Absolute Returns: Investment Secret Of The Wealthy
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. The Secret Is Out – The Wealthy Usually Seek Absolute Returns
2. What Are Absolute Returns? See My Latest Special Report
3. What The Wealthy Know That You May Not Know
4. Managing Risk – The #1 Key To Long-Term Success
5. Managing Expectations & Being Realistic
6. Putting It All Together
I often receive both e-mail and direct mail solicitations for the latest investment fads. One of the more common schemes I see preys upon the public’s greed, and on a general feeling that rich people have options available to them that no one else knows about. For only the cost of a subscription, these promoters promise to let you in on these “super-secrets” of the wealthy so you, too, can become rich.
The problem I have with these shameless offers is that they make it sound as if, upon becoming wealthy, a person becomes a member of a secret club. If he or she gives the secret Wealthy Club handshake, someone will let them in on super-secret investments that the general public is forbidden from knowing about.
Truth be known, the only thing secret about most of these promotions is that they withhold telling you exactly what they are talking about until you have paid your money. Only then do you learn that what they have described is not really a secret at all. I have seen this type of promotion used for virtually all types of investments – stocks, bonds, precious metals and coins, foreign currencies, collectibles, real estate and even hedge funds.
Actually, there are no “secret investments” that only the wealthy know about. Instead, there are investments that only the wealthy can access due to government regulations, size of the investment required or those that by their nature may not be suitable for all investors. The bottom line: just say no to any promotion that promises to make you rich by disclosing a super-secret strategy available only to the wealthy.
Even though there are no “secrets,” there IS a lot that you can learn from the way the wealthy approach investing, especially in regard to managing risk.
It has been my experience that the primary characteristic that sets many of the wealthy apart from the average investor is their interest in “ absolute returns” rather than “relative returns.” While the concept of absolute returns has been receiving a lot of press recently, I rarely see this strategy explained sufficiently for investors to determine whether or not they should seek these types of investments.
So, in this week’s E-Letter, I’m going to explain and discuss the concept of absolute returns, and tell you how you can get a copy of my latest Special Report on the subject. I’ll also discuss other investment techniques employed by the wealthy that may help you in your personal investing.
Just Who Are “The Wealthy?”
As I noted above, a number of Internet and direct-mail investment promoters have discovered that average investors are very interested in how wealthy individuals invest their money. At this point, it may be beneficial to define exactly what I mean when I say “wealthy.” As you might suspect, the exact definition of wealthy is hard to pin down. At what point does a person go from making a comfortable living to being “wealthy,” “set for life,” “filthy rich” or whatever other term you would like to use?
SEC regulations set the bar for an “accredited investor” at a $1 million net worth. At this point, an investor might be sophisticated about financial matters, but does it mean they are wealthy? There are also other categories established by the SEC at $1.5 million and even $5 million or more net worth. Can we set the bar for “wealthy” at one of these levels?
The general public’s definition of wealthy also varies. Bill Gates, with a net worth in the tens of billions, is obviously wealthy. However, if you ask people on the street, many would likely say that anyone who is a millionaire fits the definition.
The truth of the matter is that wealth really depends upon what makes up the net worth. There are many millionaires today who reached that plateau simply by having their homes skyrocket in value. I can tell you from discussions with my clients that someone with a million-dollar home and $200,000 in investments feels far less wealthy than someone with a $1 million investment portfolio and a $200,000 home.
For purposes of the following discussion, I will assume that “wealthy” means a net worth of $5 million or more, excluding the primary residence. At this level, I feel a person knows that he or she is financially independent and can face virtually anything that life has to throw at them. I’m sure some of you may disagree with where I set the bar, but we’ll just have to agree to disagree. I also know that it takes more than money to make true wealth, but since this is primarily a financial E-Letter, I’m going to focus on material wealth and leave the other aspects of our lives that provide enrichment to others.
So, should you stop reading this E-Letter if you don’t fit the definition of a wealthy person? No way! The benefits of the strategies employed by wealthy investors are not limited to them alone. The potential to have consistent positive returns over an investor’s lifetime, without major losing periods along the way, is a compelling goal that can apply to virtually any investor.
