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hello I'm Russell Dow president of Dell Wealth Management and I like to talk to you about the fundamentals of wealth management more specifically my presentation is on how my company views the investment landscape and the challenges that investors confront I will then describe for you how we seek to overcome those challenges for our clients enabling them to have rewarding long-term investment experiences first a few comments about myself and our company Dell wealth management is a closely held family owned firm with offices in Falmouth Maine and Bradenton Florida just north of Sarasota depending on how we might view the situation I have either the good or bad fortune of coming from a family that has been especially involved with the securities markets the Dow family is now in its third generation in which we've devoted ourselves to the investment business we think it is perhaps a genetic condition it's our family's all-consuming passion my grandfather and his two brothers started their careers of stockbrokers back in the 1930s joining together is Dow investment group in 1937 during the Great Depression of all times in time they each had sons who joined them one of whom is my father Clifford Dow senior much of what I will discuss emanates from what he has taught me over the years along with myself today my father and three brothers are all active in the securities business as for my personal background I have an economics degree from Cornell University and a law degree from the University of Connecticut despite that background in my business title when asked what I do for a living perhaps the best response is that I'm a computer programmer I founded Dow Software Corporation have spent much of the past quarter-century writing software to help analyze company's financial data and manage client portfolios comprised of financial securities a uniqueness of our business is that because it has involved so many family members who have focused on the same subject for so long our collective effort has enabled us to develop a highly refined investment approach and that approach has become increasingly supported by substantial technical capabilities an asset that's critical to successful portfolio management in today's world here's what we do that wealth management assists clients and the management of their family and corporate wealth in the securities markets that is our specialty the management of securities portfolios which typically include stocks and fixed income investments our clients rely on us for advice and guidance to help protect and grow their portfolios in most instances we're responsible for most of their investable assets their faith in us is an honor and we take that responsibility most seriously our clients include individual investors and their families corporations trusts and nonprofit organizations in this period of recent financial crisis the safety of client assets is a common concern our accounts our custody with the Bank of New York's wholly owned clearing firm of Pershing with over 24 trillion in assets under custody administration Bank of New York Mellon is one of the largest and strongest banks in the world the reason that the investment approach that we advocate tends to be well-received I think has to do with the fact that Dow wealth management invest traditionally in many ways we invest as my grandfather invested while the rest of the financial world has changed its approached frequently in ways that have not benefit investors or worse have caused more harm than good as I'm sure you're well aware when we survey the landscape of the financial industry it's littered with formerly prominent investment firms and investment funds that have gone out of business that observation alone is testament that many newer investment strategies strayed badly from the lessons of history the fundamentals of sound investing simply tend not to change with time and so cannot be ignored those who have been around long enough know this implicitly it is also worth noting that the principles of good investing are universal they apply equally in Europe as in the GCC and just as much in Asia as in the United States so what I'm going to discuss does not apply only to investing in the US or rather to wherever we might place our money in a free economy the underlying principles of capitalism and unrestricted financial markets are the same wherever we may be that Wealth's investment philosophy has always been grounded in academics our approach is disciplined and reliant on fundamentals rather than any humans predictions or conjectures about what the future may hold as you will see later unlike many investment firms we don't put our faith and analysts abilities to predict the future although Dow wealth continues to evolve its investment approach and refine our capabilities we have always remained true to our roots and focused on our investment principles a well honed in rigidly implemented investment strategy that is supported by 76 years of experience and academic research using 200 years of investment data has served our family and clients well also significance being in the business of helping other investors has provided us with a unique vantage point that is not available to the typical investor specifically we've had the privilege to see in detail how many others have invested some successfully others not so fortunately it's fair to say that we've probably seen just about every investment strategy out there we hope that our in-depth and long-term family involvement with the securities markets has made us wiser investors it has at least made us more opinionated and dogmatic about what we believe are the good and bad ways to invest today I would like to share with you some of what we dowse have learned I hope that will help you become more successful investors and better stewards of your own family's wealth there are three topics that I wish to address part one the life cycle of family wealth accumulation preservation and the growth of mature wealth part two defining the investment problem the del wolf management analysis in part three the dau approach now for part one what I like to refer to as the life cycle of family