Investment Lessons from a Big Dog: No New Tricks

“By following a disciplined policy of maintaining a well-diversified set of portfolio exposures, regardless of market zigs and zags, investors establish the conditions for long-run success.” – David Swensen.

I recently attended a meeting hosted by a very large financial services company about their approach to investment management. This presentation was given to a group of financial planners in Northern New Jersey, and the goal was to identify those planners who would like to outsource the money management portion of their practice.

This company manages almost $200 billion in assets for pension funds, wealthy individuals, not-for-profits, and financial institutions. They had a marvelous bound handout with great graphics. And they used some very impressive terminology such as Distribution-Focused Strategies and Total Return Investing.

However, after listening to their sales pitch and reading through the propaganda, I remain unconvinced that they are doing anything that innovative, at least when compared to that which an experienced financial planner already does. Because using them would only add an additional layer of fees and not provide any significant value, I was not interested in using their services.

Their presentation, though, brought up several valid points that you should consider in managing your own affairs or when finding a financial planner. Summarizing the key points to consider in creating a portfolio:

• Your Goals
• Your Time Horizon
• Your Risk Tolerance

All of these are inter-related, and it is important to remember that the real risk is not meeting your goals.

In creating and managing a portfolio, the basic factors are the same for everyone:

• Asset Allocation
• Costs
• Tax Management

Keeping these basic, yet profound, concepts in mind will serve you well over the long term.

The Total Return Investing concept is actually valid and quite useful, and worth explaining. What is implied from that term is that investment decisions should be based on total returns, not just interest and dividends. Many people looking for an amount to replace a paycheck in retirement, for example, often focus only on the yield of their portfolio. This translates to dividends and interest income.

There are three reasons, though, why the Total Return Investing strategy is at a disadvantage.

First, while interest and dividends appear to be something you can count on, only about 20-25% of stocks actually pay dividends. If you excluded the rest merely because they don’t pay out dividends, you are excluding the majority of companies.

Second, dividends are not always secure; they can be reduced or eliminated. Loading up on stocks that pay a high dividend can be riskier than you thought.

Third, when investors realize that the projected income is not going to be “enough” to meet their goals, they frequently “reach” for yield by either buying riskier bonds that promise to pay higher returns, or they buy longer term bonds, which ordinarily pay more in interest. Unfortunately, as we have seen recently, if you buy riskier bonds you may suffer a substantial loss, rather than get a higher yield. And if you buy longer term bonds, you will lose principal if and when interest rates go up.

Fourth, you are not likely to keep up with inflation, if you concentrate too much on current yield. To keep up with inflation, you need to own equities.

I am not suggesting that you should avoid bonds in your portfolio, only that they are usually not sufficient for most people.

As I said, these concepts are standard operating procedure for experienced investment managers. I just thought that their importance bore repeating.

photo credit: mahalie