What The Wealthy Know That You May Not Know
In my experience, the difference between how a wealthy investor approaches the market versus an average investor has nothing to do with secret strategies, and everything to do with mindset. In other words, most wealthy investors have a different mindset toward investing than most average investors, in my opinion.
The reasons for this are fairly straightforward. Wealthy individuals are usually keenly aware of their wealth and the freedom and lifestyle it affords them. Thus, wealthy individuals are usually more interested in protecting their wealth than swinging for the fence to build even more wealth. Not meeting goals for investment growth would be bad news to a wealthy investor, but losing their financial independence would be devastating.
Average investors, however, have not yet reached the ranks of the financially independent, so they are more concerned about investment growth than about losses, in most cases. The wealthy, as a general rule, do not have this concern unless their lifestyle is such that they can burn through their entire fortune in their golden years.
My observation about the mindset of wealthy individuals may sound simplistic to you, but it is an important distinction. The wealthy know that they are set for life UNLESS they make a major mistake. Can such mistakes happen? You bet!
Here’s an example: Over the years, we have been approached by a number of prospective investors who worked for major high-tech companies. In the go-go 90s, they had accumulated multi-million dollar portfolios of their employers’ stock, only to see its value dwindle as the tech bubble burst. At that point, several of them decided to diversify and put the money with several large brokerage firms. The net results were that after the bursting of the tech bubble and Wall Street’s callous disregard of their desire to manage further risks to their wealth, these individuals were no longer wealthy. Our calculations showed that the net worth of one of these individuals had shrunk 90%!
Horror stories like this are, unfortunately, not uncommon among wealthy investors, especially those who find themselves “suddenly wealthy” from stock options, an inheritance, or selling a business. That’s why those who counsel wealthy individuals typically place a high priority on preservation of capital, more so than building additional wealth.
The desire to maintain wealth is also a big reason why wealthy individuals flock to hedge funds. Today, the hedge fund industry is viewed as being populated by speculative ventures, but this was not always the case. Early hedge funds were developed primarily to reduce the risk of being in the market, by using short positions to reduce losses in a down market. The definition of a “hedge” is to reduce the risk of loss. These funds also promised the potential for absolute returns, which I defined above and in my Special Report.
Managing Risk – The #1 Key To Long-term Success
Even though the interests of wealthy investors are not always necessarily aligned with those of the average investor, there are a number of the principles and strategies employed by wealthy investors that do apply to virtually anyone who seeks to invest for the future. Above, and in my Special Report, I discuss the concept of absolute returns. How and why absolute returns are generated comes down to the management of risk.
While we all know that past investment returns are a poor predictor of future returns, a recent Morningstar study has shown that measurements of past risks are more likely to predict future risks. Morningstar stated, “[The] relationship between past risk and future risk is stronger than that between past return and future return.” (Morningstar.com, “Risky Business”)
I frequently write about risk management and preservation of capital in these E-Letters. The most common example I use to illustrate the importance of avoiding large losses is what I call the “Breakeven Table,” showing how much it takes to recover from various levels of loss. For example, a 20% loss requires a 25% return to recover; and a 30% loss requires 43% to get back to breakeven.
During the 2000-2002 bear market, the S&P 500 Index plunged almost 45%, and anyone in an index fund at the time suffered the same downhill ride. Now those investors must make an 82% cumulative investment return just to get back to where they were in early 2000, before the start of the bear market. This is precisely why I do not recommend that investors have most of their money in passive buy-and-hold strategies or index funds.
Just as important as the losses that were incurred by buy-and-hold investors, there is also the “time factor” to consider. Five years later, the S&P 500 Index is still not back up to where it was at the peak in 2000. Five years is a very long time to lose in any financial plan. And it’s not over yet.
Most financial professionals help clients set investment goals based on an assumed level of return over a set time horizon. The principle of compound interest tells us that the longer an investor has to accumulate earnings, the larger the eventual accumulation can be. However, when that time horizon is interrupted by several years required to regain a large loss, the effect on the overall investment plan can be devastating. And the shorter the time horizon, the worse the effect of losses can be.
