help you achieve
nancial success, it’s necessary to rst recognize the most signicant issues
aecting investors today.
Chances are you’re nding it more challenging than ever these days to
wrap your arms around your increasingly complex nancial life and
make good sense of the entire picture. But the sooner you determine
where you are now and where you want to be in the future, the sooner
you can set out to build a plan that tackles the major issues that impact
your life.
For more than two decades, we have worked closely with hundreds
of top nancial advisors who together serve thousands of investors.
Our experience helping advisors help their clients achieve their most
important nancial goals has taught us that investors today share six
major concerns:
Concern 1: Preserving Wealth in Retirement
How are you going to grow and preserve your wealth so that you have
the money required to meet your needs and fulll your goals — not just
today, but for decades to come?
It’s a huge question — one that investors are asking themselves more
and more. e vast majority, regardless of their level of wealth, are
concerned about preserving their wealth so they will have enough
money throughout retirement.
6 — The Wealth Solution
Chapter 2: The Key Challenges Facing Today’s Investors — 9
is makes perfect sense. Few of us want to be forced to downsize our
lifestyles. And yet, many investors are not nancially positioned to max-
imize their chances of maintaining their lifestyles during retirement —
especially when you consider the challenges that today’s pre-retirees and
retirees must contend with. For example:
• Ination’s impact. Rising prices can decimate your purchasing
power, savings and your ability to preserve wealth throughout your
golden years. Assuming the long-term historical annual ination rate
of around 3%, an annual xed income of $100,000 would be worth
just $86,000 in ve years and only about $40,000 in 30 years. e
same purchase that would cost $100,000 today would soar to more
than $240,000 in 30 years. And if ination runs at a much higher
rate than normal for an extended period — a real concern given the
huge amount of government spending that has occurred in recent
years — the goal of wealth preservation and income replacement
throughout retirement could become even tougher to achieve.
• Rising life expectancies. anks to continued advances in health
care, American seniors are living 50 percent longer than they were in
the 1930s. According to the Centers for Disease Control, a 65-year-
old can now expect to live another 18 years, on average.
1
For a 65-year-
old married couple, there’s a 58% chance that one of them will live to
90 and a 29% chance that one will reach 95.
2
While that is certainly
good news, it also means that you must make your money last much
longer or risk running out of money before you die.
• Soaring health care costs. e cost of health care has been rising at
a much faster pace than the overall rate of ination in recent years. is
should be of particular concern to aging investors who are more likely
than younger Americans to consume substantial amounts of health care
goods and services. What’s more, Medicare might only cover about
50% of a typical retiree’s medical expenses. Consider that seniors age 65
and over spend an average of $4,888 per person annually for deductibles,
copayments, premiums and other health care costs not covered by
insurance, according to the most recent National Health Expenditure
Survey.
3
at amount is more than two times the amount spent by
8 — The Wealth Solution
average non-elderly adults. And the largest expenditures occurred
among those 85 and older. According to the Employee Benet
Research Institute (EBRI), a retired couple age 65 would need
approximately $338,000 to have a 90% chance of covering their
out-of-pocket health care expenses in retirement.
4
• A weakened Social Security system. It’s no secret that Social
Security has long been in trouble, but a look at the numbers is
particularly sobering. Under current assumptions, Social Security
trust fund expenses are expected to exceed income from taxes some
time around 2016. By 2024, those expenses are expected to exceed
income from taxes plus interest income, and the trust fund is
expected to be exhausted by 2037, according to EBRI.
5
• e diminished role of pensions. Retirement has become a largely
self-funded venture, as evidenced by the fact that just 32% of
workers today participate in some type of dened benet (pension)
plan. at’s down from a full 84% in 1980, according to EBRI.
ese days, the majority of workers (55%) participate in dened
contribution plans — 401(k)s and the like.
6
• Taking care of kids and parents. According to the Pew Research
Center, one out of every eight Americans, ages 40 to 60, is raising
a child while also caring for at least one aged parent at home. In
addition, roughly 7 to 10 million Americans are caring for their
aging parents from a long distance away.
7
_________________________
1 Center for Disease Control and Prevention, “National Vital Statistics Reports,” Vol. 56, No.
10, 2008
2 American Academy of Actuaries, 2008.
3 “National Health Expenditure Data: Personal Health Care Spending by Age Group and
Source Of Payment, Calendar Year 2004,” Centers for Medicare and Medicaid Services
4 “Savings Needed for Health Expenses in Retirement: An Examination of Persons Ages 55
and 65 in 2009,” June 2009, Vol. 30, No. 6, Employee Benefit Research Institute, 2009
5 “The Basics of Social Security Updated with the 2009 Board of Trustees Report,” July 2009,
Employee Benefit Research Institute
6 EBRI Databook on Employee Benefits, updated April 2010, Employee Benefits Research Institute
7 “From The Age of Aquarius to the Age of Responsibility,” Pew Research Center, 2005.
Chapter 2: The Key Challenges Facing Today’s Investors — 9
8 — The Wealth Solution
Chapter 2: The Key Challenges Facing Today’s Investors — 11
e end result: Too many investors saving for retirement today face a
higher level of uncertainty about their future prospects than their parents
and grandparents did. In the wake of that uncertainty, you simply have
to be smarter, plan better and question many of the assumptions long-
held by previous generations and many in the nancial services industry.
We believe that traditional “rules of thumb” advice such as needing 70%
of your working income during retirement cannot be taken as gospel
anymore. Your retirement plan needs to reect the realities of the world
today and going forward. In chapters ve through nine, we will explore
how you can position your portfolio to capture the growth and
profits that the nancial markets generate, while minimizing downside
risk through proper portfolio allocation and ongoing risk maintenance
and rebalancing.
Concern 2: Minimizing Taxes
You’ve probably heard the adage that “it’s not what you make, it’s what
you keep that counts.” Not surprisingly, mitigating income taxes is a
major concern for most investors. No one enjoys paying taxes and in-
come taxes are typically the most obvious and onerous taxes investors
face. In addition, mitigating estate taxes and capital gains taxes also
ranks high on the list of many investors’ concerns.
Such concerns are well founded, as taxes can signicantly erode your ability
to grow and preserve wealth. From 1926 through 2009, for example,
stocks as represented by the S&P 500 Index, gained 9.8% annually.
After taxes, however, that return fell to just 7.7%. Bonds’ 5.4% annual
return dropped to a mere 3.4% once taxes were taken into account.
In real terms, a $1 investment in stocks back in 1926 would have grown,
before taxes, to $2,592 at the end of 2009 — but just $510 on an after-
tax basis.
8
ere’s cause for additional concern. Taxes during the past decade or
so have been hovering at relatively low levels — but may be set to rise.
Trying to predict tax code changes is a risky bet, of course. But you
need to be aware that higher taxes across the board could be on their
way — and at the very least, build exibility into your plan so you can
10 — The Wealth Solution
make adjustments should your tax situation change. e good news:
You can take steps to minimize the taxes you pay and keep more of what
is yours by using a variety of wealth management techniques, such as
tax ecient investment vehicles and smart asset location strategies that
will be explored later.
Concern 3: Eective Estate and Gift Transfer
e ancient Chinese adage that “wealth never survives three generations”
seems equally applicable today. A major concern for many investors is
ensuring that their heirs, parents, children and grandchildren are well
provided for in accordance with their wishes. And yet, our experience
is that most investors don’t have an estate plan — and many of those
who do, have outdated plans. Even more troubling: 65% of all American
adults don’t even have a will, according to a 2009 Harris Interactive study.
9
Many investors don’t take the appropriate actions in this key area of
their nancial lives because they assume they don’t possess enough
wealth to necessitate an estate plan. Regardless of your net worth, the
ability to ensure that your assets go to where you want them to has
numerous and important potential implications — from being able to
help a child or grandchild go to college to ensuring the continuity of a
family-owned business to simply avoiding probate. Take college tuition,
for example. College education expenses have risen at a rate of more than
5% annually during the past decade, according to the College Board.
10
at means a child born today could need over $220,000 to attend a
four-year public college in 2028 — more than triple today’s college costs.
Passing on wealth and using it to benet your heirs as you see t doesn’t
happen automatically — it requires the implementation of the right
strategies for your goals and situation. As you’ll see later, those strategies
might include everything from correct titling of assets to smart gifting
strategies and trusts designed to provide maximum benets to a spouse,
family members or charities.
_________________________
8 Morningstar, Inc. 2010
9 www.lawyers.com/understand-your-legal-issue/press-room/2010-Will-Survey-Press-Release.html
10 “Trends in College Pricing 2009,” The College Board
Chapter 2: The Key Challenges Facing Today’s Investors — 11
10 — The Wealth Solution
Chapter 2: The Key Challenges Facing Today’s Investors — 13
Concern 4: Wealth and Income Protection
A signicant number of investors today are worried about keeping
wealth safe from potential creditors, litigants, children’s spouses and
potential ex-spouses, as well as from catastrophic loss. ey also want to
be sure that their loved ones are protected in the wake of major health
problems or other unforeseen events. Certainly many professionals
(such as attorneys and physicians), business owners and entrepreneurs
need to focus on protecting their hard-earned wealth. And in today’s
highly litigious culture, nearly everyone needs to consider the possibility
of having their wealth unjustly taken from them. Increasingly, investors
are realizing the importance of confronting some tough and potentially
uncomfortable questions:
• WhatwouldhappenifIwasthevictimofafrivolouslawsuit?
• Whatwouldhappenifoneofmychildrenmarrieda“golddigger,”
then divorced and was sued for a large sum?
• Whatwouldhappenifoneofmychildrenwasinanaccidentinmy
car or someone suered an injury in my home?
• Whatifamajordisabilitypreventedmefromworkingandgenerat-
ing an income for my family?
• WhatifIendupneedingtoliveinanursinghomeorrequirehome
health care services?
Wealth management strategies aimed at wealth protection can motivate
creditors to settle, mitigate the possibility of being sued or minimize the
nancial impact of a judgment. Various trusts and business structures
can work eectively in this area. Trusts and insurance can also play a role
in protecting your wealth and income from an unexpected hardship.
We’ll examine some of these strategies in Chapter 10.
Concern 5: Charitable Gifting
Helping to facilitate and increase the eectiveness of their charitable
intentions is also very important to many investors. From direct gifts
to formal gifting structures like donor advised funds and private family
foundations, many investors are looking to ensure that their money is
12 — The Wealth Solution
being used by their chosen charities to generate the maximum impact
on the social and economic issues they care about most.
Simultaneously, these investors want to make sure that their philan-
thropic goals don’t conict with or endanger their own nancial futures
and their ability to secure a comfortable retirement for themselves and
leave a legacy for their families.
Concern 6: Finding High-Quality Financial Advice
Many investors have long been concerned about working with capable
nancial professionals. It’s little wonder. For decades, much of the nancial
services industry has been driven by a sales-oriented culture that stressed
pushing products instead of providing comprehensive wealth manage-
ment services.
is concern reached a peak during the market downturn of 2008 and
2009 fueled by enormous market volatility, the revelation of the largest
Ponzi scheme in history, and the fact that the largest investment rms in
the world suered tremendous losses from bad investment decisions they
made on their own behalf. All of this created a signicant and still-grow-
ing sense of dissatisfaction in and distrust of the nancial services industry
among many investors. Consider the following from a 2008 Survey:
• 81percentofinvestorssaidthattheyplannedtotakemoneyaway
from their current advisor.
• 86percentofinvestorsplannedtotellotherinvestorstoavoidtheir
advisor.
• Amere2percentplannedtorecommendtheiradvisortootherinvestors.
11
We recognize that many of you are looking for guidance and assistance
in managing your nancial life. With that in mind, we’ve included a
chapter in this book to help you nd professionals who oer objective
advice and who would act as a true duciary on your behalf. e good
news is that during the past decade or so, more and more advisors have
begun implementing a true wealth management process and acting as
_________________________
11 Prince and Associates, 2008
Chapter 2: The Key Challenges Facing Today’s Investors — 13
12 — The Wealth Solution
duciaries to their clients. If you choose to work with an advisor, you
may nd great benet in using the guidelines and best practices in
this book.
You most likely share at least some or possibly all of the aforementioned
nancial concerns. Each one is a sizable challenge on its own — and
taken together, they present you with a potentially enormous hurdle on
your path to a comfortable, secure and meaningful nancial life. is
is where the wealth management process brings tremendous value. By
helping you develop integrated solutions to these concerns and creating
a plan that strikes the optimal balance between them, you can simplify
your nancial picture and achieve greater overall nancial success than
you could by dealing with these challenges on a case-by-case basis.
14 — The Wealth Solution
Chapter 3
e Structured Wealth
Management Solution
As you’ve seen, the nancial challenges you face may be sizable and
complex — and they can aect every facet of your life. To address them,
you need a disciplined process that will allow you to consistently make
the prudent decisions that will help you achieve your most important
goals. Without this approach, you may needlessly put your future and
your family’s future at risk.
We believe that the most eective way for most investors to address the
many challenges they face is by adopting a comprehensive Structured
Wealth Management process. Indeed, that’s exactly what many of today’s
most successful families are doing.
But what exactly do we mean by comprehensive Structured Wealth
Management? e term “wealth management” has become a buzzword
in recent years. Financial advisors of all types are now calling themselves
“wealth managers” and claiming to oer wealth management services.
Unfortunately, many of these advisors are wealth managers in name only
— after all, the title “wealth manager” sounds much more impressive
than “stockbroker.”
We believe that wealth management is not a term open to interpretation
or multiple denitions. In order to benet from true wealth
management, you need to make sure you’re actually bringing together
wealth management professionals who possess the capabilities and
expertise to address your biggest nancial challenges and goals.
14 — The Wealth Solution
Chapter 3: The
Structured Wealth Management Solution
— 17
16 — The Wealth Solution
Structured Wealth Management Dened
At its core, Structured Wealth Management encompasses each specic area
of your nancial life (i.e. tax planning, estate planning, risk management,
etc.) employing professionals who have expertise in these specic areas.
e wealth management process stands in stark contrast to how most
investors operate today. e vast majority of investors tend to address
nancial goals like college and estate planning on an ad hoc basis — treating
these issues as separate concerns. ese investors neglect to understand
that the complex scope of issues they face are often deeply interconnected
and must be managed in a coordinated manner. Usually, issues are dealt
with only as they arise, and typically just enough information is gathered
to implement the particular solution to the problem at hand.
Structured Wealth Management should be thought of as a detailed
blueprint guiding all your decisions, ensuring that they all work together
in a coordinated manner.
Structured Wealth Management accomplishes this in three ways:
1. Using a consultative process to gain a detailed understanding of
your deepest values and goals. is process helps ensure that your
wealth is utilized to pursue your key life objectives.
2. Employing customized solutions designed to t your specic needs
and goals beyond simply investments. e range of services and
tools involved in crafting wealth management solutions might include
insurance, estate planning, business planning and retirement planning.
3. Delivering these customized solutions in close consultation with
other professional advisors. is enables investors to work closely
— and in a coordinated manner — with trusted advisors to identify
potential issues, implement solutions and regularly monitor your
overall nancial situation. Such advisors oer valuable expertise,
perspectives and analysis that can help investors avoid making
irrational decisions that jeopardize their nancial goals.
Broadly, this process incorporates all the main components of wealth
management:
• Investment planning allocates your assets based on goals, return
objectives, time horizons and risk tolerance and is the foundation
upon which a comprehensive wealth management solution is created.
• Advanced planning addresses the entire range of nancial needs
beyond investments in four primary areas: wealth enhancement,
wealth transfer, wealth protection and charitable gifting.
• Trusted advisory relationships are created by assembling and managing
a network of experts who will be involved in providing solutions to a
variety of nancial issues where they have specialized expertise.
To organize your thinking and approach to wealth management, you
can use this formula:
Structured Wealth Management = investment planning +
advanced planning + trusted advisory relationships
Investors rarely take this type of coordinated and comprehensive approach
with their nances. is can lead to problems that may jeopardize the
nancial health of their families, their businesses and themselves. is is
why wealth management is so important: It enables you to see the big
picture at all times and make decisions within this framework instead of
focusing on only one aspect.
Incorporating a Structured Wealth Management approach requires
you to think through the full range of the nancial challenges you
and your family face, and develop optimal solutions that work in a
coordinated manner. Whether you act as your own wealth manager or
work collaboratively with a professional wealth advisor, you will gain a
tremendous advantage over other investors who take a less disciplined,
ad hoc approach to managing their nancial lives.
Chapter 3: The
Structured Wealth Management Solution
— 17
16 — The Wealth Solution
Chapter 3: The
Structured Wealth Management Solution
— 19
18 — The Wealth Solution
e Wealth Management Consultative Process
e Wealth Management Consultative Process is a formal series of ve
structured steps, which are typically conducted as meetings:
1. e Discovery Meeting. is rst step is to help you uncover and
clearly identify your true nancial goals — the things you want and
need most out of life. e overarching goal of the Discovery Meeting
is to understand your unique situation — your key goals and values
— and identify the challenges you face in achieving what is most
important to you. Once these goals are established and understood,
your optimal plan can be designed.
2. e Investment Plan Meeting. At this meeting, the wealth manager
presents a detailed series of investment recommendations designed
around the information uncovered during the Discovery Meeting.
A well-crafted investment plan can help ensure that your investment
decisions are based on rational analysis, which can help you avoid
making long-term investment decisions based on emotional respons-
es to short-term or one-time events. Each investment plan should
include these seven important areas of discussion:
• Your long-term goals, objectives and values. Long-term goals
can consist of anything from early retirement to purchasing a new
home to achieving nancial independence. ese goals are the
bedrock upon which your investment plan will be based.
• e expected time horizon for your investments. Your time
horizon consists of the period of time your portfolio is expected
to remain invested. For example, a 65 year old retiree should plan
for a potential time horizon of at least 25 to 30 years.
• A denition of the level of risk that you are willing and able to
accept. It is important for you to understand the amount of risk
you are willing and able to tolerate during your investment time
horizon. In designing your portfolio, your advisor will help you
determine both your nancial risk tolerance (the amount of loss
you might have to absorb in order to meet your goals) and your
emotional risk tolerance as well (the amount of loss that you can
accept without acting on your emotions by changing your prede-
termined asset allocation).
• e rate-of-return objective and asset classes that will be used.
Your advisor will help to identify the specic return/risk proles
of each potential portfolio, and use these proles as the frame-
work to determine your asset allocation.
• e investment methodology that will be used. We rmly be-
lieve that investors are best served by accepting a market rate of
return and using low-cost investment vehicles in order to try and
achieve that return.
• A rebalancing plan. You also will need to establish the means for
rebalancing and making periodic adjustments to the portfolio as
needed. Rebalancing your portfolio will help ensure it maintains
the desired risk and return parameters.
• Monitoring and reporting methods. Your goals won’t remain
static over time — they’ll change as your life changes. at’s why it’s
important to regularly monitor your portfolio and ensure it reects
where you are today and where you want to be down the road.
3. e Mutual Commitment Meeting. It’s important that you con-
sider the proposed investment plan thoroughly before committing
to work with a wealth manager. After you have reviewed the plan
carefully, this meeting will allow you to ask any questions or voice
concerns you have about the plan and decide whether to move ahead
with implementation.
4. e 45-Day Follow-up Meeting. is meeting allows your wealth
manager to help you understand and organize the nancial docu-
mentation involved in working together. It’s also an opportunity to
review any initial concerns and questions.
Chapter 3: The
Structured Wealth Management Solution
— 19
18 — The Wealth Solution
Chapter 3: The
Structured Wealth Management Solution
— 21
5. Regular Progress Meetings. Regular Progress Meetings focus on
reviewing the steps you’ve taken toward meeting your various goals
and making any necessary adjustments based on changes in your
personal, professional or nancial situation.
e Discovery Meeting and Total Investor Prole
As noted above, one reason why wealth management can be so eective
in addressing investors’ needs is because of the Discovery Meeting, which
is focused on helping you identify your most important nancial goals.
e reality is, you simply cannot solve the complex and sometimes
conicting issues you face until you position your nancial assets around
the values, needs, goals and issues that are most signicant to you.
e Discovery Meeting enables you to identify all that is truly important
to you in seven key areas of your life. In working with an advisor, there
must be a close and thorough understanding between you in these seven
areas — an understanding that goes well beyond the simplistic aspects of
a typical investment review. Your answers to the types of questions below
will enable you to develop a holistic, all-encompassing picture of your
life goals so that your assets can be positioned appropriately:
1. Values. What is truly important to you about your money and your
desire for success, and what are the key, deep-seated values underlying
the decisions you make to attain them? When you think about your
money, what concerns, needs or feelings come to mind?
2. Goals. What do you want to achieve with your money over the long
run — professionally and personally, practically and ideally?
3. Relationships. Who are all the people in your life who are important
to you — including family, employees, friends, perhaps even pets?
4. Assets. What do you own — from your business to real estate to
investment accounts and retirement plans — and where and how are
your assets held? Conversely, what do you owe to lenders, and what
continuing obligations do you have (to family, charities, etc.)?
20 — The Wealth Solution
Chapter 3: The
Structured Wealth Management Solution
— 21
5. Advisors. Whom do you rely upon for advice, and how do you feel
about the professional relationships you currently have?
6. Process. How actively do you like to be involved in managing your
nancial life, and how do you prefer to work with your trusted
advisors?
7. Interests. What are your passions in life — including your hobbies,
sports and leisure activities, charitable and philanthropic involve-
ments, religious and spiritual proclivities, and children’s schools
and activities?
If you have a spouse or partner, he or she should be equally involved in
this discussion. It’s not uncommon for couples to have diering values,
priorities or interests. Such dierences need to be recognized and
accounted for so that you have a better understanding and appreciation
of each other — and so that the plan you create can be eective in
meeting your collective goals.
Your wealth manager can then use that information to create a Total
Investor Prole that will serve as a roadmap — a guide so that every
nancial decision you make supports what you want most from life (see
Exhibit 3.1).
If, like many investors, you currently work with one or more nancial
advisors, you are probably aware that most use some type of fact-nding
process in the rst meeting. However, you may also have noticed that
these questions usually focus entirely on your investable assets and net
worth. In contrast, note that only one of the seven categories that make
up wealth management’s Total Investor Prole concerns assets. Six of
the seven are focused on helping you (and your wealth manager) better
understand who you are as a person. By engaging in this Discovery
Process and using the insights learned from it to create a personalized
prole, your wealth and all the choices you make about it become
perfectly aligned with the life you want to build for yourself, your
family and those you care about most.
20 — The Wealth Solution
Chapter 3: The
Structured Wealth Management Solution
— 23
22 — The Wealth Solution
Exhibit 3.1: The Total Investor Profile
Assets
Goals
Advisors
Process
Relationships
Interests
Values
You
Of the seven categories that make up the Total Investor Prole, we
believe the most important is the one representing your values.
Values are one of the core motivations for everything we do in our lives,
and have a profound impact on every important decision we make,
from what we choose to do for a living to whom we marry to how we
spend our free time — in short, who we are as people. For example, if
you’re a parent you probably value your children above almost every-
thing else in the world. As a result, you want to protect them, to educate
them well and to set them onto a smooth path in life. Financially
speaking, one of the things you may want to do is build an adequate
college fund for your children’s education. is is a common goal.
But underlying that goal is the fundamental value of loving your
children. Values run the gamut from the basic — such as security,
nancial freedom and not having to worry about paying the bills —
to deeper such as family, community, faith and reasons for being.
As important as values are, however, most of us are not particularly
good at articulating them. e Discovery Meeting step can therefore
bring substantial advantages to the process of managing wealth
eectively by helping you uncover and clarify your core values.
One way to go about this is to ask yourself: “What is important to me
about money?”
Let’s say that your rst answer is “Security.” You would then want to ask
yourself, “Well, what is so important to me about security?” You might
decide that the answer is “Knowing that I can take care of my family.”
You would then ask, “What is important to me about taking care of my
family?” You would continue uncovering your values in this way until
there is nothing more important to you than the last value you stated. At
that point, you will have uncovered your single most important value.
While this is straightforward on the surface, it’s important to realize that
it takes perseverance to drill down to your most important value. Most
of us simply don’t spend a lot of time thinking about the issue. at is
why the best results occur by having a collaborative conversation about
values with an advisor.
In the following chapters, we’ll explore each of the three
main components of wealth management — investment plan-
ning, advanced planning and trusted advisory relationships — in
more detail. Armed with this information, you’ll be ideally
positioned to bring solutions to your nancial issues and achieve your
biggest goals.
