Photo: Camilla Webster
Excerpt with permission from The Seven Pearls of Financial Wisdom.There are millions of articles on the Webencouraging investors to buy the same stocks as Bill Gates, Warren Buffett, or Carlos Slim, the world’s wealthiest billionaires.
This advice seems at best confusing and at worst irrelevant, since most people don’t have the same amount of money that these mega investors have.
However, there is one thing that many of the world’s billionaires, including Oprah, do have: a private company that is staffed by people who do nothing but select and watch after their boss’s investments. This company is called a family office.
We believe that you can learn to think like a billionaire’s family office, and that this is the best approach to take with your money. A family office offers the Rolls Royce of wealth- management services— integrated advice on investment management, tax planning, estate planning, philanthropy, and financial education for future generations.
According to the 2010 Multifamily Office Study, conducted by the Family Wealth Alliance14the top 70- two multifamily offices currently manage a staggering $357.3 billion in the United States; the average amount of assets under management for each client is $49.6 million.
Carol has been running a family office in behalf of a number of clients for the last 10 years; prior to that she worked for the Rockefeller family office.Carol is hired by billionaires to create family offices for them, so she is an expert in this area.
Develop an Investment Philosophy
One of the principal jobs of a family office is to help families develop an investment philosophy. The vast majority of families working with the firms surveyed by the Family Wealth Alliance use the family office to create an asset allocation, to select and monitor investment managers, and to select alternative investments, such as hedge funds or private- equity investments.
We all know that the financial markets fluctuate every day, often to an alarming degree. Turn on any financial news program, and you can hear how much the Dow is up or down for the day, hear about the latest interest- rate move, or about the trading patterns of the day’s hot stock. There is tons of information out there but very little useful guidance— and almost no sense of long- term strategy. Family offices receive the same conflicting information, but are savvy in the ways of WallStreet and the brokerage community.They know that a broker selling you products is a salesperson and cannot deliver completely objective advice. Investors working with brokers are expected to look out for their own interests, according to the standards set by the SEC.
Registered InvestmentAdvisers are held to a higher standard, but that does not necessarily completely protect your money. That is why family offices develop an investment philosophy and write an investment policy statement for their clients before they begin investing.
One assumption that underlies all family-office investment philosophies is long- term thinking. Family offices consider investments in light of generations, not weeks or months or even a year. Ofcourse, the family office makes sure that a family’s short- term cashneeds are met and that there is always sufficient money available to meet expenses. But long- term thinking is critical to investment success, and can be practiced by everyone.
For example, it is much better to start saving for achild’s college education when she is born rather than when she becomes a teenager; the power of compound interest means that you can start with a smaller initial investment than you would otherwise.
Thinking for the long term can also mean having the patience to wait for the right time to sell an investment. For example, waiting to sell a valuable piece of art until its style is popular again, even it if means waiting a couple of years, might be a better decision than selling it at a fire sale price today.
Like a family office, you need to develop an investment philosophy and policy before you approach the markets. Some elements of your investment philosophy are going to be universal— good practices that all investors should follow, regardless of their personal preferences— and some are going to be unique to your own situation. We’ll explore the universal elements first.
Adopt the Universal Keys to Good Investing
The first key to investing is to realise that the only reason to make an investment is to achieve a return on it. The fact that you like the broker, like to attend events sponsored by a particular bank, or that your friends are making the same investment are not good reasons toinvest your money.
The only reason to invest is that you think you will receive all your money back, plus an appropriate return. So the first universal principle of your investment philosophy should be, “I am going to invest my money only where I think I can make a return; that is, I have conviction when I invest.”
The second key to investing relates to the question, why do you believe that this particular investment will give you a return? This is one of the principles followed by Warren Buffett. He is famous for investing only in companies and businesses that he understands. Certainly, in the post- Madoff world, this is an important tenet. Not understanding how an investment proposes to give you a return is a big mistake. So the second key is, “I invest only where I have an understanding of how it will make money for me.”
