Our approach to investing has a basis in over fifty years of research, several Nobel prizes and decades of successful use among institutional investors. In addition, we focus special attention on the challenging issues unique to private investors in minimizing taxes and meeting changing cash flow needs from a portfolio over an investor’s lifetime.
The key ideas behind our investment process are:
- Asset allocation is the primary determinant of a broadly diversified portfolio’s performance
- Market timing and individual security selection are far less important in determining performance
- Portfolio return is related to risk. Generally, the more risk the greater the return.
- Diversification is essential. Investors are not compensated for the additional risk of concentrated investments.
- Passive, not active management, is preferred
- Reducing expenses and minimizing taxes increases net return
- Rebalancing maintains portfolio structure and risk level
- Asset location is powerful in reducing taxes
- Alternative investments can increase return while reducing risk
Asset Class Investing
The core of our investment approach is known as asset class investing. Asset classes are groups of investments with similar characteristics that behave similarly in the market. Examples of asset classes are small stocks, large stocks, cash, bonds, international stocks, and emerging markets stocks. Asset allocation is the process of combining asset classes in different proportions to create portfolios.
Asset Allocation Determines Performance
Research examining eighty years of capital market history indicates that the structure of a portfolio is the primary determinant of its performance. In particular, asset allocation decisions between stocks and bonds, small and large stocks, and value and growth stocks to a large extent determine the performance of broadly diversified portfolios. These characteristics have been verified in markets worldwide and continue to the present. Asset allocation and structuring client portfolios based on these findings is central to our investment approach.
In selecting specific asset class investments to build portfolios, we prefer broadly diversified, passively-managed investments such as index mutual funds and exchange traded funds in publicly-traded securities markets. We maintain a healthy skepticism of active managers who attempt to time markets or select individual securities for two reasons. First, active managers as a group consistently under-perform their benchmarks on a cost-adjusted basis. Active management is expensive and the additional return earned by active managers typically does not cover their additional costs. Second, no reliable method has yet been developed to identify in advance the few active managers who will outperform their benchmarks in any given year.
Reducing Expenses and Minimizing Taxes
We cannot predict the direction of financial markets nor can we guarantee investment returns. However, we can control investment expenses and we can minimize the impact of taxes. Fund expenses and taxes reduce your return; lowering expenses and minimizing taxes effectively increases your investment return. Lowering expenses and minimizing income, capital gains and estate taxes can lead to significant increases in net worth when compounded over many years.
For traditional asset classes, we invest in low expense, no-load, passively-managed (index) mutual funds and exchange traded funds which are tax efficient. In addition, we have access to quality institutional mutual funds with low expenses and high tax efficiency.
Careful structuring of portfolios and constant attention to the tax consequences of portfolio changes helps us to further minimize income, capital gains and estate taxes.
Alternative Asset Classes
When possible and cost effective, we include alternative asset classes such as real estate, commodities, venture capital, private equity and hedge funds in portfolios to increase return and further diversify. Alternative asset classes have investment characteristics different from traditional asset classes which gives them their potential for higher return and their diversifying benefits. Because alternative asset classes are actively managed, we focus on investing with intelligent, hardworking and ethical managers having proven track records and sound ideas for generating an economic return.
We rebalance client portfolios to maintain their asset allocations as asset class components change in value over time. Rebalancing allows us maintain the proper risk level in a client portfolios. Rebalancing during periods of market volatility also may add return.
For example, a hypothetical portfolio holds 70% stocks and 30% bonds. After a period of time, the stocks increase in value to represent 75% of the portfolio and bonds decrease in value to represent 25% of the portfolio. The overall risk of the portfolio has increased because the portfolio is now holding more of the risky stocks. To reduce the risk of the portfolio and return the portfolio to the original target asset allocation, we rebalance the portfolio, selling stocks and buying bonds until the portfolio is again comprised of 70% stocks and 30% bonds.
