Adaptive Asset Allocation
An optimized portfolio must be structured in a way that allows quick response to changes in asset class risks and relationships, and the flexibility to continually adapt to market changes. To execute such an ambitious strategy, it is essential to have a strong grasp of foundational wealth management concepts, a reliable system of forecasting, and a clear understanding of the merits of individual investment methods. Adaptive Asset Allocation provides critical background information alongside a streamlined framework for improving portfolio performance.
Adaptive Asset Allocation
The Most Important Concepts in Wealth Management
Years ago, in the span of a couple weeks, we sat down with two prospective clients. Both of them were nearing retirement and wanted to make sure that they were prepared. Both were senior executives at their respective firms, had high incomes, solid benefits, and substantial investment portfolios. And most importantly, both had large holdings of their company's stock.
Both worked for Fortune 500 organizations: the first for a pharmaceutical company, the second for an energy firm. Both of them had financial backgrounds, including master's degrees in business. In other words, they were "numbers" guys. Being a senior executive in finance is an interesting role, inasmuch as it tends to instill a sense of confidence.
It was this confidence, borne of familiarity with their respective companies, that made them resistant to the idea of diversifying their substantially concentrated positions of firm stock. It certainly didn't help matters that the success of these firms was one of the primary reasons that they were both so well off. Comfortable in the idea that their levels of wealth would afford them the luxuries of a leisurely retirement, neither of them was willing to sell any of their company stock.
But, there was a problem: the pharmaceutical company was Abbott Labs and the energy firm was Enron.
After Enron's 2001 bankruptcy, the stories of destitute ex-employees covered the airwaves. We were bombarded by countless tales of heartbreak: Entire investment accounts had vanished, along with the dreams they had previously inspired. It was, in every sense, a national tragedy. It was also a cautionary tale, and in its retelling now, a teachable moment.
Despite reaching out on several occasions, we never heard from Mr. Enron again. Mr. Abbott, having internalized the reality that fate alone spared him a more tragic outcome, ultimately sold 85 percent of his company stock and diversified his portfolio with the proceeds.
Concentrated investments are but a single example of the myriad ways investors lose their financial bearings. Messrs. Abbott and Enron were laser focused on returns as the primary way of measuring success. Indeed, during their respective tenures, Abbott and Enron both outperformed the S&P 500 causing a false sense of security to set in.
Their confidence, nay, overconfidence in their firms was almost certainly exacerbated by a natural compulsion to seek out information that confirmed their positive biases. As long as one analyst in the financial or media world had something positive to say about Abbott or Enron, it was reason enough not to sell. They accepted the positive information that supported their biases while rejecting those opinions that ran contrary to what they thought they knew. And as if that wasn't enough, the lauds of peers-jealous that Messrs. Abbott and Enron's stocks were doing so well-cemented their beliefs.
That the stock was "beating the market" was all that mattered in the moment. But with the benefit of hindsight, their belief that they knew why was a complete delusion and the social pressure they were under completely inhibited their skepticism.
The sad reality is that this isn't an isolated, one-time incident. We see this happen more than we care to recount.
Even for the most sophisticated investors, there exists an unrelenting psychological urge to know whether we're succeeding or failing at this very moment . The easiest way to do this is to measure individual performance against a benchmark such as the S&P 500 or the S&P/TSX Composite Index. What few people realize, however, is that such comparisons are ultimately just distractions from what really matters. Those who judge their portfolio by its performance relative to some narrow benchmark are focusing on an issue that is largely irrelev