If you’ve been following our blog for any length of time, you may have noticed a central theme: For managing your life and legacy wealth, it’s important to differentiate between investing in the market’s expected long-term growth, versus betting on its random, short-term outcomes. Amidst the recent MF Global collapse, it seems like a good time to revisit this theme, lest you be buried in the avalanche of sensational news; ever-present in the popular press and ever-tempting investors to fall prey to a short-term financial mindset.
Bottom line, it’s risky to speculate on the random outcomes of short-term market events. Whether you’re as mighty as MF Global or as modest as an individual investor diligently saving for retirement, you’re taking a gamble when you stray from a broadly diversified portfolio to take concentrated positions in allegedly promising corners of the market. The “dotcom,” technology bubble of the 1990s, the real estate bubble that busted in 2008, financial stocks from the subprime era, the Dutch tulip mania of the 1600s … regardless of the bubble and its era, overexposure to a security, sector, or asset class can be hazardous to your wealth.
When you add leverage (borrowing money to invest more money than you actually own), the hazards are compounded, often dramatically. This is what occurred during the financial crisis when firms like Bear Stearns, Lehman Brothers, and others borrowed money to invest in subprime securities. It’s also what appears to have happened at MF Global, when they decided to take a $6.3 billion position on European government bonds using borrowed money. MF Global was not alone in speculating on Europe this year. In a third-quarter letter to his clients, hedge fund manager John Paulson apologized for losing up to 44 percent of the value of some clients’ investments so far this year (as of October 31).
So what’s the best defense against such losses? We all wish there were such thing as a risk-free scenario, but there is not. If you are invested in the two-sided coin that the market represents, you are exposed to both its expected long-term growth as well as the flip side of its temporary downturns. The more you’re invested, the greater the expected risk and reward. But, in our mind, the best way to manage the risk and plan for your personal, long-term goals is to build a broadly diversified portfolio … and stay the course with it throughout your investment lifetime. This doesn’t eliminate the short-term volatility, but it helps you avoid speculating on it, and minimizes your being harmed by it.
Charles D. Ellis is a respected long-time Wall Street observer, financial author and founder of Greenwich Associates. When prompted by a newspaper reporter for his opinion on the conventional wisdom that security selection based on painstaking analysis leads to investment success, Ellis said the truth was actually quite the opposite:
“The best way to achieve long-term success is not in stock picking and not in market timing and not even in changing portfolio strategy. … Sure, these approaches all have their current heroes and war stories, but few hero investors last for long and not all the war stories are entirely true. The great pathway to long-term success comes via sound, sustained investment policy, setting the right asset mix and holding onto it.”
Each “category” or asset class of investments will have its seasons in the sun and the shade at different times. Like a sturdy tree, the long-term investor can best expect to thrive across these seasonal cycles by adopting a patient, disciplined approach to portfolio construction, maintenance and cash-flow management. Beware of the passing squalls generated by the Jim Cramers of the world, or the local stockbroker pitching the latest low risk, high reward strategy. Have a plan, stick to the plan, and weather the storms.
In the wake of the MF Global bankruptcy, the eighth largest in American history, investigators will continue to determine the whereabouts of some $1.2 billion. Time will tell as to whether or not there was any criminal behavior involved.
This begs the question, “How do I know my money is safe from identity theft, unauthorized activity, or the unlikely event of the bankruptcy of the financial entity in which my assets are held?” One important antidote is to ensure that your assets are held in your name by a custodian who is separate and independent from your investment advisor. In our case, we use Charles Schwab as an independent custodian for our clients’ accounts. Schwab reports directly to the account holders, and offers a variety of other security measures and protections. This enables a “trust but verify” environment where clients can (and should) keep an objective eye on their money and their money manager.
Ultimately, there is no cure-all for life’s risks, financial or otherwise. The best we can do is take prudent action to prevent it when possible and manage it when we must. Whether it’s via broad diversification for your investments, or checks and balances for your trusted relationships, by spreading your risk around some, you can rest a little easier.