August 2005
The process of investing is simply about making choices. Unfortunately, the investment industry has muddled that simplicity a bit. Common sense would tell you that every investor has a rather straight forward question to ask themselves, "Do I keep my money in cash or is there a better place to put it to work."
If they can't answer it with a reasonable level of confidence, then deciding to just keep it in cash makes good sense. In other words, every new investment opportunity and for that matter, any existing investment holding, should be put to that test. Amazingly, that is often not the way it works in the investment industry.
Instead, investors consistently put themselves between a rock and hard place. For a number reasons they tend to force themselves to choose between two relatively unattractive alternatives. For example, it isn't at all uncommon to hear an investment manager say, "So, now that we've decided to sell our holding in Home Depot, let's invest the proceeds in Lowe's."
It always strikes me as odd that of the thousands of other possible investments they could make, they choose to reinvest the money in a look-a-like investment. That kind of thinking may work out well at times, but it appears to be mental shortcut in the analytical process.
The history of how a good portion of the investment industry evolved this way may shed some light on the subject. More and more, financial advisers and planners choose to outsource the day-to-day investment management process to other professionals. They may choose to put their clients' money into mutual funds, separate accounts or even hedge funds. Clearly, mutual funds are the biggest home for the outsourced management duties.
Not all, but many advisors increasingly see themselves as mainly needing to make the decision of how much of their clients' money should be exposed to the stock market or how much should be in the bond market. In the industry lingo, this is the asset allocation decision.
Once that task is complete, the details of which particular stocks or bonds to actually own becomes the responsibility of the outsourced investment managers. In essence, the advisor/planner runs the big picture stuff and the investment manager does the singular job of investing the money.
For example, a typical portfolio of mutual funds might result in 30% of the money in funds that own the biggest companies around, 15% in funds focused on international stocks and 15% invested in a smattering of funds that specialize in choosing smaller companies. And to complete the targeted asset allocation, the portfolio might hold a mix of bond mutual funds.
With this, the adviser/planner has done his part and the outsourced mutual fund managers' task is to fully invest the money in their particular segment of the market - no matter what and often regardless of price. Their benchmark is the market's return.
When portfolio managers decide to sell a really overpriced stock and then immediately reinvest in a somewhat overpriced one, they are just doing their job. Their world largely revolves around the index they're measured against.
Success to them may literally mean that they've lost less than their benchmark. And failure is making less than their index's return. Clearly, this risk/reward trade-off is a bit upside down. In a very real way, they are often choosing to preserve their jobs rather than your money.
Commonly, the big picture decision of not being invested is instead left to the financial adviser or planner in charge. My big worry is that many advisers/planners firmly preach the concepts of "investing for the long haul" and that "you can't time the market". Naturally, they may not be inclined to change your asset allocation much once it's set up.
This begs the question, if your adviser isn't likely to make changes along the way and, at the same time, the outsourced portfolio manager has little incentive to do so, then who exactly is left managing your money?
My opinion is that a segment of the investment industry is playing a game of pass-the-buck. The problem is it's your buck they're passing - take the time to understand how it all works.
Jason P. Tank, CFA
jason@frontstreet.com