wealth because of my profession people come to me after they've already accumulated sizable portfolios an observation that's probably not lost on any of us is that the ability to accumulate wealth cannot be taken for granted therefore we can assume that if we lose a substantial portion of our savings we'll simply earn it back prosperity and dynamic growth opportunities don't last forever and it can be a decade or longer before the next high growth period arrives if we're speaking of family wealth the individual responsible for creating the wealth originally may have retired or passed on consequently a focus on preservation of wealth must lie at the heart of any long term investment program it is also worth noting that the skills used by a person or corporation to amass wealth often are quite different from the skills and knowledge base that we required to ensure the preservation and further growth of those assets therefore for a long term financial security that might last through retirement or for generations in the case of wealthy families it is essential to transition successfully from a wealth accumulation phase to a new phase in which they focus on preservation and growth of mature wealth those who get it right ensure the financial security for their retirements and possibly future generations of their families those who get it badly wrong just once might never get a second chance for most investors as they prosper the goal of wealth starts to become increasingly important relative to wealth accumulation at the risk of stating the obvious growing a portfolio from 1 million dollars to 1.5 million might not greatly improve an investor's lifestyle or sense of well-being but if he happens to lose his estate and then need to go back to work he's apt to feel rather distressed much of my job then is to help educate our clients about investing giving them a perspective and how to view the financial markets to understand the challenges that they are sure to confront and how to take advantage of them rather than to be victimized by them which brings us to part two defining the investment problem my childhood state of Maine has a rich maritime history so I'm inclined to use boating analogies imagine then that we wish to sail across the ocean before we can decide on the type of boat that we're going to need we first must come to understand the winds and currents the likely severity of storms that we might experience how different boat designs might be expected to behave under different circumstances and how long the trip could take only once we have a clear picture can we then construct an appropriate vessel to take us on our journey let us assume that at present all we know is that we need a boat that will get us to our destination as quickly as possible by that it also will minimize the possibility that it will capsize and cause us to drown usually these two goals compete with one another the safest boats tend to be large with slow ocean liners while the fastest boats are small and light but less safe so we have a challenge a successful investment strategy must somehow address both the safety and performance concerns rather than compromise either in my next section let me outline for you eight aspects of the investment environment the Dell Wealth Management considers to be essential to understand in order to design an appropriate portfolio in a strategy that seems capable of getting us to our destination safely and at a good pace these are one the natural behavior of financial markets to the problem of perceived market trends three the high risk of even seemingly unlikely events for the efficient market hypothesis and the limitations it imposes on investors five a distinction between risk and volatility 6 the relationship between risk and reward 7 two types of irrecoverable portfolio loss that investors must guard against and eight the importance of the efficiency of an investment strategy so let's first start by getting an understanding of how financial markets behave the real estate and stock markets have a course been through a recent boom-and-bust cycle so that you don't feel alone let me show you a few other markets this is the behavior of the US stock market back in the 1920s and 1930s and as you can see there was an enormous rise in valuations up 467 percent followed by a precipitous decline here's how low quality stocks performed in the 1990s and early 2000s is the low quality index of the Nasdaq with a enormous rise followed by a precipitous decline you've probably heard that gold only goes up that's why I keep hearing on television here's a graph of gold prices in the early 1970s and 1980s as you can see after its decline it took 28 years before price levels reached their former high let's look at another geographic region of the world the Far East and the experience of Japan in the late 1980s and onward here is the Nikkei 225 there's been no recovery even decades later what we can see then is that large market gains followed by steep declines are not all that unusual in fact such behavior should be expected this behavior can be said to be true for all markets for all time periods and for all geographic regions of the world so the market declines recently experienced here and elsewhere are not unique and they're not a new phenomenon of our modern times rather they have been ever present since trading markets first evolved if it's not already apparent let me show you in just one other format how we understand the ever-present dangers of any financial market all is progressing well and then a suddenly exploding volcano is the best metaphor that I've been able to imagine for how many investors probably felt as they watch their portfolios come apart during the recent financial crisis these destructive volcanic eruptions will happen from time to time this is simply the unfortunate nature of the environment in which we as investors must work so as we think about how to construct a portfolio we need to be aware that regardless of the market in which we invest eventually is sure to suffer a devastating crisis let me discuss another aspect of these abrupt changes in the financial markets sometimes trends can last for exceedingly long periods of time before there's