Chapter 3: The
Structured Wealth Management Solution
— 23
22 — The Wealth Solution
24 — The Wealth Solution
Chapter 4
e Investment Planning Process:
An Overview
Investment planning is the foundation of a properly Structured Wealth
Management plan. While not everyone needs to worry about minimizing
estate taxes or eective charitable giving strategies, all investors need to
position their nancial capital to provide them with the money they
need to live comfortably — both today and in the future. Without a
well-developed and carefully maintained investment plan, investors risk
not achieving their goals and failing to live the lives they want most.
For those reasons, chapters ve through nine of this book are devoted
to the investment planning process. Over the course of the next ve
chapters, you will learn (or be reminded of) the key principles used by
highly successful investors to guide their decisions. For example:
1. Beating the market is virtually impossible. Most active money
management strategies — such as stock picking and timing the
markets — have consistently failed to add value or give investors an
edge over the long term. is has held true in both bull and bear
markets throughout history. In fact, nancial markets operate in
ways that make it extraordinarily tough for investors to beat them
consistently.
2. Owning a broadly-diversied portfolio of stocks is a prudent
approach to investing. e power of capitalism and free markets
mean that it is not unreasonable for investors to expect stock prices
to gradually rise over time.
24 — The Wealth Solution
Chapter 4: The Investment Planning Process — 27
3. Risk and Return are Related. Academic evidence suggests that there
are at least three types of risk worth taking. e rst is market risk:
Stocks have outperformed bonds over time. e second is size risk:
Shares of small companies have outperformed large-company stocks
over time. e third is value risk: Value stocks (those with high book-
to-market ratios) have generally outperformed growth stocks (those
with low book-to-market ratios) over time. By taking these risks,
investors may potentially generate stronger returns in their portfolios.
4. Structured diversication can reduce volatility and enhance
wealth. It’s impossible to know with certainty when an asset class
will outperform all others and when it will underperform. Structured
diversication — owning a mix of assets that have dissimilar price
movements and overweighting equities and small and value company
stocks — helps ensure that your portfolio is not over-exposed to any
single asset class that is performing poorly at a given moment. e
result: Your portfolio should experience more consistent returns from
year to year instead of more dramatic swings in value — which, in
turn, could enable your investments to build greater wealth for you
over the long run.
5. Building an ideal portfolio depends on each investor’s risk
capacity, risk tolerance and investment preferences. Building
a portfolio that is right for you will depend on your goals, income
needs and time horizon. You’ll also need to consider factors such
as your feelings about market volatility, your reaction to potential
declines in the value of your portfolio, and the types of investments
and asset classes that you prefer to own in pursuit of your objectives.
6. A disciplined long-term perspective is the key to staying on
track and realizing your key nancial goals. Once your portfolio
is created, let it do its job. at means staying invested instead of
trying to time market movements, avoiding unnecessary trading
and shutting down the many emotional and behavioral reactions to
economic and market developments that can lead to costly mistakes.
26 — The Wealth Solution
It also requires a system of regular portfolio rebalancing to ensure
that your portfolio’s desired risk/return characteristics remain in
place. Investors can maintain their disciplined approach by taking
advantage of resources such as investment policy statements to help
stay on track.
Some of the information contained in the following chapters will no
doubt be familiar — while some may surprise you. By the end, we
believe you will understand what it takes to build and maintain an
investment plan that maximizes your chances of achieving your goals.
Chapter 4: The Investment Planning Process — 27
26 — The Wealth Solution
28 — The Wealth Solution
56%
of intermediate fixed income
managers
underperformed the Barclays
Intermediate Government/
Credit Bond Index
Chapter 5
Markets Work
Few things are more exciting to investors than the prospect of beating
the market. If you can pick the right stocks and navigate your way
successfully in and out of various market sectors at the right times, or
nd money managers to do the job for you, you’ll generate outsized
returns that will get you to your goals faster and help you achieve the
lifestyle you desire. Not to mention that you’ll get to brag to your friends
and associates about the fortune you’re making.
It’s a wonderful and highly-appealing idea. Unfortunately, it suers
from a fatal aw: History suggests that it’s virtually impossible for even
experienced money managers to beat the market consistently. We believe
that by attempting to do so, you could put your nancial dreams, goals
and wealth at greater risk.
We realize that this probably isn’t the rst time you’ve been told that
your chances of beating the market are extremely slim. We nd that
most investors understand and believe this on some level. But beating
the market is such a tempting proposition that they often forget. And
when the markets run into trouble — as they did in recent years —
there’s always a resurgence of the idea that “things have changed” or “it’s
dierent this time,” which causes many investors to look for ways to try
and outperform the market as a whole.
Very few sources of information that investors access — such as nancial
advisors, the media and even academics — take the time to explain how
nancial markets work. In this chapter, we’ll show you not only that the
28 — The Wealth Solution
Chapter 5: Markets Work — 31
markets are incredibly dicult to beat, but also why that’s the case —
regardless of whether we’re in a raging bull market or a volatile bear market.
Our point is not simply to show that investors’ attempts to beat the
market are largely futile. We believe that you don’t need to beat the
market to enjoy success as an investor. In fact, we think that the alternative
approach — capturing the overall rates of return oered by the market’s
major asset classes — may help put you in a stronger position to address
the major challenges you face and achieve the meaningful goals you’ve
set for yourself, as part of the wealth management consultative process.
e Case Against Active Management
Who wouldn’t want to outperform the market? Certainly many
investors and money managers devote a great deal of time and energy
trying. But all the long-term historical data boil down to one inescapable
conclusion: Trying to outperform the stock market’s overall rate of
return by actively trading stocks or engaging in market timing — has
seldom succeeded over the long run.
Consider some of the most recent evidence from what has become a
huge body of research over the years:
• Active management fails over short periods. A recent study by Standard
& Poor’s Index vs. Active Group (SPIVA) found that the S&P 500, the
well-known unmanaged index of large U.S. stocks, outperformed 62
percent of actively managed large-capitalization mutual funds during
the ve years through 2010. Meanwhile, the S&P Small Cap 600,
an unmanaged index of small U.S. stocks, performed better than 63
percent of actively managed small-cap stock mutual funds during that
period. e results were even more dramatic among non-U.S. stocks.
e S&P 700, an unmanaged index of international shares, beat 82
percent of actively managed international stock funds (See Exhibit 5.1).
30 — The Wealth Solution
Exhibit 5.1: Active Mutual Fund Manager 5-Year Performance
from 2006 – 2010
Active Money Managers Have Difficulty Beating the Market
56%
of intermediate fixed
income managers
underperformed the
Barclays Intermedi-
ate Government/
Credit Bond Index
62%
of large-cap
managers
underperformed
the S&P 500
Index
63%
of small-cap
managers
underperformed
the S&P SmallCap
600 Index
82%
of international
managers
underperformed the
S&P700 Index
Source: Standard and Poor’s Index Versus Active Group, March 2011 (For the period 1/05 – 12/09)
Indexes are not available for direct investment. Their performance does not reflect the expenses
associated with the management of an actual portfolio. The fund returns used are net of fees,
excluding loads. Returns are based upon equal-weighted fund counts. The data assumes
reinvestment of income and does not account for taxes or transaction costs. The risks associated
with stocks potentially include increased volatility (up and down movement in the value of your
assets) and loss of principal. Bonds are subject to risks, including interest rate risk which can
decrease the value of a bond as interest rates rise. Investing in foreign securities may involve
certain additional risks, including exchange rate fluctuations, less liquidity, greater volatility,
different financial and accounting standards and political instability. Past performance is not a
guarantee of future results.
Additionally, the majority of actively managed funds in seven common
equity categories underperformed their various benchmark indices
during the ve years through December 2010 (see Exhibit 5.2).
Chapter 5: Markets Work — 31
30 — The Wealth Solution
Chapter 5: Markets Work — 33
Exhibit 5.2: Percentage of Active Public Equity Funds that
Failed to Beat Their Indices
(January 2006 – December 2010)
US Large
Cap
US Mid
Cap
US Small
Cap
Global International International
Small
Emerging
Markets
62%
78%
63%
60%
82%
24%
90%
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Equity Fund Category
% of Active Funds that Failed to
Outperform Benchmark
Source: Standard & Poor’s Indices Versus Active Funds Scorecard, March 2011. Index used for
comparison: US Large Cap — S&P 500 Index; US Mid Cap — S&P MidCap 400 Index; US
Small Cap — S&P SmallCap 600 Index; Global Funds — S&P Global 1200 Index; International
— S&P 700 Index; International Small — S&P Developed ex. US SmallCap Index; Emerging
Markets — S&P IFCI Composite. Data for the SPIVA study is from the CRSP Survivor-Bias-Free
US Mutual Fund Database.
32 — The Wealth Solution
Exhibit 5.3: Percentage of Active Managers Who Outperform Due to Skill
Universe of Active Mutual Fund Managers 1975-2006
0.6% Outperformed their
Benchmark Due to Skill
• Activemanagementfailsoverlongperiods.In a 2008 research study
12
— perhaps the most comprehensive ever performed — a team of
professors used advanced statistical analysis to evaluate the performance
of active mutual funds. ey looked at fund performance over a 32-
year period, from 1975-2006.
e study concluded that after expenses, only 0.6% (1 in 160) of
active mutual funds actually outperformed the market through the
money manager’s skill (see Exhibit 5.3). e study concluded that this
low number “can’t eliminate the possibility that the few [funds] that
did were merely false positives.” In other words, they were just lucky.
Recent research, conducted by Eugene Fama of the University of
Chicago and Kenneth French of Dartmouth, further supports these
ndings of luck versus skill.
13
In their research, they found that
managers of actively managed funds, as a whole, possess only enough
skill to cover their trading costs. Fama and French conducted 10,000
_________________________
12 Barras, Laurent, Scaillet ,Wermers, and Russ, “False Discoveries in Mutual Fund Performance:
Measuring Luck in Estimated Alphas” (May 2008).
13 Fama, Eugene F. and French, Kenneth R., Luck Versus Skill in the Cross Section of Mutual Fund
Returns (December 14, 2009). Tuck School of Business Working Paper No. 2009-56 ; Chicago
Booth School of Business Research Paper; Journal of Finance, Forthcoming. Available at SSRN:
ssrn.com/abstract=1356021
Chapter 5: Markets Work — 33
32 — The Wealth Solution
Chapter 5: Markets Work — 35
simulations of the eect of luck on fund returns and found that, “e
challenge is to distinguish skill from luck. Given the multitude of
funds, many have extreme returns by chance.”
Despite the existence of these lucky few outliers, Fama and French
concluded that very few fund managers have superior enough skills to
beat their indices, once costs were taken into consideration.
e research is further evidence that the majority of strong performing
managers are simply lucky rather than skillful traders and that top-
performing managers are unlikely to noticeably outperform large
index funds in the future.
e inability of active money managers to beat their respective market
indices isn’t limited to stocks. As seen in Exhibit 5.4, the vast majority
of active xed-income managers — close to 100% in some instances
— have failed to outperform their benchmarks.
34 — The Wealth Solution
Exhibit 5.4: Percentage of Active Fixed Income Funds that Failed to
Beat Their Indices
January 2006 – December 2010
Government
Long
Government
Intermediate
Government
Short
Investment-
Grade Long
Investment-
Grade
Intermediate
Investment-
Grade Short
National
Muni
68%
68%
75%
70%
56%
97%
86%
CA Muni
98%
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Fixed Income Category
% of Active Funds that Failed to Outperform Benchmark
Source: Standard & Poor’s Indices Versus Active Funds Scorecard, March 2011. Index used for
comparison: Government Long — Barclays Capital US Long Government Index; Government
Intermediate — Barclays Capital US Intermediate Government Index; Government Short — Barclays
Capital US 1-3 Year Government Index; Investment Grade Long — Barclays Capital US Long
Government/Credit; Investment Grade Intermediate — Barclays Capital US Intermediate Government/
Credit; Investment Grade Short — Barclays Capital US 1-3 Year Government/Credit; National Muni
— S&P National Municipal Bond Index; CA Muni — S&P California Municipal Bond Index. Data for
the SPIVA study is from the CRSP Survivor-Bias-Free US Mutual Fund Database. Barclays Capital data,
formerly Lehman Brothers, provided by Barclays Bank PLC.
e evidence leads to three conclusions: 1) Historically, it has been extremely
dicult for most active management strategies to outperform the market
over short periods such as ve years, 2) Most active managers have also failed
to outperform the market over long periods and 3) A successful investment
experience is not dependent on outperforming the market.
ese points are especially important to keep in mind. After all, many of
your most important goals in life are a decade or more away — such as
ensuring that you have enough money to see you through a retirement
that could last twenty or thirty years or even longer.
Chapter 5: Markets Work — 35
34 — The Wealth Solution
Chapter 5: Markets Work — 37
What About Bear Markets?
Some investors believe that while active managers will always have a
tough time beating the market when times are good, active managers’
market-beating abilities will be revealed during bear markets when lots
of negative trends are hurting the market. Stock pickers and market
timers, the argument goes, can use their intelligence and insight to
sidestep the worst stocks with the poorest prospects or avoid entire asset
classes and sectors that stand to get pummeled during a downturn.
Unfortunately, for these active managers, the research shows otherwise. For
evidence, we only have to look as far back as 2008 — the year of the Great
Recession, that saw U.S. stocks (as represented by the S&P 500 Index)
plummet 37 percent in the wake of the worst global nancial crisis since
the 1930s. at year, actively managed funds as a group underperformed
the S&P 500 by an average of 1.6 percent (see Exhibit 5.5). SPIVA also
found similar results in 2003 when it reviewed the performance of actively
managed funds during the 2000 to 2002 bear market.
Exhibit 5.5: Active Manager Performance During the 2008 Bear Market
Average U.S.
Equity Fund
Manager
Underperformed
S&P 500 by
1.67%
Source: Standard and Poor’s Investment Service, May 2009. Indexes are not available for direct
investment. Their performance does not reflect the expenses associated with the management
of an actual portfolio.. The data assumes reinvestment of income and does not account for taxes
or transaction costs. Past performance is not a guarantee of future results.
36 — The Wealth Solution
Why Has Active Management Failed So Often?
e case against active management is compelling. Yet many investors
have a dicult time accepting the facts. It’s extremely tempting to think
that if we make smart investment decisions we can outperform the
market — or nd a hard-working, brilliant money manager or advisor
who can do the job for us. After all, just because many active managers
have struggled to beat the market in the past doesn’t mean that someone
won’t be able to do so in the future, right? If you can nd that manager
and give him or her all your money today, you’ll be rich in no time.
We understand how powerful and motivating that idea can be when
making investment decisions. To be honest, there’s nothing we’d like
better than to nd a manager who could beat the market year in and
year out for decades and make us fabulously wealthy, too.
e problem with this thinking is that the nancial markets operate
in ways that make beating them extraordinarily dicult, even for the
world’s smartest managers. Specically, there are ve challenges that
active managers face in trying to outperform the overall market:
Challenge 1: Success Requires Predictive Ability
Wall Street and the popular nancial press want you to believe that
in order to make money in the market, you need to invest based on
what’s about to happen. at’s the message sent out every day by market
strategists, brokers, analysts, mutual fund managers and the media —
predict the future accurately, and you’ll score big.
In truth, there is no crystal ball when it comes to investing your money.
No one can accurately forecast market movements on a consistent basis
over the long term. Why? Because we’re talking about the future, and the
future is by its very nature and denition unknowable. We simply cannot
know with certainty the future direction of the economy, stock prices
or the myriad events and developments that will occur that will have an
impact on the markets.
Chapter 5: Markets Work — 37
36 — The Wealth Solution
Chapter 5: Markets Work — 39
Ah, but what about the countless PhDs and other experts on Wall Street
who devote their time to sizing up economic and market developments
and using their insights to make predictions? Surely they must have an
ability to gauge the future that the rest of us lack?
For the answer, consider the following Wall Street predictions for where
the S&P 500 would stand on December 31, 2008:
Morgan Stanley ...................................................... 1520
Merrill Lynch ........................................................... 1525
A.G. Edwards ......................................................... 1575
Wachovia Securities .............................................. 1590
JP Morgan Chase .................................................. 1590
Bank of America Securities .................................... 1625
Goldman Sachs ...................................................... 1675
Citigroup ................................................................. 1675
Strategas Research Partners ................................... 1680
For the record, the S&P 500 ended 2008 at 903.
14
In other words, none
of these highly experienced rms, with access to a wealth of resources and
information was able to predict even the down direction of the market
that year.
Or take something as seemingly simple as predicting how the broad
economy is going to do. As the New York Times noted in a May 5, 2009
article, “Amazingly enough, Wall Street’s consensus forecast has failed to
predict a single recession in the last 30 years.”
15
e media’s track record is equally abysmal. One of the most famous
examples is Business Week’s August 13, 1979 cover story, “e Death of
Equities.” e article inside reached the conclusion that “e death of
equities looks like an almost permanent condition — reversible someday,
but not soon.”
38 — The Wealth Solution
(For the record, the next decade was one of the strongest performing periods
for the stock market in history, with the S&P 500 up 17.5 percent annually.)
For a more recent example, consider this advice from a February, 2009
Forbes article:
“It’s way too early to get back into U.S. stocks…Expect meltdowns in
securities backed by credit card debt, home equity, student and auto
loans as well as commercial real estate…Avoid emerging markets,
especially China.”
16
(For the record, U.S. stocks as measured by the S&P 500 soared 26.5
percent in 2009, emerging markets as a group shot up 79 percent and
the Chinese market rose 62.6 percent.)
We could literally ll this book with hundreds of examples of various
nancial experts and gurus getting it wrong year after year after year. e
upshot: Even the brightest analysts, the most famous, highly regarded
money managers in the world or the most plugged-in and well-respected
nancial publications can seldom tell you what’s going to happen next,
let alone give you reliable advice on how to position your portfolio
to take advantage. at doesn’t mean that a fund manager, a talking
head on CNBC or the guy who walks his dog down your street every
morning won’t sometimes get it right. ey will. e credit, however, as
we’ve seen, usually goes to luck — not skill. And your nancial future is
too important to leave to chance.
_________________________
14 Source: USA Today. 2008 predictions for the S&P 500. January 2, 2008.
15 www.nytimes.com/2009/05/06/business/economy/06leonhardt.html
16 www.forbes.com/forbes/2009/0216/106.html
Chapter 5: Markets Work — 39
38 — The Wealth Solution
Chapter 5: Markets Work — 41
Challenge 2: e Market Doesn’t Give Investors Many
Opportunities To Beat It
Every day, there are millions of participants in the stock market. e
majority are professional money managers, analysts, strategists and
traders with advanced degrees who spend the bulk of their day doing
one thing: trying to determine the accurate price of the stocks they’re
looking to buy and sell. ese investors make their judgments by learning
all they can about each company: Examining corporate documents and
nancial statements, reading analysts’ reports and articles about the
rms, listening to conference calls with management, and watching the
news for developments about the companies, their suppliers and their
competitors as well as the overall economy.
In other words, all these market participants use all the available
information that exists to come up with their opinion of the right price.
Investors looking to sell believe the price should be lower than the
current price, while potential buyers believe the current price is too low.
As a result, the market participants are constantly negotiating a “fair”
price at which they’re willing to strike a deal. It’s a bit like selling your
home and negotiating back and forth with a potential buyer to reach
an acceptable price. When both parties agree — a willing seller nds
a willing buyer — the transaction closes. Multiply that by millions of
transactions every day, and you’ve got the stock market.
e fact that so many market participants are constantly processing
huge amounts of new information to arrive at a fair price means that
most stocks are priced eciently — that is, the price of any stock at any
given moment accurately reects all the known information about it.
Whenever any new information comes out, it gets seen and processed
by millions of investors at essentially the same time. at causes the price
of the stock to almost instantly rise or fall to a new agreed upon “fair”
value that once again reects all the current knowledge about that stock.
40 — The Wealth Solution
As an investor, this means you should generally accept that the price of
any stock at a given moment is the price it should be. Why? Because
it reects the collective knowledge of all the investors in the market at
that point in time. Naturally, then, the value of the stock market as a
whole is accurate at any moment. After all, if those millions of buyers
and sellers didn’t think prices were fair, no one would ever make a trade.
But the fact that more than 8,000 listed stocks change hands every day
in the U.S. proves a crucial point: Capital markets are ecient. ey
allow buyers and sellers to make trades at prices that the participants
deem to be fair.
e result of this market eciency is that the market doesn’t easily present
any single investor or group of investors with a huge opportunity for
outsized prots. ink about it this way: Let’s say you are a professional
investor with a huge brain and an unagging work ethic who is trying
to beat the market. To do that, you need to uncover opportunities that
the other investors don’t see. e challenge is, you’re surrounded on all
sides — on all continents, really — by a million other extremely smart,
incredibly hard-working investors who are also looking to uncover
opportunities that go unnoticed. Meanwhile, thanks to technology, all
of you are receiving and viewing the same new nancial information
about companies and the economy at once. Given all that, you would
eventually have to ask a key question: What are the chances that you’ll
see a mistake — a mispricing, in other words — that some or all of
your 999,999 colleagues, peers and competitors won’t?
Chapter 5: Markets Work — 41
40 — The Wealth Solution
Chapter 5: Markets Work — 43
Challenge 3: Proting From Occasional Mispricings Is Tough
at said, just because markets are ecient doesn’t mean that market
participants are perfectly rational and always make optimal decisions.
It’s possible that ineciencies — mispricings — could appear from
time to time, as investors’ emotions get the best of them and they make
judgments about the market based on greed or fear. is concept was
most recently evidenced in 2008 and early 2009. Markets plunged, in
part because most of the new information that was coming out during
that time was extremely negative, but also because much of that new
information was unclear and created a huge amount of uncertainty.
Investors, left with information that they didn’t always know how to
process, panicked and drove the market deep into bear territory.
In that environment, an investor might have gone against the herd
by aggressively buying stocks when they were severely beaten down
— and generated huge gains, when, starting in March 2009 the
stock market began to soar. With the benet of hindsight, you might
even claim that any idiot could have seen how mispriced the market
was and that stocks were a screaming bargain.
But here’s an interesting fact. Although any number of investors could have
done exactly those things, they didn’t. In fact, they did the exact opposite —
they sold stocks and bought bonds. What we witnessed was the same fear
that prompted investors to sell stocks when times were bleak also stopped
them from buying stocks when they were “cheap” and oered the potential
for outsized gains. erefore, the vast majority of investors missed the
opportunity to fully participate in stock market’s surprising 2009 surge. e
result was — you guessed it — that they missed an amazing opportunity to
take part in a tremendous market rally and potentially make a lot of money.
It’s not just emotions that make it dicult to take advantage of the
occasional mispricing. Once again, think of yourself as that professional
investor trying to uncover hidden opportunities. As noted before, in order
to generate a market-beating return, you would rst need to identify a
42 — The Wealth Solution
mistake that everyone else fails to see. But that’s just step one. Next, that
mistake would have to stay around long enough for you to do something
about it — another highly unlikely scenario. But let’s say that occurs. You
“get it right” by buying the stock that you and you alone have identied as
mistakenly priced too low by the rest of the world. You’re still not done. You
have to sell that stock at just the right time to a buyer just before it dips in
value. In other words, to win you have to “get it right” not once, but twice.
Keep in mind that this is just one example. If you or your money manager
want to beat the market consistently, you need to make a habit of nding
mispricings that last long enough to trade on them and then “get it right
twice.” Having one great idea isn’t going to allow you to beat the market
and make you wealthy. You may very well get lucky once or even a few
times. But how likely is it that you’ll get lucky month after month, year after
year for decades? Of course, you already know the answer from Exhibit
5.3 above: Less than one percent of active mutual fund managers had the
skill to outperform the broader market over the 32-year period from 1975
through 2006. As an investor with a lengthy time horizon, you need to
honestly assess whether you think you, or your investment managers, fall
into that tiny group. Odds are you and your managers won’t.
Bottom line: While there may very well be occasional mispricings in
the nancial markets, there’s very little you or anyone can do to actually
prot from those ineciencies consistently enough to have a positive
impact on your wealth. e smart move is therefore to act as if those
mispricings don’t exist.
Chapter 5: Markets Work — 43
42 — The Wealth Solution
Chapter 5: Markets Work — 45
Challenge 4: e Market’s Returns Are Driven By A Select Group
Of Stocks at Is Always Changing
You know that stocks overall have delivered positive returns over the
long run. What you might not realize is that a relatively small group of
stocks has been responsible for that positive return.
