Balancing risk and return in an uncertain world

Most people are not naturally suited to be wise investors. While traditional economic theory advocates making decisions in a calm, collected, and rational way-and only after carefully evaluating all viable alternatives (homo economicus)-the day-to-day reality is usually much different.

Dating back to the frenzy over tulip bulbs in the 1600s, public asset markets have been subject to panics, hysterias, euphoric blow-offs, and wider-than-dictated-by-mere-fundamentals interim volatility with a regularity that traditional theory cannot explain. In most corners of the markets, greed and fear mark the extremes more often than rational thought process. This is perhaps not all that surprising, given that we are talking about humans actively engaged in money-denominated activities.

An emerging branch of financial study-incorporating recent advances made in psychology and neuroscience-takes a very different approach. Behavioral finance is based on the premise that our financial choices are dictated more by emotions than by rational planning and risk assessment.

It's not our fault, really-its just that our brains have not yet had sufficient time from an evolutionary standpoint to adapt to the challenges of our modern world. For millions of years, our survival as a species depended upon the finely tuned fight, fright, or flight responses of our brains and our endocrine and circulatory systems. The problem is, the world has changed more dramatically in the past seven or eight decades than the cumulative change witnessed in all previous millennia. Not only have our brains had insufficient time to adapt, but that fight-or-flight response is so hardwired into our psyches that it erupts subconsciously, with only the slightest provocation.

Unfortunately, the public markets are organized to bring out the worst in our ancient wiring. By their very nature, the markets are not predictable. The resultant uncertain environment is an exceedingly disconcerting place in which to operate. Humans are naturally wired to crave order; we infer predictable patterns and reliability even where none exist. We place greater weight on the story that we just heard than on more verifiable or logical long-term (but distantly experienced) evidence, and we want desperately to believe that those we view as successful are experts, even if their advice does not make sense or is not meaningful to our specific situation.

This conflict between an uncertain environment and the deep-seated reactions it prompts can lead us to make investment choices that are contrary to our long-term best interest. While we will devote much more attention to this topic in the next column, it is important to set the stage for this quarter's topic-balancing risk and reward trade-offs in developing an investment program that works for you-by acknowledging that we are often irrational in our approach to money issues.

These counterproductive tendencies can actually be even more pronounced in successful, high-performing executives. This can make the job of planning and executing a successful investment program after retirement or the sale of a business that much more challenging. Entrepreneurs and corporate executives are used to having control over many variables that affect their businesses: hiring and firing, payroll, benefits, inventory levels, suppliers, location, level of business debt, marketing and sales programs, etc. Unfortunately, though, it is virtually impossible (and almost assuredly illegal) for a single individual to control the outcome or progress of individual markets, classes, sectors, or specific assets. For those who have spent a lifetime successfully commanding nearly all aspects of their business environment, making the transition to investing hard-won assets in the public securities markets can be overwhelming. In other words, the skills needed to be a good steward of a pool of assets are different than the skills used to create it.

Time horizons may shorten (I need X million to build a retirement home by the end of next year ) or lengthen (How do I protect these assets so that my great-grandchildren will benefit from them? ). Cash-flow planning must be done against the backdrop of an asset base that has the ability to fluctuate - both up and down - within any given day, quarter, or year. Estate and gift tax planning gain importance. Assessing adequate yearly progress and long-term success involve different techniques and measurement tools than those that were used to measure business profit and loss.

Plotting a course for investment success

Though the playing field changes (public markets vs. private business), the stakes may be higher (keeping the asset base intact and inflation-resistant vs. the struggle to grow it), and the threats may be different than those most familiar to an entrepreneur, outlining the hallmarks of a successful investment program is very doable. The key is to focus your time and effort on the factors you have some ability to control, and to ignore the vast quantity of noise that seems to run rampant in the investment industry.

The process involves three primary steps:

1. Fully grasping the basic nature of the financial markets, i.e., that they are uncertain and unpredictable;

1. Identifying the risks that are specific to your situation; and

1. Establishing return goals that are reasonable, specific, and pertinent to your own circumstances.

Investing in an uncertain world

If you listen to the market strategists, financial news channels, and articles in leading publications, you might believe that the markets and the economy are somewhat predictable. While over the very long term, aggregate prices should reflect underlying fundamentals, in shorter time frames rumor, innuendo, emotions, and supposition are just as likely to affect prices. Further, our economy has become so multifaceted and so global that old relationships and yardsticks often cannot do a good job at divining future trends. The sooner you move beyond the notion that you can control or predict broad aggregates such as the market or the economy, the sooner you can focus on what really matters.

