Portions of this article are excerpted from the case written by Dave Turner of Cascade Financial Management that appeared in my book Behavioral Portfolio Management: How Successful Investors Master their Emotions and Build Superior Portfolios, recently published by Harriman House.
Success in building long-term wealth is largely determined by the simple idea of compounding, or earning as much as you can for as long as you can. For example, if you start with $1 million and earn 9.7% per year (the stock market average) for 20 years, you end up with $4.6 million.
If you invest for an extra 10 years, you end up with $10 million. If you earn an extra 4% per year instead, you end up with $10 million. If you do both, you end up with $30 million, or six times the wealth!
While the math is straightforward, building wealth can be difficult. But if you use an approach based on the principles outlined below, the accumulation of real wealth is within reach.
It’s not easy to stay invested
Over the last 20 years, investors have experienced and had to navigate a number of challenging markets. We have seen entire regions collapse financially (the 1997 Asian contagion), world powers default on their sovereign debt (1998 Russian crisis), the brink of the collapse of the U.S. financial markets (1998 Long Term Capital Management implosion), the dot-com bubble bursting, terrorist attacks in America, the near collapse of the U.S. financial markets (2008 global financial crisis), the threat of default of the U.S. on its sovereign debt and the 2013 shutdown of the U.S. government. Yet in that time period, the S&P 500 generated a total annual compound return of 9.5%, approximately equal to the long-term average for the stock market. Earlier eras all have their own events that seemed just as daunting and yet produced remarkably similar results.
The lesson of history is that investing in the markets works over time. The key to being a successful investor is to have a comprehensive investment strategy that provides the liquidity, cash flow and security needed, so the component of the portfolio allocated to stocks (capital-growth assets) is given the time it needs to work. Clients need to be able to stay invested through the trials and tribulations of the marketplace, allowing them to extract the benefit of their investments.
Thus, building wealth necessitates focusing on long-term results, while simultaneously avoiding the distractions of emotional short-term volatility. In this regard, a major challenge for investors is to avoid myopic loss aversion (MLA), in which investors feel twice as bad about a loss than they feel good about the equivalent gain (this is called 2:1 loss aversion) and choose to focus on short-term performance over a year, a quarter or even a month at a time. The combination of 2:1 loss aversion and a short attention span produces the hard-wired cognitive error of MLA. As a result, long-horizon wealth suffers. MLA permeates every aspect of wealth-building, from portfolio construction to selecting investment managers to selecting individual investments to managing over time.
The wealth-builder model
The wealth-builder model (WBM) deals with these problems by helping clients master their emotions and avoid the cognitive errors that destroy long-horizon wealth. The model is based on a few core concepts:
- Segment the portfolio based on short and long-term needs.
- Create a strategy-diverse portfolio, but don’t over-diversify.
- Select truly active managers to generate excess returns and grow wealth,
- Evaluate managers based on strategy, consistency and conviction.
Segment the portfolio by client needs
The time has come to start thinking about portfolio construction differently, to allow investors to confidently remain in the markets when current events might challenge their belief in those markets. Traditionally, investment advisors have used asset allocation as a method of diversification to stabilize returns in volatile times. We have all seen the pie charts representing slices of bonds, international investments, large-capitalization stocks, small- capitalization stocks, value stocks, growth stocks, etc. While asset allocation makes some sense, it does little to reassure investors when markets move down in lockstep, as many markets did in 2008.
The best way to avoid the investing mistakes driven by MLA is to segment the portfolio to meet the clients’ short-term needs separate from their long-term capital-growth objectives.
Short-term operating portfolio
Investors must have confidence that their short-term needs will be taken care of regardless of what the market does. The way to achieve success in the investment market is just as dependent on allocation by client objective as it is on allocating by asset. This means making sure the money needed to live on – the money that pays the bills, provides liquidity and funds the “rainy day” account – should be thought of and managed differently from funds dedicated to the capital-growth portfolio. In an effort to let the markets work over time, it is important that the timeline for those assets be clearly defined, with liquidity and income needs clearly determined and the resulting strategy built to support those objectives.
The operating portfolio should cover emergency needs as well as provide short-term income. Invest in savings, certificates of deposit, money-market instruments, or short-term notes to insulate from market volatility
Long-term capital growth portfolio
This pool of money builds long-horizon wealth. While investors do not have an infinite time horizon, most have very long investment horizons. Those in their 20s, 30s and 40s face long horizons as life expectancy increases. (When I taught at the University of Denver, I would say to my undergraduates that their investment horizon was maybe 80 years, a point that was often met with a scowl as they could hardly imagine living to age 100!)
Even those who have recently retired face a long horizon. For example, I recently retired from the university. My wife and I have a joint life expectancy of 30 years, the same length of time that I taught at the university. In addition, we have set up trusts and foundations that will exist at least 20 years after we are gone. Consequently, we use a 50-year time horizon for building our capital-growth portfolio.
The most important determinate of long-term investment performance is expected market returns. The capital-growth portfolio should be largely invested in those markets with the highest expected market returns. For example, if you agree that stocks provide among the highest expected returns among all asset classes (the stock market has produced an average 10% compound annual return over long time periods), then stocks should play a prominent role in this bucket. The primary consideration for including an investment in this portfolio is the magnitude of its expected return.
By taking a long-term view, the importance of volatility and correlation diminish. In this context, the current infatuation with alternative investments (such as commodities, managed futures and real assets) is harmful for building long-horizon wealth, as those investments often provide lower volatility and lower correlations at a significant reduction in returns.
Remember, the goal is to build long-horizon wealth. Unfortunately, any investment comes with emotionally charged short-term volatility. But short-term volatility is relatively unimportant in the performance of a capital-growth portfolio.