Unique Issues for Private Investors
Much of investment management industry practice and academic research in financial economics has arisen to meet the needs of institutional investors such as pension funds and university endowments. The needs of private investors are more complex and require additional consideration. Private investors face numerous complicated tax and estate laws and changing cash flow needs from their portfolios over their lifetimes. We believe we have put into practice the best current thinking about how to maximize wealth for private investors. We continue our active study of this area.
Our comprehensive approach to personal financial management addresses the additional complexities facing private investors by ensuring that investment strategy, tax planning, cash flow and estate planning are all well integrated. Investment decisions are not made in isolation, but instead are made in the context of a client’s overall financial plan.
As a private investor, your capacity and willingness to bear risk are particularly important factors in the design of your investment portfolio. After reviewing your current financial situation and objectives we understand your capacity to bear risk. Your financial plan further indicates how much risk you can and need to take in order to meet your future commitments, whether retirement, educational, or charitable. And after getting to know you personally, we also understand your temperament with respect to investment volatility. Your investment portfolio design and ongoing management reflect all of these important factors.
Asset location is another important issue unique to private investors. Asset location involves the preference for placing particular asset class investments in certain types of investment accounts to reduce taxes. It matters what types of investments are held in what types of accounts.
For example, high-yield bonds pay high interest which is taxable at ordinary income tax rates. By locating high yield bonds in tax deferred accounts, such as Individual Retirement Accounts (IRAs), the interest income on high-yield bonds is shielded from current taxation, which increases portfolio net return. A recent study indicates that proper asset location can result in an additional 5% to 15% net worth over an investment lifetime.
Proper asset location also reduces transaction costs by not replicating an asset allocation in all of the accounts in a household. Instead, asset class investments are distributed among the various accounts, resulting in fewer initial trades and fewer ongoing trades during rebalancing. Less transaction cost increases net return which compounds over time to increase your net worth.
While conceptually simple, proper asset location is difficult to achieve in practice, particularly when properly rebalancing client portfolios across multiple accounts in a household. We helped develop powerful new software which allows us to design and manage portfolios with proper asset location and rebalance them regularly across all accounts in a household.
Education and the Financial Media
While the mechanics of building and managing portfolios is an important part of what we do in the investment area, equally important is preparing you mentally to have a successful investment experience. We have found that two issues can get in the way. One is investing emotionally. The other is paying attention to the financial media.
Emotional decisions in investing lead to poor performance. To address the emotions clients face in investing, our interactions with clients throughout the investment process stress education. We work to ensure you understand the fundamental attractiveness of our approach so that you will be steadfast during inevitable market ups and downs.
We also have a few thoughts on the financial media. The financial media has different goals than you have as an investor. The financial media is a business which exists to sell advertising. Fads, trends, top-10 lists, and expert forecasts sell magazines; they do not necessarily contribute to investment success. Successful investing has more to do with mundane processes and maintaining discipline over a long period of time. As part of our educational process, we make you aware of the biases in the financial media.
And finally, tying it all together, our investment process can be summarized in a few, simplified steps:
- Develop an asset allocation for each client which meets financial plan requirements and document that asset allocation in an Investment Policy Statement
- Construct an asset class portfolio using broadly-diversified, passively-managed mutual funds and exchange traded funds (also called index funds) which are low cost and tax efficient
- When transitioning existing portfolios, carefully consider individual stock and bond positions taking into account possible adverse tax consequences and diversification benefits
- Include alternative investments such as real estate, venture capital, private equity, commodities and hedge funds in portfolios when possible and cost effective to increase return and further diversify
- Focus extra attention on concentrated stock positions, stock options and restricted stock, and other large, illiquid or restricted investments
- Optimize the location of assets held in various accounts across the household (“asset location”) to reduce tax drag and minimize transactions costs
- Rebalance portfolio as required across all accounts in the household to maintain target asset allocation and possibly earn extra return during periods of market volatility
- Calculate portfolio performance periodically and compare to benchmark indices and financial plan requirements
- Review current investments’ performance, expenses and conformance to prospectus objectives periodically, and study new investment products and opportunities on an ongoing basis
- Review asset allocation annually to verify it remains consistent with financial planning objectives