But here’s the absolute worst part: many investors bailed out of the market completely near the bottom in 2002, and have never gotten back in. They have missed the market’s recovery, and now find themselves, as the old saying goes, up the creek without a paddle.
Managing The Emotional Side Of Risk
I have written about a number of studies showing that the average investor does not necessarily participate in the gains enjoyed by mutual funds. The reason frequently given is that investors are chasing hot returns, and frequently switch among mutual funds to try to access the highest returns at any given time. Unfortunately, many investors end up buying high and selling low.
From my experience, what these studies show is that most investors are not emotionally prepared to take investment losses, so they frequently sell out near the bottoms and end up moving from investment to investment. As a general rule, these investors will move to the latest “hot” fund promoted by the financial press.
The trouble is that this publicity causes a huge number of other investors to do the same, and they are all often buying in at the high point of the fund’s performance. Some investors continue in this cycle repeatedly. This “buy high, sell low” method of investing can lead to a significant erosion of an investor’s nest egg, even in periods of rising markets.
In my business, I am able to observe the emotional side of risk every day. As I have previously written, we encourage our prospective clients to complete a Confidential Investor Profile questionnaire in order to help my staff determine the goals and risk tolerance of each potential client. (Click HERE if you would like to download a copy of our Investor Profile and receive a free risk assessment.)
It is very interesting to see how many investors tell us that they are quite comfortable with occasional moderate losses, and more aggressive investors say they can deal with even larger setbacks now and then. However, it has been my experience that when faced with real losses, most investors are able to stomach far less loss than they indicate on a questionnaire, and my company is not alone in this observation.
We recently attended a conference where a money manager told of one of his clients who had recently asked to liquidate his account due to short-term losses. The manager was surprised to find that this investor (a stock broker) had originally indicated that he could withstand a loss of up to 30%, but was jumping ship when losses were only in the 7% range. All of the other money managers at the conference chimed in to say that they had similar experiences.
The moral of this story is that it is hard to determine actual risk tolerance on a questionnaire, since emotions are not involved when answering the questions. When losses become real, emotions take over, often to the detriment of the investor.
So, which is the best plan – to try to condition your emotions to accept larger losses, or invest using a strategy that seeks to minimize losses, even in down markets. Since I’m a better investment manager than I am a psychologist, I always recommend my clients opt for the latter. It just makes sense to me that an investment program that emphasizes capital preservation and seeks to minimize losses can help investors avoid the emotional “knee-jerk” reaction to losses in their accounts.
Managing Expectations & Being Realistic
Another factor that wealthy investors have going in their favor is that they are generally better able to manage their investment expectations. Obviously, this is a broad generalization and not every wealthy investor is so inclined, but it has been my experience that successful wealthy investors have a very realistic outlook in regard to their potential future investment returns.
I attribute this ability to the fact that most wealthy investors work with professionals in the financial services business, rather than forming their expectations based on the financial media, an arbitrary market index, or some other rule of thumb.
As I noted above, wealthy investors tend to want to minimize the chance of losing substantial portions of their wealth. However, they also do not want the purchasing power of their fortune to decline due to inflation. In addition, most wealthy individuals want to see their wealth grow at a reasonable rate over time, whether it be to pass on to heirs, fund a foundation or charity, or other desires. Thus, “risk-adjusted returns” are the order of the day.
However, risk management usually comes at a cost of giving up some of the market’s return. Using the hedge fund example, if part of the account is dedicated to hedging the portfolio, it just makes sense that the investor will not participate in 100% of the gain of the securities held long in the portfolio. The same goes for “active management” strategies that can go to cash in down markets. Rarely do money managers get out at the very top or buy in at the very bottom (no one does), so some potential returns are “left on the table,” so to speak. However, in light of the value of risk management, these wealthy investors are comfortable with the tradeoff. All investors could learn a lesson from the wealthy in this respect.
Many investors base their investment return expectations on outside factors that have absolutely nothing to do with their individual goals and risk tolerances, and this is big mistake. Even some financial professionals will use historical market averages to set expectations. However, historical return numbers can be manipulated by selecting a time period that helps prove a point. For example, anyone who invested in the 1990s got used to market returns in the 20% to 25% range, so some investors still believe that 20-25% returns ought to be a reasonable expectation.