a sharp reversal it is during such periods that many investors become complacent they forget how quickly the financial weather can change and how harsh the storms can be in a sense then financial markets almost set traps for investors as memories of bad times fade many investors will subject their portfolios to increasing amounts of risk consequently when the reversal finally comes their portfolios are badly positioned to survive and therefore they lose far more wealth than what they may ever recover we might put it this way if the volcano has been quiet for decades then someone without the perspective of time might be tempted to build his house on its slopes in order to get a good view but perhaps he'll get a view he never intended what we have discussed so far is that the market storms can be severe but that the upward trends sometimes last so long that we all might be dead before the next calamity if that is the case then should we even care about the risk of an economic or market crisis especially if one doesn't seem eminent if the skies look clear maybe we should just set sail and hope for the best suppose for example we conclude that a severe recession tends to occur just once every 40 years we might be tempted to believe that this risk is remote and so disregarded however if we do the calculation an event that is expected to happen only once every 40 years means that there is a 25% chance that will happen during the next 10 years who among us would risk a one-in-four chance of being financially wiped out in the next 10 years because we are usually working with irreplaceable assets and because our clients are usually invested with a multi-generational time horizon at that wealth management we take the view that even a seemingly remote risk of an irrecoverable loss is too big for us not to try to guard against it long term investors are sure to confront a storm eventually and must be prepared so as not to get wiped out understanding how financial markets behave is an important consideration if we're going to invest in them if economic crises happen from time to time why don't we just get out of the market before it crashes if we see a storm coming just pull into a safe harbor and wait it out certainly that would seem like the prudent approach and would solve all of our foregoing concerns let me introduce you to a few guys you've might have met before this fellow says the markets going up as colleagues as real estate never goes down you can't go wrong with copper the markets about to crash get out quick and last fellow the markets going to return 30% next year these are the guys who make their living telling others what they think the markets will do next which sectors would do well and which won't unfortunately nobody has such a talent here is a simple concept with an elaborate name the efficient market hypothesis the efficient market hypothesis states that at any given time security prices fully reflect all available information this hypothesis is broadly accepted in academic circles and has been demonstrated to be valid in countless studies this simple statement has profound implications without access to inside information the current price of a security can only be assumed to be it's correct price it's impossible to know if a stock is under priced or that a stock is overpriced therefore we cannot predict if stock price is going to rise or fall in the short term we cannot predict short-term movements in their overall stock market we cannot predict changes in interest rates the inflation rate or currency exchange rates we cannot outperform the market sector in which we invest depressing isn't it we cannot do those very things which if we could do them could enable us to create enormous wealth you may be sure then that it is only regression Li that we subscribe to the efficient mark
t hypothesis so this is bad news for us in designing our investment strategy because we cannot rely on our financial advisor our neighbor or the guy we read about in the newspaper to tell us when to get out of the water their accuracy is no better than that of random chance however we're not helpless passengers on a boat we can at least select the vessel there's not just one securities market but many markets in many market sectors in which we can participate selecting an appropriate market in sector or critical decisions acceptance of the efficient market hypothesis should not be discouraging rather a big part of being successful in investing is appreciating what cannot be done so that we don't expend time money and mental energy in its pursuit or rely wrongly on our approach only to be disappointed but are the markets really efficient my colleagues and I are not oblivious to the substantial and recurring debate among investors about whether the financial markets are efficient in fact superficially there would seem to be much evidence that they're not let me comment on that for a moment let us suppose that it is possible to predict the future and that there is some investment professional some academic or some investment firms computer program that can accurately predict future market moves how then do we go about figuring out who this person or forum is or let me ask it another way if there were such a talent out there why did so many financial companies across the globe with billions of dollars at their disposal to find such a person go belly-up if these companies could not identify such a person and why should we expect to have any better luck if you watch the media carefully the people who are considered to be market gurus change every few years they have a bad habit of being badly wrong eventually so please forgive me I've grown weary of people in my profession who claim to know far more than they really do successful investing must begin with a good sense of humility I don't do my clients or myself any good by relying on claimed talents that just don't exist now consider our view over the world first we know that devastating market reversals happen from time to time second we cannot even rely on the ability of our advisor to tell us when to get out of the water before a storm that is a troubling and dire prospect so what does that tell us about designing and building