For example, looking at the University of Chicago’s CRSP total market
equity database as representative of the U.S. market for the period
1926-2009, we nd that only the top-performing 25% of stocks were
responsible for the market gains during this timeframe. e remaining
75% of the stocks in the total market database collectively generated a
loss of -0.6%. (see Exhibit 5.6).
Exhibit 5.6: The Impact on Returns of Missing the Top-Performing Stocks
(1926-2009)
Compound Average Returns: 1926-2009
All US Stocks Excluding the Top 10%
of Performers Each Year
Excluding the Top 25%
of Performers Each Year
9.6%
6.2%
-0.6%
Source: Dimensional Fund Advisors. Past performance is not indicative of future results. Indexes
are unmanaged baskets of securities in which investors cannot directly invest. The data assume
reinvestment of all dividend and capital gain distributions; they do not include the effect of any
taxes, transaction costs or fees charged by an investment advisor or other service provider to
an individual account. The risks associated with stocks potentially include increased volatility
(up and down movement in the value of your assets) and loss of principal. Small company
stocks may be subject to a higher degree of market risk than the securities of more established
companies because they tend to be more volatile and less liquid.
44 — The Wealth Solution
e common response from some investors to this statistic is: If a small
percentage of stocks could possibly account for the market’s long-term
returns, why not avoid all the headaches and just invest in these top
performing stocks? You know the answer, of course. It’s the one written on
every prospectus you’ve ever received: “Past performance is not indicative
of future results” — and we know that no one can predict the future with
perfect accuracy. A portfolio of even the most carefully screened stocks could
easily wind up with none of the best-performing stocks in the market —
and thus could possibly produce at or negative returns over time. As the
performance of active managers in Exhibits 5.2 and 5.4 above showed, very
few of them are accomplished stock pickers. Missing out on even a handful
of the top-performing stocks can leave you well short of market returns.
Clearly there is great diculty and danger inherent in selecting individual
stocks. If you had tried to pick winners and avoid losers during the timeframe
cited above, you would have put yourself at great risk of not owning the
small group of stocks that drove most of the market’s return. In essence, you
would have been trying to seek out a few needles in an enormous haystack.
If you got it right, you did great. If you got it wrong, you did very, very
poorly. Either way, the results would have been the same: You would have
failed to beat the market.
Conversely, you could have sought out a smart fund manager who you
hoped could pick the stocks that would fall into that top 25 percent
category over the long term — or better yet, pick just the best performers
from among that select group of winners. But once again, the data tells us
that almost no one has been capable of beating the market consistently over
long periods of time. By trying to nd the tiny handful of managers who
might be capable of doing so from among the thousands of professional
managers in the business, you’d once again be seeking a small number of
needles in a huge haystack.
Chapter 5: Markets Work — 45
44 — The Wealth Solution
Chapter 5: Markets Work — 47
Challenge 5: Trying To Beat e Market Is Expensive
A nal challenge to active management is that returns for active mutual
funds may be reduced by higher expenses, since active funds often charge
substantial fees and incur heavy trading and tax costs in the eorts to
actively move in and out of markets, select specic stocks and “be right
twice.” e truth is, all those smart and hard-working professionals —
the ones who can’t seem to beat the market — don’t come cheap. In one
study, Kenneth R. French, a professor of nance at Dartmouth College’s
Tuck School of Business, added up the fees and expenses of U.S. equity
mutual funds, investment management costs paid by institutions, fees
paid to hedge funds, and the transaction costs paid by all traders in 2006.
en he deducted what U.S. equity investors would have paid if instead,
they had simply bought and held an index fund benchmarked against
the overall stock market. e dierence between these amounts — the
amount that investors pay trying (and failing) to beat the market — was
a whopping $102 billion.
17
A better approach: Accept the market rate of return — it has plenty to oer.
Remember, our goal is to help give you a framework you can utilize
to make the smartest possible decisions about your money so you can
achieve all that is important to you. One of the smartest decisions you can
make is to avoid doing things that history has shown don’t work. And the
evidence is clear: Trying to beat the market through active management
techniques like stock picking and market timing is a real challenge.
e good news is that you don’t have to beat the market in order to be a
successful investor. Instead, you can take a much smarter, more eective
and simpler approach: Own the entire market and stay invested through
thick and thin. We saw how missing just a few stocks can diminish your
returns. at means the only way you can be assured of owning all of
tomorrow’s top-performing stocks is to own the entire market all the time.
46 — The Wealth Solution
If you do that, you stand a much better chance to capture the rate of
return that the market has historically generated over time. e less you
do to put that positive historical return at risk, the better your chances
of coming out ahead in the end.
Here’s why: e common goal of all publicly-traded companies is to earn
money and maximize the value they provide to their shareholders — the
people who own stock in their companies. Some of these companies fail
to generate earnings and eventually go out of business. Other companies
succeed wildly. On balance, more companies have created wealth than
destroyed it. We know this because if more companies destroyed wealth
than created it, our economy wouldn’t grow. Capital markets would
have essentially “gone out of business” long ago. But in fact, the exact
opposite has occurred.
A portfolio of stocks is more than the actual shares themselves — it’s a
sign of condence that, for example, Starbucks will continue to serve
a cup of coee for $2. If you invest your money in shares of publicly-
traded companies, you literally own a stake in the wealth that they may
create. And as companies create more and more wealth, investors become
increasingly willing to pay higher prices to own a piece of that wealth.
is proposition — that you can succeed by joining your fortunes
to the future of U.S. and global industry — is hugely powerful. We
believe this means that it is prudent and rational to expect stock prices
to gradually keep rising over time. We think the market should produce
a long-term positive rate of return because wealth will continue to be
created by companies, and stock prices reect that continual creation of
wealth. It means that investing in stocks is not akin to gambling with
your money in the hope of making a prot. It’s investing in the belief
that prots will still be made, that innovation will still occur and that
companies will continue to nd ways to make money going forward.
_________________________
17 Kenneth R. French, “The Cost of Active Investing,” March 2008.
Chapter 5: Markets Work — 47
46 — The Wealth Solution
at’s not to say there won’t be blips, speed bumps and the occasional
enormous potholes along the way — there most certainly will be. But if
you believe in the power of innovation and invest accordingly, you have
the opportunity to participate in any rewards and growth that result.
e rates of return you may receive as an investor in the entire market
will be dierent for each type of company, depending on the level of
risk that is involved in generating its wealth. For example, small rms
that are just starting out are generally riskier for investors than large
rms that dominate their industries. at’s one reason why shares of
small publicly traded companies have outperformed shares of the largest
rms over time.
To illustrate, Exhibit 5.7 shows the annualized return of 13 dierent
types of publicly traded companies from 1926 – 2010, as categorized
by the Center for Research in Security Prices. Decile indices one, two,
three, four and ve represent the largest companies that trade in the
U.S. market (with decile one representing the very largest rms). Decile
indices six, seven, eight, nine and ten represent small companies (with
decile ten representing the smallest of the small). e Deciles 1-10 Index
represents the entire market, the Deciles 1-5 Index represents large-cap
stocks as a group, and the Deciles 6-10 Index represented small-cap
stocks as a group.
48 — The Wealth Solution
Chapter 5: Markets Work — 49
48 — The Wealth Solution
Exhibit 5.7: The Long-Term Annualized Returns of 13 Asset Classes
Annualized Returns 1926 - 2010
CRSP
Decile 1
Index
CRSP
Decile 2
Index
Largest Companies Smallest Companies
CRSP
Decile 3
Index
CRSP
Decile 4
Index
CRSP
Decile 5
Index
CRSP
Decile 6
Index
CRSP
Decile 7
Index
CRSP
Decile 8
Index
CRSP
Decile 9
Index
CRSP
Decile
10
Index
CRSP
Decile 1-
10 Index
ALL
CRSP
Decile 1-
5 Index
LARGE
CRSP
Decile 6-
10 Index
SMALL
14%
12%
10%
8%
6%
4%
2%
0%
Source: Center for Research in Security Prices, 2011. Past performance is no guarantee of future results.
Our message is that you shouldn’t spend your time and energy picking
the right stocks or hunting for the winning manager to achieve your
goals. e alternative — investing in assets classes — oers you a simple,
straight forward and broadly-diversied approach and frees you from
having to worry about the ups and downs of individual stocks.
In the end, we can’t force you to invest one way or the other. e choice is
yours. But given the tremendous challenges that an active management
approach faces, you at least have to ask yourself if it’s the most sensible
approach to take. If your managers can accomplish the task, you’ll be
in great shape. If they can’t — and there’s no doubt that the chances of
this are slim — then you expose yourself and your family to the risk of
earning below-market returns.
Is it worth the risk? We believe it isn’t.
Chapter 5: Markets Work — 49
50 — The Wealth Solution
Chapter 6
Risk & Return Are Related
So far we’ve seen that taking certain types of risks, such as trying to pick
winning stocks — and avoiding the losers — and attempting to time
markets, have historically failed to generate market-beating returns over
the long run. In fact, they may have left many investors with less money
than they had originally.
e good news is that there are other types of risk that you may want
to consider taking. Markets can be chaotic, but over time they have
shown a strong relationship between risk and reward. is means that
the compensation for taking on increased levels of risk is the potential to
earn greater returns. In fact, when it comes to investing, the return your
portfolio earns will be substantially driven by the overall amount of risk
you take. But all risks aren’t created equal.
According to noted academic research, there are three “factors” or
sources of potentially higher returns with higher corresponding risks:
18
1. Stocks (market risk)
2. Small Companies (size risk)
3. Value Companies (value risk)
_________________________
18 Cross Section of Expected Stock Returns”, Eugene F. Fama and Kenneth R. French, Journal of
Finance 47 (1992).
50 — The Wealth Solution
Chapter 6: Risk & Return Are Related — 53
ese risks were identied and tested by two professors, Eugene Fama
and Ken French, in the early 1990s. eir research resulted in what is
known as the Fama-French ree-Factor Model, which has become
the basis for portfolio construction for many top investors (See Exhibit
6.1). One of the most important jobs for an advisor or investor is to
understand the risk factors contained in this model in order to decide
how to incorporate them into your portfolio.
Exhibit 6.1: Three-Factor Model
52 — The Wealth Solution
Value
(High BtM)
Growth
(Low BtM)
Total
Stock Market
Small
Large
Increased
Expected
Return
[
Risk 1: Market Risk
Market risk is the risk of investing in the equity market versus investing
in a “riskless asset,” such as a 30-day Treasury Bill. Stock investors
demand a higher rate of return than investors who buy government
bonds in order to compensate them for the increased risk of holding
equities. While past performance is no guarantee of future results,
stocks as a whole have outperformed bonds and Treasury bills by a large
margin over the last eight decades.
19
As seen in Exhibit 6.2, $1 invested
in stocks in 1927 would have grown to $2,577 by the end of 2010 —
while that same investment in T-bills would have grown to a mere $20.
Exhibit 6.2: Stocks Outperform Bonds Over Time 1927 - 2010
1927 1997198719771967195719471937 2007 ’10
$2,577
$87
$12
$20
$0
$1
$10
$100
$1,000
$10,000
Fama/French Total U.S. Market Index 9.8%
Long-Term Government Bonds 5.5%
One-Month U.S. Treasury Bills 3.7%
U.S. Consumer Price Index 3.0%
Compound Annual Return
Source: Morningstar’s 2010 Stocks, Bonds, Bills, And Inflation Yearbook (2011); Fama/French
Total U.S. Market Index provided by Fama/French from Center for Research in Security Prices
(CRSP) data. Includes all NYSE securities (plus Amex equivalents since July 1962 and NASDAQ
equivalents since 1973), including utilities. Risks associated with investing in stocks potentially
include increased volatility (up and down movement in the value of your assets) and loss of
principal. Indexes are unmanaged baskets of securities that investors cannot directly invest in.
Past performance is no guarantee of future results. Hypothetical value of $1 invested at the
beginning of 1927 and kept invested through December 31, 2010. Assumes reinvestment of
income and no transaction costs or taxes. This is for illustrative purposes only and not indicative
of any investment. An investment cannot be made directly in an index.
_________________________
19 Represented by the Fama/French Total U.S. Market Index, which consists of all the securities
listed on the New York Stock Exchange plus American Stock Exchange equivalents since July
1962 and NASDAQ equivalents since 1973.
Chapter 6: Risk & Return Are Related — 53
52 — The Wealth Solution
Chapter 6: Risk & Return Are Related — 55
Also called “systematic risk,” market risk cannot be minimized
or eliminated through diversication — in other words, if you invest
in stocks, you must be willing to accept market risk. By contrast,
unsystematic risk — the risk that’s inherent in investing in a single
company or even a group of companies in a single industry — can be
mitigated by diversication. In a market like 2008, the risk of concentrating
on a single stock or sector was a potential invitation to catastrophe.
e relationship between risk and return makes sense. Investors can
buy a short-term Treasury bill, which is essentially a loan to the U.S.
government, and take minimal risk. Or they can invest in the broad
stock market — in other words, own a piece of many companies and
their current and future prots. As a partial owner of public companies,
you accept more risk than if you are simply a lender to the government
— and you should expect a greater return because of your willingness
to accept that additional risk.
is relationship also extends to bonds issued by corporations. If a
company declares bankruptcy, its bondholders may be able to recover
some or all of their original investment. Stockholders have less likelihood
of recovering their investment, as their claims are subordinate to those
of bondholders. Because of additional risk, stockholders have tended to
demand a higher return than bondholders.
Investing in the stock market carries risk that doesn’t always reward you
year in and year out. ere have been several long periods when bonds
outperformed stocks — most recently, for example, the 10-year period
through 2010 saw the Fama/French Total U.S. Market Index return
2.6 percent annually while the BofA Merrill Lynch 1-3 Year Treasury/
Agency Index gained 4.0 percent.
e good news, however, is that historically, investors have been compensated
for their willingness to take on market risk over the long term.
54 — The Wealth Solution
Risk 2: Size Risk
One common way investors categorize stocks is by size. Large-company
stocks are shares of rms with large market capitalizations (dened as the
stock’s price per share multiplied by the number of shares outstanding),
while small-company stocks have small market capitalizations. A large
company might be an international rm with tens of thousands of
employees. A small rm could have just a few hundred or even several
dozen employees.
When dividing the entire stock market by size, we see that small-
company stocks have tended to reward investors with signicantly higher
returns over time than large-company shares. In Exhibit 6.3, CRSP
Decile 1 stocks are the largest U.S. stocks while CRSP Decile 10 contains
the smallest U.S. stocks. Notice the clear relationship between risk and
reward — the smaller the stocks, the higher the returns. Indeed, the very
smallest stocks (Decile 10) have signicantly outperformed all other
stocks from 1926 - 2010.
Chapter 6: Risk & Return Are Related — 55
54 — The Wealth Solution
Chapter 6: Risk & Return Are Related — 57
Exhibit 6.3: Small-Caps Outperform Large-Caps Over Time
Return-Standard Deviation
Monthly: January 1926 - December 2010; Default Currency: USD
1. CRSP Decile 1 Index
2. CRSP Decile 2 Index
3. CRSP Decile 3 Index
4. CRSP Decile 4 Index
5. CRSP Decile 5 Index
6. CRSP Decile 6 Index
7. CRSP Decile 7 Index
8. CRSP Decile 8 Index
9. CRSP Decile 9 Index
10. CRSP Decile 10 Index
11. CRSP Decile 1-10 Index
16% 18% 22% 26% 30% 34% 38%
15%
14%
13%
12%
10%
9%
8%
7%
6%
5%
1
11
2
3
4
5
6
7
8
9
10
The Center for Research in Security Prices (CRSP) ranks all NYSE companies by market
capitalization and divides them into 10 equally-populated portfolios. AMEX and NASDAQ
National Market stocks are then placed into deciles according to their respective capitalizations,
determined by the NYSE breakpoints. CRSP Portfolios 6-10 represent small caps. Standard
deviation is a statistical measurement of how far the return of a security (or index) moves
above or below its average value. The greater the standard deviation, the riskier an investment
is considered to be.
56 — The Wealth Solution
Why is this the case?
Simple: Small-company stocks are riskier than large company stocks.
Smaller rms typically are younger and less nancially stable than their
larger, older peers. Smaller rms also tend to be located in smaller
geographic areas and are less able to withstand economic downturns.
ey also tend to have less stable or consistent earnings from year to
year than the largest, most established rms. For example, compare
Starbucks with a hypothetical smaller, upstart competitor, who we’ll call
for the sake of this example: New Brews.
Smaller rms (like New Brews) have the potential to grow into giants
(like Starbucks). But they also are more likely to go out of business if
they experience problems; their lesser size and capital base mean they
have a smaller nancial cushion to help them weather a downturn in
business conditions. Because of these risks, investors demand a higher
return when they buy shares of small companies. e risk that Starbucks
will implode is relatively low. After all, they’re on practically every street
corner in America. As a result, investors in Starbucks are willing to accept
a relatively low return on their investment. However, the risk that New
Brews will implode is signicantly higher. Investors will only buy shares
in New Brews if they can reasonably expect to earn a higher return to
compensate them for incurring additional risk. In short, if New Brews
didn’t oer a higher potential return, do you think any investors would
choose them over Starbucks?
But just like in the example in Market Risk above, small-company
stocks do not always outperform large-company stocks. In fact, many
years can go by during which this size premium reverses and shares
of larger rms beat shares of smaller companies — sometimes by very
signicant margins. However, as you can see from Exhibit 6.4, small-
company stocks have historically outperformed their larger peers over
time. In fact, small stocks beat large stocks 88% of the time over rolling
20-year periods from June, 1926 through 2010, and 97% of the time
over rolling 25-year periods.
Chapter 6: Risk & Return Are Related — 57
56 — The Wealth Solution
Chapter 6: Risk & Return Are Related — 59
Exhibit 6.4: US Small vs. US Large
July 1926 - December 2010
In 25-Year Periods Small beat large 97% of the time
In 20-Year Periods Small beat large 88% of the time
In 15-Year Periods Small beat large 82% of the time
In 10-Year Periods Small beat large 75% of the time
In 5-Year Periods Small beat large 59% of the time
Periods based on rolling annualized returns. 715 total 25-year periods. 775 total 20-year periods. 835
total 15-year periods. 895 total 10-year periods. 955 total 5-year periods. Indices are not available for
direct investment. Their performance does not reflect the expenses associated with the management
of an actual portfolio. Past performance is not a guarantee of future results. Indices used: Fama/French
US Small Cap Index, Fama/French US Large Cap Index. The risks associated with investing in stocks and
overweighting small company stocks potentially include increased volatility (up and down movement in
the value of your assets) and loss of principal. Small-cap stocks may be less liquid than large-cap stocks.
Risk 3: Value Risk
A third type of risk identied by Fama and French’s research pertains to
growth stocks versus value stocks. Similar to how investors divide stocks
into small and large, they also divide stocks by whether they fall into the
“growth” category or the “value” category.
Value stocks are usually associated with corporations that have experienced
slower earnings growth or sales, or have recently experienced business
diculties, causing their stock prices to fall. ese value companies are
often regarded as turnaround opportunities, where a change in
management, strategy or other factors could improve the company’s
prospects and its earnings.
Historically, the earning streams of value stocks have been much more
uncertain than growth stocks. is means the market has to assign them
lower prices in order to attract investors.
58 — The Wealth Solution
ough they are riskier than growth companies, emphasizing value
companies in a portfolio may lead to both increased diversication and
the expectation of potentially higher returns.
In Exhibit 6.5, you can see how Value has fared versus Growth over
various time periods.
Exhibit 6.5: Value Outperforms Growth
July 1926 - December 2010
In 25-Year Periods Value beat growth 100% of the time
In 20-Year Periods Value beat growth 100% of the time
In 15-Year Periods Value beat growth 95% of the time
In 10-Year Periods Value beat growth 91% of the time
In 5-Year Periods Value beat growth 82% of the time
Periods based on rolling annualized returns. 715 total 25-year periods. 775 total 20-year periods. 835
total 15-year periods. 895 total 10-year periods. 955 total 5-year periods. Indices are not available for
direct investment. Their performance does not reflect the expenses associated with the management
of an actual portfolio. Past performance is not a guarantee of future results. Indices used on this chart:
Fama/French US Large Value Index (ex utilities), Fama/French US Large Growth Index (ex utilities. The
risks associated with investing in stocks and overweighting value stocks potentially include increased
volatility (up and down movement in the value of your assets) and loss of principal.
Here again risk drives reward. In this case, consider the characteristics
of value stocks: ey are out of favor with investors, who see such rms
as risky — especially when compared to growth companies, which are
usually characterized by their high prices, strong earnings growth and high
returns on equity.
In order to allocate investment capital to value stocks, investors demand
greater compensation than they do from the more stable growth
companies. If these value stocks didn’t oer higher expected returns, no
one would bother investing in them.
Chapter 6: Risk & Return Are Related — 59
58 — The Wealth Solution
Chapter 6: Risk & Return Are Related — 61
As an example, consider two well-known retailers: Sears and Wal-Mart.
In recent years Sears has encountered numerous hurdles that caused its
sales to signicantly lag its competitors. In fact, Sears was actually bought
by Kmart — the discount retailer that was in such bad nancial shape
in 2002 that it declared bankruptcy. By contrast, Wal-Mart experienced
strong growth in sales and prots during the past decade and by many
metrics would have to be considered superior to Sears (and Kmart).
And yet, as seen in Exhibit 6.6, Sears stock has delivered much higher
returns than Wal-Mart stock during the past seven years or so. While
Sears stock was up nearly 400% during that time, Wal-Mart stock was
essentially at. How can that possibly be the case? It’s because Sears
was a riskier investment than “sure-thing” Wal-Mart. Notice how
volatile Sears’ stock returns are compared to Wal-Mart’s; that extra risk
compensated investors with a much higher return.
Exhibit 6.6: Sears Stock Versus Wal-Mart Stock
May 2, 2003 - December 31, 2010
5/03 5/04 5/05 5/06 5/07 5/08 5/0911/0311/04 11/0511/06 11/0711/08 11/0
91
1/105/10
-200%
0%
200%
400%
600%
800%
1,000%
1,200%
1,400%
Sears Walmart
Source: Loring Ward; Yahoo Finance. This is for illustrative purposes only. This type of value
vs. growth phenomena is not always the case. Value companies will not always outperform
growth companies, and there have been historical periods when growth has significantly
outpaced value.
60 — The Wealth Solution
Still, this idea that value stocks are riskier than growth stocks is hard
for some investors to grasp. Many investors assume the opposite —
that because innovative growth companies take bigger chances than
distressed value companies they’re riskier and therefore more likely to
reward investors.
On rst blush, this sounds reasonable. But remember that value stocks
are stocks with low relative prices. Why? Because investors have pushed
down value stocks’ prices to compensate for all that risk. Value stocks
have much greater earnings uncertainty than growth stocks, for example.
In the face of this type of uncertainty, investors often sell value stocks
driving their prices lower. en, as many of these distressed companies
solve their nancial problems and become healthier, investors start to
pay attention, buy the shares and drive up the prices. So even though it
might sound a little strange, the “bad” value companies perform better
as an investment than the “good” growth companies over the long run,
as we saw Exhibit 6.5.
e risks that compensate investors domestically also are in evidence
internationally. As you can see from Exhibit 6.7, from 1975 – 2010
in the international markets, value stocks have outperformed growth
stocks — and small-cap stocks have outperformed large-cap stocks —
in a majority of all rolling return periods measured. e value premium
has been strongly positive more often than the size premium.
Chapter 6: Risk & Return Are Related — 61
60 — The Wealth Solution
EXHIBIT 6.7: International Risk Dimensions
January 1975 - December 2010
In 25-Year Periods Value beat growth 100% of the time
In 20-Year Periods Value beat growth 100% of the time
In 15-Year Periods Value beat growth 100% of the time
In 10-Year Periods Value beat growth 100% of the time
In 5-Year Periods Value beat growth 98% of the time
In 25-Year Periods Small beat large 100% of the time
In 20-Year Periods Small beat large 97% of the time
In 15-Year Periods Small beat large 82% of the time
In 10-Year Periods Small beat large 78% of the time
In 5-Year Periods Small beat large 78% of the time
Based on rolling annualized returns. Rolling multi-year periods overlap and are not independent.
