I have a broad set of interests, and one of those interests is financial management. I recently (re)read The CFA Institute Text Wealth Management and learned a few new things.
1. Wealth management is not synonymous with wealth growth. Building wealth involves taking risks and having an end goal of increasing monetary value. Wealth management is building a portfolio that focuses on real world returns after taxes. It is about managing money in a way that leads to maintaining quality of life in retirement.
2. In order to achieve this objective, wealth management focuses on optimized asset allocation and modern portfolio theory. This theory stipulates that clients want maximum returns for the lowest level of risk on the efficient frontier. The Optimizer used will determine what that allocation is across the different asset classes (domestic and international stocks and bonds of different company sizes, growth vs. value stocks, real estate, etc)
3. Developing a strategy takes time and the cornerstone is understanding the client and their needs. There is not a one size fits all strategy and each person has unique risk tolerances that need to be considered.
4. Have a 5 year plan of cash flows in a safe haven. This allows clients to sleep at night and provides the cash necessary to meet short term goals without being worried about what the market is doing. A dip in the market will not affect this cash.
5. Markets will go up and down, plan accordingly. Being diversified will decrease the overall exposure, but when the market is down the portfolio is affected.
6. Having diversification can be achieved with relatively few stocks. 10-12 stocks in different sectors and classes can actually diversify the entire portfolio. The weightings of these stocks make a difference, though.
7. The choice to use active or passive funds is not an easy one. Research has not definitively closed the argument on what is better. When deciding, factor in manager success, asset turnover, and fees. If the fees and the risk the manager take do not offset the alpha in the actively managed fund, stick with passive.
8. Along this line, there is no rule that the advisor cannot use both. The strategy can, and often should, have money in different tax efficient accounts, different classes and different funds. Having a core asset allocation can be augmented with smaller satellite funds to target specific sectors to enhance growth.
9. Growth and value funds change in their success over time. Value has greater upside potential over the long term, but both can be used in the construction of a portfolio.
10. One of the real risks that needs consideration is that clients will outlive their portfolio. The past rule of thumb is that clients decrease their spending as they age, but that may no longer be the case. Many clients are living longer and have need of more money well into their retirement to enjoy travel, trips and the pursuit of the hobbies.
11. The other rule of thumb that the older the client is the less they should have in stocks means that they are losing the potential to make money through capital gains. Optimizing the portfolio should include stocks in order for clients to maintain their standard of living. Many bonds are not delivering enough return to fund retirement and clients need exposure to the market for additional capital requirements.
Reading this text helps to understand the process of wealth management, and to a smaller extent, wealth accumulation. Knowing how advisors make decisions helps understand the process so that when you deal with your own finances, you are more informed. Wealth advisors should be chosen who understand the principles and work for their clients, not themselves.
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