Wealth management

Some basic principles of wealth and asset management

Wealth management is an investment advisory discipline that incorporates financial planning, investment portfolio management and other financial services. Wealth management includes asset and liability management, e.g. for future pension plans and the risk of income fluctuations. Asset management or investment management is a subdiscipline with a partial view.

The common advertorial from the wealth and asset management industry stresses their presumed ability to increase the investment returns. Many investors want to believe it and assume that the wealth and asset management professional has somehow acquired the magical skills to achieve the investment return ambition. Academic studies show that the promise of high returns is a fairy tale - nothing more than regular tv advertising, at least as far as the normal investor is concerned. The average wealth, asset, fund manager does not outperform his benchmark market index (adjusted for risk, etc.); some professionals exhibit investment skills, but simply collect the excess return as part of the investment management fees at the expense of the ordinary fund investor; some high-profile fund managers appear to be lucky with some of their bets, sometimes, but they are not normally able to repeat their performance over time (i.e. historical performance is no guarantee for future performance). Only a handful of people seem to have the extraordinary entrepreneurial skills that are needed to identify firm/market/product opportunities that ultimately pay a handsome return to the timely investors (e.g. Warren Buffet?).

Basic principles

Even within the framework of efficient markets and in the absence of abnormally high returns, the wealth and asset management professional can be of help to the ordinary investor. But more as a humble financial advisor than as an investment guru.

Basic principles for investment strategy:

* lower costs (taxes, transactions, management fee)

* diversify (do not gamble on one or few investments)

* risk management (limit your downside risk, take advantage of correlations between ups/downs in market values and your income and/or liabilities)

* adjust your risk profile over time (towards retirement the possibilities to address (unanticipated) negative investment returns with more work / more saving become less)

Failed investment strategies:

* Stock picking

* Country picking

* Market timing

* Sector rotation

* Characteristics-based strategies

The required crystal ball of forecasting to make these strategies work simply does not exist. Do not fall for tempting empirical studies claiming to support theses strategies, because they are based on various fallacies.

Passive investment strategies:

* Index benchmarks

* Portfolio optimization (market indexes are not optimal portfolios)

Although market indexes (stocks, bonds, etc.) are to some extent useful tools because of their objective return measurement and minimal trading cost, the problem with market value indexes is that they do not necessarily represent optimal investment portfolios in practice. Some indexes are even accused of leading to perverse investment strategies (for example, in bond markets it is not logical to automatically invest more in countries with more debt). Both the selection of constituents (exchange listed securities) and their weights (market value) are quite arbitrary in practice. Even within a passive, low cost investment strategy it should be possible to beat the index benchmark, by carefully constructing an optimal portfolio; not based on the fantasy of abnormal high returns, but based on expected average returns and the correlation structure of returns. Inputting adequate expected return (in fact, return differences or risk premiums) and correlations requires good economic analysis and is not easy, but is not based on the fallacy of outperforming the market. Future returns and correlations are subject to change over time under the influence of structural change, and the varying effects of different types of economic shocks (inflation, real economy, etc) the distribution of which is also not constant over time. Too much reliance on historical returns can be seriously misleading.

Vista Capital Partners, 2011, The optimal portfolio, updated PDF 2011: http://www.vistacp.com/wp-content/uploads/2011/03/The-Optimal-Portfolio.pdf

Efficient Frontier: An Online Journal of Practical Asset Allocation, Ed. William J. Bernstein, Susan F. Sharin http://www.efficientfrontier.com/ef/index.shtml