The secrets of wealth destruction

According to Richard Branson the quickest way to become a millionaire is to start out as a billionaire. While you and Warren Buffett might choose wisely not to invest in an airline (the context for this advice), there are plenty of other ways to lose money through investing. Here is a list of some things not to do investing and growing your wealth.

Don’t be an undocumented investor

Some find investing so interesting they jump to picking stocks before first documenting a boring set of rules about how much of what they should invest in, and how they should make investment decisions like keeping portfolio risks in balance and allocating cash flows.

Instead, many investors build their portfolios bottom-up through security and investment selection, and not top-down filling a budget of assets to buy and choosing the best ways to access them. They are at risk of having too much of one thing (like top 10 ASX listed shares, deposits and/or direct property) and none of others (like international equities, inflation-linked bonds). In good times they may fail to take profits in parts of their portfolio that run hot, and in difficult times they are more at risk of fleeing markets. In today’s diverse investment supermarket, you can appreciate how unhealthy your financial diet may become if you go shopping without a list.

Much has been written about investing, but very little about investment decision making. Donald Trone and co-authors provided a guide (click here) to American investment fiduciaries back in 1996 whose lessons are still current, including for DIY investors. Some of the important decisions that need to be made in the design part of an investment strategy are laid out in the following hierarchy.

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Some will find the discipline of writing down their strategy for assembling a portfolio of investments (a compliance requirement of all SMSFs) and managing it too hard – if that’s you, then maybe you shouldn’t be investing alone)? Many also suffer from not getting enough feedback about what risks they are taking and rewards they’re getting. As I have said before (in Your investment dashboard), if you know more about the performance of your $10,000 car than your million-dollar portfolio, something is wrong.

George Soros reminds us that “good investing is boring”. It is even worse than that, as much about investing and wealth management is about neurotically planning to avoid risk or at least being properly compensated for it. In Your five biggest wealth risks, I summarised the big wealth risks you need your investment strategy to defend you from.

Stop concentrating too much

All investments are unreliable. If they weren’t, you couldn’t expect to earn a premium return from them. The BRW Rich List is a list of lucky wealthy survivors. If you look at this list over time, you’ll notice the proportion of rich from each industry changes. Sometimes it’s property developers, other times miners, earlier it was “internet-preneurs”. This is because each industry, and by implication each investment sector, has its day. Hard working entrepreneurs in industries not going through a profitable cycle don’t make it on the list as much. So if you don’t want luck to play too big a part in your wealth creation, you’re going to have to limit concentrating your wealth in any one asset class, industry sector or security/investment – in short you need to diversify. A lot of wealth destruction is associated with failing to do this when bad luck strikes.

Professional investment funds often cap the holding of any one stock at 10% of a portfolio and about 30% in any one sector. This is quite hard to do in Australia, where I pointed out in Goodbye to the All Ordinaries our market is in three parts: “dirt, debt and diversified”, and two-thirds of it are the top 10 sized companies. 

Investing outside of Australia is one way to help address this concentration issue. Another is to buy an index fund to make up perhaps half your asset class exposure, leaving you to invest the balance more speculatively. Your investment strategy should lay out how much of your money will be speculating rather than boringly owning or lending to different companies in different industries – maybe only 20%?

If you’re a direct property investor, given Australia’s unusually high property prices, you need to be a multi-millionaire to try to cap your exposure to one single property at perhaps a prudent one-third. While land tax aggregation gives you an incentive to invest next outside of your home state, it makes you an out of town landlord. Investing in syndicates might help but “agency risk” and fund “illiquidity” issues often introduce bigger risks.

Listed company executives have problems also with concentration risk. They often have not just too much invested in their own company but also their career! This co-varying risk is a problem and can only be dealt with carefully through progressive share sales and option strategies – and perhaps getting a career coach. If you work for the Commonwealth Bank you’ve done well – if you worked for Babcock and Brown, Enron or Nortel you didn’t. If you own a private business, your business is often your superannuation, and managing that concentration risk and succession is critical – sadly not all get what they deserve for all their hard work.

Successful US investor Peter Lynch remarked: “In this business if you’re good, you’re right six times out of 10. You’re never going to be right nine times out of 10”. If you don’t overly concentrate your investments then you can recover from the four or so times you’re not right.

Don’t follow the herd

Investing has momentum. There are fads, and often bubbles emerge propped up by come-lately investors. Statistics show that the average investor is brilliant at buying high and selling low. For instance, US researcher Dalbar found that over the last 20 years investors in US share mutual funds earned an average 4.3% compared with the index 8.2%. Morningstar calls the difference between what funds earned and money-weighted investor returns as a “behaviour gap”. They find this gap fortunately has been falling to 0.2% over the last three years, from 0.5% and 1% annually over the last five and 10 years respectively. I suspect, however, this reduction is more to do with a recent stable rising US market than a change in behaviour.

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Herd following is just one of seven behavioural traits you need to counter if you are to minimise losing money. Other important ones are:

1. Loss of aversion, which may see you hold on to losing investments too long.
2. Decision paralysis, which can lead you to staying out of markets.
3. Overconfidence perhaps about concentrating your investments and market timing.
4. Anchoring where you might keep holding an asset falling in price below what you think it’s worth.
5. Mental accounting, where you may tend to compartmentalise your money allocation and not look at it in its entirety.
6. Innumeracy, which for example makes many vulnerable to creeping inflation.

When in doubt you are probably more likely to make money doing the opposite of what the market is doing – for instance taking profits in recent months when the market was rising, and buying now after our fair weather foreign investor friends desert.

