F. Scott Fitzgerald is often quoted for saying that, “The rich are different than you and me.” This begs the question, “How are they different?”
Three economists set out to answer this question by studying the investment strategies, portfolios and behaviors of a good-sized group of wealthy families in the United States. What they found out is valuable to a wide range of investors, regardless of your net worth. This week I review the findings of their unpublished report and include my personal observations.
The study, which examined 260 families with an average net worth of $90 million from 2000 – 2009, was also reviewed by the Wall Street Journal in an article entitled, How the Rich Play the Market.
Four Lessons Learned from Wealthy Investors:
- Active Trading Is Uncommon. The families that were studied were not active traders, and they were thoughtful about taking tax losses. In my experience, many private investors are reluctant to take a loss because they perceive it as a sign of failure. Further, some investors will continue to hold an investment even after they have lost confidence in it, hoping that it will recover and they will break-even. Unfortunately, sometimes the investor’s loss of confidence is warranted and the investment does not recover as they had hoped. One way to be disciplined about taking tax losses is to invest in a tax-aware index-tracking fund or account. As the description suggests, this type of account provides you with an investment return that closely tracks a capital markets index (e.g., the S&P 500). The account manager is tasked with harvesting tax-losses on a regular basis and reinvesting sales proceeds so as to track the target index. This allows investors to take full advantage of tax losses, while remaining fully invested in their target asset allocation.
- Diversification Can Be Helpful. The study found that wealthy families own a substantial number of individual securities, mutual funds and exchange traded funds. This is consistent with my client-related experience as well. Diversification allows you to achieve a broad range of asset exposures (e.g., home and other developed country equities, emerging and frontier markets equities, large cap, mid cap and small cap exposures, global fixed income, natural resources and commodities, and real estate). However, less well-executed diversification can also be inefficient, if you are paying fees to active managers with overlapping mandates. Avoid paying fees to active managers to create a portfolio that essentially looks a lot like an index fund.
- Private Investments Are Typically Embraced. One conclusion, which may or may not be universally applicable to my readers, is that the families in the study invested 20% of their assets in hedge funds, private equity funds and private direct investments. Based on my professional experience, wealthy individuals and families often invest 10% to 20% of their portfolio in hedge funds, and are likely to invest another 10% in private equity venture capital, direct company investments, natural resources and real estate partnerships. Many investors, however, do not have the appetite to allocate more than 20% of their assets to investments with limited liquidity. Further, they are unlikely to have the necessary research to access the best hedge funds or private equity/venture capital and private investments. Similarly, Diana Frazier, a co-founder of FLAG (a global private-investments management firm), is often quoted as saying, “Private investments are not an asset class; they are an access class.” Fees can be steep, liquidity is constrained and manager research is extraordinarily important. Accordingly, if you wish to emulate other wealthy families in private investments then it is important to seek the best conflict-free professional advice.
- Rebalancing Can Make A Real Difference In Your Investment Results. The study concluded that wealthy families understand and undertook asset class rebalancing. However, I was disappointed to learn that these families, who were likely to be well-advised, were not disciplined about rebalancing their assets in the Financial Crisis. Specifically, when equity values were impaired and the value of high quality long-term bonds had appreciated, these investors were over-allocated to bonds and under-allocated to equities. Nonetheless, they failed to rebalance away from the bonds into equities at fire-sale prices. As a consequence, their aggregate portfolios fell from $8 billion to $3 billion – a stunning 63% decline over the 2008 / 2009 period! During this time, the S&P 500 fell severely (36%), but less drastically than the results of the study-families. A more successful approach would have been for those investors to sell some of their bonds and to invest their proceeds in equities, rebalancing their overall portfolios back to their long-term asset allocation targets.
It is hard to rebalance into an asset class that is declining, because one does not know when it will hit bottom. It is equally hard to rebalance out of an asset class that is appreciating, because one does not know when it will hit the top. However, in recalling the simplest investment concept, it is generally good to ‘sell high and buy low,’ and the 2008 Financial Crisis offered investors this very opportunity. I do not recommend liquidating an entire asset class that has appreciated to invest in an asset class that is falling, nor do I necessarily recommend rigidly re-balancing to your long-term targets. However, I do recommend re-balancing toward your long-term asset allocation targets when your actual exposures differ substantially from your targets.
If you have perspectives to share about how you manage the investment assets that you are responsible for, I invite you to leave a comment below. If you prefer, you can contact me personally at Jack@RGPIC.com or ring me at 617.945.5157.