our boat it tells us that we had better make it rugged enough to withstand even the rarest of severe storms because sure enough if we're investing for decades to come in time we're going to run across some very bad weather and if our portfolio capsizes the family fortune likely will be forever lost because they're rarely ever rebuilt there are two additional concepts that we think are important to understand when working within the financial markets these are the concepts of risk versus volatility and risk and reward economists have their own definition for risk but for our purposes my company defines it simply as follows risk is the potential for incurring a permanent loss suppose that I invest a million dollars into a speculative hedge fund shortly thereafter the fund goes bankrupt and I get wiped out I'll probably conclude that I had incurred considerable risk volatility on the other hand is a cause for temporary loss suppose that I invest a million dollars into a portfolio of blue chip stocks which then declines in value to 700,000 but a few years later it's worth two million I'll probably conclude that the initial decline was simple volatility and that my risk of an irrecoverable loss was small when investing in Dell wealth management view we hope to minimize risk while being willing to endure a volatility such investors seem apt to reap considerable rewards while not losing sleep that they might lose everything in during market vault is not desirable or Pleasant however in theory capitalism must pay greater returns to such investors or no one would ever expose this capital to such fluctuations in value another boudin analogy might help to clarify the difference between how we perceive risk and volatility and our desire to cross the Atlantic Ocean suppose that we have the choice between two vessels we can take a speedboat or we can travel by ocean liner if the seas are calm the speedboat will get us to the shores of the UK in a few days but if there is a storm we'll all drown on the other hand if we take an ocean liner our travel will be slower but the storm will only cause us motion sickness we're relatively assured that we'll reach our destination those who travel by speedboat expose themselves to risk those who travel by ocean liner expose themselves to volatility most investors can usually find temporary volatility to be acceptable the risk of permanent loss is obviously not you probably have all heard that risk equals reward in other words if we want a higher return on our investments then we must take greater risk this has become the expectation of many investors the implication is that if we risk our money we deserve higher compensation and we'll eventually get it at thou we consider that view to be nonsense if that were the case the no one would ever put his money in anything but risky investments since they would in fact not be risky there seems to be a sentiment that risk can be adequately addressed by broad diversification in other words we might own a large number of risky investments in this manner even if a number of them suffer irreversible losses the others might be prospering giving us an overall positive experience this is Dow Wealth Management spew on risk and reward high-risk generates high returns for some investors sometimes or to put it another way sometimes all high-risk investments collapse at the same time so that diversification among them does not do any good so let us remember high risk does not guarantee high returns when we think about wealth preservation we need to be aware that there are two ways that we can suffer irrecoverable losses the first is the loss of our principle as previously stated if we invest a million dollars in a fund and it goes bankrupt there is no hope of recovery the second is the loss of our principles purchasing power due to inflation suppose that an investor places a million dollars in a safe deposit box our investor might believe that he can sleep well at night he's assured that his money is secured and available to him whenever he wants it we say however that although the investors principle is safe he has merely taken on a new kind of risk in fact he probably shouldn't sleep well at all the great risk borne by the investor is the safety of his purchasing power today's dollar euro pound or other currency surely will not be as valuable ten years from now because of inflation they won't be as valuable even one year from now using constant dollars at a 3% inflation rate the purchasing power of a million dollars erodes to 740 thousand dollars in ten years a 26 percent loss of purchasing power at a ten percent inflation rate in just a decade a million dollars would be worthless three hundred fifty thousand dollars in today's currency what have we accomplished then if we succeed in protecting our principal but after a few years it buys much less than it does today moderate inflation is always a problem that we have to guard against from time to time countries experience what is known as hyperinflation when the inflation rate exceeds fifty percent annually that kind of event can wipe out a fortune literally overnight if one is not protected against it so I want to dispel the notion that paper money is safe here is a list of countries that have experienced hyperinflation historically globally even this worst of the worst is not exactly uncommon during the recent financial crisis many investors fled to cash thinking it would afford them good protection against loss in many instances they could be in for a surprise ultimately cash is only income paper or an entry on a computer screen government's routinely devalue their currencies and sometimes they devalue them quickly some examples a 1 million mark note from Germany 1924 a 10 million Pengo note from Hungary 1945 a hundred dinara note from Bosnia in 1992 the value to 1/10 of 1% when the government stamp three more zeros on them Yugoslavia issued a 500 billion dinar note in 1993 not to be outdone Zimbabwe issued a 50 trillion dollar bill in 2008 followed by a hundred trillion dollar note that I purchased off eBay for a few US dollars if our president would print just a single such bill you could pay off the 15 trillion dollar US debt six times over the loss