I would be very cautious making big shifts in asset allocation to counter over-confidence. Moving entirely in and out of shares is likely to be dangerous to your long-term wealth. Accordingly, your investment policy should put tolerances of at most /- 30% of the target percent of your equity mix (for instance, if the target is 50% then don’t trust yourself to reduce this below 35% and above 65%). Most studies show that keeping this tighter through rebalancing leaves you better off.

While the biggest risk of market timing is mispricing, frequent buying and selling also incurs costs and taxes. There is no rule that says the more active you invest the better the return you deserve. Transaction costs add up, as do professional fees. Demand that your investment returns are benchmarked so along with other value-adding services you can also estimate your return-on-fees (ROF).

Physician turned investment writer William Bernstein was fond of reminding us: “The biggest obstacle to your investment success is staring out at you from your mirror”.

Stop searching for Sugar Man

Many investors are in a lifetime search for an investment guru. I’m sorry to tell you there aren’t any (or many), and if there are they don’t need to know you – other than perhaps to have you serve them Pina Coladas by the pool. Ironically the more desperate someone is to have you invest with them, the more you need to run away from them and their possible scam.

Numerous studies reinforce how very hard it is for active managers to outperform and for forecasters to forecast. For those who do (and don’t), often it’s to do with their strategic style of investing having its time (or not) – like when value investing beats growth, and when defensive or high-yield companies are in demand. Asset managers need not be avoided. Sometimes you need them to access an asset class you can’t get to, or when you want to invest differently than the index – say for small company and bond investing.

Before I put myself and an industry out of a job, there are plenty of ways an experienced professional adviser can add value. A good co-pilot/navigator can educate and help you develop a highly personalised risk-managed investment approach and help you stick to it or adapt it when needed. They can also let you focus on what you are good at, like earning more money in your career, or enjoying things like traveling overseas or spending time with family. 

Never forget debt is a four letter word

Many investment failures, personal bankruptcies and now sovereign problems have debt as a root cause. Not all debt is alike – some suggest deductible debt for investing is productive “good debt” and debt to buy lifestyle assets like a home is “bad debt”. Relatively speaking I agree and also I would consider debt used for consumption and any left on your credit card as “very bad debt”. However, even good debt can be bad if you have too much of it. Generally I worry if a family’s debt-to-assets ratio is more than a one-third, and when debt is more than three times income – in those cases focusing on debt reduction may take priority over investing.

When you or your investment fund borrows to invest, you need two things to happen: (i) The asset price grows faster than your interest, and (ii) you can sell your asset before the lender demands its money back. Earlier problems with listed property trusts in Australia illustrate this doesn’t always happen. Easy access to debt fed a bubble in property prices, which when pricked saw amplified collapses in the net value of property assets. Confirming the adage “a banker is someone who lends you an umbrella only when the sun is shining”, trusts found it difficult to roll over their debt as asset value promises were broken. Unlisted funds closed their doors locking up investors’ money, and both they and listed funds had to raise capital at the worst time to pay down debt.

Never being a forced seller is important to avoid wealth destruction – debt can force your hand.

Avoid contracting “Affluenza”

High income doesn’t translate into high wealth – it only gives you the potential to create it through diligent saving and investing. Many suffer from Affluenza – “a painful, contagious, socially transmitted condition of overload, debt, anxiety and waste resulting from the dogged pursuit of more”.

Since 2007 I have been helping Australians anonymously analyse and compare their wealth and have found many people’s net worth can be estimated based on how long they have been working and what they have been earning, according to:

Expected Net Worth equals one-quarter of (Age minus 20) times (Annual Income ).

In many cases, if your wealth is above or below this, then you have been efficient or inefficient building wealth for your age and income. Some of the factors that I have found that drive wealth inefficiency are:

• Being a self-diagnosed “big spender” (at least 10% worse off than a “smart spender”).
• Having no investment focus.
• Not having been actively investing as long as others your age.
• Living in a capital city where costs are higher (though most earn more to compensate).
• Being single and not being in a partnership to share expenses, or having had a divorce.

Stop thinking you’re immortal

While the world’s oldest man Jiroemon Kimura gave it a real good go, passing away last week at the age of 116, to the best of my knowledge no one lives forever. So dying is not a risk, it’s a certainty. In the wealth management context, your risk is dying or becoming ill before making work optional (after that your financial risk swaps to living too long).

Dying before completing your family’s wealth building journey is a risk most should offload to a life insurance company. In Australia we have an under-insurance problem with death and permanent disability protection, and an un-insurance problem with income protection insurance. What I mean is that many have basic death cover, just not enough of it, which devastates hundreds or thousands of families every year. In the latter case not enough people insure their income and let the ill health lottery permanently derail their journey to financial security. There are plenty of quality insurance advisers able to help you fix this and now DIY solutions including Australia’s first automatic online advice service.

Inefficient transfer of wealth costs Australians billions of dollars overly enriching the Tax Office and dispute lawyers. As discussed recently in Tackling investment dementia head-on, you need a plan in case you lose capacity before you lose your life. Most need a wealth succession plan, not just a will, which considers the different ways you own assets – in your name, jointly, as tenants in common, in public super or in a SMSF, from insurance or an annuity, in trust, or in a company.

Unfortunately it is far easier to lose money than make it. Hopefully you can avoid learning from experience.

Dr Doug Turek is Principal Advisor of family wealth advisory and money management firm Professional Wealth [www.professionalwealth.com.au].