Making Your Profits Where You Can: Greater results with less effort

The funeral business is facing new competitive forces from Chinese coffins to cremation services to internet sold merchandise. It seems pricing pressure exists in a greater way than ever. One natural, and proper, response is to take a good look at overhead expenses and make sure you are running as efficiently as possible in order to retain profitability. Every Funeral industry conference I know about for some time now has been addressing this issue. I want to encourage you to take this thinking one step further. As Wealth Managers, we take a holistic look at your wealth (not just your business) and the ability to make and retain wealth. Would you purposely over-pay for services in your funeral business, especially if those services underperformed less expensive alternatives? Why would you do that? Unfortunately, it happens sometimes because the owner/operator isn’t doing his homework sufficiently. Others may do it because the overpriced underperforming service has some kind of panache or ego boost for the owner. He has something to brag about at the next conference hospitality hour. But in these days of high competition, I would think it would be better to brag about your efficiency rather than luxurious consumption. You will have more terminal wealth if you do that. Let the over- spender brag, as an efficient manager you can laugh all the way to the bank.

Now, let’s apply this principal to your personal investment portfolio. Do you have excessive overhead and underperformance in your personal investment portfolio? How many of your friends have those cocktail party investments, you know, the one’s they brag about at the cocktail hour at the country club. You do know that full disclosure isn’t required in those discussions. They don’t have to tell about all the losers they own or have owned in the past. They don’t tell you how much they have paid in commissions and margin interest and bid ask spreads and just plain bad stock picking. All these are excessive overhead and produce underperformance. There is a way to have a positive investment experience with minimal expense and you will never underperform the market by more than the appropriate cost of investing.

(There is no such thing as “free” investing.) THINK ABOUT THIS: IF YOU NEVER LOSE YOU WILL ULTIMATELY WIN.

Here is an example: you play tennis, never hit acrowd wowing slam but also always return the other player’s serve and his other slams and lobs. You just keep returning your competitor’s play until he makes a mistake. You score. It’s not sexy, but you win. When investing, it is wise to play the boring winner’s game, not the exciting loser’s game. So, how do you do that?

There is a body of law that defines “prudent” investing. People who invest other people’s money (such as Trustees) are held to this standard. If one carefully reads the Uniform Prudent Investor Act (UPIA) and its precursor, The Restatement (Third) of Trusts (Prudent Investor Rule), hereafter “Restatement”, you will discover how to play the winner’s game and never again get caught in the loser’s game. Wall Street hates this because they don’t get to continue selling the overpriced underperforming investments and investment strategies. Heed this advice and always be a winner going forward over time.

Key Principles

In any discipline, presuppositions determine the ultimate outcome. It is critical that an investor understand how markets work in order to have a successful investing experience. The following are the academically sound fundamental concepts of how the markets work. You won’t read a lot about this in Wall Street marketing materials unless it is “spun” in their favor. Invest on the basis of these principals and you will have a successful investing experience. I am not saying you will “get rich quick”, that doesn’t happen to investors. It sometimes, as a matter of luck, happens to speculators. We are not encouraging speculation, but prudent investing that will succeed over time.

Principle #1. Markets Work – The Restatement accepts the academic understanding that the markets are essentially efficient.  [1]

Academic literature refers to this as the Efficient Market Hypothesis (EMH). This means that securities are properly priced at essentially all times so there is no point in attempting to buy “underpriced” securities or “time” the markets and prove you are “smarter” than the other investors.

Principle #2. Risk and Return are Related – The introduction to the Uniform Prudent Investor Act states that the primary task is to control risk. “The tradeoff in all investing between risk and return is identified as the fiduciary’s central consideration .”  [2]

Principle #3. Diversification is Essential – The Restatement indicates two types of diversification: 1. Diversification between Asset Classes  [3], and; 2. Diversification within Asset Classes. There is more emphasis in the Restatement regarding Diversification within Asset Classes than Diversification between Asset Classes. Most investment professionals will talk about Diversification between Asset Classes.

Principle #4. Structure Determines Performance – Asset Allocation (Diversification between Asset Classes) determines most of the variation in performance. The now classic study by Brinson, Beebower and Singer Brinson, [4] makes it clear that more than 90% of the variations of returns in an investment portfolio are determined by Asset Allocation. Consequently, the Asset Allocation decision is the most important decision one makes when building an investment portfolio.

Implementation

Here is how you apply these principles.

