November 24, 2022
Robin Powell

Portfolio size makes no difference

As with all industries, participants in the investment industry look to sell themselves, by advertising their own ‘secret formula’. Yet, given the complexity of financial markets and economics, these participants can use ‘poetic license’ more than most. For the lay person, markets can be confounding, and so it is often difficult to challenge bold corporate claims or predictions in the moment. The people are smart, the brochures are glossy – and yet so often the claims fall short.

Nowhere is this more evident than at the ritzy end of town, where private banks and up-market brokers, endlessly chase the investment dollar of Australia’s wealthy families. In so doing they make bold claims about their “exclusive products” and privileged access to global teams of analysts and researchers.

But just because you are wealthy enough to get into this Club, doesn’t mean you necessarily should.

While these (often in-house) products almost always provide a better return per dollar for the business selling them, the investor’s return is often lower than could be achieved from low-cost, mainstream investments. Likewise, evidence suggests the efficacy of their investment research and predictions has historically been poor.

The paradox here is that often the most widely accessible, and least exclusive investments are the best. Think of stocks like Apple or Amazon. These are among the most accessible and least exclusive investments around – anyone can open a CommSec account and press ‘buy’ – and yet the ten-year returns of these tech giants have been phenomenal. Or better still, you could buy these stocks, along with hundreds of others, by purchasing a low-cost ETF or managed fund.

So, do wealthy investors really need to go to the ‘exclusive’ big end of town to get access to investments? Are wealthy people’s investment needs really any different to the rest of us?

It might just be that ‘good independent advice’ is what’s required… Financial journalist Robin Powell explores in this edition of Insights.

I am sometimes contacted by very wealthy people who’ve read my blog (TEBI – The Evidence Based Investor), asking to be put in touch with an adviser who can help them. My response is always the same: I’m happy to do so, but the size of their investable assets doesn’t make the slightest difference to who I recommend. I only refer readers to firms who advocate long-term investing, global diversification, and a low-cost, systematic portfolio approach.

I avoid recommending firms or advisers who claim to have special skills for predicting where markets may go in the short-term, or see a key part of their value as providing clients with access to exclusive investment products, initial public offerings or nefarious research.

That’s right: the most suitable investment products for the very wealthy are virtually the same as those for the average man or women on the street. To quote the legendary investor Warren Buffett, “both large and small investors should stick with low-cost index funds.”

Buffett wrote those words in his 2016 letter to Berkshire Hathaway shareholders. That letter, I suggest, is essential reading for high-net-worth and ultra-high-net-worth investors.

A lesson in human behaviour

“Over the years,” Buffett writes at the bottom of Page 24, “I’m often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behaviour.

“My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion.

“I believe, however, that none of the mega-rich individuals… has followed that same advice when I’ve given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager.”

How, then, does Warren Buffett explain the reluctance of very rich people to follow his advice?

“The wealthy,” he writes, “are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket, you name it. Their money, they feel, should buy them something superior compared to what the masses receive.

“In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial ‘elites’ have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars.”

Effort and intelligence make little difference

Though I broadly agree with the point that Buffett is making, I personally think he’s being a little harsh. I have another suggestion as to why the very wealthy often overlook index funds in favour of more “sophisticated” investments like hedge funds, and structured products. The rich have often earned their wealth Buffett by working very hard and being exceptionally good at what they do. They assume, therefore, that if only they can find someone as good as they are in the field of investing, they can make their money grow even faster.

The problem, of course, as we’ve explained on this blog many times, is that investing doesn’t work like that. How smart your investment manager is, or how hard they work, is more or less irrelevant. Consistently beating the market in the long run is extremely hard to do. You really are better off capturing the market return as cheaply and efficiently as possible.

Of course, it’s perfectly possible that you could find, say, a hedge fund manager who goes on to become a star investor. Or you could identify, in advance, the next Apple or Google. But the odds are heavily stacked against you.

Remember as well that trying to outperform through active management comes at a significant cost. “My calculation,” Buffett wrote in that 2016 letter, “is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade.”

Familiarise yourself with basic academic finance

My own advice for very wealthy investors is to invest some time in reading some academic finance. You don’t need to go into it in huge detail; just familiarise yourself with the most important findings. What does the peer-reviewed evidence tell us about the challenge of timing the stock market? Or the chances of identifying outperforming fund managers ahead of time? What does it say about the importance of diversification? Or the need to stay disciplined and tune out market noise?

Once you’ve done that, choose a financial adviser with an evidence-based investment philosophy. And yes, that means one adviser to look after all of your investable wealth. Having multiple advisers managing your money only results in what we call “false diversification”; you’ll end up largely owning the same securities through different investment houses, which is far more costly, and riskier, than a centralised approach.

Can investors control the way they behave?

The investor’s worst enemy, it’s been said, is likely to be himself. Regardless of whether they invest actively or passively, investors often harm their portfolios through the way they behave.

November 24, 2022