Physicians News Health news for doctors and patients.
By Scott Keffer
Time is running out, Dr. James “Bud” Young thought, how did I ever get myself into this? His thoughts raced back to his conversation with Franklin five years before.
“You aren’t a racehorse just because you can outrun a cow!” Dr. Franklin J. Wise, III has said. For Franklin, being the III, whose dad and granddad were both physicians, wasn’t easy. Growing up, he sometimes resented the pressure – the pressure to carry on the tradition, to walk in “their” footsteps. He wanted to walk in his own footsteps, to determine his own destiny. In the end, tradition prevailed and he followed the well worn family path. Truth is, he actually enjoyed the path more than he ever let his dad know. Now, in his retirement, he was even prouder of his heritage. He wished he could tell his dad and granddad how much he admired their success – and how much he didn’t mind being called Franklin anymore.
“Bud” Young, ten years younger than Wise and still operating his practice, was still struggling with his resentment and his desire to forge his own path.
“What does that mean – I’m not a racehorse?” Young responded sharply.
“You’ve been bragging about how well a few of your investments have done,” answered Wise. “Here’s my point: your investments have done well compared to what? What are you comparing your returns to – a cow? Everyone has done well. Also, you only brag about the returns of a few of your investments. How has your entire portfolio fared?”
“I hate when you ask me two questions at once,” Young responded. “I guess I keep an eye on the S&P 500, but I don’t directly compare each investment. And I don’t know how my entire portfolio has fared; it’s all over the place. Nobody is really tracking the return on my entire portfolio.”
“I guarantee you have what my kids used to get: selective amnesia. You remember the winners and forget the losers,” Wise continued. “Without comprehensive reporting and benchmarking, it’s impossible to know if your strategy is working. That’s like playing a football game and bragging about particular plays without paying attention to the score. You can lead in some statistics and still lose the game. Are you winning the investment game?”
Young didn’t even want to answer. The problem was – he didn’t know the answer!
Wise continued without waiting for an answer from Young. “Young, you still believe that by picking the right securities or timing the market, you can achieve superior returns. It just doesn’t work.”
“How do you know?” Young questioned.
“I’ve seen the research.” Wise went on. “In 1986, a prestigious pension consulting firm released an astounding research report. The report sent shockwaves throughout the investment world. The report analyzed the three primary investment strategies that determine portfolio performance. The first two are what you believe in: market timing and security selection. The third is multi-asset class allocation. The first two combined accounted for less than 10 percent of portfolio performance. Multi-asset class allocation was the strategy which accounted for over 90 percent of the portfolio performance.”
“Who came up with this idea and why aren’t more people using this multi-asset class strategy?” Young challenged.
Wise replied, “Here’s some history. Harry Markovitz sought to create a method or system that would allow an investor to earn a particular return with the least amount of risk. He first published the theoretical foundation for his system some 45 years ago. The scientific system he pioneered came to be known as Modern Portfolio Theory. It is accepted worldwide as the authoritative blueprint for prudent investing.”
Young reiterated, “Sooo, why aren’t more people aren’t using his system?”
“Modern Portfolio Theory is popular among institutional investors. It is not very well known by the general public.” Wise said.
“Because…?” Young queried.
Wise continued, “Brokers are taught that they or some expert can ‘out-pick’ or ‘out-time’ the market. Wall Street firms spend billions of dollars annually trying to ‘out-pick’ or ‘out-time’ the market, or at least trying to convince you that they can – or worse, that you can. A recent Vanguard study found that over 85 percent of the equity mutual funds studied did not beat their market index, the S&P 500 Index. They didn’t even beat their market benchmark.”
“Franklin, aren’t you just talking about diversification?” Young asked.
“No!” Wise answered emphatically. “Harry Markovitz, who in 1990 won the Nobel Prize in economics for his work, taught about two kinds of diversification: ineffective diversification and effective diversification. My grandmother practiced ineffective diversification, or what I call ‘horse and cart diversification.’ For her, diversification meant owning not just IBM, but also Coke and GM and Abbott Labs, etc. When one of these moves, the others in the same asset class tend to move in the same direction. As I said, horse and cart diversification. By combining asset classes that move more opposite to one another, like a teeter totter, then the risk of the total portfolio is less than the average risk of all the asset classes. If you have two portfolios with the same average return, the one with less volatility – or risk – will have a greater compound return. Most people believe that diversification reduces returns – it is really the other way around. Effective diversification enhances portfolio returns.”
“However, you need a specialist to help you. First, they will help you design the appropriate mix of asset classes – just like they did for me.” Wise instructed. “Different mixes produce different expected returns and different risk levels. Harry Markovitz found that for every given level of risk there was an ‘ideal’ portfolio – in other words, that combination of asset classes that would produce the highest possible return. When he plotted out each optimal portfolio on a graph, the result was a curved line called an efficient frontier. The concept is to pick an asset class mix that falls on this efficient frontier, designed to achieve the highest possible return for your given level of risk.”
Wise continued, “Then, the specialist will hire managers for you who specialize in each asset class and they will benchmark their performance to ensure that they are beating the market over time. If a manager does not beat the market, the specialist will fire them and hire another manager who specializes in that asset class. Once your strategy has been put in place, they should provide you a comprehensive report that allows you to view each manager against the appropriate benchmark and the return, after all costs, of the entire portfolio as well. Your specialist should also rebalance your portfolio at regular intervals to ensure that the original asset class mix is maintained over time.”
Young was beginning to understand the strategy, but truthfully he liked the thought that he could “out-pick” or “out-time” the market. He loved “swinging for the long ball,” but he knew that like most, more often than not, he struck out. Up until now, he never really kept track of the winners and losers.
He makes sense, Young thought, and he has the empirical data to back it up. But he couldn’t let Wise know – his pride was at stake. Young fancied himself an astute investor. So he couldn’t help himself when he challenged Wise and his multi-asset class strategy to a bet – for five years – to see whose strategy really worked.
And now, five years later, his time was up – they were to meet and compare results. I couldn’t have picked a worse time to make the challenge, Young thought. The market had been awful and his portfolio was way down. Wise had been showing him his comprehensive reports all along, so Young knew that Wise’s managers had been meeting the market indexes. And Young knew that Wise had lost very little by following Markovitz’s strategy and benchmarking his managers. Young also knew what Wise would say when they compared results, “Hire a specialist today to help you design and manage a multi-asset class investment strategy.”
I hate it when Wise is right, Young thought, the investment losses hurt and being wrong hurts. Worse then that, I’m going to have to face Wise and hear him say, yet again, “You are not a race horse just because you can outrun a cow!”
Scott Keffer is president and founder of Wealth Transfer Solutions, Inc., a legacy planning company in Pittsburgh
