What Should Smart Investors Do? Part II

East Bay Business Times
By Hutch Ashoo & Christopher Snyder

Smart Investors

• Rise above the investment noise.
• Smart investing is about utilizing your wealth and achieving your goals with a high degree of confidence.
• Investment sizzle can be had, but you need to know what you are sacrificing for it.

Last month (Sept. 14), we discussed how smart investing is about rising above the investment noise from Wall Street, newspapers, friends/family and TV. We concluded by advising smart investors to focus on managing investments for the sake of the one life you dream of living and for achieving everything that is important to you.

Sometimes it helps financial planning to visualize financial goals with pen and paper. Try writing down your financial aspirations and goals, and why exactly you want to attain these goals. This can do wonders for understanding precisely what you want, even if you do not know it.

While managing returns, taxes and risks is important, be sure your decisions are made purely based on increasing your confidence of achieving the retirement lifestyle and family legacy you dream of.

After all, it is very easy to get lost in the often monotonous tasks you will be faced with as an investor. In fact, it might be even easier to become obsessed with these aspects we have already mentioned (such as managing returns, taxes and risks).

To help our readers reach their ultimate goals, we will illustrate using two hypothetical plans.

Scenario A: Say you have developed a family vision plan with your wealth manager. He told you that your investments would track the performance of the capital markets (stocks/bonds/cash) and since you can’t buy into the markets for free, you are sure to underperform the capital markets by the expenses of the investments, or by about .2 percent.

Scenario B: Now let us assume a different wealth manager ran a similar plan for you (goalswise) and she presented to you 10 money mangers, hedge funds and investment companies that outperformed the markets, after their fees, consistently over the past 10 years to the tune of 1.5 percent to 2 percent.

In Scenario A your wealth manager recommended capital markets returns (Beta) with very low expenses, while in Scenario B the wealth manager offered you investments with some sizzle that have historically outperformed the markets net of their expenses (Alpha). Each plan appeared to show that you would meet or exceed your goals.

Knowing this, do you think you are ready to decide which scenario is best for you?

But everything isn’t equal! What if we shared with you empirical proof (mathematical/ statistical analysis) concluding that adding sizzle/Alpha to your investments creates uncertainty (due to the managers’ over or under-performance relative to the capital markets) and this additional uncertainty leads to less confidence in achieving your goals! The analysis also reflects more taxes due to portfolio turnover with active money managers vs. investing passively in the capital markets (Beta); this too negatively impacts your confidence level.

What if we also told you that based on the proof, which assumes all 10 money managers will outperform the markets by 2 percent for the rest of your life, you have an 84 percent confidence level in exceeding your goals with Scenario B.

So how intelligent would it be for us to base our future financial security on a plan that presumes 10 out of 10 managers will outperform the capital markets by 2 percent for the rest of our lives? You need not go far to find the answer, just look up what percentage of managers have outperformed the S&P 500 for the last 10, 20 or 30 years.

We can actually measure the effect of one or more managers under-performing; here is how the numbers look. Your confidence in achieving your goals trends from 84 percent if you pick 10 out of 10 managers who outperform by 2 percent for the rest of your life, to 81 percent confidence if you pick 9 out of 10 managers who outperform by 2 percent for the rest of your life, to 78 percent if you pick 8 out of 10 managers who outperform by 2 percent for the rest of your life.

The final fact you should know is that Scenario A, which gives you the capital markets’ returns minus expenses, has an 86 percent confidence level in exceeding your goals.

That’s right, you have better confidence in exceeding your goals if you implement Scenario A, even if you had picked 10 out of 10 managers who outperformed by 2 percent over your lifetime in Scenario B.

Smart investors deploy investment strategies that create the highest confidence in achieving and exceeding everything that is important to them. Beta type investing, even though it is not glamorous, is best suited for this. Alpha or sizzle can be had but we use it sparingly, after tremendous thought and due diligence and only after understanding what we may have to sacrifice for that sizzle.

As an example: In a scenario where Beta would give our client an 86 percent confidence level of receiving $750,000 of annual income, we may tell this client that if we chose to add sizzle and if it pays off, he could receive an additional $69,000 of annual retirement income. We would also let him know that if the Alpha/sizzle doesn’t pay off then it may mean a 20 percent chance of having to live on an annual income of $532,000. Finally, if he chooses to live on $819,000 ($750,000 plus $69,000) with the assumption that Alpha will pay off, but it doesn’t, then he has a strong chance of running out of money in retirement!

As you probably figure, running out of money in retirement would be a nightmare, especially when one of your primary goals in life was to save enough money solely for retirement. To younger investors, retirement planning often seems “far off” — a problem to worry about in the distant future. However, that simply is not the case. It is arguably the single most important thing you can set funds aside for.

If you need help with retirement planning or you would just like to speak with someone whose entire life revolves around finances, call a wealth manager today. After reading this article, you realize just how critical gaining confidence in exceeding your financial goals and aspirations is. But there is no need to worry if you are not confident at this point — that is where financial planning and top wealth managers come in.

It is easy to find a financial advisor in Palm Beach, Florida, so make that first step as early as you can.

Authors Haitham “Hutch” Ashoo and Christopher Snyder are partners at Pillar Financial Services Inc. in Walnut Creek. Ashoo is founder, president and CEO. Reach them at [email protected] or 925-356-6780.