Another factor lending to the aura of uncertainty in the economy and the markets is the fact that their movements are reported frequently-by the day or even by the minute. While this may not seem like such a big deal, this high reporting frequency provides a constant flow of information to us-and our psychological wiring leads us to want to respond to it. It is a very different analysis than building or running a business, where big-picture progress is often assessed much less frequently. How often do you obtain appraisals of your real estate or business, for example?

The ability to check portfolio or stock values daily provides a very short-term report card, the analysis of which can be seductive-whether or not the asset owner is aware of it. Up days and increasing portfolio values feel as if they have been earned. Once reported on paper, it is painful to see these values decrease. Would you feel different about the value of your home if you saw a list price for it quoted each day in your local newspaper? What if that price fluctuated widely based on the weather, how frequently you mow the lawn, whether dandelions sprouted in your garden, or the number of your neighbors sporting new landscaping?

The bottom line: all public markets are changeable. Particularly over the short run, the factors that cause this variability are virtually impossible to predict. Your asset base can, and will, move up and down from period to period. Even if you invest all in fixed income, for example, the market value of bonds that shows up on your statement will fluctuate from month to month as the prices move to keep the coupon rates on the bonds in line with prevailing interest rates. Variability is a fact of investment life. The key to successfully living with that variability is getting your arms around how much you can stomach, and identifying the trade-offs necessary to provide for inflation-adjusted long-term growth.

Defining risk

It is not uncommon for most people to view market variability as the one and only investment risk. However, true risk comes in many different forms and flavors. Risk for you might be outliving your assets or having to cut back travel if you retire too early. For your business partner, risk might be not having enough to put grandchildren through school; or having so much that the government gets a bigger share of the estate than do the heirs. Crafting a portfolio that suits you requires you to carefully balance various risk and return parameters pertinent to your unique situation.

• Really understanding the trade-offs important to you. There is no such thing as the perfect investment. There is no security out there with a whopping tax-free yield, high potential for price increase, and guaranteed principal repayment. A simple rule-of-thumb asset allocation (e.g., one minus your age = the percentage you should have in stocks ) is not likely to be flexible or dynamic enough to constitute the right investment fit for any length of time.

A host of considerations specific to your situation must be evaluated, including pre-existing investment and assets (e.g., concentrations in a specific security or asset class), investment time frame, anticipated withdrawal rate relative to the size of the asset base, outside sources of income, income tax bracket, family situation, past experience with investing in public asset markets, age, health, and sensitivity to watching interim portfolio values fluctuate. A thorough understanding of the rank order and interplay of these factors that matter in your evolving financial life will point toward a workable asset allocation. For example, a 50-year-old entrepreneur with no spouse and no need for withdrawal will likely have a different tolerance for an equity-heavy exposure than a 50-year-old with two families and a need to withdraw 5 percent of assets each year.

• Market variability. As we have already established, variability is normal and, in fact, to be expected. One way to help mitigate sharp ups and downs in total portfolio value is to diversify the assets among various subcategories (growth and value stocks, large cap and small cap, international and domestic, general obligation bonds as well as local municipalities, etc.). Another strategy is to be sure you have matched key future liabilities-such as mortgage balloon or near-term educational expenses-with assets sufficient to pay them. Dividing your portfolio into different buckets, such as one for lifestyle maintenance and one for legacy, can go a long way toward assuaging the psychological toll that interim variability imposes. It is easier to consider investing legacy issues with a long-term growth bias (typically signaling more short-term variability) when you know that your mortgage payments or monthly stipend are covered by less volatile assets in your maintenance portfolio.

• Control costs. While markets go up and down, costs go on and on. Few things in the investment arena are guaranteed, but it is a pretty sure bet that fees, taxes, and transaction costs will be around for as long as your portfolio is, so it pays to have a thorough understanding of their impact. According to Morningstar (an aggregator of mutual fund industry data), the average actively managed large cap growth mutual fund charges a front end load of 0.89 percent, an ongoing net annual fee of 1.49 percent, and 12b1 expenses (statutorily allowed marketing and distribution expenses) of 0.39 percent of assets. The average foreign stock fund has a front-end load of 0.85 percent, ongoing net expenses that average 1.64 percent, and 12b1 fees of 0.37 percent. You don't readily see these fees, since they are deducted automatically from your fund balance, but not typically itemized on your statement.