However, someone who lived through the sideways markets of the late 1960s through the early 1980s would argue that double-digit returns on certificates of deposit are far better than the virtually flat performance of the stock market. It’s all a matter of perspective, but unfortunately, the only perspective that counts is what the market is going to do in the future, and no one knows what that may be.
Whether you are managing a family fortune or the money in your employer’s 401(k) plan, it is important to base your return expectations on your overall investment goals. I am constantly amazed at how many prospective investors will contact us for a review of their portfolio, only to find that they have invested far more aggressively than is required to meet their goals. Many investors have no idea what kind of return it will take to meet their investment goals, so they swing for home runs in the stock market when singles and doubles would do just fine.
If you have done a good job saving for retirement, children’s educations, long-term care, etc. and you only need a moderate level of return to meet these goals, why subject your portfolio to any larger risk than it will take to potentially produce this level of return? In light of what we have seen in the markets over the last five or so years, it just doesn’t make sense to invest in such a way that might subject your nest egg to significant losses.
If you don’t heed any other advice I provide in this article, make sure you do this: Determine what level of investment returns is necessary to meet your financial goals, and invest accordingly. Whether you use my firm, a local financial planner, or even Internet resources, it is important to know what kind of investment returns are necessary for you to meet your goals. Any other expectation, whether from the financial media, investment company promotions, or wherever cannot substitute for this knowledge.
What Is Your Time Worth?
While I said above that I would steer clear of life enrichment issues, I do want to touch on just one. It has been my experience that many wealthy individuals use the services of financial professionals rather than doing it themselves. That doesn’t mean that they do not monitor the professionals they engage, just that they have better things to do with their time than pore over financial data and watch the markets all day. In short, the wealthy tend to make their money work for them, rather than the other way around.
Most investors have better things to do with their time than micro-manage their own investment accounts. While some investors greatly enjoy researching markets and trading their accounts, most everyone else would rather spend time with family, engage in a hobby, or volunteer their time to a good cause.
Unfortunately, the financial media coupled with the wealth of information on the Internet have gone far in convincing the investing public that not only can they do it themselves, they should do it themselves. For those who are so inclined, I would say “go for it.” But, for the rest of you who would rather spend your time doing something else, I strongly recommend the use of professional investment managers.
After all, you can get information on the Internet about home cures and sample legal documents, but most people don’t use this resource rather than going to the doctor or seeing a lawyer when the need arises. I think the same goes for financial professionals, and I have put my money where my mouth is.
In my latest Special Report, you will learn about the AdvisorLink® Program developed by my company in 1995. The purpose of this program is to introduce my clients to Investment Advisors who specialize in providing absolute returns and managing risk. We have checked out their investment strategies, track records, and even their administrative offices in an on-site evaluation.
Many of the strategies employed by these Advisors are similar to those used by hedge fund managers to manage risk, but you don’t have to be wealthy to access these programs. Minimum investments start as low as $15,000.
AdvisorLink® brings the benefits of risk management and absolute returns, once employed only on behalf of the wealthy, to virtually any investor. If you are interested in investment strategies that stress capital preservation along with growth, I encourage you to read my Special Report and check out AdvisorLink® for your investment needs.
While many investors are tempted to believe that the wealthy have special, secret investments only available to them, I have shown that this is generally not the case. In fact, today it is possible for virtually any investor to enjoy the kinds of risk-managed investment strategies that were once primarily available to the wealthiest of investors.
However, investors can learn important lessons from the wealthy, specifically the need to manage both risk and their own investment expectations. The failure to match expectations to the risk an investor is willing to take can result in frequent switching among investments, or even worse.
Mismatched risk and reward expectations can even lead investors to be taken in by scam artists who promise high returns and no, or low, risk. Without the benefit of someone helping them to manage their return expectations, they are ripe for the picking and could end up far worse off. It is important to always remember that something that sounds too good to be true, usually is too good to be true, especially in relation to investments.
I encourage you to download my latest Special Report, and learn more about absolute return strategies and why they should be a part of your overall portfolio.
Gary D. Halbert
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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.