This leads us to the third universal key: It is critical to have the information necessary to monitor investments so that you can determine whether your original conviction and understanding prove to be correct. Unless you get detailed monthly information, you can’t tell how the investment is doing. You should choose only investments that give very detailed disclosure of how they are performing and how fees are being charged. So the third universal key is, “I invest only where there is transparency on an investment’s performance and fees.”
We now have the first three universal keys of our investment philosophy: conviction, understanding, and transparency— or CUT. With these, we can “cut” through a great deal of hype and focus in on only the most suitable investments. Any investments that don’t pass muster, that don’t meet the criteria of these first three keys, won’t make the “cut”!
customise Your Philosophy to Reflect Your Preferences
After you adopt the universal principles of good investing, you need to take your own fundamental inclinations and preferences into account. If you like bargains and hate to overpay, you are probably going to be happier following the value-investing path. If you love looking for the next great success, then growth investing will be more appealing to you.
The good news is that growth investments sometimes outperform value investments, and value investments sometimes outperform growth investments, so your natural inclination will be most successful at least some of the time.
Understanding whether you are a growth or a value investor by preference is critical to investment happiness. It is impossible to get a value investor excited about high- priced, high- growth investments, just as it is impossible to get a growth investor excited about a company that to her looks half dead but to a value investor reveals hidden potential. The key is to adopt the principle, “I invest primarily in my favourite style.”
How much risk are you really comfortable taking? How did you feel when your portfolio swooned during the crisis? Understand that this could happen again in your lifetime, and invest accordingly. Be honest with yourself about how well you handle market volatility. The principle here is, “I accept only an appropriate level of risk.”
Your financial adviser should spend a great deal of time with you to make sure that he or she understands your risk tolerance, and it is crucial that you are honest about this subject. Don’t let an adviser talk you into taking more risk than you are comfortable assuming.
How much time do you have to devote to understanding the markets and participating in them? For example, Carol no longer trades stocks, because she doesn’t have enough time to watch the market closely every day. It is part of her investment philosophy that if she can’t devote the amount of attention required for trading individual stocks, and then she would rather invest in well- managed funds. Here the tenet is, “I invest in a way that makes sense given the amount of time I have to devote to it.”
How strongly do you feel about funding guns, tobacco, or alcohol? For some investors this is a big problem, and they will be happier if they avoid making money on these types of investments. How strongly do you feel about funding community banks, alternative energy, ororganic farming? There are investments that fall in the “socially responsible” or “sustainable” categories that will help you fund the things that are important to you.
If you want to make these kinds of investments, you should seek out experts who are familiar with the growing number of options in these areas—many traditional advisers simply don’t know where to find the best socially responsible or sustainable funds. The tenet here is, “I invest in a way that comfortably reflects my values.”
In summary, your investment philosophy should reflect three universal investment best practices— conviction, understanding, and transparency—which will help you “cut” through the noise in the market. You should then consider your style, risk tolerance, time commitments, and values as you decide where to focus your energy.
Armed with this personalised investment philosophy, you can now map out a strategy. You can even write up a simple document to share with your financial adviser that reflects your investment principles. Th is will be the beginning of your investment policy statement.
Develop an Asset Allocation for Each Portfolio
The first step in turning your investmentphilosophy into a smoothly functioning portfolio is to develop an asset allocation for each pool of money. Your financial adviser will help you with this task. An asset allocation is the mix of cash, stocks, bonds, and other investments that you choose to have in your portfolio.
The appropriate mix will depend on the amount of time you have available for investing, your risk tolerance, and the purpose to which you want to put each pool of money. You may have one particular asset allocation for your long- term retirement plan and quite a different asset allocation for investments that will eventually be used to buy a home.
Before you start picking funds or individual investments, make sure that you and your adviser have crafted the correct asset allocation first. You might like to see what the world’s wealthiest individuals are doing in terms of asset allocation by consulting the World Wealth Report, published each year by Merrill Lynch Global Wealth Management and Cap gemini, and available for download on the Internet.
The 2010 report stated that wealthy individuals around the world kept 17 per cent of their assets in cash and 41 per cent in fixed- income securities— a much more conservative asset allocation than is normally promoted by many financial advisers.15 Don’t be afraid to insist upon the level of cash and fixed- income securities that will make you feel comfortable.
