Counterpoint — A Commentary of Jurika, Mills & Keifer LLC
September 2009

Wealth Mismanagement

Karl Mills, CFA

Over the past year, many people have come to us for advice with beautiful financial plans and devastated portfolios.

Cartoon

The plans were prepared at considerable expense and contained colorful pie charts, Efficient Frontier analysis, Monte Carlo simulations and rosy projections compounded far into the future.

A number of critical assumptions upon which these plans were based proved faulty.

The current financial crisis has turned a lot of conventional beliefs about investing upside down. It has also exposed serious flaws and shortcomings in the “wealth management” industry and in the quality of financial advice it offers to investors.

Questionable Assumptions

Part of the problem is that the assumptions upon which a lot of financial advice is based presume that markets are efficient, investors are rational, and that one can reliably forecast the future by extrapolating the past.

Economic and market history suggests otherwise. It is a history of major boom and bust cycles; periods of expansion, prosperity, recession, depression and war; of unexpected shocks, ever-changing conditions, and the frequent and often catastrophic misallocation of capital along the way.

At the root of all this dysfunction is the eternal human struggle between fear and greed. Markets may be efficient but investors most certainly are not.
Investors are human and have a propensity to do the wrong thing at the wrong time, investing by looking in the rear-view mirror rather than anticipating the road ahead.

The future almost always unfolds differently from expectation. “Perfect storms” are supposedly rare, but seem to happen frequently. One needs to plan accordingly.

Moreover, conventional notions about risk, volatility, and diversification need to be reexamined. Actual risk is often inversely proportional to perceived risk and volatility. For example, volatility was low in the summer of 2007, while the actual risks in the system were very high. Conversely, in March of this year, when volatility was high and the perception of risk was great, it was also a great time to be investing. Finally, diversification does not always guarantee safety. When things fall apart, most asset classes become highly correlated and fall apart together.

The next 10 -20 years are unlikely to resemble the past. They will likely involve enormous change and challenge. Those factors that were tailwinds, such as declining interest, inflation and savings rates, are likely to become headwinds. The convention of “buy and hold” (or hope) needs to give way to a more active and dynamic approach to asset allocation and investment management. Investing on autopilot is not a good strategy.

Problematic Motivations

A second part of the problem is motivation. While there are many good financial advisors, there is a very real tendency for the motivation and culture of a “wealth management” firm to change with growth, size and success. When this happens, investor interests can be subordinated to firm interests. It is something to watch out for.

All firms want and need to grow, and investors should want to make sure that their advisory firms are stable and successful. However, bigger is not always better.
There is a point in the evolution of a firm when its focus can change from asset management to asset gathering, when clients become “accounts,” when advice becomes a “product,” and new products are offered based on what is “hot” and can be sold, rather than what has lasting investment value and merit.

And so it was that two years ago, at the peak of the credit bubble, many of Wall Street’s finest firms were selling their best clients a toxic smorgasbord of mortgage pools, private equity partnerships, and hedge funds, at the very time they should have been steering them clear of these investments. These investment products tend to generate high fees for the firms that sell them, but too often generate low returns for those who buy them.

An environment where firms look to their clients, first and foremost, as revenue sources, where the prime directive is to sell more stuff to more clients at higher margins, is one where client interests are at odds with those of the firm.

What’s an investor to do?

As investors look to the future, large changes are afoot. We anticipate a long, winding and bumpy road. Good defensive driving skills are in order. It is therefore critical that investors take a more active role in their asset allocation and investment selection, making more frequent adjustments in response to changing conditions.

It is also important that investors seek advice from qualified financial professionals who have the experience and perspective to steer their clients along this road, and whose interests are closely aligned with their own. Favor substance over style.
Finally, the life-blood and success of a great advisory firm is the combination of its people, its clients and its culture. It is possible but difficult to maintain culture as a firm grows. Great firms grow from the ground up and cannot be easily cobbled together through mergers and acquisitions. Many of the most successful firms close their doors to new clients before they reach a size beyond which they can no longer preserve the quality of their service to existing clients. Sometimes, less is more.

Jurika, Mills & Keifer, LLC
September, 2009

Important Disclosures

Opinions expressed are those of Jurika, Mills & Keifer, LLC, and are subject to change.

Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

This communication is neither an offer to sell nor the solicitation of an offer to buy a security or advisory services, which can only be made by the appropriate offering document.