This statistical dependence must be considered when assessing the reliability of long-horizon return
differences. International Value vs. International Growth data: 133 overlapping 25-year periods. 193
overlapping 20-year periods. 253 overlapping 15-year periods. 313 overlapping 10-year periods. 373
overlapping 5-year periods. International Small vs. International Large data: 193 overlapping 25-year
periods. 253 overlapping 20-year periods. 313 overlapping 15-year periods. 373 overlapping 10-year
periods. 433 overlapping 5-year periods. International Value and Growth data provided by Fama/
French from Bloomberg and MSCI securities data. International Small data compiled by Dimensional
from Bloomberg, StyleResearch, London Business School, and Nomura Securities data. International
Large is MSCI World ex USA Index gross of foreign withholding taxes on dividends; copyright MSCI
2011, all rights reserved. The risks associated with investing in stocks and overweighting small
company and value stocks potentially include increased volatility (up and down movement in the
value of your assets) and loss of principal. Small-cap stocks may be less liquid than large-cap stocks.
Foreign securities involve additional risks including foreign currency changes, taxes and different
accounting and financial reporting methods. All investments involve risk, including loss of principal.
62 — The Wealth Solution
Chapter 6: Risk & Return Are Related — 63
What e Market, Size And Value Premiums Mean For Investors
e data in this chapter, culled from decades of research, is intended to
help investors understand the risks that may generate returns. Research
on nancial markets is ongoing, and our knowledge will continue to
expand. But what we do know about risk and return provide a sound
framework for building and maintaining your portfolio. Your job
doesn’t need to be — nor should it be — focused on picking the right
stocks and avoiding the wrong ones.
Instead, we believe your investment strategy should center around
three major decisions. First, decide how much overall market risk you
want and are able to take. at decision will impact how much money
is allocated to stocks versus bonds, T-bills and cash. en within the
equity portion of your portfolio, do you want stocks to be larger or
smaller on average than the overall market, and do you want them to be
more value or growth oriented?
If you want and are able to take on more risk in pursuit of higher
expected returns, you can increase your exposure to small-cap stocks,
value stocks or both. If you’re more concerned about safety and stability,
you can increase your exposure to xed income.
In the next chapter, we’ll discuss specic diversication strategies that
will help you keep your wealth management plan on track regardless of
what the markets are doing.
62 — The Wealth Solution
Chapter 6: Risk & Return Are Related — 63
64 — The Wealth Solution
Chapter 7
Diversify with Structure
e third component of successful investing is diversifying your portfolio
across multiple types of assets and investments. Diversifying with structure
enables investors to potentially reduce the overall risk in their portfolios
and increase their portfolios’ long-term potential returns over time.
Diversication is a well-known term, of course. But far too many investors
still don’t fully understand what it really means or even why they should
take the time to build and maintain well-diversied portfolios. Even if
you think you know all there is to know about diversication, we urge you
to read this chapter so you can determine if your eorts at diversication
are truly on target or if you need to reevaluate your approach. We will
also introduce the concept of “diversifying with structure,” which diers
signicantly from conventional approaches to diversication.
e Case for Diversication
Investors sometimes question the need for diversication. Instead of
allocating their wealth by investing in a wide range of assets, investment styles,
and markets, they ask, “Why not just put all your money in investments
that have a history of beating other assets and the overall market?”
e reason, as anyone who lost sleep during the market meltdown of the
“Great Recession” can tell you, is that no single type of asset always performs
well. It’s true that stocks, as measured by the Fama/French Total U.S. Market
Index, have beaten all other asset classes over time, gaining 9.8 percent
annually from 1927 through 2010.
20
But that superior return was of little
_________________________
20 Risks associated with investing in stocks potentially include increased volatility (up and down
movement in the value of your assets) and loss of principal. Indexes are unmanaged baskets of
securities that investors cannot directly invest in. Past performance is no guarantee of future results.
An investment cannot be made directly in an index. Fama/French Total U.S. Market Index provided
by Fama/French from Center for Research in Security Prices (CRSP) data. Includes all NYSE securities
(plus Amex equivalents since July 1962 and NASDAQ equivalents since 1973), including utilities.
64 — The Wealth Solution
Chapter 7: Diversify with Structure — 67
66 — The Wealth Solution
comfort during the 2008 bear market when the S&P 500 index plummeted
nearly 40 percent. Even the size and value premiums didn’t pay o in 2008.
But remember: Investing is all about the future — what’s going to
happen. In order for you to successfully shift your money from one
investment to the next, you would have to know what stock, sector
or asset class is going to outperform the others going forward. And
the future is, by its very nature, unknowable — none of us can be
completely certain what is going to occur in the next ve minutes, ve
days or ve years. ere will always be unanticipated events that aect
the world and, therefore, your investments.
For example, ask yourself if you’ve ever had an investment that didn’t
work out. Why didn’t it perform as planned? Because you (or the person
managing your money) didn’t anticipate a development that aected
your investment. Every active money manager wants to beat the market
— yet, so few actually do. We believe that no one — not even the
brightest minds on Wall Street — can accurately predict the future time
and time again. If they could, they’d beat the market year after year after
year. As you saw in Chapter Five, that just hasn’t happened.
e upshot: It’s nearly impossible to know when an asset class will
outperform and when it will fall to the bottom of the pack. Indeed, the
asset class that wins the performance race in one year rarely is capable
of defending its crown the next — and a losing asset class one year
often unexpectedly soars to the top of list the next year. As you can see
from Exhibit 7.1, in 1999, for example, emerging markets shares soared
almost 66% and were the top-performing stock category for the year.
e worst category that year was REITs, which fell 5%. But in the very
next year, emerging markets fell to the bottom of the pack, declining
30%. e top performing category of 2000 was REITs, up 26%.
Exhibit 7.1: Asset Class Index Performance 1996-2010
Asset Class Performance
High
Low
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Annualized
Returns
REITs
Small
Value
Large
Growth
Emerging
Markets
REITs
Small
Value
5 Year
Gov't
Small
Value
REITs
Emerging
Markets
REITs
Emerging
Markets
5 Year
Gov't
Emerging
Markets
Small
Value
Small
Value
35.27% 36.94% 36.65% 65.82% 26.37% 40.59% 12.95% 74.48% 31.58% 29.32% 35.06% 36.87% 13.11% 84.74% 34.59% 12.10%
S&P 500
Index
Large
Value
S&P 500
Index
Small
Growth
5 Year
Gov't
REITs REITs
Emerging
Markets
Emerging
Markets
EAFE
Emerging
Markets
Large
Growth
Inflation
(CPI)
Small
Value
Small
Growth
22.96% 33.75% 28.58% 54.06% 12.60% 13.93% 3.82% 70.66% 28.00% 13.54% 31.84% 15.70% 0.09% 70.19% 31.83% 10.54%
Small
Value
S&P 500
Index
EAFE
Large
Growth
Inflation
(CPI)
5 Year
Gov't
Inflation
(CPI)
Small
Growth
Small
Value
REITs EAFE EAFE
S&P 500
Index
Large
Growth
REITs
22.36% 33.36% 20.00% 30.16% 3.38% 7.61% 2.39% 54.72% 27.33% 12.16% 26.34% 11.17% -37.00% 38.09% 27.96% 10.15%
Large
Growth
Large
Growth
Large
Value
EAFE
Small
Value
Inflation
(CPI)
Emerging
Markets
EAFE EAFE
Large
Value
Large
Value
5 Year
Gov't
REITs
Small
Growth
Large
Value
S&P 500
Index
21.27% 31.67% 11.95% 26.96% -3.08% 1.55% -9.68% 38.59% 20.25% 9.70% 21.87% 10.05% -37.73% 38.09% 20.17% 6.77%
Large
Value
REITs
5 Year
Gov't
S&P 500
Index
Large
Value
Large
Value
Small
Value
REITs
Large
Value
Small
Growth
Small
Value
S&P 500
Index
Large
Growth
Large
Value
Large
Growth
19.97% 20.26% 10.22% 21.04% -6.41% -2.71% -11.72% 37.13% 17.74% 6.02% 21.70% 5.49% -39.12% 37.51% 17.64% 5.82%
Small
Growth
Small
Growth
Small
Growth
Large
Value
S&P 500
Index
Emerging
Markets
EAFE
Large
Value
Small
Growth
S&P 500
Index
S&P 500
Index
Small
Growth
EAFE EAFE
Emerging
Markets
Large
Growth
13.22% 14.88% 4.08% 6.99% -9.10% -3.65% -15.94% 36.43% 11.16% 4.91% 15.80% 4.99% -43.38% 31.78% 17.34% 5.80%
Emerging
Markets
5 Year
Gov't
Inflation
(CPI)
Small
Value
EAFE
Small
Growth
Large
Growth
S&P 500
Index
S&P 500
Index
Small
Value
Small
Growth
Inflation
(CPI)
Small
Growth
REITs
S&P 500
Index
Small
Growth
10.83% 8.38% 1.60%
4.37%
-14.17% -4.13% -21.93% 28.69% 10.88% 4.46% 9.26% 4.09% -43.41% 27.99% 15.06% 5.16%
EAFE EAFE
Emerging
Markets
Inflation
(CPI)
Large
Growth
S&P 500
Index
S&P 500
Index
Large
Growth
Large
Growth
Inflation
(CPI)
Large
Growth
Large
Value
Small
Value
S&P 500
Index
EAFE EAFE
6.05% 1.78% -3.32% 2.68% -14.33% -11.89% -22.10% 17.77% 5.27% 3.42% 5.97% -12.24% -44.50% 26.46% 7.75% 4.70%
Inflation
(CPI)
Inflation
(CPI)
Small
Value
5 Year
Gov't
Small
Growth
Large
Growth
Large
Value
5 Year
Gov't
Inflation
(CPI)
Large
Growth
5 Year
Gov't
REITs
Emerging
Markets
Inflation
(CPI)
5 Year
Gov't
3.33% 1.70% -10.04% -1.76% -24.50% -21.05% -30.28% 2.40% 3.25% 3.39% 3.15% -15.69% -52.67% 2.72% 7.12% 3.92%
5 Year
Gov't
Emerging
Markets
REITs REITs
Emerging
Markets
EAFE
Small
Growth
Inflation
(CPI)
5 Year
Gov't
5 Year
Gov't
Inflation
(CPI)
Small
Value
Large
Value
5 Year
Gov't
Inflation
(CPI)
Inflation
(CPI)
2.09% -24.26% -17.50% -4.62% -30.40% -21.44% -34.63% 1.88% 2.26% 1.35% 2.55% -18.38% -53.14% -2.40% 1.50% 2.40%
*Data Sources: Center for Research in Security Prices (CRSP), BARRA Inc. and Morgan Stanley Capital International, March 2011. All investments involve risk. Foreign securities involve additional risks, including foreign
currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Past performance is not indicative of future performance. Treasury bills are guaranteed as to repayment of principal
and interest by the U.S. government. This information does not constitute a solicitation for sale of any securities. CRSP ranks all NYSE companies by market capitalization and divides them into 10 equally-populated
portfolios. AMEX and NASDAQ National Market stocks are then placed into deciles according to their respective capitalizations, determined by the NYSE breakpoints. CRSP Portfolios 1-5 represent large-cap stocks;
Portfolios 6-10 represent small caps; Value is represented by companies with a book-to-market ratio in the top 30% of all companies. Growth is represented by companies with a book-to-market ratio in the bottom 30% of
all companies. S&P 500 Index is the Standard & Poor’s 500 Index. The S&P 500 Index measures the performance of large-capitalization U.S. stocks. The S&P 500 is an unmanaged market value-weighted index of 500
stocks that are traded on the NYSE, AMEX and NASDAQ. The weightings make each company’s influence on the index performance directly proportional to that company’s market value. The MSCI EAFE Index (Morgan
Stanley Capital International Europe, Australasia, Far East Index) is comprised of over 1,000 companies representing the stock markets of Europe, Australia, New Zealand and the Far East, and is an unmanaged index.
EAFE represents non-U.S. large stocks. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes and different methods of accounting and financial reporting. Consumer
Price Index (CPI) is a measure of inflation. REITs, represented by the NAREIT Equity REIT Index, is an unmanaged market cap-weighted index comprised of 151 equity REITS. Emerging Markets index represents
securities in countries with developing economies and provide potentially high returns. Many Latin American, Eastern European and Asian countries are considered emerging markets. Indexes are unmanaged baskets
of securities without the fees and expenses associated with mutual funds and other investments. Investors cannot directly invest in an index.
REITs
5 Year
Gov't
Large
Value
Emerging
Markets
Data Sources: Center for Research in Security Prices (CRSP), BARRA Inc. and Morgan Stanley Capital
International, March 2011. All investments involve risk. Foreign securities involve additional risks,
including foreign currency changes, political risks, foreign taxes, and different methods of accounting
and financial reporting. Past performance is not indicative of future performance. Treasury bills are
guaranteed as to repayment of principal and interest by the U.S. government. This information does
not constitute a solicitation for sale of any securities. CRSP ranks all NYSE companies by market
capitalization and divides them into 10 equally-populated portfolios. AMEX and NASDAQ National
Market stocks are then placed into deciles according to their respective capitalizations, determined
by the NYSE breakpoints. CRSP Portfolios 1-5 represent large-cap stocks; Portfolios 6-10 represent
small-caps; Value is represented by companies with a book-to-market ratio in the top 30% of all
companies. Growth is represented by companies with a book-to-market ratio in the bottom 30%
of all companies. S&P 500 Index is the Standard & Poor’s 500 Index. The S&P 500 Index measures
the performance of large-capitalization U.S. stocks. The S&P 500 is an unmanaged market value-
weighted index of 500 stocks that are traded on the NYSE, AMEX and NASDAQ. The weightings make
each company’s influence on the index performance directly proportional to that company’s market
value. The MSCI EAFE Index (Morgan Stanley Capital International Europe, Australasia, Far East Index)
is comprised of over 1,000 companies representing the stock markets of Europe, Australia, New
Zealand and the Far East, and is an unmanaged index. EAFE represents non-U.S. large stocks. Foreign
securities involve additional risks, including foreign currency changes, political risks, foreign taxes and
different methods of accounting and financial reporting. Consumer Price Index (CPI) is a measure of
inflation. REITs, represented by the NAREIT Equity REIT Index, is an unmanaged market cap-weighted
index comprised of 151 equity REITS. Emerging Markets index represents securities in countries with
developing economies and provide potentially high returns. Many Latin American, Eastern European
and Asian countries are considered emerging markets. Indexes are unmanaged baskets of securities
without the fees and expenses associated with mutual funds and other investments. Investors cannot
directly invest in an index.
Chapter 7: Diversify with Structure — 67
66 — The Wealth Solution
Chapter 7: Diversify with Structure — 69
68 — The Wealth Solution
Based on historical stock market information, returns appear random in
the short term. So if you want to own winning assets each year, you can’t
just invest in one or two asset class categories. Instead, you need to own
a variety as to avoid concentration in any one in particular. Some of
these asset classes may be performing well at a given time, while others
will be lagging. at’s how the market works.
During the nancial crisis and market meltdown of 2008, if you had
been invested in just one asset class such as the S&P 500, your net
worth may have been down about 37%. However, if you diversied
and built a portfolio that included bonds and T-bills, asset classes which
both experienced positive returns in 2008, you would have been in
better shape.
In fact, the benets of diversication are often most evident during bear
markets. Exhibit 7.2 illustrates the growth of stocks versus a diversied
portfolio during two of the worst performance periods in recent history.
e blue line illustrates the hypothetical growth of $1,000 invested in
stocks during the mid-1970s recession and the 2007–2009 bear market.
e gray line illustrates the hypothetical growth of $1,000 invested in a
diversied portfolio of 35% stocks, 40% bonds, and 25% Treasury bills
during these same two periods.
Over the course of both time periods, the diversied portfolio lost less
than the pure stock portfolio.
Exhibit 7.2: Diversified Portfolios in Various Market Conditions
Performance during and after select bear markets
1/1973 1/1974 1/1975 1/1976 7/2000 7/2001 7/2002 7/2003
$500
$750
$1,000
$1,250
StocksDiversified Portfolio
$1,101
$806
$1,140
$1,014
Past performance is no guarantee of future results. Diversified portfolio: 35% stocks, 40% bonds,
25% Treasury bills. Hypothetical value of $1,000 invested at beginning of January 1973 and
November 2007, respectively. This is for illustrative purposes only and not indicative of any investment.
An investment cannot be made directly in an index. Stocks in this example are represented by the
Standard & Poor’s 500®, an unmanaged group of securities considered to be representative of the
stock market in general. Bonds are represented by the 20-year U.S. Government Bond, and Treasury
bills by the 30-day U.S. Treasury bill. The data assumes reinvestment of income and does not account
for taxes or transaction costs. © 2010 Morningstar. All Rights Reserved. 3/1/2010.
ink about the potential benets of diversication this way. Say you’re
packing to go on an extensive road trip across the country. Along the way
you plan to hit some Florida beaches, so you pack sunscreen. You also
will visit relatives in New England, so you pack some sweaters in case it’s
cold. In addition, your travels will take you to the Pacic Northwest, so
you make sure to include an umbrella. By being prepared for the wide
variety of conditions you’re likely to experience during your long trip,
you’ll reduce the risk of having negative moments and maximize your
probability of enjoying your experiences no matter where you are along
the way.
Chapter 7: Diversify with Structure — 69
68 — The Wealth Solution
Chapter 7: Diversify with Structure — 71
Investing can also be compared to a journey. As an investor, you’re
going to experience some days that are sunny and warm and others that
are stormy and cold. Conditions will sometimes change unexpectedly
and with great force, while other times you’ll enjoy long stretches of
consistent weather. Knowing that, you’d need to ask yourself: How will
I pack for this trip so that I maximize my chances of having a great
experience and minimize the risk of having a really bad time?
Diversication is the key to packing wisely for an investment journey.
It helps make you better prepared to deal with the various experiences
you’ll have along the way.
Investors tend to understand that diversication can reduce the overall
amount of volatility in an investment portfolio. If your portfolio consists
entirely of one stock — a nancial services company, for example —
your level of wealth is dependent entirely on the value of that stock. If
the company experiences a signicant setback or goes out of business,
your wealth can be destroyed. Consider, for example, if all or even the
majority of your portfolio was invested in Lehman Brothers stock or
Wachovia or GM or AIG or any of the other companies that ran into
severe troubles during the “Great Recession.”
But adding another stock to that portfolio immediately reduces the risk
that a blow-up at the rst company will destroy your wealth. If that
second stock is from an entirely dierent industry — technology, let’s
say — whose health and stability are aected by dierent factors, that
risk may fall even further. If you then add a third stock from an entirely
dierent area of the market — an oil company in a small overseas market,
let’s say — you cut your risk further still. Repeat this process thousands
of times and you have the basis for a diversied stock portfolio in which
no one company, industry or country has a disproportionate ability
to damage your wealth. en by adding other types of assets beyond
equities — such as bonds or REITs, for example — you can further
enhance your diversication and cut down on risk even more.
70 — The Wealth Solution
e end result: e losses you’ll experience when some asset classes
perform poorly may be somewhat (or entirely) oset by gains from
other asset classes that are doing well.
is approach is what we refer to as “diversifying with structure” — using
academic and economic research, such as Fama and French’s research
on equities and small and value stocks, to build a broadly diversied
portfolio that tries to maximize return for your chosen level of risk.
If you own many dierent asset classes and many dierent individual
securities within those asset classes, you don’t have to worry as much
if one or even many of those investments don’t pan out — you have a
whole host of other investments to help make up for the losers. And your
portfolio likely won’t experience the extreme, nerve-wracking swings in
value that a highly concentrated portfolio would. e less worried you
are about your portfolio and the less volatile it is from year to year, the
less likely you’ll be to panic during market downturns and make poor
decisions — like selling out of stocks right at a market bottom — that
could damage your nancial future.
ere’s another potential benet to diversication that is just as powerful
yet less appreciated: lowering volatility has a potential impact on returns.
For illustration purposes only, consider exhibit 7.3, which shows two
$100,000 portfolios. Each one has an average monthly return of 1 percent.
But note that Investment A’s return each month swings dramatically
between +10 percent and -8 percent. By contrast, Investment B is much
less volatile. Its monthly return alternates between just +4 percent and
-2 percent. Even though both investments produce the same monthly
return, the lower volatility Investment B generates much more growth
over time. An investor in volatile Investment A would have ended up
with much less wealth over three decades — some $2.2 million less, in
fact. In stark contrast, an investor in the less volatile Investment B would
have done a much better job protecting and growing his or her wealth.
Chapter 7: Diversify with Structure — 71
70 — The Wealth Solution
Chapter 7: Diversify with Structure — 73
Exhibit 7.3: The Potential Impact of Volatility on a $100,000 Portfolio
Original Investment After 10 Years After 20 Years After 30 Years
$100,000 $100,000
$204,565
$313,015
$410,467
$979,783
$856,036
$3,066,865
$4,000,000
$3,000,000
$2,000,000
$1,000,000
$0
Investment A (=10% & -8%)
Investment B (=4% & -2%)
Source: Loring Ward. For illustrative purposes only. Each investment has an average monthly
return of 1%, but very different volatility profiles. Investment A (higher volatility) achieves the
1% return by alternating monthly between 10% and –8%, while Investment B (lower volatility)
achieves the same average return by alternating between 4% and –2%. The table shows the
value of an initial investment of $100,000 with no additions or withdrawals invested over
10, 20 and 30 years. Investment A and B are not representative of a real investment, i.e., no
dividends are paid and there are no management fees deducted.
Is Diversication On e Ropes?
It’s important to recognize that while diversifying with structure can
help reduce a portfolio’s overall volatility and increase its potential
returns, it cannot guarantee that you won’t lose money. is is especially
true when there are huge shocks to global markets and economies —
such as the worldwide credit crisis that resulted from the blow-up in
subprime mortgages in 2008. e depth and breadth of these problems
shook the global nancial system to its core and left investors with very
few places to hide.
In that environment, asset classes that would normally react dierently
to an event tended to move together. For example, most major equity
categories — large-cap stocks, small-cap stocks, large-cap foreign shares
and emerging markets equities — all fell by 30% or more. Holding a
mix of various types of stocks did investors little good that year — a
72 — The Wealth Solution
situation that prompted some investors and investment gurus to declare
that diversication was dead.
However, we believe that diversication is as alive and well as ever. One
common misconception about diversication is that as one market or
asset class goes down, another invariably goes up — for example, when
the U.S. market falls, overseas markets rise. Such an oset is more than
we can reasonably expect from diversication.
To see why, it’s necessary to understand the concept of correlation.
Correlation represents the relationship between asset classes during an
investment cycle. If two asset classes have a correlation of +1, their values
will move simultaneously in the same direction. If the two asset classes
have a correlation of -1, their prices will move in opposite directions.
Combining asset classes with low correlations therefore can give your
portfolio a smoother ride over time. By contrast, owning various asset
classes with high correlations gives you less overall diversication.
Many people assume that the correlation between dierent asset classes
is completely negative and that their prices move in opposite directions.
In fact, nearly all correlations between investments are positive to some
degree. As seen in Exhibit 7.4, U.S. and international stocks have a
correlation of +0.886 — meaning that international stocks are likely
to post gains when the U.S. market is rising, and post losses when the
U.S. market is falling. But note that the correlation between U.S. and
international stocks is not a perfect correlation of +1. is means that the
magnitude of the gains and losses will be dierent. Indeed, that’s exactly
what we saw during the recent bear market. e S&P 500 plunged 37%
in 2008, while international stocks did even worse — falling 43%.
From a diversication standpoint, an investor who held both U.S. and
foreign stocks would have done better — less bad, really — than an investor
who was heavily concentrated in international stocks and had little or no
domestic exposure. Both investors obviously would have suered big losses.
But the diversied investor would have a smaller hole to climb out of.
Chapter 7: Diversify with Structure — 73
72 — The Wealth Solution
Chapter 7: Diversify with Structure — 75
e upshot: Diversication isn’t dependent on negative correlations.
Obviously, combining two negatively correlated assets is highly
desirable. For example, U.S. small-cap stocks (as represented by the
CRSP Deciles 6-10 in Exhibit 7.4) have a -0.21 correlation with ve-
year U.S. Treasury notes. at means when small-cap stock prices rise,
prices of ve-year Treasuries should fall (and vice versa). However, even
asset classes with positive correlations will experience dierences in the
magnitude of their gains and losses. What’s more, their various rates of
recovery will likely be dierent.
