Cooking and investing: What could they possibly have in common? As it turns out, quite a bit. Just as too many cooks can spoil the broth, too many investment advisers can spoil your investment returns. In fact, your “investment soup” tastes best when it comes from the kitchen of one investment adviser.
When I meet with individual investors or potential investors, I am amazed at the number of individuals who use or believe in using multiple investment advisers. These folks are of the perception that more than one investment adviser translates to a safer, more diversified portfolio. With many things in life, perception often differs from reality, and this thinking certainly holds true in investing. While it may look attractive, using multiple advisers does not guarantee a safer, more diverse portfolio.
Initially, using multiple investment advisers seems appealing; however, it creates problems — namely “diworsification,” a failure to gain the benefit of diversification, the exact opposite of what the investor wants.
In the investing world, it is commonly accepted that risk and reward travel in the same direction; however, proper diversification can go a long way to reducing risk without sacrificing return – the holy grail of investing. Dr. Harry Markowitz won the 1990 Nobel Prize in Economics for his work in Modern Portfolio Theory, which proved investors could reduce risk without reducing return by properly diversifying their investments. According to Markowitz, “The only free lunch is diversification.” Markowitz’s seminal work, now nearly 30 years old, has stood the test of time and remains the gold standard for portfolio construction. Investors do not need two investment advisers to reap the benefits of Markowitz’s research.
Because the value of holdings in a portfolio tends to change over time, a key ingredient to making diversification work is rebalancing. Rebalancing involves buying and selling certain asset classes to ensure a portfolio is in line with its original percentages, preserving the full advantages of diversification.
Advisers are not in complete agreement on methods for rebalancing. Some use time as the basis for rebalancing, i.e. once per year, while others rebalance based on stated percentages. Employing more than one adviser pretty much guarantees your rebalancing process will not be synchronized, thus defeating the benefits of diversification. Remember, when investing, it is all about diversification. Diversification, diversification, diversification.
Diworsification and Inefficiencies
1. Investors have only so much money to invest. Using two or more investment advisers limits the amount of money that can be spread around for investment in the requisite asset classes and among different money managers. For example, mutual funds and separately managed accounts have minimum investment levels. When investors divide their money among several advisers, they may not have enough money to reach the stated minimums of top-rated mutual funds or separately managed accounts. As a result, the investor does not “max out” on the money being invested in essential asset classes and/or top-rated money managers. This “limitation effect” can produce long-term negative results.
2. Employing two or more investment advisers increases the likelihood of investors owning more than the intended amount of the same mutual funds, ETFs and stocks. Instead of a diversified portfolio, the investor has a portfolio of unintended concentrated bets, a classic case of “diworsification.”
3. Most investment advisers charge a fee based on assets managed. These fees decrease as assets increase. Mutual funds have various share classes. With a bigger investment, the investor gains access to a lower-fee share class. Higher fees create inefficiency and sub-optimization for the investor, reducing portfolio returns. In contrast, using one investment adviser gives the investor leverage over costs, ultimately increasing portfolio returns.
4. Investors should meet with their investment adviser at least once per year and if possible, twice per year. With multiple investment advisors, the investor’s oversight time is at least doubled. Not only is this a time drain but also a brain drain caused by information overload – two of everything to read and review…and the formats of the reports will be different.
The institutional model
When seeking an investment adviser, individual investors would be well served to follow the institutional investors’ model. Pension plans and endowments, known as institutional investors, typically hire only one investment adviser. Institutional investors hire advisers to: 1) advise on asset allocation, 2) research, select and monitor funds and portfolio managers within each category of the asset allocation, 3) calculate and report investment performance, 4) rebalance the asset allocation as needed, and 5) provide market commentary. This process is exactly what individual investors should do too.
Hiring the one right investment adviser
How do investors hire the right investment adviser? Ask the right questions! Here is a list of questions that will help investors search for and hire “the one” right investment adviser:
— How many years of investment experience does the investment adviser have? When it comes to investing, there is no substitute for experience.
— What specific investment experience does the investment adviser have? Is it retail or institutional? And with what size of accounts?
— What are the adviser’s investment certifications/designations? There are planning certifications, and then there are investment certifications; there is a difference. Ask the investment adviser to describe and explain his/her certification(s).
— Which asset classes does the adviser’s experience include? Stocks, bonds, funds, ETFs, international, domestic, private equity and alternative investments?
— What is the adviser’s practice like? Ask the adviser to describe his/her practice.
— Can the adviser provide a track record of performance? If so, make sure it contains accounts similar to your return and risk objectives.
— Does the adviser issue an investment report? How often is the report provided? The report should contain an investment commentary and performance update. Who writes the investment commentary? Who calculates your investment performance? It should be an independent party. Is the report succinct, and do you, the investor, understand it? Ask for a sample report to make sure you understand the report you will eventually receive.
— How often can you meet with the adviser?
— What are the adviser’s fees and when and how are they billed?
Individual investors, like institutional investors, don’t need to employ multiple investment advisers. Investors should hire, trust and garner the benefits of the right investment adviser. Those benefits are a diversified, optimal and efficient portfolio.
You need only one investment adviser to make your investment broth taste good.
(Article written by Terry Savage)