Markets Work: What not to do: 1. Don’t try to pick winning stocks. 2. Don’t try to time the market by being “in” when it is going up and “out” when it is going down. This is exactly what “active” managers attempt to do and sell you on the need to use their expensive “superior” services. Think the tennis game. The active money manager or broker is the one who attempts to hit the game winning serve or slam. It is the loser’s game. Every year there are some active managers who outperform the market, but they do not persist.  [5] Each year it is a different manager.

What to do: Purchase low cost broadly diversified mutual funds. This includes index funds and structured asset class funds. These funds purchase essentially all of the stocks that make up the asset class they are intended to represent. Since they aren’t attempting to pick the “best” stocks, there is low turnover in the fund. This lower turnover results in lower costs: lower bid ask spread costs, lower internal brokerage commissions, lower realized capital gains and consequently lower taxes in the case of taxable portfolios. Another way to say this is “lower overhead” with full asset class performance.

Risk and Return are Related: In order to have higher performance over time, one must accept greater volatility in their portfolio. This is the way capitalism works. If a new unproven business wants to borrow money to go into business, that business will pay a higher premium in interest for the money (higher cost of capital) than a solid long proven profitable company like Wal-Mart, for example. The new business is more risky and must therefore pay more to investors for their capital. If you want more investment return, you must invest with more risk. It is fundamental.

Equities, or stocks, are more “risky” than bonds. You can reduce the risk of a stock portfolio by adding some bonds or fixed income securities to the asset allocation. For most private investors, the primary purpose of bonds in the portfolio is to reduce volatility, not to produce income. Income is secondary to volatility control.

Diversification is Essential: There are two kinds of diversification referred to in the Restatement and UPIA; Diversification between Asset Classes and Diversification within the Asset Classes. The importance of diversification within Asset Classes can easily be illustrated by the now famous impact on the portfolios of all those Enron employees whose portfolios were concentrated in one stock. If, instead, they had owned all one thousand of the stocks in the Russell 1000 Index (a frequent proxy for large cap stocks) the impact on their holdings when Enron imploded would have been minimal since they would have owned 1000 stocks instead of 1. The risk of owning only a few stocks of an asset class is known as non-systematic risk. Systematic risk is risk that cannot be diversified away. This is the risk for which you are compensated when investing. Those folks who took on all the non-systematic risk of one company were not compensated for the extra risk they took. The markets have no obligation to compensate you for not diversifying fully across each asset class but will compensate you fully for all systematic risk that you take.

Structure Determines Performance: To implement diversification between Asset Classes, you should purchase multiple asset classes like Large Cap Value Stocks, Small Cap Stocks, Short Term Government bonds, a Real Estate Investment Trust fund and international stocks, etc. These different Asset Classes behave differently from one another; some are more volatile than others and have greater returns than others. And the really important characteristic is the fact that they do not do the same thing at the same time or in the same magnitude. This is known as correlation. The goal is to have high performing Asset Classes that have low, or if possible even negative, correlation. There is mathematically an optimal mix of Asset Classes for each risk level. You may need a professional advisor, such as a CFP® Professional, to assist you with this calculation and to be sure the portfolio fits your tolerance for risk. This decision will include exactly which Asset Classes to include in your portfolio and in what proportions.

The bottom line of this investing process is that by purchasing low cost index funds or structured asset class funds for your investment portfolio in the proper asset allocation model for you and your circumstances you will significantly improve your long term investing experience for two reasons: 1. You will have reduced or essentially eliminated all non-systematic risk (the kind you don’t get compensated for), and; 2. You will have significantly reduced the expenses related to your investment portfolio and increased the percentage of the portfolio performance that will stay in your pocket instead of the pocket of Wall Street institutions and the IRS. Doesn’t this just make good business sense? In your funeral business you only take business risks you believe will be profitable and you reduce your overhead as much as you can. Why not apply the same metrics to your investment portfolio?

Charles L. Stanley CFP® ChFC AIF®In addition to many published articles and quotes in the financial press, Mr. Stanley regularly conducts continuing education classes for Attorneys and CPAs and is available for public speaking, seminars and private consultations. He is also a wealth manager with Capital Financial Advisors, LLC, a fee- only Wealth Management Firmin La Jolla, CA whose mission it is to provide Wealth Management to Successful Business Owners. Mr. Stanley can be reached at 858-395- 8694 or cls@charlesstanley.cc or www.charlesstanley.cc