Exhibit 7.4: Correlation of Various Asset Classes
Data Series
One-Month US Treasury Bills
Five-Year US Treasury Notes
CRSP Deciles 1-10 Index (market)
Fama/French US Large Value Index (ex utilities)
CRSP Deciles 6-10 Index
Fama/French International Value Index
Dimensional International Small Cap Index
Dimensional Emerging Markets Index
Dow Jones Wilshire REIT Index (Full Cap)
One-Month US Treasury Bills 1.00
Five-Year US Treasury Notes 0.14 1.00
CRSP Deciles 1-10 Index
(market)
0.06 -0.12 1.00
Fama/French US Large
Value Index (ex utilities)
0.09 -0.13 0.82 1.00
CRSP Deciles 6-10 Index -0.03 -0.21 0.83 0.65 1.00
Fama/French International
Value Index
-0.09 -0.14 0.65 0.66 0.56 1.00
Dimensional International
Small-Cap Index
-0.23 -0.19 0.57 0.47 0.64 0.85 1.00
Dimensional Emerging
Markets Index
-0.15 -0.21 0.71 0.60 0.72 0.65 0.67 1.00
Dow Jones Wilshire REIT
Index (Full Cap)
-0.05 0.01 0.29 0.34 0.38 0.29 0.24 0.30 1.00
Source: Dimensional Fund Advisors
74 — The Wealth Solution
Structural Diversication
To enjoy the potential benets that diversication oers, you need to
diversify structurally and intelligently. Simply buying a bunch of stocks,
bonds, mutual funds or other investments doesn’t automatically mean
that you have dampened your portfolio’s risk and enhanced its potential
return. Structural diversication requires you to be thoughtful and
systematic in your approach to building and maintaining your portfolio.
Too often, however, investors tend to simply collect investments. ey
buy a stock because they heard it was hot or because their uncle works
for the rm, or they invest in several funds that they read about in
various magazines without regard for whether those funds complement
each other.
For example, say you own an index mutual fund that attempts to track
the performance of the S&P 500 and you decide to add to your portfolio
an ETF that tracks the Dow Jones Industrial Average. at move doesn’t
add any meaningful diversication benets because both of those
investments hold shares of domestic, large-company stocks. erefore,
those two investments should react similarly to new developments in
the markets and the economy. When domestic large-cap stocks are
down, both of your investments should decline — and probably by
roughly the same amount, since their holdings are so similar. As a result,
there’s nothing in your portfolio to help dampen the impact of those
losses on your wealth.
To avoid that type of scenario, investors need to stop simply collecting
investments for random reasons and instead own assets that are
designed to work together to create portfolios that are stronger than
their individual component pieces. at means holding asset classes
and investments that have dissimilar price movements from each other
and don’t react the same way to new developments — in other words,
asset classes with relatively low correlations that can “zig” when others
“zag.” Here’s how:
Chapter 7: Diversify with Structure — 75
74 — The Wealth Solution
Chapter 7: Diversify with Structure — 77
1. Diversify among large- and small-cap stocks. We’ve seen that small-
cap stocks have tended to outperform large-cap shares over time. But
that journey has not been a consistently smooth one. As shown in
Exhibit 7.5, large-caps and small-caps tend to take turns leading the
performance race. What’s more, small-caps can lag large-caps for years
(and vice versa). For example, large-cap stocks gained 16.5% annually
from 1984 through 1991, while small-caps gained just 9.5% a year on
average during that time. Even if you are a rm believer in the advantages
of small-caps, could you stick with an entirely small-cap portfolio as you
watched it lag for eight years? For the vast majority of investors, the
answer is a resounding “no.” Likewise, large-caps can experience years of
poor performance — as they did from 1975 through 1982, returning
14.9% annually while small-caps soared 31.7%.erefore, it may make
sense to include both large- and small-cap stocks in the equity portion of
your portfolio. However, given the long-term historical outperformance
of small stocks, we do believe in overweighting small vs. large.
76 — The Wealth Solution
Investing in foreign securities may involve certain
additional risks, including exchange rate uctuations,
less liquidity, greater volatility, and less regulation.
Investing in foreign securities may involve certain additional risks, including
exchange rate fluctuations, less liquidity, greater volatility, different financial
and accounting standards and political instability.
Exhibit 7.5: Small-Caps Versus Large-Caps Over Various Time Periods
12-Month Rolling Returns
2010
1972
1977
1982
1986
1991
1995
2005
2000
60%40%20%0%20%40%60%
Large stocks
outperform
small stocks
Small stocks
outperform
large stocks
Percent Outperformance
Source: Dimensional Fund Advisors. Large-cap stocks are represented by the Standard & Poor’s
500 Index, an unmanaged market value-weighted index of 500 large company stocks that are
traded on the NYSE, AMEX and NASDAQ. The Center for Research in Security Prices (CRSP)
ranks all NYSE companies by market capitalization and divides them into 10 equally-populated
portfolios. AMEX and NASDAQ National Market stocks are then placed into deciles according
to their respective capitalizations, determined by the NYSE breakpoints. CRSP Portfolios 6-10
represent small caps.
2. Diversify among value and growth stocks. We saw in the last chapter
that value stocks have historically outperformed growth shares over
time. But just like small- and large-caps, value and growth stocks each
go in and out of favor over various time periods — and each has a habit
of going on extended runs at the expense of the other (see Exhibit 7.6).
Chapter 7: Diversify with Structure — 77
76 — The Wealth Solution
Chapter 7: Diversify with Structure — 79
78 — The Wealth Solution
While growth stocks as a group handily beat value shares in aggregate
from 1995 through 1999 (31.2% versus 21.9%, respectively), value
won from 1972 through 1989 — gaining 16.6% versus 9.8% for
growth. Again, given the long-term historical outperformance of
value stocks, we do believe in overweighting value vs. growth.
Exhibit 7.6: Growth Versus Value Over Various Time Periods
12-Month Rolling Returns
2010
1972
1977
1982
1986
1991
1995
2005
2000
60%40%20%0%20%40%60%
Growth stocks
outperform
value stocks
Value stocks
outperform
growth stocks
Percent Outperformance
Source: Dimensional Fund Advisors. The Center for Research in Security Prices (CRSP) ranks
all NYSE companies by market capitalization and divides them into 10 equally-populated
portfolios. AMEX and NASDAQ National Market stocks are then placed into deciles according
to their respective capitalizations, determined by the NYSE breakpoints. Value is represented by
companies with a book-to-market ratio in the top 30% of all companies. Growth is represented
by companies with a book-to-market ratio in the bottom 30% of all companies.
3. Bring international stocks into the mix. Events that aect U.S.
companies don’t always have the same impact on rms in foreign
countries. As a result, shares of overseas companies may rise when
the overall domestic market is slumping. is is especially true with
emerging markets stocks — shares of rms in developing nations
such as Brazil and ailand that have dierent economic drivers
behind their growth than the U.S. (see Exhibit 7.7). For example,
emerging markets stock returned 29 percent in 2005 — a year when
the U.S. market gained just 4.9 percent.
Exhibit 7.7: Emerging Markets Stocks Versus U.S. Stocks Over Various
Time Periods
12-Month Rolling Returns
2006
2010
1988
1992
1997
2001
150%100%50%0%50%100%150%
U.S. market
outperforms
emerging markets
Emerging markets
outperform
U.S. market
Percent Outperformance
Source: Dimensional Fund Advisors. Investing in foreign securities may involve certain additional
risks, including exchange rate fluctuations, less liquidity, greater volatility, different financial and
accounting standards and political instability.
Chapter 7: Diversify with Structure — 79
78 — The Wealth Solution
Chapter 7: Diversify with Structure — 81
80 — The Wealth Solution
ere’s another reason to diversify internationally: Currently, more
than 50% of the global stock market’s value comes from non-U.S.
companies. erefore, investors who forsake foreign investments
don’t own many of the world’s most well known and successful
companies — including Sony, Nokia, Honda and Royal Dutch
Shell. By adding international stocks to the mix, investors can
not only better diversify their portfolios but also give themselves
more opportunities to prot from the growth of capitalism across
the globe.
4. Add short-term, high-quality bonds to reduce risk. Bonds are a
crucial asset class for many investors, as only the more aggressive
among us are comfortable owning portfolios made up entirely of
stocks. Bond prices are much less volatile than stock prices and they
often move in the opposite direction of stocks, making bonds an
excellent potential source of diversication and risk reduction that
can help protect wealth when stocks suer. Most recently, we saw
this during the market meltdown of 2008. As stocks plummeted
by 37% or more, intermediate-term U.S. government bonds rose
by 13%.
We believe the most eective way to diversify a stock portfolio with
bonds is to allocate a percentage of your portfolio to high-quality,
short-term xed-income investments. Why those investments,
specically? Because bonds with longer maturities and of lower
quality entail more risk than do short-term bonds of very high quality.
Bonds that mature farther in the future are hit harder by unexpected
increases in interest rates, while bonds with lower credit quality have
a higher risk of default.
Unfortunately, these additional risks don’t typically provide adequate
compensation to investors who take them. Note in Exhibit 7.8 that
the risk (as measured by standard deviation) of 20-year bonds is
much greater than the risk in Treasury securities with maturities of
just one year or less. Now notice how similar the historical returns in
each category are. Clearly, owning relatively volatile long-term bonds
doesn’t oer much in the way of extra returns over extremely low-risk
short-term issues. Likewise, as seen in Exhibit 7.9, bonds with lower
credit ratings (such as BBB and high-yield bonds) do not tend to oer
ample enough return potential over higher quality bonds to justify
their additional risk.
Exhibit 7.8: The Risk/Return Trade-Off in Fixed-Income — Long-Term
vs. Short-Term Bonds
BofA Merrill BofA Merrill
One-Month U.S. Lynch Six-Month Lynch One-Year Five-Year U.S. Long-Term
Maturity
Treasury Bills U.S. Treasury Bills U.S. Treasury Notes Treasury Notes Government Bonds
Compound Return (%) 5.45 6.20 6.41 7.27 7.37
Standard Deviation (%) 1.42 1.77 2.34 6.21 11.30
12%
10%
8%
6%
4%
2%
0%
Compound Returns
Quarterly 1964 - 2010
Standard Deviation
Source: One-Month US Treasury Bills, Five-Year US Treasury Notes, and Twenty-Year (Long-Term)
US Government Bonds provided by Ibbotson Associates. Six-Month US Treasury Bills provided
by CRSP (1964-1977) and B of A Merrill Lynch (1978-present). One-Year US Treasury Notes
provided by CRSP (1964-May 1991) and B of A Merrill Lynch (June 1991-present). Ibbotson
data © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago (annually
updated work by Roger G. Ibbotson and Rex A. Sinquefield). CRSP data provided by the Center
for Research in Security Prices, University of Chicago. The Merrill Lynch Indices are used with
permission; copyright 2011 B of A Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights
reserved. Assumes reinvestment of dividends. Past performance is not indicative of future
results. Standard deviation annualized from quarterly data. Standard deviation is a statistical
measurement of how far the return of a security (or index) moves above or below its average
value. The greater the standard deviation, the riskier an investment is considered to be.
Chapter 7: Diversify with Structure — 81
80 — The Wealth Solution
82 — The Wealth Solution
Exhibit 7.9: The Risk/Return Trade-Off in Fixed-Income —
High Quality vs. Lower Quality Bonds
Quality Government AAA AA A BBB High Yield
Compound Return (%) 7.40 7.80 7.95 8.03 8.58 9.07
Standard Deviation (%) 4.16 4.33 4.77 5.13 5.06 9.49
10%
8%
6%
4%
2%
0%
Compound Returns
Quarterly 1983 - 2010
Standard Deviation
Source: Government rating is Barclays Capital US Government Bond Index Intermediate, AAA
rating is Barclays Capital US Intermediate Credit Aaa Index. AA rating is Barclays Capital US
Intermediate Credit Aa Index. A rating is Barclays Capital US Intermediate Credit A Index.
BBB rating is Barclays Capital US Intermediate Credit BBB Index. High Yield rating is Barclays
High Yield Composite Bond Index Intermediate. Indices are not available for direct investment.
Assumes reinvestment of dividends. Past performance is not indicative of future results. Standard
deviation annualized from quarterly data. Standard deviation is a statistical measurement of
how far the return of a security (or index) moves above or below its average value. The greater
the standard deviation, the riskier an investment is considered to be.
ere are two key lessons here. One is that short-term, high-quality xed-
income investments should do a much better job at dampening the volatility
of an overall portfolio than other types of bonds because their prices are
more stable. at stability can help to reduce a portfolio’s amount of price
uctuation. e other is that you may want to think twice before seeking to
generate lots of additional return by owning long-term, low-quality bonds
that require you to take on signicant risk for not much reward.
We hope by now that it’s become clear that diversifying your portfolio is
not just a smart move but can even be a liberating experience. Diversifying
means that you no longer have to go through the futile and oftentimes
fruitless eort of trying to predict the future and make the right moves all
the time. Instead you can spend your time on your business, your family
or yourself — instead of trying buy and sell the “right” investments.
Chapter 8
Building and Implementing Your
Investment Portfolio
e next step in the Structured Wealth Management investment
consulting process is to create a portfolio based on your particular
situation and then implement it using specic investment vehicles. As
you’ll see in this chapter, it’s also important to place those investment
vehicles in the appropriate types of accounts, as well as formally
document your portfolio choices and the reasons behind them by
implementing an Investment Policy Statement.
Key Questions to Consider When Building Your Portfolio
To begin, you need to consider a series of issues that will help you build
the right portfolio for you — one that intends to take into account
your specic goals, time horizon, liquidity needs and your views on
investment risk. ese issues will help ensure that your portfolio
provides you with the appropriate trade-o between risk and return
so that you can stick with your plan during a variety of market cycles
and let your portfolio do its most important job: working to get you
to your biggest nancial goals.
Broadly, the issues to consider are divided into three main areas: risk
capacity, risk tolerance and investment preferences.
82 — The Wealth Solution
Chapter 8: Building and Implementing Your Investment Portfolio — 85
84 — The Wealth Solution
Risk Capacity Considerations
Your capacity to bear investment risk on a purely objective basis will
be determined by factors such as:
• Your portfolio goals. Nearly all investors have one of ve
primary goals: retirement funding, education funding, wealth
accumulation, capital preservation, or estate maximization. Of
course, you may have more than one of these goals — for example,
funding a comfortable retirement for yourself and your spouse
while also passing on a signicant portion of your estate to children
and grandchildren. erefore, you might choose to create multiple
portfolios, each one designed to achieve a specic objective.
• Your time horizon. You must determine the approximate length
of time that your money will need to be invested in order to
determine an appropriate allocation to stocks in your portfolio.
Because equities can generate substantial losses over the short-term
— the worst-ever one-year loss for the S&P 500 index was -37
percent (see Exhibit 8.1) — it is usually inappropriate to invest
in equities for any goal with a time horizon of ve years or fewer.
Generally, however, portfolios with longer-term goals have a higher
capacity for stock market risk. e reason: Stock returns uctuate
less and less the longer you hold equities. Indeed, as seen in Exhibit
8.1, stocks have generated positive returns during 100% of rolling
15-year periods since 1972.
Exhibit 8.1: The Range of Stock Market Returns Over Various Time
Periods — S&P 500 Index Rolling Returns 1972 - 2010
40%
60%
20%
0%
-20%
-40%
-60%
1 Year
Horizon
37.58%
15.80%
-37.00%
3 Year
Horizon
13.35%
31.15%
-14.55%
5 Year
Horizon
14.05%
28.56%
-2.30%
10 Year
Horizon
14.13%
19.19%
-1.38%
15 Year
Horizon
13.74%
18.94%
6.46%
The chart above shows the maximum, median and minimum returns for the S&P 500 index
over 12-month rolling periods since 1972. Source: Standard & Poor’s. Past performance is no
guarantee of future results, and values fluctuate. Principal value, share prices and investment
returns fluctuate with changes in market conditions, so that an investor’s shares when redeemed
or sold, may be worth more or less than their original cost.
• Your income and liquidity requirements. Another key factor
in determining the right asset allocation is your need for current
income from the portfolio. What is your current income requirement
from your portfolio this year per $100,000 invested: 0-1 percent,
1-2 percent, 2-3 percent, 3-4 percent, 4-5 percent or more than
6 percent? In addition, consider if you will require a signicant
withdrawal of principal from the portfolio within the next ve years
to fund a major expense — such as buying a home or paying for
college tuition. If that’s the case, how big a withdrawal from your
portfolio will you need to take, per $100,000 invested: 1-10%, 10-
20%, 20-40%, 40-60%, or more? As a rule of thumb, you should
have enough money invested in relatively stable short-term, high-
quality xed-income investments to meet three to ve years’ worth
of liquidity and income needs.
Chapter 8: Building and Implementing Your Investment Portfolio — 85
84 — The Wealth Solution
Chapter 8: Building and Implementing Your Investment Portfolio — 87
86 — The Wealth Solution
Risk Tolerance Considerations
To create the right portfolio for your situation, you also need to
consider questions that go beyond your objective ability to incur
investment risk and help you assess your emotional comfort with
risk. e reason: If you cannot psychologically withstand the amount
of risk in your portfolio, you may be tempted to deviate from your
investment plan during periods of extreme market behavior — for
example, selling out of stocks during deep bear markets and missing
the benets of future stock market rallies. e capacity to take on risk
based on your goals and time horizon won’t do you much good if
you panic when the markets tumble and make rash changes to your
portfolio that could throw o your entire nancial plan.
To help you get a better handle on your tolerance to accept risk,
consider issues such as:
• Your general comfort level with risk. Do you try to avoid risk
as much as possible in your life, including in non-nancial areas?
Would you describe yourself more as cautious or willing to take
some calculated risks? Or are you generally a risk taker?
• Your feelings about market uctuations. ink about watching
the ups and downs in your portfolio — especially back in 2008 and
early 2009 when the market was rising and falling by hundreds of
points on a given day. When you think about those wild swings,
do you say to yourself, “I can accept lots of ups and down so I
can maximize returns?” Or are you more likely to be willing to
tolerate some uctuations in the value of your portfolio in order to
keep pace with ination? Or would you rather not experience any
uctuations even if that means accepting lower returns that don’t
keep up with ination?
• Your reaction to market declines on your portfolio’s value. Let’s
say you have a portfolio worth $1 million, and a bear market causes
the value of that portfolio to plummet by $300,000 over the course
of a 12-month period. If you looked at your account statement
and saw that your portfolio was now worth just $700,000, what
would you do? Can you condently say that you would not sell?
Would you be uncertain about what to do next? Would you almost
certainly sell after experiencing such a large loss in just one year? Or
would you never even have invested in a portfolio that could lose
so much money so quickly in the rst place?
Investment Preferences
Finally, given what you’ve learned about the diversication benets and
risk/return characteristics of international investments, value-oriented
stocks and small-company stocks in previous chapters, how comfortable
are you with owning each of these three types of investments in your
portfolio — very uncomfortable, somewhat uncomfortable, somewhat
comfortable, comfortable or very comfortable?
Establishing your investment preferences in these areas will enable
you to better decide if you want to tilt your portfolio toward those
asset classes that have shown to reward investors over time — and
if so, determine an allocation strategy that will help you realize your
most important goals.
Implementing Your Portfolio Strategy
Investors today have more options than ever in terms of investment
vehicles and products. Despite the increasing number of choices that
exist, we believe that mutual funds are an excellent solution for the
vast majority of investors looking to achieve their long-term goals.
e major benets of mutual funds include:
• Diversication. Mutual funds typically hold huge numbers
of stocks and bonds — upwards of 500 in some cases — from
numerous industries, and may even invest in multiple countries
from around the globe. In other words, funds can provide instant
diversication at a much lower cost than if you tried to create your
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86 — The Wealth Solution
Chapter 8: Building and Implementing Your Investment Portfolio — 89
88 — The Wealth Solution
own diversied portfolio of thousands of stocks, bonds and other
investments.
• Regulations. Mutual funds are one of the most highly regulated
investment vehicles. It is noteworthy that many of the failed Ponzi
schemes and frauds that were uncovered during the Great Recession
(Mado, Stanford, Phillip Barry) were in investment products
other than mutual funds.
Unlike unregistered investment products, a mutual fund is one of the
most highly regulated investment products.
• emutualfunditselfisregisteredwiththeSECasaninvestment
company under the Investment Company Act of 1940.
• A mutual fund can only be advised by an investment advisor
registered with the SEC pursuant to the Investment Advisors Act
of 1940.
• e shares of a mutual fund are generally securities themselves
registered with the SEC pursuant to the Securities Act of 1933 and
regulated per the Securities and Exchange Act of 1934.
Also, mutual funds have ticker symbols through which valuations can
be determined quickly and easily, either by calling a nancial advisor,
typing in the ticker into a nancial website, or looking in a newspaper.
More complex securities, like mortgage-backed securities, derivatives,
and private placements are not always easy to evaluate and price and
therefore can be sources of abuse.
Active Versus Passive
Among fund options, there are passive funds and active funds. Passive
funds attempt to match the performance of an entire asset class or a
particular index that represents an asset class. Active funds attempt
to beat the performance of an asset class or index by actively buying
and selling securities. If you’ve read this far, you no doubt can guess
that we believe the best option for investors is to use passive funds that
do not attempt to pick winners, avoid losers or jump in and out of the
market at the most opportune times. As we’ve illustrated, investors who
take those actions fail the vast majority of the time and therefore this
methodology does not seem a prudent way of investing for the future.
Passive funds also oer the key benet of style consistency. If you
create an overall structure for your portfolio — an asset allocation
strategy — you need the investments you use to stay committed to
their respective investment styles. You don’t want a fund that is in
stocks one day, cash the next. is makes maintaining a suitable asset
allocation very dicult. For that reason, active funds aren’t always
appropriate for investors who wish to build and maintain well thought
out, diversied asset allocation strategies that require consistency.
Finally, passive funds typically have much lower costs and management
fees than active funds. at’s because passive funds simply own all the
stocks that make up their target index or asset class. ey don’t have to
spend lots of time, money and human resources trying to identify the
winners and losers and making numerous trades that generate costs —
costs that get passed on to their shareholders. e dierence between
the costs of the average actively managed mutual fund and those of
the average passively managed fund can be substantial. As you can see
from Exhibit 8.2, this cost dierential in 2009 was 1.54%. at’s a
big dierence to pay someone, when the odds are that they may not
be able to outperform the passive managers over the long-term.
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Chapter 8: Building and Implementing Your Investment Portfolio — 91
90 — The Wealth Solution
Exhibit 8.2: Average Mutual Fund Costs in 2009
Funds
Annual Reported
Net Expense
Ratio
SAI Charges* Total Fees
Average Actively
Managed Mutual Fund
1.14% 1.53% 2.67%
Average Passively
Managed Mutual Fund
0.52% 0.61% 1.13%
*Statement of Additional Information (SAI). Based on Turnover Ratio % times average SAI of 1.47%.
The illustration results are only an estimate and do not reflect advisory fees charged by your
investment advisor. Source: Lipper Data as of December 31, 2009
Among passive funds, there are three main options to consider:
• Index funds. As you’re probably aware, index funds attempt to
replicate the performance of specic commercial indices (the S&P
500, the Russell 2000, the MSCI EAFE, etc.). ey oer investors an
easy way to gain exposure to a broad range of investment categories
and styles. e downside to index funds is that, because the funds
need to track their indices as closely as possible, their managers
must buy and sell certain stocks whenever their target index deletes
or adds securities. Such trading can generate unwanted costs.
• Exchange traded funds. An ETF is similar to an index fund in that
it seeks to mirror the holdings of a commercial index and match
its performance. Because of how they’re structured, however, ETFs
have expenses that are often even lower than those of traditional
index mutual funds. ey also oer a high degree of tax eciency.
An enormous number of ETFs exist, allowing investors to build
broadly diversied passive portfolios with exposure to a wide variety
of investments.
• Asset class funds. Less well known among investors than index
funds or ETFs, asset class funds — as the name suggests — attempt
to deliver the investment returns of an entire broad asset class. In
that respect they are extremely similar to index funds and ETFs.
But unlike those two options, asset class funds don’t necessarily own
the exact same securities that are found in a commercial index like
the S&P 500. Instead, they hold large numbers of securities with
similar risk and expected return characteristics. A small-cap stock
asset class fund, for example, might dene small-caps somewhat
dierently than would an index fund or ETF that tracks the Russell
2000 index of small-company stocks. Asset class fund investors
believe that these funds oer truer and more accurate exposure to
various segments of the nancial market.
A Word About Asset Location
Once you’ve created your ideal portfolio strategy and implemented
your plan using specic investment vehicles, you still have another
important duty: Deciding how to best locate your assets in your
portfolio.