of our investments purchasing power can be every bit as devastating to our portfolio as would be the permanent loss of principal in structuring an investment portfolio Dow wealth management view is that if we're to be successful in preserving our wealth we must have an investment approach that guards our portfolio against a permanent loss of principal and an erosion of its purchasing power and the strategy must accomplish both of these goals simultaneously why simultaneously why don't we wait to adopt an investment strategy that guards against inflation until just before it becomes a problem because we must assume that quickly accelerating inflation cannot be predicted either therefore if we wait to take action the damage may already be done before we realize just how bad the problem is now let me discuss the last of the elements over the years we have observed that many investment products badly underperform the markets in which they invest for example during a period when the stock market rises 25% perhaps a mutual fund underperforms it and earns just 20% or if the market Falls 15% the mutual fund declines even further tumbling 20% in other words the fund Arne's less during the good years and it loses more during the down years during prosperous times many investors don't even notice the underperformance because they're earning high returns even despite the costs investors tend to be dismissive of high costs when they're making money unfortunately as investors continue to suffer the high costs of an investment program during this stagnant or declining market their overall investment experience can prove to be dismal in this table we assume $1,000,000 is invested in a mutual fund that has embedded costs at 5% annually therefore with the stock market going up 25 percent annually after five years giving a two million dollar return the mutual fund investor making 20% annually ends up with 1.5 million dollar return but now assume as happens the bull market ends and the market stagnates for the next five years the stock market generating 0% for the next five years still leaves us with two million dollars while the mutual fund investor losing 5% annually now ceases 1.5 million dollars declined to $900,000 and so referring back to the efficiency of portfolio design an essential criterion of a successful portfolio experience is to be aware of and avoid investment products and strategies that have high costs and we need to be aware of these costs even during periods when profits come quickly and expenses merely appear not to matter we simply can't justify giving away a large portion of our investment returns during the bull market stage because we therefore would not have earned enough to sustain the portfolio during periods of famine or to use another beaudion analogy we don't want to build the perfect boat only to be slowed down by dragging the anchor this then is the animal the doubt wealth management believes we must tame in order to improve our prospects for being successful investors over the long term we must be able to design a portfolio that addresses these critical problems and that functions well within the dynamics it will confront while recognizing our own inherent limitations there is no magic so far then have not painted a very encouraging picture for us however it is only by first understanding the dynamics of investing and the nature of the financial markets that we then have a possibility of finding a way to work effectively within them now we'd like to describe for you how Dell wealth management approaches this investment challenge we're now ready to design and build a proper boat for our voyage one that will get us to our destination both assuredly and at a good pace at first glance it might appear that any design that addresses all of the foregoing will need to be complex with lots of moving parts let me illustrate for you how I view the intricacy of some people's investment strategies a visual analogy of over complication in my mind this is a portfolio that tries to time the markets feud early rotating from market sector to market sector it's a portfolio that uses what I call buffet investing it invests in some of everything it's the kind of portfolio that suffers from unnecessary cost caused by the friction of multiple layers of portfolio management and product investing fortunately a recurring hallmark of a successful investment program is that it tends to be simple simple to understand and simple to implement now let me illustrate how we view our own investment approach simple and direct in our view an investment approach that takes a rocket scientist to decipher probably has something wrong with it or more cynically the investment strategy is hiding something from the investor usually high fees and high risk in fact investment success often is highly correlated with simplicity of design and execution so let me caution you against what are often marketed as sophisticated and hard to understand investments by our industry they have a depressingly high rate of catastrophic outcomes for their investors let's start with the most critical design element of this boat that we're constructing avoidance of an irrecoverable portfolio loss because as we have said the first priority of an investment strategy must be the preservation of wealth we have identified two ways that our portfolio might get sunk we can see our purchasing power our road because of inflation or we might simply make a bad investment that becomes worthless let's first address the need to preserve our portfolios purchasing power inflation usually won't damage your portfolio quickly even so inflation is like a constant wind pushing us backwards a decade from now when we go to spend the funds they won't buy nearly as much as they will today one way to address the problem of ever escalating consumer prices is to own assets for which their replacement cost Rises because of inflation inflation means that it will cost more to rebuild our homes years from now and it means that it will cost more to rebuild an office building so if we own a house or building and even if we suffer through a period of high inflation we might expect such assets to appreciate similarly ownership of equity therefore