As we know all too well, emotions often override the most carefully constructed logical argument. This is where a conscious decision has to be made to remain focused on the long-term. The cost to do otherwise is steep. For example, investing $10,000 in stocks in 1951 and remaining fully invested in this volatile market over the 63 years through 2013 resulted in a portfolio worth $6.9 million, If the same amount were invested in bonds, the portfolio would be worth $400,000.
You can always look backward and find short time periods in which other asset classes have outperformed stocks, but it is what we expect going forward that matters when building portfolios. The highest expected return markets, historically equity markets, should dominate the capital-growth portfolio.
For both the operating and capital-growth portfolios, the emotional damage of market volatility is much diminished. In the former, the portfolio is constructed to avoid volatility entirely, while in the latter the focus is on long-term expected returns and not on short-term volatility. It is best to view volatility as an emotional issue that can be largely sidetracked as an ongoing investment concern through careful portfolio construction, disciplined decision-making and skilled client communication.
Create a strategy-diverse portfolio
Rather than simply investing in broad asset classes in the capital-growth portfolio, pursue specific strategies. The investment strategy should encompass the manager’s general approach to investment selection as well as the specific elements upon which the manager focuses, such as the quality of the company’s management or the growth prospects for the company. Aim to invest in six to eight distinct strategies that you and your client determine to be the most attractive.
Simple 60/40 asset class allocations no longer function as they have in the past. Because people routinely live into their late 80s, holding a high percentage of bonds doesn’t allow the portfolio to keep growing fast enough to keep pace with the rising costs of living.
Avoid portfolios of global mush with many tiny positions that have little chance of outperforming. Over-diversification at the asset-class and manager level is particularly tempting as portfolios get larger. A major portion of the benefit of diversification, the reduction in short-term portfolio volatility, is garnered with as few as 10 to 20 stocks. After 20 stocks, portfolio volatility changes very little with each additional stock. In fact, 83% of the diversification benefit is achieved with 10 stocks, 91% with 20 stocks and the remaining 9% with 275 stocks. So there is little argument for more than 20 stocks in a portfolio, other than to keep clients comfortable with the approach.
Invest for excess returns with truly active managers
Within the capital-growth portfolio, it is important to earn excess returns. Passive indexing yields the market return, at the lowest possible cost, but successful active managers can provide excess returns. Excess returns matter over long time periods. For example, a 4% excess return on top of a 10% expected return generates an additional $3 million for each $1 million invested over a 30-year period.
There is a compelling stream of research that supports the fact that excess returns can be generated over the long-term by active equity managers. The first step to identifying these managers is to separate truly active managers from closet indexers. Unfortunately, the active equity mutual-fund category is widely populated with bloated funds that hug their benchmarks. Look for low R-squared values and high active-share values to identify truly active managers within this group. Truly active managers represent only 30% of the overall active equity fund universe, while the closet indexers make up the remainder (See Cremers and Petajisto, 2009).
Select and evaluate managers on behavior
Truly active portfolios look very different than their benchmarks. Such portfolios do experience some short-term volatility and display high tracking error. They can both underperform and outperform their benchmark by wide margins in the short run. As a result, short-term-return-performance measures and benchmarking provide little help in identifying and assessing successful active managers.
The best way to select and assess good managers is to focus on manager behavior: strategy, consistency and conviction. Make every effort to determine if the manager continues to consistently pursue a narrowly defined strategy and continues to take high-conviction positions. Past performance is an unreliable indicator of such desirable behavior.
In evaluating an active equity manager, understand the manager’s investment strategy as well as his or her level of consistency and conviction. The best active managers consistently pursue a narrowly defined investment strategy, which can be found in the prospectus.
A manager’s strategy zeroes in on aspects of the market that he or she believes produce superior returns. For example, a “valuation” equity manager identifies and invests in undervalued stocks.
After managers analyze the full range of investment opportunities based on their strategic criteria, the good ones heavily invest in their best ideas, in which they have high conviction. High-conviction positions are an important aspect of successful active portfolio management. The relative weights, rather than absolute weights, of positions within a portfolio define a manager’s level of conviction.
In order to appropriately assess an active manager’s performance, allow them to hold strategic positions for significant time periods, even sacrificing liquidity at times in exchange for returns. If the capital-growth portfolio is invested in six to eight distinct strategies, it may be suitable to perform one to two manager evaluations each year. Perform an overall review of the capital-growth portfolio every four to five years.
The wealth-builder model summarized
The systematic building of wealth can be built upon a few key principles that allow investors to unplug their hardwired emotional barriers and to invest with confidence over long periods of time.
Since most investors face a long investment horizon, it makes sense to build portfolios to sidetrack emotional short-term volatility, while focusing on long-term expected returns.
The first step is to segment into an operating portfolio for short-term needs and a capital-growth portfolio for long-horizon objectives. Both are intended to meet different needs and are managed differently. A critical benefit of this approach is to reduce the importance of short-term volatility in managing the overall portfolio and communicating with clients.
Second, the capital-growth portfolio should be concentrated in a reasonable number of strategies with high expected-return potential. Select successful active managers that can provide excess returns rather than delivering market returns from passive indexing.
To find and evaluate active managers, focus on strategy, consistency, and conviction — not on volatility, tracking error or past performance — and give them sufficient time to perform.
The goal is to allow clients to comfortably meet short-term needs, while at the same time building long-term wealth by remaining invested in the highest potential investments. While emotionally challenging to do, the rewards are significant: up to six-times the wealth could be accumulated in a generation.
Tom Howard is CEO and director of research for Denver-based AthenaInvest and professor emeritus at the University of Denver.
Read more articles by C. Thomas Howard, PhD