Asset location is all about placing each of your various investments
into one of two types of accounts — taxable or non-taxable/tax-
deferred — to achieve optimal tax eciency, defer taxes and generate
the best after-tax returns possible. e best location for your assets
depends on factors such as the tax laws at the time, the tax and return
characteristics of the securities you own, your income tax bracket, and
your need for liquidity.
ere are some general guidelines that you can use to start thinking
about which of your investments are best-suited to each type of
account. For example, low-cost index funds, ETFs and asset class
funds that don’t make a lot of trades and are already highly tax ecient
— as well as investments like tax-free municipal bonds — are often
placed in taxable accounts, because placing them in tax-advantaged
accounts doesn’t add much benet in terms of minimizing taxes. But
investments that generate signicant taxable income — such as some
taxable bond funds and real estate investment trusts (REITs) funds
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— are often placed in tax-deferred or non-taxable accounts to help
mitigate current tax liabilities. ere is no one “right” answer when
it comes to asset location. Your specic needs, circumstances and tax
situation should drive the decision.
Put It in Writing
e nal step in this part of the Structured Wealth Management investment
consulting process is to create an Investment Policy Statement. is is
a written document spelling out the key components of your nancial
situation and investment plan, and the reasons behind why you have
structured your portfolio the way you have. It should contain your
answers to the types of questions outlined earlier in this chapter —
answers regarding your goals, time horizon, risk tolerance and ability to
withstand risk, liquidity and income requirements, and your approach
to your portfolio’s asset allocation and investment vehicles.
By putting this information in writing, you’ll clarify what goals you
are hoping to achieve by investing and why you have chosen to use
the approach you are using. Such clarity can be extremely benecial
to you — both when markets are soaring and possibly tempting you
to chase hot market sectors and also when markets are plummeting
and perhaps tempting you to cash out of stocks and deviate from
your plan. An Investment Policy Statement can help you avoid the
worst and most dangerous emotional reactions to various market
developments — a topic we’ll tackle in detail in the next chapter.
For that reason, we strongly encourage that you create an Investment
Policy Statement that you can refer to whenever you think it’s time
to make big changes to your portfolio or overall saving and investing
strategy. It may be one of the most valuable documents you’ll ever use.
Chapter 9
Invest for the Long Term
By creating and implementing a portfolio strategy customized around
your needs and situation, you’ve put yourself on a sound path toward
achieving your investment goals. However, your job isn’t nished.
In fact, you now must contend with perhaps the biggest challenge
you’ll ever face as an investor: avoiding the foolish mistakes that can
jeopardize your nancial future.
As investors — and as human beings, really — we are predisposed
to constantly take action. We’re always racing around trying to “get
ahead of the curve.” It’s counterintuitive in our culture to believe that
doing nothing is in any way a better idea than doing something.
And yet, when it comes to investing, being overactive is the downfall
of too many investors. at’s why one of the smartest moves you can
make is to be patient and disciplined regarding your portfolio and
your wealth management plan. Being patient and disciplined and
investing for the long term means doing less, not more. It means
exercising restraint instead of charging ahead. And it means staying
focused on what is truly important to your life goals and ignoring
the enormous amount of emotion and “noise” that too often clouds
investors’ judgment and prompts them to make rash moves that hurt
their chances of achieving all that is important to them.
As you’ll see in this chapter, a long-term perspective is a key driver
of investment success. But it’s also a task that can be extraordinarily
dicult to achieve because of our hard-wired tendencies. e good
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Chapter 9: Invest for the Long Term — 95
94 — The Wealth Solution
news: ere are steps you can take that will help you be a more patient
and disciplined investor — one who is in the best position to reach
your long-term goals with the least amount of eort and stress possible.
e Importance of Staying Invested
Once you’ve built your portfolio and are invested the way you want
to be, it’s critical to stick with your plan and not jump in and out of
various investments and asset classes. e reason: Deviating from your
disciplined approach by being out of a particular market segment can
decimate your portfolio’s long-term returns.
Consider Exhibit 9.1, which shows the performance of the S&P
500 from 1970 through 2009. e index during that entire 40-year
period generated an annualized compound return of 9.8 percent. If
you owned an index or asset class fund that tracked the S&P 500 and
matched its returns over that entire period, you would have earned the
same return (minus expenses).
If, however, you traded actively and moved in and out of the fund,
your returns would most likely have suered. By missing just the
single best day for the S&P 500 during those 40 years — that’s one
day out of 40 years — your annualized return would have fallen to
9.6 percent. And if you had missed the best 15 days over that entire
period, you would have earned a mere 3.7 percent on your investment
— less than you would have made by investing in Treasury bills. Put
in dollar terms, the dierence is even more startling. If you’d stayed in
the market for the whole period, your $100,000 would have grown to
$4,961,400. Missing the best 10 days in that period would have cut
your returns almost in half to $2,186,801. is more than $2 million
dollar dierence is a stark illustration of the dangers of trying to time
the markets.
Exhibit 9.1: The Effect of Missing the Market’s Best Days
“Time in” vs. “Timing” the Market — Performance of the S&P 500 Index 1970 - 2009
Total
Period
Missed 1
Best Day
Missed 5
Best Days
Missed 15
Best Days
Missed 25
Best Days
One-Month
US T-Bills
9.99% 9.70% 8.84% 7.41% 6.22% 5.56%
Total
Period
Missed 1
Best Day
Missed 5
Best Days
Missed 15
Best Days
Missed 25
Best Days
$4,961,400
$5,000,000
$4,500,000
$4,000,000
$3,500,000
$3,000,000
$2,500,000
$2,000,000
$1,500,000
$1,000,000
$500,000
$0
$1,188,900
$1,873,400
$3,225,900
$4,449,200
Growth of $100,000
Annualized
Compound
Return
One-Month
US T-Bills
$918,600
Performance data for January 1970-August 2008 provided by CRSP; performance data for
September 2008-December 2009 provided by Bloomberg. The S&P data are provided by Standard
& Poor’s Index Services Group. US bonds and bills data © Stocks, Bonds, Bills, and Inflation
Yearbook™, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and
Rex A. Sinquefield).
Indexes are not available for direct investment. Their performance does not reflect the expenses
associated with the management of an actual portfolio. Dimensional Fund Advisors is an investment
advisor registered with the Securities and Exchange Commission. Information contained herein is
compiled from sources believed to be reliable and current, but accuracy should be placed in the
context of underlying assumptions. This publication is distributed for educational purposes and
should not be considered investment advice or an offer of any security for sale. Past performance is
not a guarantee of future results There is always the risk that an investor may lose money.
e upshot: A relatively small number of trading days tends to be
responsible for the stock market’s strong returns over time. Miss even
a handful of those days and you stand to end up with a lot less wealth
than you would if you simply stayed “all-in” the entire time.
Of course, it’s tempting to think about the ip-side of this situation
and wonder what would happen if you avoided the market’s very
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worst days over time. In that case, your returns would look a lot
dierent. However, you’ve got to ask yourself: Do I feel lucky? Are
you agile enough to avoid the market’s very worst days year in and
year out over several decades? And after you’ve avoided those down
days, are you also astute enough to get back in to the market in time
to catch the next big “up” day? To test yourself, answer the following
two questions:
• HowwasmyportfolioallocatedonOctober15th,2008?Onthat
day, the S&P 500 plummeted 9.0 percent — one of its worst single-
day performances in the past 40 years. Did you see that day coming
and shift your portfolio out of U.S. stocks to avoid the damage? Or
did it hit you unexpectedly?
• Howwas myportfolioallocatedonOctober28,2008?Onthat
date — just 13 days after one of the S&P 500’s worst single-day
performances — the index delivered one of its best single-day
performances, soaring 10.8 percent. ink back. Did you know
that was about to happen and therefore get back into stocks or
increase your allocation to equities? Or were you, like most other
investors, still worried about the possibility of a global nancial
meltdown and taking a more cautious approach?
If you got it wrong, don’t feel bad: You had plenty of company.
Investors time and time again get nervous or impatient and break
their discipline — typically at exactly the wrong times.
As a result of such ill-timed shifting of money, investors experience
substantially lower returns than what the market oers them. For
example, while the S&P 500 gained 9.14 percent annually from
1991 through 2010, the average equity fund investor gained just 3.83
percent a year on average — that’s a full 5.3 percentage points less
than the index (see Exhibit 9.2).
Exhibit 9.2: Market Rates of Return vs. Investors’ Actual Rates of Return
Average Investor vs. Major Indices 1991 – 2010
14%
12%
10%
8%
6%
4%
2%
0%
9.14%
6.89%
3.83%
2.57%
1.01%
S&P 500
Index
Barclay’s
Bond Index
Average Equity
Fund Investor
Inflation Average
Fixed Income
Investor
12%
10%
8%
6%
4%
2%
0%
Average stock investor and average bond investor performances were used from a DALBAR
study, Quantitative Analysis of Investor Behavior (QAIB), 03/2011. QAIB calculates investor
returns as the change in assets after excluding sales, redemptions, and exchanges. is method
of calculation captures realized and unrealized capital gains, dividends, interest, trading costs,
sales charges, fees, expenses, and any other costs. After calculating investor returns in dollar
terms (above), two percentages are calculated: Total investor return rate for the period and
annualized investor return rate. Total return rate is determined by calculating the investor
return dollars as a percentage of the net of the sales, redemptions, and exchanges for the period.
e fact that buy-and-hold has been a successful strategy in the past does not guarantee that it
will continue to be successful in the future.
e damage of missing 5.3 percentage points of return a year on average
is devastating. A $500,000 investment in a hypothetical mutual
fund that earns 9.14 percent annually would grow to roughly $2.94
million in 20 years (not accounting for fees, taxes or expenses). But
an investor who earned the typical return of 3.83 percent would have
just $1 million — a dierence of roughly $1.9 million. Fixed-income
investors fared even worse. While the Barclay’s bond index gained 6.89
percent annually from 1991 through 2010, the average xed-income
fund investor realized an annualized gain of just 1.01 percent — less
than the average rate of ination during that period.
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e upshot: Investors are trading too frequently. ey are chasing after
hot investments just as those investments are about to go cold. And
they are avoiding investments that are positioned to post strong gains.
If they weren’t, they would perform at least as well as the indices, if not
better — and clearly they’re not.
Cognitive Biases and the Challenge of Staying Disciplined
ere’s a good reason why investors tend to consistently make these
and other mistakes with their money — mistakes that can cause them
to not accumulate nearly as much money as they could. As human
beings, we have ingrained tendencies to let our short term emotions
guide our longer term decisions, such as investing.
For example, strong emotions can quickly cause us to misinterpret
facts and make the wrong moves at the wrong time — repeatedly.
To see how this cycle of emotion plays out in real life, consider
Exhibit 9.3. It shows a hypothetical example of what happens to
many investors. When the market is on the rise and racking up big
gains, investors quickly change from being optimistic to excited to
downright elated. ey eventually start to worry that they’re being left
behind by not buying stocks — that their friends are all getting rich
and that they better invest heavily in equities in order to look smart
and make money. So after spending weeks or even months watching
the stock market post strong returns, they buy in or ramp up their
allocation to stocks.
Typically what happens is that shortly thereafter the market starts to
show signs of weakness and begins to fall. At rst, investors might be
a bit concerned about these developments, but they nd reassurance
by telling themselves that “it’s only a temporary setback.” But it isn’t.
Stock prices continue to decline and investors become alarmed and
frightened — with a growing certainty that “it’s dierent this time”
and that stocks have become a sucker’s bet that will never pay o. As
that fear really kicks in, they sell their stocks or transfer huge chunks
of their investment capital money into bonds.
If you paid attention at all during the past few years, you know what
typically happens next. Stocks begin to rally once again — often
unexpectedly posting outsized gains in a very short window of time.
Exhibit 9.3: The Cycle of Market Emotions
OPTIMISTIC
EXCITED
ELATED
CONCERNED
NERVOUS
ALARMED
FRIGHTENED
RELIEVED
OPTIMISTIC
Greatest Potential Risk
Greatest Potential
Opportunity
“
T
i
m
e
t
o
b
u
y
”
“
T
i
m
e
t
o
r
e
-
e
v
a
l
u
a
t
e
”
“
T
i
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e
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e
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”
“
T
h
i
s
i
s
o
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y
t
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p
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a
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”
For illustration purposes only
e bottom line for too many investors is that they buy at the top,
driven by elation and greed. ey then sell out at the bottom and
lock in their losses, driven by fear. And they miss the start of the next
upswing.
is cycle will no doubt look familiar to many of you. But the question
remains: Why do we let our emotions replace our capacity for rational
thought and drive our investment decisions in the rst place?
e answer lies in a eld of academic and economic study called
behavioral nance — which studies the many biological and
psychological factors that drive our decision-making processes. We
like to think of ourselves as fairly rational, but behavioral nance
shows otherwise.
Behavioral nance is a fascinating and rapidly evolving eld of study.
Information about how investors really make decisions is being
researched all the time. However, work in this important new eld
— some of which has won the Nobel Prize in economics — has
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Chapter 9: Invest for the Long Term — 101
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identied several key ways in which our brains trick us into seeing
the investment world one way, when in reality it’s something quite
dierent. ese cognitive biases include:
• Anchoring bias. is reects our tendency to latch our thinking
onto a reference point that we are familiar with — even if that
reference point isn’t relevant to our particular situation. In an
investment context, we tend to “anchor” to the long-term average
return of stocks and expect stock returns in any given year to
approximate the average. But, of course, stock returns in any given
year may be wildly dierent from the long-term average. is
conicts with our mental “anchor,” which causes us to panic when
returns are negative in a single year or get extremely exuberant when
returns are abnormally high — and make bad investment decisions
as a result.
• Conrmation bias. is bias occurs when we look only for evidence
that conrms our existing beliefs while ignoring or discounting
evidence that shows them to be false or questionable. If you think
a potential investment is going to be a huge winner, you’ll probably
seek out other opinions that match yours and believe that people
with conicting beliefs “just don’t get it.” e investment could
be a dog in many ways — but you’re not willing to hear it. e
result, too often, is a sizeable investment loss. A good historical
example of this was in the late 90s high-technology stock boom.
Many investors over-allocated their investment capital to high tech
stocks, ignoring both their risk proles and the key principles of
diversication. e resulting decline in these technology stocks had
a greater eect on investors who had concentrated much of their
wealth to this industry.
• Hindsight bias. Often we feel that whatever happened was bound
to happen — that luck or chance couldn’t play a part in a given
situation and that ultimately, everything that occurred could have
been predicted. If stock prices fall after a long bull run, it must
have been because “trees don’t grow to the sky” — we knew it all
along. But if stock prices continue to rise, it’s because “the trend is
your friend.” Looking back on investments’ past performance, it’s
natural for us to think that we — or someone — should have seen
it coming and taken the appropriate action.
For example, think back about the above referenced technology stock
bubble back in the late 1990s. With the elapsed time, it’s easy for an
investor to acknowledge there was a bubble and that stock prices had
to plummet. But in the moment, that investor most likely a) didn’t see
a bubble, b) saw it but didn’t do anything to protect himself or c) felt
(like so many) that “it’s dierent this time.” Hindsight bias often leads
to a sense of overcondence among investors — making them think
they’re much smarter or adept at picking stocks than they are. Another
name for hindsight bias is “Monday morning quarterbacking”, named
for the tendency for football fans to see so clearly what decisions
coaches should have made in the games on Sunday.
By understanding these and other cognitive biases that aect us all,
you can do a better a job of recognizing your particular biases and try
hard to overcome the tendency to act on your short term emotions.
It’s not always easy to notice your biases and shut them down, of
course. But if you can keep your emotions in check when making
investment decisions, you’ll nd yourself in much better shape down
the road.
e Need to Review and Rebalance
Keep in mind that patience and discipline don’t mean burying your
head in the sand and doing nothing at all. e point is to do only
those things that will maximize your chances of having a successful
investment experience, and no more.
Take rebalancing. When you review your portfolio’s performance,
rebalancing should be a key strategy on your list. As nancial markets
and asset classes rise and fall, your portfolio’s exposure to stocks,
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bonds, cash and other investments will uctuate as well. Over time,
your overall target asset allocations will shift — leaving you with
more money invested in stocks than you prefer, for example, and less
invested in bonds. e result: You may nd that your portfolio now
carries more investment risk than you feel comfortable with or need.
Rebalancing is one of the keys to keeping your portfolio on track
and maintaining the right balance between growth potential and risk
exposure. By rebalancing your portfolio back to its target allocations,
you’ll better control the level of risk in your portfolio, build more
wealth over time, and give yourself a system for shutting down
emotional decision making. In fact, you’ll be better equipped to
consistently do something that all investors say they want to do but
rarely accomplish: buy low and sell high.
Rebalancing is a relatively straightforward, easy process to implement.
Let’s say you have $500,000 invested. Based on your goals and risk
prole, you want your portfolio to have a long-term target asset
allocation of 60 percent stocks and 40 percent bonds. Initially,
$300,000 would be allocated to stocks and $200,000 would be
allocated to bonds. If your stock holdings gained 10 percent over the
next 12 months and your bond holdings lost 5 percent, your asset
allocation would then be 63 percent stocks (worth $330,000) and 37
percent bonds (worth $190,000). To get back to your target 60/40
mix, you would need to sell a portion of your stocks and reallocate the
proceeds to your bond holdings.
Two recent periods in market history show the potential advantages
of rebalancing back to a target asset mix. In the late 1990s, large-
company growth stocks and technology stocks were posting huge
gains. An investor using a disciplined approach to rebalancing would
have sold some of those stocks as they soared in value and reinvested
the proceeds into bonds, in order to keep their desired allocation
between stocks and bonds. is would have beneted the investor
in two ways: When tech and large-cap stocks began plummeting
in 2000, the investor would have avoided some of the worst losses.
Additionally, by maintaining his target bond allocation, he would
have been well positioned to benet from the strong gains that bonds
began generating as stocks fell.
Also consider the more recent bear market that occurred in 2008 and
its eect on a hypothetical static portfolio that is never rebalanced. For
example, a portfolio of 50 percent stocks (S&P 500) and 50 percent bonds
(ve-year Treasury notes) in 1987 would have shifted to an allocation of
73 percent stocks and 27 percent bonds by the end of 2007 — making
the portfolio signicantly riskier than the original 50/50 portfolio going
into one of the worst bear markets for stocks in decades. e return
on this more aggressive portfolio would have been a whopping -23.6
percent in 2008. By contrast, the 50/50 portfolio would have declined
by just 12 percent — a dierence of 11.6 percentage points.
Of course, 2008 wasn’t a comfortable time for any investor. But if you
had to choose between a regularly rebalanced portfolio with a negative
12 percent return or a portfolio that was never rebalanced and lost nearly
24 percent, chances are you’d be a lot more comfortable with the rst
option. And as we’ve seen, your comfort level with and commitment
to your investment plan is vitally important. If you can emotionally
withstand the ups and downs in your portfolio, you’re far less likely to
take reckless actions like jumping in and out of the market, or falling
victim to some of the cognitive biases highlighted above.
But comfort is only one reason why it makes sense to reduce risk
through rebalancing. Lower volatility also means that your portfolio
can regain any ground it’s lost during bad market environments faster
than it could otherwise. For example, say your portfolio declines by
20 percent during a bear market. To get back to where you started,
you’d actually need to earn a 25 percent return. And if it fell by 50
percent, you would need a return of 100 percent just to get back to
where you stood before that decline.
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ere’s yet another reason why it makes sense to use periodic
rebalancing as a way to manage risk: greater overall wealth.
Your rebalancing decisions can be made as part of your overall
portfolio review, which should be done on a regular basis such as
quarterly, semi-annually or annually (depending on your preferences
and the complexity of your portfolio). If, during your review, you
see that your portfolio’s current allocation to any single asset class is
signicantly higher than your target allocation to that asset class (say,
3 - 5 percent or more), you might sell some of those assets to realign
with your target. Likewise, if you see that your exposure to an asset
class is 3-5 percent lower than your target, you might buy more of that
investment. By creating strict rebalancing parameters like these, you
can more easily overcome the tendency to do what so many investors
fail to do time and time again — buy low and sell high.
Your overall portfolio review should also go beyond rebalancing and
determine if there have been any major developments in your life or
nancial situation that necessitate making changes to your overall portfolio.
e birth of a child or grandchild, a new job (or loss of an existing job)
or other signicant life developments can have implications for your
investment and wealth management strategies. For example, a new child or
grandchild could mean it’s time to change the beneciary designations on
your investment accounts, or set up a college savings plan. A new job may
mean that you can now increase the amount of money you save toward
your long-term goals. It’s these types of major developments that should
guide your portfolio strategy decisions — not the short-term uctuations
of the markets or your emotional responses to them.
Staying On Track
Being disciplined about our investments is dicult even for the most
patient among us. Despite our best intentions, the emotions that rise up
in us during extreme market environments can quickly override logic and
cause us to make poor decisions with our money. at’s why it makes
sense to arm yourself with as many tools as possible in order to help you
maintain your discipline and stay on track in the face of market volatility.
One such tool is an Investment Policy Statement. As we discussed in
chapter 8, your IPS will serve as a written record of your investment
strategy and the guidelines you have chosen to follow as an investor. It
should spell out all the reasons why you have structured your portfolio
as you have, and include details about your chosen approach to
rebalancing your portfolio. During every portfolio review, your IPS can
remind you of the key facts and tenets of your investment plan — which
can help you avoid making short-sighted, emotionally-driven decisions.
In addition, many IPS’s contain historical high and low returns for
various types of portfolios. Such data can be invaluable during a market
downturn. For example, say your portfolio is down 20 percent over the
past year — a return that could make you panic and sell a big chunk
of your investments. However, a review of your IPS might remind you
that historically, a portfolio like yours experienced a decline as large as
35 percent over a one-year period. In light of that information, a 20
percent decline could be seen not as an extreme or unlikely event but
instead as well within the range of possibility — helping to put the
situation in historical perspective and helping you stick with your plan.
A second important resource for investors is a fee-based investment
advisor. As the name suggests, fee-based advisors charge clients a fee
for their services and are therefore not compensated by commissions
on sales of investments. As a result, fee-based advisors’ interests are
aligned with their clients’ interests: e advisors do well only if clients’
portfolios do well. at means a fee-based advisor is highly motivated
to give you the best advice for your situation at all times — even if
that advice is to sit tight and do nothing.
Indeed, one of the biggest ways advisors add value is by bringing
discipline to your investing. As we’ve seen, it’s all too easy to let both
good and bad events cause us to make changes to our portfolios.
Having an advisor to guide you through those ups and downs can
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help you stay on course and avoid the mistake of breaking your
discipline. In that sense, think of an advisor in the same way you
might think of a dietician or a personal trainer — as someone who
helps you set up a plan, then watches and motivates you to keep doing
the right thing so you end up with the results you want. In an advisor’s
case, you might not lose weight or gain strength — but you might
just end up making more money than you would otherwise. Many
advisors can bring substantial additional value to your nancial life.
For example, some may be able to help you with complex tax issues
or estate planning needs. Others can integrate these and any other
aspect of your nances into one comprehensive solution. In Chapter
12, you’ll nd information that can help you assess your needs and
determine what type of advisor and level of service will suit you best.
Chapter 10
Advanced Planning and Trusted
Advisory Relationships
As vitally important as the right investment plan is to your nancial
well-being, it is far from the only thing that matters. In order to
fully benet from Structured Wealth Management and maximize your
potential for success in all areas of your nancial life, you may need to
look beyond investments.
at means accurately identifying the key non-investment nancial
risks you face and then determining the best strategies for mitigating
or eliminating those risks. In short, you need to bring Advanced
Planning into the mix and make it part of your overall Structured
Wealth Management plan.
Remember from chapter three that Structured Wealth Management consists
of three main components: Investment Planning, Advanced Planning and
Trusted Advisory Relationships. Since we’ve covered Investment Planning
in depth, we’ll now turn to the other two components.
Advanced Planning addresses the entire range of nancial needs
beyond your portfolio.
Trusted Advisory Relationships involve working eectively with a team
of professional advisors (such as attorneys, accountants and advisors)
on a regular basis to understand and address your critical needs. ese
can include: enhancing wealth through tax minimization, transferring
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wealth to heirs, protecting wealth and supporting charitable causes
and non-prot organizations (see Exhibit 10-1).
Exhibit 10-1: Key Advanced Planning Concerns
Wealth/Income
Protection
Wealth
Transfer
Charitable
Planning
Wealth
Enhancement
Investor
Let’s look at how you might develop a smart Structured Wealth
Management plan for addressing each of these challenges.