Insist on Quality Guidelines for Selecting Investments
It is not enough to create an asset allocation, however; you should also create quality guidelines for your financial adviser and make sure they are adhered to. In all cases, you want to have the highest- quality investments, managed by the most experienced team possible.
If you are considering funds or portfolios, you want to see the longest track record possible, with good performance during difficult markets. Although all financial investments come with the disclaimer that “past performance is no guarantee of future results,” the truth is that a fund with good pastperformance is a safer bet than a fund with no past performance to evaluate.
Each type of investment has its own particular set of criteria— for example, investors judge corporate bonds differently from high- yield bonds, small- capitalisation stocks differently from large- capitalisation stocks. If this is new territory, ask your adviser to help you develop a set of criteria to judge the quality of your investments.
Use Online Tools to Assess Mutual Fund Quality
When selecting investments, it is helpful to use ratings agencies to help you assess the quality of any mutual funds you are considering. Most online brokerage websites will give you mutual fund ratings from a company called Morningstar. If you are investing in mutual funds, you can set minimum standards by insisting on funds that are highly rated by Morningstar. There is very little reason to invest in a mutual fund with fewer than three stars.
Another good rule of thumb is to look for investment management teams with at least 10 years of experience working together. You can also assess the track record of a fund by comparing its performance to that of its corresponding investment index.
Your adviser can provide this information for you. You can also look up mutual fund performance information on free websites like Yahoo! Finance, which offers a great deal of detail on mutual funds. You can also set up an online tracker for your funds so you can see their performance every day.
It is also important to look at the size of the fund. Beware of mutual funds or ETFs (exchange- traded funds) below $200 million in size— they are just too small to operate efficiently. Don’t let your adviser put you into a brand- new fund with no track record— many brokers get paid higher commissions for selling new funds. This helps them, not you!
Separately Managed Accounts
If you have a large amount of cash to invest, your financial adviser may suggest that he or she set up separately managedaccounts for your money rather than mutual funds. Separately managed accounts, which are created for you and have a personal portfolio manager, offer the advantage of allowing the portfolio manager to more carefully manage the realised gains and losses in your portfolio by deciding when to buy and sell securities.
It is very important to investigate the track record of any adviser who is proposing a separately managed account. If the account is going to hold different types of assets— for example, stocks and bonds in the same account— ask the manager to create subaccounts for each asset class. The manager should also give you performance information for each asset class separately, as well as for the account as a whole.
There should be a ratings number for the performance of bonds as compared to the appropriate bond index, and a number for the stocks compared to the appropriate stock index. Otherwise, it is very difficult to judge whether the account is performing well for you.
Pay Attention to Cash and Liquidity
There are two key tenets to consider whenconstructing your portfolios: the amount of liquidity, or cash, in the portfolio, and the degree of liquidity of the securities in your portfolio. The need for liquidity— or, more simply stated, the need to have cash— was painfully brought home during the crash of 2008 and 2009. Investors who had enough cash to feel comfortable were not so likely to panic and sell at thebottom. The degree of liquidity of your securities refers to how long it takes to sell an investment and receive your return in cash.
On one end of the spectrum, most mutual funds and ETFs have daily liquidity. On the other end, private- equity- fund investments cannot usually be sold for 10 to fifteenyears, making them highly illiquid.
Although there may be a secondary marketfor illiquid investments— that is, someone willing to buy them from you— you typically receive only 10 to 30 per cent of the amount you invested back, so they are a very poor choice and a last resort when you absolutely must get some cash.
Make Sure to Diversify
It is critical that you specify to your adviser that you don’t want to take too much risk by concentrating investments in just a few stocks or bonds. Most mutual funds hold more thanthirty stocks, the minimum considered necessary to diversify a fund appropriately.
Make sure that if you have a separately managed account, themanager is limited to the size of the positions he can take, which means that there should be a limit on the percentage of the total portfolio invested in any one stock or bond.
A good rule of thumb is that there should be no morethan 5 per cent of the total value of the portfolio invested in any one fund,and within a fund or portfolio, there should be no more than 2 to 3 percentinvested in any one stock or bond.