It pays to know precisely where all of the fees in a relationship are. If you are hiring someone to pick managers for you, for example, will there be fees charged within each fund, plus fees charged by the person putting the investment program together? Are there annual per-account charges, early withdrawal fees, fees for making distributions or paying bills, transaction fees, hourly planning rates, fees for exiting an investment before a certain time period elapses, etc.? Fees are not necessarily bad, but you will want to know precisely what the fees are, and be able to calculate their impact on your assets.

Aside from the fees, you have choices and control over some portion of the tax efficiency of your asset management program. The average domestic growth mutual fund, for example, as detailed by Morningstar, had annual turnover of 96 percent, meaning nearly every holding was held less than a year. To the extent that the manager was not careful finding losses to offset gains, such lofty turnover rates can signal that the bulk of capital gains will be taxed at short-term ordinary income tax rates rather than the preferential long-term capital gains rate of 15 percent.

• Loss of purchasing power. While the markets may take weekends and holidays off, Uncle Sam (taxes), your investment manager (fees), and inflation (erosion of your purchasing power over time) do not. As we discussed in last quarter's column on asset allocation, inflation nibbles away at your purchasing power each and every minute of each and every day. Assuming just 3 percent inflation, today's dollar buys $0.97 worth of goods in 12 months and $0.70 worth in 12 years. To counteract this insidious creep (assuming your time frame is longer than a couple of years), you must seek out asset classes that regularly generate returns that are better than inflation (plus the costs to generate those returns). Statistically, broadly diversified stock portfolios have managed to accomplish this over long time frames. On the other hand, if your portfolio is sufficiently large and/or you are more concerned with leaving too much to your heirs, you may view it as okay to invade a measured portion of your principal each year. Obviously, the key will be balancing the withdrawal rate each year so that you do not outlive your assets.

Outlining return needs and expectations

Once you have put together what you believe is a well-diversified, well-constructed portfolio, how do you tell if it is performing as it should? Just as you should set an asset allocation customized to your circumstances and meeting your needs, you should adopt a “performance bogey that will evaluate what is most important to your situation.

It is human nature to compare ourselves to other beings or things. In the investment world, this desire to see where we fit in has evolved into an endless chase to outperform static indexes, an activity fraught with problems. It is possible, for example, for the stock in your portfolio to show a paper return of 5 percent when the market is up only 1 percent-but for your portfolio value to be declining because you are withdrawing too much. In this situation, your assets could look on paper as if they are performing very well, even though your asset base is steadily being depleted.

In our rush to summarize, compare, and stack ourselves up against our golf buddies, we naturally tend to toss out (or to hear) a single percentage return number without considering the portfolio risk taken to generate that number. If half of your portfolio is invested in fixed income to allow you to sustain a given spending lifestyle, you cannot expect your portfolio's return to keep up with that of your colleague who invested in an aggressive mixture of high-growth small cap names and emerging market debt private placements. Nor is performance as easy as calculating the difference between the bottom line of two periods-if that calculation ignores cash flows, tax implications, etc.

The key to setting up your own performance bogey is the ability to answer the question I will know my investment program has been successful when ______, and filling in the blank with concrete, measurable, and realistic goals, such as:

• My portfolio generates $200,000 in aftertax income each year without noticeably invading principal,

• My equity turnover is not higher than 15 percent, or

• We can pay off the mortgage on the second home.

Learning to invest hard-earned assets wisely can seem like a bigger challenge than the risks you've overcome to create them. Through it all, though, remember to keep your sights firmly focused on what matters to you-not what matters to your golf buddy or to the media. And remember to take enough of a step back from all newly minted concerns to really enjoy what you spent a lifetime working for. At the end of the day, isn't a life well and thoroughly lived what we are all after?

Carol M. Clark, CFA, is a partner and investment principal of Lowry Hill Private Wealth Management, a 20-year-old firm offering comprehensive investment and financial management services to more than 300 families from its offices in Minneapolis, Scottsdale, Ariz., and Naples, Fla. Prospective clients are willing to invest at least $10 million.