Wealth Enhancement
is is the process of maximizing the tax eciency of current assets
and cash ow as well as minimizing fees and unnecessary costs. Key
wealth enhancement steps that you should consider implementing as
part of a Structured Wealth Management plan include the following:
• Get organized and consolidate accounts. Before you can maximize
the eectiveness of your wealth and do comprehensive Advanced
Planning, you need to get a handle on your nancial situation. A
comprehensive list of all assets and liabilities, as well as income and
expenses, should be the starting point for this process. Investors
often nd that they have numerous investment and bank accounts
spread out across multiple fund companies, advisors, banks and
brokerage rms. ey also might have 401(k) or other retirement
accounts from previous jobs, still with their previous employers.
Trimming down the number of accounts you own can help to
simplify your nancial life and make it easier to manage. Also, by
consolidating all of your investment assets with a single rm and
meeting a specic minimum, you may be eligible for lower overall
pricing on the management of those assets. Likewise, allocating more
money to one bank could allow you to earn higher interest rates.
• Review tax returns. e importance of having a good CPA
should not be overlooked. Your CPA should work with you (and
your other advisors) to ensure that they have all relevant nancial
information in order to accurately project your current tax liability,
and avoid underpayment penalties and interest. Additionally, your
CPA may recommend alternative strategies that can serve to reduce
your taxable income.
• Assess cash management strategies. You also might examine the
eectiveness of your cash management strategies. Are you earning
the maximum amount possible on your short-term cash (consistent
with your need for safety and liquidity, of course), or could you put
your cash to work more eectively? Many banks and investment
rms oer “sweep” accounts that can link up your checking and
money market accounts: the majority of your funds are kept in
interest earning accounts, with transfers made to your checking
accounts as checks are presented for payment.
• Maximize use of qualied retirement plans and IRAs. Examine
retirement plan options such as IRAs and Roth IRAs to determine
their potential as a way to generate tax-deferred or tax-free retirement
income. Also, consider converting existing IRA assets to a Roth
IRA. is strategy requires tax to be paid at the time of conversion,
but eliminates the need to pay taxes as funds are withdrawn.
Additionally, there are no required minimum distributions for
Roth IRAs, so these funds can continue to grow for the benet of
your heirs.
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• Explore the possible advantage of “wealth shifting.” ere are
a variety of techniques that can serve as vehicles to transfer wealth
from one generation to the next while minimizing both estate and
gift taxes. ese techniques allow assets that may have a current
“low” valuation to be transferred to the next generation in hopes
that the valuation increases over time; in this case, you have shifted
potential future capital gains out of your estate.
• Evaluate corporate plans. Make a point to analyze all executive
compensation programs or benet plans to ensure that they are
being maximized on both a tax and benets basis.
• Determine ideal asset location. As we discussed in Chapter 8,
owning certain types of assets in taxable accounts and other types
in nontaxable or tax-deferred accounts can reduce your tax burden
signicantly over time. ese asset location decisions will come
down to factors such as the amount of taxable income an investment
tends to generate, your marginal income tax rate, capital gains tax
rates and your liquidity needs.
• Consider your own “investor environment.” For investors who are
approaching retirement or already retired, wealth can be enhanced
through cost- and tax-cutting measures such as trading down to a
smaller home or re-locating to a state with lower taxes.
• Involve family members where possible. Review the opportunities
in any family-controlled business or investment entities for younger
generation family members to “learn on the job” and be compensated
as they develop valuable employment skills for the future.
Additionally, ensure that the next generation is educated about the
fundamentals of wealth and especially about the responsibilities
and obligations that come with the transfer of sizable wealth.
Wealth Transfer
Proper estate planning is the most eective way to help ensure that
you are able to pass along assets in ways that satisfy your wishes and
that provide for the nancial health and well-being of your family.
It also can reduce or prevent much of the stress that so often occurs
when heirs attempt to sort out a family member’s estate.
Many people assume that estate planning is applicable only for the
very wealthiest among us. is is simply not the case. Even if your
net worth is relatively small, you need basic legal documents that
give instructions for how you want your assets distributed at your
death or if you become incapacitated. Of course, estate planning often
gets ignored because it involves considering your own mortality and
what will occur after you die (two topics that many of us prefer to
avoid). But by asking some tough questions now — How should
assets be distributed at death? How and when should heirs receive an
inheritance? — you can ensure that your wishes are carried out and
that your heirs receive your assets in the most ecient manner.
While tax and investment advice unique to your situation is beyond
the scope of this book, there are some key wealth transfer action steps
that you may want to consider implementing as part of a Structured
Wealth Management Plan. We recommend discussing these steps with
your nancial advisor and other advisors to determine if they make
sense for your particular situation.
• Create/review your will. Without a will, you face numerous risks
that your assets won’t go to whom you want — risks that you
might not even know exist. If you are married, for example, you
might assume that all of your possessions will simply go to your
spouse when you die. However, surviving spouses automatically
inherit everything in only some states. Additionally, a will allows
you to appoint a guardian for your minor children at your death.
Without a will, your children will be considered wards of the state,
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who will decide who will act as guardian. If you already have a will,
review it every few years to ensure that it remains relevant and true
to your wishes.
• Review beneciary designations and asset vestings. A beneciary
designation on a bank account, life insurance policy, investment
account and the like is the ultimate and overriding determinant in
how the assets are transferred at death — even if your will or other
documents state that the assets should go elsewhere. e upshot:
Make sure that your beneciary designations on all accounts are
accurate, up-to-date and reect your wishes. Additionally, make
sure that the vesting of all assets is accurate. For example, if you
have created a family trust, make sure that the assets contributed to
the trust are re-titled in the trust’s name.
• Create a living will. is is a document that spells out the specic
actions you want (and don’t want) taken in regard to your health
care in case you can’t make such decisions because of illness or
incapacity. By creating clarity, such wills can save your family pain,
uncertainty and money.
• Consider various trusts. One example is a revocable living trust,
which can help your assets avoid probate. Avoiding probate saves
money and also prevents the details of your estate from becoming
public information. You might also consider trusts designed to
pass on assets in ways that reduce estate and gift taxes — including
irrevocable life insurance trusts and qualied terminable interest
property trusts. ese more complex trust options require the
help of an estate planning attorney who can set up the trusts in
accordance with all applicable laws.
• Review life insurance opportunities. Ownership of life insurance
policies by a trust or family member other than the insured will
ensure that the policy and its proceeds are not considered part of
your estate. Since life insurance rates change over time and insurers
create additional enhancements to policies, it is important to have
existing policies reviewed every few years. Oftentimes, an existing
policy can be exchanged for a new, less expensive or enhanced
policy with no tax eect to the owner of the policy.
• Consider making annual gifts. Some smart wealth transfer
strategies can be implemented while you are alive, of course. You
can make direct gifts to anyone up to a certain amount without
incurring a tax bill or eroding your lifetime exemption. is has the
potential to reduce the size of your taxable estate in the process.
Wealth and Income Protection
is component of Advanced Planning involves employing strategies
to ensure that your wealth is not subjected to claims from potential
creditors, litigants, ex-spouses and children’s spouses, as well as to
protect against catastrophic losses and identity fraud.
It is best to start by evaluating all current insurance policies to determine
if you are over- or under-insured for certain coverages, then decide if
there are areas of coverage you are missing that need to be addressed.
Some types of insurance to consider include:
• Insurance on your home, car and other assets. You need enough
liability insurance to protect your wealth as well as adequate
property insurance for your belongings. You should make sure that
your insurance coverage includes all perils applicable to each asset
(such as re, ood, earthquake, hurricane, etc.).
• Long-term disability insurance. If a major disability prevented
you from working, this insurance would help replace the job-
related income you would lose. In particular, younger, high-income
earners should consider disability insurance.
• Long-term care insurance. e costs associated with an extended
nursing home stay or home health care services can decimate wealth
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quickly. Long-term care insurance is becoming an increasingly
important area of coverage, especially as the millions of baby
boomers enter into their retirement years.
Business owners might also want to consider strategies to protect
their wealth and the value of their businesses. Some options to
consider include:
• Buy-sell agreement. is is a type of agreement between co-owners
of a business that details what happens to the rm if a co-owner dies
or leaves the business. Typically funded with life and/or disability
insurance, it can help to ensure business continuity and protect the
wealth that has been built up in a business over time.
• Ownership structures. Various types of trusts and partnerships
— such as family limited partnerships — can eectively put assets
out of reach of creditors or make it extremely dicult for them to
collect money. Likewise, structuring a business as a Limited Liability
Company can protect owners and managers from being named
in a lawsuit against their company. Even though these ownership
structures can limit personal liability, they do not eliminate the
need for liability insurance coverage for the entity itself.
Other protection strategies that may be worth considering include:
• Pre- and post-nuptial agreements. Some couples, either before
or after they are married, choose to enter into a formal, written
contract that spells out how property will be divided as well
as the terms of spousal support in the event of a divorce. ese
agreements are especially important to consider when one spouse is
signicantly wealthier than the other. Each party to the agreement
should engage his or her own legal representative in order to avoid
conicts and issues in the future.
• Identify theft protection strategies. Eective low-tech actions that
can protect you include: reducing the amount of crucial ID and
information you carry in your wallet or purse, keeping documents
like your Social Security card and passport at home and shredding
account statements and nancial documents. High-tech solutions
include sending nancial information only over a guaranteed secure
connection, never responding to unsolicited “phisher” emails requesting
personal information, installing and updating anti-virus, anti-spam and
anti-malware software on your computer and downloading security
patches to your computer that can help block intruders. ere are
also services available that can notify you anytime your credit report
has been accessed, allowing you to prevent unauthorized use of your
identity for fraudulent purposes.
Charitable Planning
is, of course, involves ways to help you fulll any philanthropic goals
you might have and maximize the eectiveness of your charitable intent
— ideally to enable you to make gifts that are signicantly greater in
value than what would have been able to be made otherwise. Commonly
used charitable planning strategies that you should review include:
• Outright cash gifts. Direct gifts of cash to qualied charities are
deductible for income tax purposes (up to a certain percentage of
your adjusted gross income and assuming you itemize and have the
proper documentation). Gifts also help to reduce the value of your
estate for estate tax purposes.
• Gifts of appreciated assets. By donating assets such as stocks that
have risen in value directly to a charity, you can generally avoid the
capital gains tax you would incur if you sold the asset rst and then
donated the cash proceeds. is technique is especially valuable
for individuals who have large unrealized capital gain positions in
specic investments.
• Donor-advised funds. Donor-advised funds are pooled investments
owned and controlled by a sponsoring organization. You, as the
donor, make an irrevocable contribution to the fund and get an
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immediate tax deduction. e fund invests the money, while
allowing you to recommend specic donations, and the donor-
advised fund makes the grant. e costs and administrative
responsibilities of using such a fund are typically much less than
running a private foundation.
• Charitable trusts. Several types of trusts allow investors to support
favorite charities while generating other benets. For example, a
charitable remainder trust (CRT) enables you to gift assets to the
trust. You would receive a tax deduction and avoid paying capital
gains taxes on the assets donated. You would then receive income
from the trust for a period of years. Once that period of time ends,
the remaining amount of assets would go to your chosen charity.
Additionally, the assets are removed from your estate for tax purposes.
• Private foundations. Charitably-minded investors who are
relatively auent and who want the maximum level of control over
their gifting often choose to set up their own private foundation.
Private foundations enable donors to control the investment of assets
and strategies for grants and gifts. However, private foundations
are more expensive than other options and include more rules and
regulations (and therefore more administrative duties) than other
philanthropic vehicles. Private foundations can be appropriate for
families who would like to leave a lasting legacy, enabling future
generations to continue a foundation’s mission for many years after
the passing of the original principals.
Trusted Advisory Relationships: Coordinating Structured
Wealth Management
Identifying and addressing all of these advanced planning issues is a
tall order. It becomes even more challenging when you attempt to
coordinate and integrate investment portfolio decisions with wealth
transfer, protection and enhancement strategies.
But the fact is, all of your nancial decisions should be made by considering
all of the other aspects of your specic situation. at’s because all of
the various components of your nancial life are connected, and they
must be treated that way in order to make optimal choices. Decisions
you make about your investment portfolio or your business, for
example, could have a signicant impact on your tax situation and
eventually your ability to transfer wealth to heirs eectively. Because
all of these issues relate to and inuence each other, you need to be sure
your Structured Wealth Management plan takes a truly comprehensive
approach.
e good news is that you don’t have to do all this by yourself. Because
no one person can be an expert in the entire range of Structured Wealth
Management needs and solutions, you (or your advisor) should instead
build relationships with specialists — trusted professionals who have
deep knowledge across the range of wealth management specialties
and who are well-versed in their particular specialty as it relates to the
needs of high-net-worth investors.
A network of Trusted Advisory Relationships is typically composed of
at least four core team members:
• Awealthmanager
• Anestateplanningattorney
• Acertiedpublicaccountant
• Aninsurancespecialist
e wealth manager should act as the general manager — the one
person in charge of dening your goals and key challenges. is role
can be lled by a trusted nancial advisor, or you can take on the job
yourself and serve as your own wealth manager. Regardless, a wealth
manager should know enough to be able to recognize when there may
be an opportunity to add value in any or all aspects of your nancial
life — but should always rely on the network of Trusted Advisory
Relationships to positively identify those opportunities.
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e estate planning attorney will be responsible primarily for estate
planning and other related legal needs — critical areas of concern
for most investors. Among these issues are the creation of your estate
plan, gifting strategies, asset protection, succession planning, business
planning for entrepreneurs and philanthropic consulting.
A certied public accountant will spearhead income tax preparation,
planning and compliance. He or she will also work closely with the
estate planning attorney to manage and minimize tax issues that result
from various estate planning initiatives and business planning strategies.
e fourth core member of your team of trusted advisors should
be an insurance specialist. He or she will work closely with the other
core team members to identify and structure solutions to mitigate or
eliminate the various risks you face in your nancial life. When it comes
to this type of professional, look for an insurance broker rather than an
insurance agent. A broker works for you — his or her client — while
an agent works for a specic company or companies. In all cases, you
want to work with a professional who puts your interests before theirs.
Additionally, there are a number of other experts beyond the four core
members that you may need to work with occasionally (or perhaps
just once). Say, for example, that you need a credit expert to read and
summarize loan documents. Very often you can nd the appropriate
expert at the community level — for example, through your bank or
mortgage lender. Other professionals who you may require on a one-
o basis include a derivatives specialist, who deals with concentrated
stock positions; a securities lawyer, who supports the work of the
derivatives specialist; an actuary, who is often needed to consult on
various pension and retirement plan issues; and a valuation specialist,
who may be required to appraise your business interests, real estate or
collectibles. Keep in mind that this is only a partial list of professionals
that may be needed on an ad-hoc basis.
You don’t need to have close relationships with every one of these experts.
Instead, you should be able to rely on your core team members to
bring in their own experts as needed. While you may have direct
relationships with some specialists, these relationships should be
secondary to your core team.
Exhibit 10-2: The Range of Trusted Advisory Relationships
Valuation
Specialist
Income Tax
Specialist
Charitable Giving
Specialist
Actuary
Derivatives
Specialist
CPA/Trust and
Estate Lawyer
Securities Lawyer
Life Insurance
Specialist
Wealth Manager
And Client
Clearly, tremendous value can be realized by building a comprehensive
plan that addresses both investment-related matters and non-investment
concerns in a coordinated manner using appropriate experts. at,
essentially, is what Structured Wealth Management is all about — providing
solutions to investors’ full range of nancial issues and integrating those
solutions in a way that enables investors to achieve all that is truly important
to them in all areas of their lives.
In the next chapter, we’ll pull together everything we’ve shown you so
far about Structured Wealth Management so you can incorporate it into
your own life and make the best possible choices about your wealth.
The tax information herein is general in nature and should not be considered legal or tax advice.
Individuals should consult an attorney or tax advisor for specific information on how tax laws
apply to their situation. Laws of a particular state or laws that may be applicable to a particular
situation may have an impact on applicability, accuracy or completeness of information
contained in this book.
Chapter 10: Advanced Planning and Trusted Advisory Relationships — 119
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Chapter 11
Putting It All Together
At this stage, you know the main components of Structured Wealth
Management. And you have seen that, unlike traditional approaches to
nancial planning, it is designed to tie together all the aspects of your
nancial life — from investments to the advanced planning concerns
that are becoming increasingly important to many Americans — and
help you manage them in a coordinated way.
As a result, Structured Wealth Management enables you to dene the
most important goals in your life and then position your assets to
pursue those goals in a systematic way. is means that your wealth
means more than just a number on your balance sheet — it is the
vehicle for ensuring that you and your loved ones live the type of
meaningful, purpose-driven lives that you dream of.
Now you’re ready to begin implementing Structured Wealth Management
into your own nancial life. Before you begin, however, take a moment
to review the key steps in the process.
Your Total Investment Prole
e rst step toward developing a plan that helps you accomplish
what you most want is to determine those people, things and values
that are most important to you, the biggest challenges you face, and
how you truly desire to live your ideal life.
To accomplish this step, you’ll want to develop a Total Investor Prole,
which, as detailed in chapter 3, is a comprehensive picture of you
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122 — The Wealth Solution
and your wealth. is Prole will encompass your key values, goals,
relationships, your assets and advisors, and your preferred process for
managing your nancial life and your interests. Armed with a clear,
detailed understanding of those issues, you can set out to create the
ideal Structured Wealth Management plan for you — one that will
serve as a guide so that every nancial decision you make supports
what you most want.
As you’ll remember, the key to developing a Total Investor Prole is to
go through what we call the Discovery Process. is systematic, detailed
interview process enables you to dene your nancial needs and goals
and compare them to your current nancial condition — giving you
the information needed to create a comprehensive and accurate prole
that will be used to create solutions and work with other advisors who
may be involved in the wealth management process.
Create Your Investment Plan
Your investment portfolio and the overall plan that guides it play a
crucial role in helping you achieve the growth and capital preservation
you need to realize your most meaningful nancial goals. e creation
of your investment plan should be driven by the following key
guidelines:
• Markets work. Investors who attempt to beat the market by
picking and choosing certain stocks or by jumping in and out of the
markets nearly always end up underperforming the overall market.
e reason: Capital markets generally work in such an ecient
manner that it is extraordinarily dicult to consistently outperform
the market. We believe a better approach is to simply attempt to
capture the rate of return that the market oers over time — and
the way to do that is extreme-broad global diversication.
• Riskandreturnarerelated.As an investor, it’s important to take
only those risks that have been shown over time to reward investors
Chapter 11: Putting It All Together — 123
consistently. Decades of academic research reveal that there are
three factors that are primary drivers of long-term returns:
1. Market factor. Market risk is the risk of investing in the equity
market as a whole versus investing in a riskless asset. Over time,
equities have higher expected returns than bonds on a risk-
adjusted basis, although that outperformance comes at the cost
of higher volatility than bonds.
2. Size factor. Small-company stocks have rewarded investors with
signicantly higher returns over time than large-company stocks.
Small companies, in general, tend to be riskier than large, well-
established companies — they may grow to be industry giants,
or they might go bankrupt.
3. Price factor. So-called value stocks of companies in some form of
nancial distress are typically riskier than shares of fast-growing,
nancially healthy growth companies. And just as with small-
company stocks, value stocks have generally rewarded investors
over time by generating higher returns than growth stocks.
Bottom line: We believe that your investment strategy should center
around three major decisions. First, how much money you will
allocate to stocks versus to bonds, T-bills and cash. Second, how
much of your equity capital you will allocate to value stocks versus
growth stocks. And third, how much money you will allocate to
small-cap stocks versus large-cap stocks.
• Diversify with structure. When it comes to investing, risk cannot
be eliminated, but it can potentially be reduced or mitigated
through the prudent approach of structured diversication:
1. Combine multiple asset classes that have historically
experienced dissimilar return patterns across various nancial
and economic environments.
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2. Diversify globally — More than 50% of global stock market
value is non-U.S., and international stock markets as a whole have
historically experienced dissimilar return patterns to the U.S.
3. Invest in thousands of securities to limit portfolio losses by
reducing company-specic risk.
4. Invest in high-quality, short-term xed income. Consider
shorter maturities that have low correlations historically with
stocks. And lower default risk with high-quality instruments.
Structured diversication strengthens your ability to grow and protect
your money over time — and oers you the potential to come out at
the end of your journey with more wealth than you would have if you
didn’t diversify.
• Determine the appropriate portfolio for your specic situation.
e right portfolio for you will take into account your specic goals,
time horizon, income and liquidity needs, and your ability and
willingness to take on investment risk in pursuit of your objectives.
Structuring your portfolio based on these issues will help ensure
that your portfolio provides you with the appropriate level of risk
and return so that you can stick with your plan during a variety of
market cycles in order to reach your nancial goals. In addition,
your portfolio should be structured to help mitigate the eects of
taxes on the accumulation and preservation of your wealth. An
example of tax management would be to place investments that
generate signicant taxable income in tax-deferred accounts.
Create Your Advanced Plan
A formal investment plan, while critically important to a successful
nancial life, is not the only component of comprehensive Structured
Wealth Management. True wealth management goes beyond nancial
and investment planning by creating an Advanced Plan to address key
non-investment related issues that the vast majority of us face each
day. For example:
• How can you preserveyour wealth so that youhavethemoney
required to meet your needs and fulll your goals — not just today,
but for decades to come?
• How can you keep more of what you earn and pay less to the
taxman?
• Howcanyouuseyourwealthtohelpchildren,grandchildrenand
other heirs lead successful and meaningful lives — now and after
you’re gone?
• Howcanyouprotectyourincomeandassetsfromcreditors,
ex-spouses, a major disability, or huge nursing home or other
health care costs?
• What can you do to maximize your support for non-prot
organizations and causes that you care about deeply?
e Advanced Planning component of Structured Wealth Management
is designed with these questions in mind. An eective Advanced Plan
will be formulated around the following four areas:
• Wealth Enhancement. is is the process of maximizing the tax
eciency of current assets and cash ow as well as minimizing
fees and unnecessary costs (while achieving both growth and
preservation goals).
• Wealth Transfer. is process can ensure that you are able to pass
along assets in ways that are the most tax-ecient, that satisfy your
wishes and that provide for the nancial health and well-being of
your family.
• Wealth and Income Protection. is involves employing strategies,
such as trusts and insurance, to ensure that your wealth is not
subjected to claims from potential creditors, litigants, ex-spouses
and children’s spouses, as well as protecting against catastrophic
losses and identity fraud.
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• Charitable Planning. is, of course, involves ways to help you
fulll any philanthropic goals you might have and maximize the
eectiveness of your charitable intent — ideally to enable you to
make gifts that are signicantly greater in value than what you
would have been able to make otherwise.
Invest for the Long Term
Taking a long term approach and exercising patience and discipline
with your Structured Wealth Management plan are in many ways
the most important determinant of your eventual nancial success
or failure. Making frequent changes to your portfolio, for example,
increases the risk of sub-par returns and less wealth over time than
if you had made fewer changes. Moving in and out of markets and
asset classes may result in investors missing those relatively small
number of days when markets soar unexpectedly. It’s therefore
vital that you stick to your investment and advanced plan —
especially during periods when the nancial markets are behaving
in extreme ways.
Of course, remaining patient and disciplined can be extremely
dicult when stocks or other assets are soaring or plummeting.
e way our brains are hard-wired can cause us to make emotional
decisions about our money at precisely the wrong moments —
such as buying hot stocks right before they’re about to fall and
selling stocks just before they’re about to rally — that can damage
our nancial lives.
e solution is to build safeguards into your Structured Wealth
Management plan that help you stay focused on the long term and tune
out the noise that occurs from day to day. Such safeguards include:
• An Investment Policy Statement. An IPS is a written document
spelling out the key components of your nancial situation and
investment plan. During particularly strong or weak market
environments, it can serve as a reminder of your reasons for
structuring your portfolio the way you have. An IPS can also
prevent you from making mistakes such as chasing performance
or market timing. Whenever you are tempted to make a change
to your investment plan, it’s best to consult your IPS and remind
yourself of the goals, needs and principles that should be driving
your decision-making. If a change you want to make conicts with
your IPS, you’ll want to stop and assess if it really makes sense
to move forward. If, however, your specic circumstances have
actually changed, and your goals and needs are greater or less than
they were before, a modication to your plan may make sense. In
that case, a revision to the IPS should be made reecting the change
of circumstances and the corresponding change to your plan.
• A rebalancing discipline. As nancial markets rise and fall, your
portfolio’s exposure to stocks, bonds, cash and other investments will
tend to uctuate as well. Over time, your overall target asset allocations
can shift — leaving you with more money in stocks and less in
bonds, for example. By rebalancing your portfolio back to its target
allocations, you’ll better control the level of risk in your portfolio and
give yourself a system for minimizing emotional decision-making.