does something that cash in our wallets can't do it can act as a hedge against inflation in this regard it probably doesn't much matter what kind of equity we own we might own real estate commodities valuable paintings or the common stock of corporations with these kinds of assets a depreciating currency means that take more currency to buy them our equity form of choice is common stocks that is the form of equity that Dow wealth management uses in its clients portfolios to help guard against inflation when we own stocks we own companies that in turn own factories in office buildings they own patents and name brands the owner organizations of workers and client relationships the own infrastructure if we had to go out and replace those assets after inflation period would cost more to do so consequently over time stock prices tend to increase along with inflation providing a measure of protection for shareholders and hence for our clients equity of course is a pretty broad classification there are seemingly an infinite number of different forms of equity but it's a good start at defining our investment strategy we still have the concern of an irrecoverable loss of our principal as we saw at the start of the presentation all financial markets and economies should be expected to suffer painful setbacks from time to time furthermore we've learned that we probably cannot rely
on anyone's ability to predict the next market crash in order to save us from financial disaster we don't want to crash on the rocks just because we have an overconfident captain who proves to be badly wrong from time to time if we cannot depend on a system to warn us of the coming financial hurricanes so that we can steer around them then the only alternative is to build a vessel that is capable of taking the storms head-on especially rare major storms we need a boat that has a sturdy hull in terms of an investment portfolio we accomplished this design criterion by building portfolios using high quality securities but what is high-quality mean a high-quality security is one for which it seems unlikely that the underlying company will go bankrupt even during the worst of times the ownership of high-quality securities may not be important during good economic periods but they can be essential in helping to insulate a portfolio against catastrophic events that occasionally befall our economy how do we determine the quality of a stock for some people quality is synonymous with the company's size and visibility Delf management's definition of high quality is much different for us high quality means that the underlying company has a strong balance sheet a strong income statement and furthermore it means that the company has a long history of making enough money to pay his liabilities and dividends in other words any two people schooled in finance should be able to agree on whether a company is of high quality or low quality this is not a matter of personal taste like deciding if a work of art is beautiful or simply a can of soup if a company has a lot of debt we do not buy it if a company is losing money we don't buy it if a company does not have a long history of good and consistent earnings we don't buy it that is a fundamentally important step in trying to protect our portfolios from suffering a permanent loss of principle in fact I would suggest that it's our only reasonable hope since we know that no one can predict with certainty the next economic crisis or market decline so as to avoid it the best we can do then is to be prepared for the storm whenever it might arrive to give us an even greater measure of protection we don't place too much money in any single company rather we broadly diversify the portfolio among a large number of high-quality stock holdings such a discipline helps ensure that however severe the storm may be the boat most likely will never sink as a rule we typically invest at least 80 percent of a client's portfolio and a diversified list of high-quality securities remember we defined risk as the potential for incurring a permanent portfolio loss and as best we can in structuring our clients portfolios that wealth management tries to eliminate as much risk as possible if someone owns a diversified list of the highest quality companies in the world the odds seem reasonably good that his boat is going to stay afloat he can probably go to bed at night and not concern himself that he may need a life vest he would seem to be well protected against an irrecoverable loss of his principal even if there is an economic depression the company's own would appear to be well suited to survive it and if takes hold the equity characteristic of the portfolio would help preserve its purchasing power that appears that we might have a theoretical investment problem what I've just described seems to contradict the most enduring and immutable rule of investing you may well have heard of it it goes like this there's no such thing as a free lunch in investing neither lunch nor dinner ever comes for free and sadly not even breakfast toast what does that mean it means that if we expect to earn an investment return then we must pay a price we must make some sacrifice and the better the lunch the higher the sacrifice that seems to make sense no one is going to pay us investors for doing something that's painless to do if our investor with is broadly diversified portfolio of high quality stocks isn't taking any appreciable risk then why should you expect to earn much of a return at all the reason is that even though we have largely eliminated risk of a permanent loss we still have not eliminated volatility from the portfolio if he is invested in stocks our investor must endure the rise and fall of the market that is the reason the markets will tend to pay us a good return nobody inherently likes the volatility of his portfolio no one likes to risk getting seasick technically what the market is paying investors to do is to suffer the uncertainty of not knowing when he'll have a permanent investment gain or how much that return will be by giving up control over the timing of our returns and the certainty of the amount stock investors have tended to be well rewarded so we do not look upon volatility as