This rule does not apply to smaller accounts, with a value of, say, five thousand dollars or less— in cases like this, you may have to invest in just one or two funds until your assets grow.
If You Are Considered a Sophisticated Investor
Depending on your income and net worth, you may be classified by the SEC and your brokerage firm as a sophisticated investor. A sophisticated investor must have either a net worth of $2.5 million or haveearned more than $250,000 in the past two years to qualify.
Once you are classified this way, you can be shown investments that have a higher risk, or less detailed financial disclosure, than investments shown to non- sophisticated investors.
The assumption is that you can afford to lose 100 per cent of the investment, that you have a high degree of knowledge of markets, and you can make decisions about complex investment products. All these assumptions may be false, however, even if you have the required net worth and income.
Do not invest in products for which you are not given enough information to thoroughly understand the risks you are taking. Don’t rely on the fact that the investment carries the name brand of a top firm—insist on understanding where your money is going.
Hedge Funds and AlternativeInvestments
If you are a woman with a large portfolio, the chances are good that you will be offered the opportunity to invest in hedge funds, private placements, or other so- called alternative investments. These investments are usually not regulated by the SEC or any other governmental body, so they are inherently riskier. Hedge funds, for example, often have lockup periods— it can take months to get your money back. In the wake of the latest financial crisis, many hedge funds have imposed gates, which means that if all the investors want to get out of a fund at once, a “gate” is slammed shut and an orderly liquidation takes place, sometimes over a couple of years.
The prevailing wisdom used to be that youwere compensated for the lack of liquidity and additional risk in hedge funds by much higher returns. However, the performance of many hedge funds was dismal during the crisis, and they did no better protecting investor wealth than traditional investments, which have significantly lower fees.
If you plan to invest in any alternative or hedge fund investments, you must have a clear understanding that you are most likely paying much higher fees and getting less transparency, less regulatory oversight, and less ability to redeem your cash. The returns you earn should compensate for all these negative characteristics—if they don’t, then stick to traditional investments.
According to the 2010 World Wealth Report, wealthy investors with more than $1 million in investable assets put, on average, only 6 per cent of their total worth in alternatives16—so don’t be pressured to overinvest in illiquid alternative investments.
Ask for a Blended Benchmark
Your financial adviser should be able to help you accurately mea sure the performance of your assets against an appropriate benchmark. Remember, you are paying the manager a fee to manage your assets, so the fund should make more money using an active money manager than you would make using a passive index account.
In order to assess how your manager is doing, each type of investment should be measured against an appropriate benchmark. Your large capitalisation U.S. stock investments should be measured against the S&P 500 index, for example. To make matters more confusing, there are actually several versions of the S&P index, including those with dividends and those without dividends, among other variations. Work with your adviser to make sure you are using the right benchmark.
It is also possible for many advisers to create a “blended benchmark” that reflects that same percentage allocation as your portfolio. For example, if your portfolio has 60 per cent U.S. large- capitalisation equities and 40 per cent municipal bonds, you can have a blended benchmark of two indices in the same ratio and use that to judge the performance of your account. This is easier to do if you have separately managed accounts than if you have mutual funds.
If you are investing in mutual funds, each will be measured against an index; your job will be to mea sure the performance of your total portfolio correctly. Ask your adviser for options.
Your Investment Policy Statement
Once you have set your investment philosophy, asset allocation, and quality standards, you can put all these elements together into an investment policy statement that you can give to your financial adviser. Most family offices and most institutions, like pension funds, provide their own policy statements to their investment advisers. There is no standard form for these statements, but there are certain elements common to all of them. Creating a written document that contains all these elements will make your intentions clear and will ensure that there are no misunderstandings between you and the people who manage your money.
To give you an idea of what an investmentpolicy statement might look like, let’s create a hypothetical example for a woman we’ll call Susan Smith, a 40- five- year- old professional who works as a corporate marketing executive and lives in California.
After taking care of her liquidity needs and fully funding her retirement accounts, Susan wants to grow her wealth, so she has decided to create an investment portfolio that she plans to leave untouched until retirement. She has 70- five thousand dollars to invest today and, based on her bud get, can contribute a good chunk of her bonus each year, so she plans to add another 20 thousand dollars annually.