Get e Help You Need
Building a comprehensive plan that coordinates investment- and
portfolio-related needs with advanced planning requires a great deal
of eort, expertise and time. Given all the components that Structured
Wealth Management seeks to tie together and manage seamlessly, it’s
challenging for any one person — even a trained professional — to
do everything alone.
For that reason, it’s important to implement your wealth management
plan with the help of a network of trusted advisory relationships —
experts who have deep knowledge across the entire range of wealth
management specialties and who can work together to coordinate all
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aspects of your nancial life. Depending on your individual situation,
this network should be composed of four core team members:
• Awealthmanager
• Anestateplanningattorney
• Acertiedpublicaccountant
• Aninsurancespecialist
Working as a team, these professionals can eectively address the
various wealth management issues that today’s investors face. e
wealth manager should act as the general manager or quarterback —
the one person in charge of dening your goals and key challenges
and coordinating the eorts of the other team members. is role
can be lled by a trusted nancial advisor, or you can take on the job
yourself by serving as your own wealth manager who will build and
oversee your network of expert professionals.
is Structured Wealth Management approach is being used by many
of today’s most successful investors and families to make prudent
nancial decisions. And while some of those investors choose to
implement Structured Wealth Management entirely on their own, we
nd that most prefer to work with a professional wealth manager
who is capable of devoting signicant expertise and resources to the
process. erefore, in the next chapter, we will discuss the benets
of working with an advisor and oer advice for selecting an advisor
who can work in your best interests by implementing Structured
Wealth Management.
Chapter 12
Selecting the Right Advisor
As you seek to implement Structured Wealth Management, you have a
critical decision to make: Should you try to do it yourself, or should
you enlist the assistance of a nancial advisor?
is decision will come down to a number of factors — such as
the level of expertise you possess in the various areas of investment
planning and advanced planning that Structured Wealth Management
addresses, as well as the amount of time you can dedicate to creating
and maintaining a comprehensive plan. You’ll also need to consider
whether you want to spend your free time personally dealing with the
full range of nancial challenges and opportunities you face, or if you
would prefer to devote that time to family, hobbies and other pursuits
that give your life purpose and meaning.
Although some investors choose to manage their nancial lives
entirely by themselves, we have noticed that in recent years, many
investors have increasingly looked to professional nancial advisors
for guidance. Additionally, as individual investors’ wealth increases, so
does their tendency to delegate the oversight of their nancial life to
a nancial advisor.
Make no mistake: Choosing a nancial advisor is one of the most
important decisions you may ever make. ere are an enormous
number of nancial professionals out there who want to work with
you. However, far too few oer the type of comprehensive, consultative
approach that we have outlined in this book. If you believe that
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Structured Wealth Management will help you make the smartest possible
decisions about your money, then you absolutely need to work with
someone who agrees with your belief and has adopted this approach.
Should You Work With An Advisor?
e challenges that have occurred in the nancial markets during the
past decade have prompted many investors to seek professional help
managing their investments as well as other areas of their nancial lives.
An experienced advisor can provide a number of benets, including:
• Expertise. We’ve all been reminded repeatedly in recent years that
navigating nancial markets is not an easy task. Additionally, the
intricacies of wealth management — building a plan that takes
into account investments, estate planning, tax strategies, wealth
preservation and other components — can make coordinating
your nancial life a dicult job. e role of a good advisor is to
understand the crucial needs and goals of clients and then assemble
the requisite expertise to address those needs and reach those goals.
at expertise should ideally come from both the advisor and a
team of trusted experts with whom the advisor works and closely
coordinates, to help solve clients’ concerns.
• Discipline. As you’ve learned, investors are often their own worst
enemies — buying high, selling low and putting their nancial
futures in jeopardy. A professional advisor should have the knowledge,
experience and objectivity to “take a step back” during volatile market
environments, prevent investors from making bad or emotional
decisions about their nances in the heat of the moment, and help
them stay true to their long-term course.
• Time. An advisor’s job is to focus on helping you at every step so that
you don’t have to do all the work — leaving you with more time to
spend with family, on leisure activities or maximizing your current
income and earnings potential. Of course, some investors enjoy
spending much of their free time working on their investments and
even their nancial plans. And while that’s certainly not a bad way
to spend your time, we nd that most investors prefer to pursue
other interests beyond wealth management when they have the
opportunity to do so.
• Perspective. Advisors work with many clients who share similar
nancial concerns and issues. Over time this can help advisors
gain valuable perspectives about how to solve problems and capture
opportunities in the most eective and creative way. By contrast,
investors working on their own are largely limited to their individual
experiences when trying to confront complex nancial issues.
Of course, in some instances, a professional advisor may not be
necessary. If, for example, you have a modest amount of assets and
your nancial situation is extremely straightforward and easy for
you to fully comprehend, you may not require the expertise that an
advisor brings. In that case, you may be well served by building a
well-diversied portfolio of low-cost mutual funds and periodically
reviewing and rebalancing your asset allocation to stay on course.
If your situation is more complex, however, an advisor may be able
to add substantial value. If, for example, you have signicant wealth,
children and other heirs you wish to take care of, an ex-spouse (or
two), and a child with special needs, it makes sense to consider
working with an advisor.
To help you decide if an advisor is a good option, consider the
following questions:
• Areyouinapositiontospendasignicantamountoftimeeachday
and week managing your nancial life? If so, do you want to spend
your free time in that way — or are there other interests you would
rather pursue?
• Whatisyourlevelofexpertiseaboutinvestments,taxmanagement
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strategies, estate planning techniques, wealth protection options,
charitable gifting tools and other key components of an investment
plan and an advanced plan?
• Howwillingareyoutostayup-to-datewithchangesinthetaxcode,
estate planning laws and other developments that could aect your
plan and nancial future?
• Howcondentareyouinyourabilitytoconsistentlymakethesmartest
possible decisions about your nancial life, year after year, in all the
areas that aect you and are important to you and your family?
What to Look for in a Financial Advisor
Any nancial advisor you work with should be willing and able to bring
signicant value to your nancial life. Unfortunately, too many advisors
today do not oer much in the way of value and don’t always put their
clients’ best interests ahead of theirs. Instead of working to coordinate
your nancial life and solve your biggest concerns, many are more
focused on selling you products and earning commissions, regardless
of whether those products are the best t for your needs and situation.
e upshot: Not any nancial advisor will do. You need to work only
with those advisors who will implement strategies that will maximize
your chances of achieving your goals. If you don’t currently work with
an advisor, that means you must locate and identify ideal advisors for
your needs. If you do currently work with an advisor, you need to
evaluate him or her carefully and ask yourself if you are truly receiving
the benets and value that you want, need and deserve.
Whatever you do, don’t settle for mediocrity. If you’re not sure that
you can implement Structured Wealth Management on your own,
get help from the right advisor. If your current advisor isn’t aligned
with the philosophy and principles of Structured Wealth Management,
consider working with an advisor who uses this approach with clients.
We have worked with hundreds of advisors over the years and have
seen the factors that dierentiate successful, client-focused advisors
from the rest of the pack. As you evaluate advisors to work with, ask
the following questions:
• What are the advisor’s designations and experience? Advisors’
professional designations can tell you a lot about them. e single
most important designation to look for when evaluating an advisor
is whether or not he or she is an independent advisor. Independent
advisors are legally required to act as a duciary — which means
they must always look out for your best interests as the client and
disclose all important information to you, including fees charged
and any conicts of interest. In short, it is illegal for them to engage
in any situation that would serve their interests over yours.
In addition, ask if the advisor has an advanced designation such as
Certied Financial Planner™. A CFP® designation tells you that the
advisor has received formal education and training on a wide variety
of nancial planning topics and has passed an exam testing their
nancial planning knowledge and skills. CFPs also are required
to take continuing education courses each year to stay current on
nancial planning-related issues. If the advisor is not a CFP, inquire
about how many years he or she has been in the nancial services
industry. With non-CFPs, you’d like to see that they have at least
ve years’ experience (and preferably more).
Here’s one title you should not automatically pay much attention
to: Wealth Manager. Today, lots of advisors have taken to calling
themselves “wealth managers.” And while some are — such as those
who follow the types of processes outlined in this book — others
are wealth managers in name only who don’t oer anything beyond
investment basics. So don’t assume that a so-called wealth manager
practices Structured Wealth Management. Instead, dig deeper.
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• What is the advisor’s fees and compensation structure? An
advisor’s fee structure can tell you a great deal about what your
experience working together may be like. For example, a fee-based
advisor usually charges a percentage of your portfolio’s assets each year.
at means the advisor does well only if he helps you grow and protect
your wealth and gets you closer to your goals. If his decisions cause you
to lose wealth, he earns less. e upshot: A fee-based advisor has a legal,
moral and economic incentive to give you the best advice about your
wealth. If, for example, the smartest thing to do at a particular moment
is to stay disciplined and maintain your current asset allocation, that’s
exactly what a good fee-based advisor should recommend. Many
investors are also increasingly choosing to work with fee-only advisors.
As the name suggests, these advisors are compensated only through fees
rather than commissions, which are generated based on trading activity.
By contrast, a commission-based advisor usually gets paid only
when he buys or sells an investment for your portfolio. He may
try to work in your best interests, but at the same time, he has a
powerful incentive to trade your stocks frequently or move in and out
of asset classes often in order to generate a higher income for himself.
Regardless of whether your wealth rises or falls, the commission-
based broker still gets paid. Clearly this presents a strong potential
for a conict of interests — which is why we believe it is best that
you work only with fee-based advisors.
• What types of clients does the advisor serve? Many top fee-based
independent advisors have a clearly dened type of client they serve. It
might be broad-based (retirees, for example) or highly-focused (such as
executives in the health care profession). is targeted approach oers
two advantages. For one, it means they have specic knowledge and
expertise to serve their clients eectively and solve their biggest issues.
It also means that if you are not a good t for a particular advisor you
are evaluating, the advisor should tell you so and recommend another
advisor who would be a better option. e advisor won’t take you on
as a client simply to bring in more revenue for herself.
• Is the advisor consultative? You also want to work only with a
consultative advisor — that is, one who works hard to understand
your specic, unique goals and needs and then works in partnership
with you and other professionals to create a customized wealth
management plan designed around those goals and needs. In short,
a consultative advisor is acutely focused on solving your problems.
Perhaps the clearest sign of whether an advisor is consultative or
not will occur the rst time you meet. A consultative advisor will let
you do plenty of talking about what you are looking for, and will ask
you questions designed to identify what is really important to you and
your family. e best consultative advisors will even have a formal
method for uncovering those issues, such as the discovery process that
we have highlighted in this book.
By contrast, a non-consultative advisor will most likely spend much
of your rst meeting talking at you — perhaps telling you how
impressive his performance record is, how big his sta is, or listing
all the impressive products he can oer you. is might sound good
on the surface. But remember: An advisor’s job is to do all he or she
can to help you reach your most important goals so you can lead a
meaningful and happy life. If you encounter an advisor who takes
little interest in those issues from the start — or asks you just a handful
of basic, cursory questions about you and your concerns — chances
are the advisor is most interested in getting just enough information
from you to recommend a specic product. He’s probably not too
concerned about helping you coordinate your entire nancial life. In
such cases, you should look elsewhere for help.
Another good indication that the advisor is consultative is if she uses a
dened process for meeting with clients and helping them on a regular
basis. In Chapter 3, for example, we outlined the Structured Wealth
Management process, which consists of a series of ve scheduled
meetings between advisor and client. ese ve meetings ensure that
your plan starts out on the right foot and stays that way year after
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year. erefore, when you meet with an advisor, make sure to ask
her to spell out her approach for working with clients on a regular
basis, and decide if her answers indicate a consultative approach
with regular meetings.
• Does the advisor sell performance? When an advisor you interview
discusses his investment methodology, pay close attention. Does she
highlight how much he’s beaten the market lately or emphasize her
ability to generate huge returns through a “specialized” or “proprietary”
approach? If so, be wary. e promise of consistent market-beating
returns (or suggestions along those lines) is a big red ag. As you’ll
remember, decades of research show that accurately predicting the
winning and losing investments, asset classes and markets year after
year is hugely dicult — nearly impossible, really. An advisor who
sells performance as the primary reason to work with him is really
just a salesman who is likely to continually buy and sell products in
your portfolio — and rack up big commissions in the process, even
if he fails to deliver that promised outperformance.
We’ve witnessed more of this performance-selling in recent years as
the markets have been increasingly volatile. Many advisors today
like to talk about the ability to oer “downside protection” and
“advanced” techniques that will get clients in and out of the markets
at just the right times. We think this is simply market timing disguised
as risk management. Using these approaches, you may win — but the
greater likelihood is that you will lose. Regardless, it’s a huge gamble
to take with your nancial future.
If you believe (as we do) that the most prudent investment approach
is to try and capture market rates of return, then it clearly makes sense
to work with an advisor who is aligned with your thinking and
investment philosophy.
• Does the advisor bring specic expertise to solve your biggest
concerns? As we’ve noted before, the full range of your wealth
management concerns are diverse and complex. To eectively
understand and solve them in an integrated and holistic manner, an
advisor needs to bring expertise and skilled resources to the process.
In rare cases, an advisor may possess all the skills needed to build and
maintain a well-crafted Structured Wealth Management plan. Typically,
however, you’ll want to see that an advisor has access to the expertise
you require and can coordinate the eorts of a team of trusted
professionals — which should typically include a CPA, an estate
planning attorney and an insurance specialist — to create ideal,
holistic solutions. ese professionals can either be located in-house
at the advisor’s rm or they can be outside of the advisory rm.
Either way, you want to be sure you are working with someone
who can provide the specic expertise needed to address the crucial
issues you face.
• What tools does the advisor use to maintain your wealth
management plan? ink about all the “moving parts” of a
Structured Wealth Management plan that we have discussed in this
book. Clearly, such a plan cannot be created and put in a drawer. It
needs to be monitored, reviewed and updated on occasion. at’s
why you need to know what tools and criteria an advisor uses to
maintain clients’ plans and keep them current.
Here you want to see that the advisor has invested in and uses
advanced technology such as nancial planning software. You will
also want to see that the advisor has a systematic, disciplined method
for reviewing clients’ objectives and risk tolerance, and rebalancing
portfolios to realign asset allocations in ways that are tax ecient.
Finally, ask if the advisor creates an Investment Policy Statement for
each client. As mentioned earlier, an IPS should detail all the key
components of your investment plan. Because of its ability to help
keep investors on track and mindful of their choices, we believe an
IPS is absolutely crucial to a successful plan.
• Do you trust the advisor? A great advisor is someone who you —
and probably your spouse or partner and other family members
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— will work with for decades. But for that to happen, you need to
respect and trust the advisor and feel comfortable working with her.
An advisor may score well on all the other questions above, but if
you two don’t “click,” the relationship may be less productive and
enjoyable than it should be. Once you’ve met with an advisor a
few times, ask yourself if you think she is the type of person who
will always have your best interests in mind, who you will want to
work with on a regular basis, and who you would refer friends and
family to. en, ask for referrals — and contact them to discuss
their opinions of the advisor and their experiences with her.
Finally, look for signs that the advisor is not “the next Bernie
Mado” who will rip you o. Some safeguards include: custodying
your assets at an outside rm and not in-house at the advisor’s rm;
using highly-regulated products such as mutual funds; and ensuring
that the rm holding your assets has Securities Investor Protection
Corporation (SIPC) insurance, which should protect your wealth
in the event of advisor fraud. Also, remember the old adage “if it
sounds too good to be true, it probably is.” If an advisor makes wild
claims — she can deliver positive returns in any environment or
can generate 10% a year no matter what — walk out the door.
• Does the advisor have a clean record? In addition, you can
research an advisor’s background to see if he’s ever been censured or
received client complaints by going to the BrokerCheck feature on
the Financial Industry Regulatory Authority’s website (www.nra.
org/Investors/ToolsCalculators/BrokerCheck). is site only covers
advisors who work with a broker dealer. For independent advisors,
go to the Investment Adviser Public Disclosure website (IAPD) at
www.adviserinfo.sec.gov. If an advisor has any prior complaints or
enforcement actions on his record, go back and ask the advisor for
details about the situation and decide after that if you should consider
working with him or her. For some investors with substantial wealth,
having a background check run on a potential advisor can ensure that
the advisor has not run afoul of nancial regulatory agencies in the
past, or has not been convicted of certain crimes.
e Next Step Is Yours
Whether you work with a nancial advisor or go it alone, we rmly
believe that the single most important move you can make today is
to start implementing Structured Wealth Management into your own
nancial life.
Now that you’ve read this book, take a minute to think again about
your most important goals — the things you truly value on a deep and
personal level, and the things you most want and need to achieve in
order to live a comfortable, meaningful and satised life. en think
about all the important people in your life- your spouse or partner,
your children or your parents — and the hopes and dreams you have
for them, as well as any challenges that they face. Finally, consider any
causes or issues that you care about and want to support — which
might include anything from ghting global poverty to supporting
your city’s symphony orchestra.
When you think about all of these components, one fact is illuminated:
You and your wealth can do an enormous amount of good for many,
many people in your family, your community and the world at large.
Even if you never become a millionaire or consider yourself wealthy,
you can still have a huge impact and positively shape your life and the
lives of others. What a fantastic position to be in! In the end, then, you
have a responsibility to make smart decisions about your wealth so that
it can do as much good as possible. You owe it to yourself and to the
people and organizations you care about most to do the job right.
Ultimately, this is where Structured Wealth Management can make all
the dierence. e Structured Wealth Management process was designed
with one overarching goal in mind: To enable you to coordinate and
comprehensively manage all the key parts of your nancial life, no
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140 — The Wealth Solution
matter how complex, so that you can solve your biggest nancial
challenges and achieve everything that is important to you.
Over our decades of experience in nancial services, we’ve seen a
lot of ideas and approaches come and go. But in all that time, we
have never seen a better, smarter or more eective way for investors
to manage their wealth than Structured Wealth Management. Its
consultative process from which customized solutions are designed
and coordinated by a team of experts to work seamlessly together has
helped many of today’s most successful families get exactly what they
want out of life.
e next step is yours. You have an opportunity to achieve a higher
level of nancial success than you may have thought possible, and have
a higher level of condence that your goals and aspirations will come to
fruition. Seize this opportunity now to create benets for yourself and
those around you that could resonate for generations to come.
We wish you a lifetime of nancial and personal success.
afterword
How to Lose Money
Harry M. Markowitz, PhD
1990 Nobel Prize Laureate in Economic Sciences and
Member, Loring Ward Investment Committee
If you want to become an acknowledged Saint, it is best if you start
by giving away all your money. If this prospect sounds too daunting,
the following are four ecient suggestions for reducing your wealth.
e rst two may only lose most of it but the nal two will make it
all disappear.
e rst advice toward achieving poverty on your way to Sainthood
is to invest in the hottest stocks in the hottest sector: Buy auto stocks
when the car is the latest new invention; purchase tech stocks when
they are the “in” thing; invest in mortgage-based derivatives when all
the “smart” money is doing the same. Under no circumstances should
you read Charles Mackay’s book Extraordinary Popular Delusions and
the Madness of Crowds. Instead, just try your utmost to keep up with
the thundering herd.
If you are too cautious to follow the preceding advice, here is some rock-
solid, very sensible, traditional advice: Put all your money in some big,
trusted company — like the one you work for, the one that already
pays your salary — like Eastern Airlines, Penn Central, or Enron.
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e aforementioned ways of losing money involve buying stocks
traded on exchanges, such as the NYSE and NASDAQ. But if you
do not want to invest in these, because you don’t trust the guy on TV
who barks advice at you, listen to your trusted neighbor or uncle who
knows a brilliant investor who has gured out how to double your
money in less than a year! I know of a guy like that: His name was
Charles Ponzi.
Last, but not least, nd a nancial advisor who will take care of your
money for you. To be sure to lose money and perfect your plan for
poverty, do not work with an advisor such as recommended in this
book. Instead, nd an advisor who provides the added service of
holding your money for you rather than having you keep it with a
large, nationally recognized custodian that periodically sends, directly
to you, reports of how your account is doing.
More generally, for optimal eect, just ignore the advice in this book.
about the authors
Alex Potts
President and Chief Executive Ocer, Loring Ward
Alex Potts is the President and C.E.O. of Loring Ward Group Inc.
and its aliates, as well as the SA Funds – Investment Trust.
Potts founded and was President, Chief Executive Ocer and Director
of Loring Ward Securities Inc. (formerly Assante Capital Management
Inc.). In addition, he served as Executive Vice President and General
Manager of LWI Financial Inc. (formerly Assante Asset Management,
Inc.). In 1999, Alex started the SA Funds – Investment Trust and was
named President and Chief Executive Ocer.
From 1990 – 2000, he served in various positions at Loring Ward and
its predecessor rms, including Senior Vice President of Investment
Operation.
Potts earned a Bachelor of Science Degree in Economics from Santa
Clara University. He also holds General Securities (Series 7), State
Law (Series 63) and General Securities Principal (Series 24) licenses.
142 — The Wealth Solution
About the Authors — 145
144 — The Wealth Solution
Joni L. Clark, CFA, CFP®
Chief Investment Ocer, Loring Ward
Joni L. Clark has advised clients on all aspects of investment strategy
and portfolio risk management for two decades. Her clients have
included auent individuals and families, investment management
organizations and large institutional pension funds.
As Chief Investment Ocer of Loring Ward, she directs investment
policy and portfolio management strategies for the company. She also
chairs the company’s Investment Committee.
Prior to joining Loring Ward in 2002, Clark held senior positions
with some the country’s most respected nancial services rms. She
began her career at Merrill Lynch PFS (1989-1991). She then worked
as Vice President of Wilshire Associates (1991-1998), consulting for
large public and corporate dened benet plans, foundations and
endowments, and institutional investment management rms. She also
was a Managing Director at Legg Mason Institutional Advisors (1998-
2000), overseeing client service for institutional client relationships.
And she was a Senior Investment Consultant and Portfolio Manager
at Enright Financial Consultants (2000-2002), a boutique investment
management rm serving auent individuals and families.
Clark received a Bachelor of Science degree in Finance in 1988, a
Chartered Financial Analyst (CFA) designation in 1994, and became
a Certied Financial Planner (CFP®) in 2004. She is a member of the
CFA Institute, the Los Angeles Society of Financial Analysts, and the
Financial Planning Association.
Eric Golberg, CFP®
Director of Wealth Management, Loring Ward
Eric Golberg is Loring Ward’s Director of Wealth Management,
responsible for providing Advisors with the tools, resources and services
to meet the wealth management needs of their high-net worth clients.
Golberg has spent over 20 years working with high-net worth
individuals and families, primarily in the entertainment industry. Most
recently, he was in charge of Private Wealth Services at Bellatore, LLC.
Previously, he spent 10 years at Nigro, Karlin, Segal & Feldstein, LLP,
one of the largest and most prestigious multi-family oces in the nation,
handling the nancial aairs of numerous executives, entertainers,
athletes and musicians. Prior to that, he was a private banker at Union
Bank of California, Chase Manhattan, and City National Bank, also
working primarily with high-net worth individuals, focusing primarily
on nancing strategies and investment analysis.
Golberg is a CFP® professional and a member of the Financial
Planning Association. He graduated from Southern Utah University
with a B.A. in Business Administration.
About the Authors — 145
144 — The Wealth Solution
146 — The Wealth Solution
Steven J. Atkinson, CFS
Executive Vice President, Advisor Relations, Loring Ward
For more than fteen years, Steve Atkinson has been dedicated to
helping create a better experience for independent nancial advisors
so that they can create a world-class experience for their clients.
As an Executive Vice President at Loring Ward, Atkinson speaks
frequently at client and advisor events and has personally coached
over 100 advisors.
He is a graduate of the University of Nebraska at Omaha, with a
Bachelor of Science degree in Finance and Investment Banking. He is
also a Certied Fund Specialist (CFS).
aCknowledgements
It took the ideas, hard work and inspiration of many people to
create this book. We especially want to thank Mark Klimek and
William Chettle for all their help in writing, editing and organizing
our thoughts. ank you to Susy McInerny for her careful editing
and proong, Matt Carvalho and Cherry Phan provided the charts
and data. Ed Robertson brought his creative talents to the layout
and cover design. Chris Stanley, Diana Dorn and Elizabeth Cordova
provided legal and regulatory guidance. And thanks above all to all
our colleagues at Loring Ward for their support and encouragement.
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