Susan cares deeply about environmental causes and travels frequently, so she is interested both in socially responsible investments and in international stocks, particularly those from Asian countries.
She realises that she does not have a very high risk tolerance, however, so she wants a fairly stable and conservative portfolio. Her investment policy statement might look something like the one on the following page.
INVESTMENT POLICY STATEMENT FOR SUSAN SMITH
This document describes the investment policy for my personal investment portfolio.
Initial investment amount: $75,000.
Tax status: This is a taxable account.
State tax: I am a California resident.
Structure: This portfolio is part of my revocable living trust.
Purpose: The purpose of this portfolio is to create wealth that I can live on in retirement.
Percentage of my liquid assets: This portfolio is 50 per cent of my liquid assets.
Percentage of my total assets: The portfolio is 30 per cent of my total assets.
Ultimate distribution: I plan to pass on any money I don’t use to my sister’s children and my alma mater.
Time horizon: I expect to invest this portfolio for the next fifteen years, or until retirement, whichever is later.
Liquidity requirements: I do not require any current income from this portfolio. I will use this money in retirement. I amkeeping cash in other portfolios.
Liquidationof investments: I want only investments that can be sold every day. I don’t want locked- up investments.
Diversification: No one fund should be more than 5 per cent of the portfolio.
Risk tolerance: I am a low- risk investor. I would like to limit the possibility of investment losses. However, I want some equities and commodities so the portfolio will grow.
Style preference: Although I know my investments should comprise a variety of styles, I am a growth investor and I prefer to invest 60 per cent of my U.S. equities allocation in growth companies and 40 per cent in value oriented companies.
Values: I do not want this portfolio invested in the traditional “sin” stocks. Do not invest in alcohol, tobacco, gaming, or military contractors.
Interests: I am interested in socially responsible investments, international investing— especially Asian equities— and clean technology. I like commodities, including gold.
Avoid: I don’t want real estate funds, as I own two buildings and have enough real estate in my net worth. I don’t want hedge funds.
Municipal Bonds 50%
U.S. Large Cap Growth Equities 8%
U.S. Value Equities 6%
U.S. Small Cap Equities 1%
International Equities 10%
Socially Responsible Equities 5%
Rebalancing: I would like to rebalance the account at least once a year to maintain the asset allocation, unless we discuss otherwise.
Investment vehicles: Use mutual funds and ETFs for the investments.
Quality standards: No mutual fund should have fewer than three stars from Morningstar unless I give specific written permission to the adviser for an exception. I want funds to have a 10- year track record with the same team of investment professionals. I do not want to invest in any fund or ETF that has less than $500 million in assets, unless I give specific written permission to the adviser for an exception.
Position size: No one fund should comprise more than 5 per cent of the
Duplication: Please analyse funds to the best of your ability to make sure
that there is not a great deal of duplication in the underlying securities.
Performance reporting: I want to see each fund or ETF compared to the appropriate
benchmark. I also want a blended benchmark that I can use to monitor the results of the total portfolio.
Informationaccess: I want online access to my portfolio, as well as statements in PDF format emailed to me each month.
Communication with adviser: I expect to speak to my adviser at least once a month. During a crisis, I want to be able to reach my adviser every day if necessary. I will be the one communicating with my adviser.
These instructions shall remain in effect until I submit written modification of them.
Structures to Hold Investments
In addition to choosing investments, family offices make sure that the right legal structures are used to hold assets, given the family’s tax and estate planning situation. Sometimes an LLC is the right answer; other times, a family limited partnership makes better sense.
Even if you are single, it is still critical to hold your assets in the right form, which may be a Revocable Living Trust, which we explain next.
The key point is this: don’t assume that having investment accounts in your own name is the best way to hold your assets. The choice of vehicle and which state to hold the vehicle are critical.
Some states, such as Alaska, Delaware, and South Dakota, have progressive trust laws. You do not need to be a resident of these states to have a trust that isdomiciled in the state Consult a good trust and estate planning attorney andconsider your options.
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