a bad thing it's merely an unavoidable aspect of stock investing and that wealth management analysis the trade-off of higher volatility for the potential of a high return can be a very good one that wealth management takes the return for enduring volatility one step further there's a certain type of company that tends to be more volatile than others the type is a growth company growth companies one whose earnings are increasing at above-average rates but also have somewhat higher price to earnings ratios and higher betas if we're willing to endure the even greater volatility inherent with growth stock investing then we might improve our expected returns growth companies tend to be agile businesses that maximize opportunities currently succeeding companies tend to have the ability to reinvest in their own futures to promote still more growth these are the companies that tend to be at the forefront of their respective industries and are recognized as market leaders an unavoidable characteristic of growth stocks however is that the trade-off for their greater total return potential is even greater volatility that we would find with common stocks in general as I said there is no free lunch if we're not paying a price in terms of a risk of permanent loss then high-quality growth stocks make us pay in terms of their greater price fluctuations to put the matter in terms of our boating experience we could build a boat so large that we wouldn't even feel the waves if we did it probably wouldn't go any faster than a cargo ship but we can probably build a smaller faster boat that is equally as rugged and no less likely to sink in a bad storm with a smaller boat will fill the waves and maybe even get seasick at times when the going is especially rough however we should expect to make far better time in reaching our destination the investment portfolio that we've designed is characterized by the ownership of a broadly diversified list of high-quality growth companies and our investment strategy is to own this portfolio throughout all market periods because we know that it's futile to try to time the markets as we've seen if high portfolio expenses caused us significantly to underperform the markets in which we invest we won't have a very rewarding investment experience when my grandfather entered the investment business in the 1930s there were predominantly only two types of investments that people owned stocks and bonds most securities investors owned one or the other or some of both today however the financial services industry has created a vast array of investment products by investment products I mean mutual funds commodity exchange rated funds hedge funds insurance products real estate investment trusts unit trusts and the list goes on investment products however are never anything more than a package that holds equity debt or some derivative of them they're merely a container so to take IBM stock for example there are two ways to own it one we could buy an insurance product then best in a mutual fund then turns buys IBM or two we can simply buy IBM shares for our portfolio the first way is indirect investing the second is direct investing the first way is frequently enormously expensive the second is highly efficient the costs associated with product investments like mutual funds are both explicit and implicit in other words some of the costs are stated in the prospectuses while other costs are hard to find one major explanation for the underperformance of funds is due to a concept called market impact costs for those who are interested chapter nine of my dad's book elaborates on the subject one way to characterize mutual fund investing among other such product investments is to choose our anchor analogy it is as though we which design the perfect high-performance boat and then race it while dragging the anchor mutual funds were originally designed for investors with limited means who wanted to invest a few hundred dollars each month they couldn't afford to buy a diversified portfolio of individual stocks as wealthy investors did unfortunately over the past three decades the financial industry has heavily marketed product investing because it's so highly profitable for the industry not for the investor investment products are now sold to the well-heeled and those of modest means alike for investors with sizable portfolios however there is simply no need or even justification for the indirect ownership of their securities to illustrate the point graphically those who own their securities outright tend to enjoy higher rates of return as compared to those who utilize the product approach a successful portfolio design will place us on the more efficient path by recent example in 2011 the S&P 500 total return was a positive 2% the average US equity mutual fund returned negative 3 percent before sales fees 5 percentage points of investor return forever vanished in short down wealth management view funds have no place in serious investors portfolios they certainly are not needed and often are the cause of chronic and debilitating underperformance what about these guys whether they tell us about our portfolio strategy what does it mean that every once in a while a rare storm will likely come upon us so quickly and with such vigor that I will sink unseaworthy vessels and what does it mean that we cannot even rely on the weather reports for an accurate forecast it means that our investment strategy must remain defensive at all times for example we can't abandon high quality securities just because the economy looks like it's improving there may be a surprise around the corner so we cannot time the markets we cannot risk owning predominantly low quality securities even for short periods of time for fear of being caught unexpectedly in other words just because the weather looks good today it's still probably isn't a good idea to head out across the ocean in a canoe now to conclude we started by defining our overriding investment objective as the preservation of wealth while we probably all agree on the paramount importance of this objective by many investors behaviors I have often found that they appear to be oddly unfazed by significance to their well-being more likely however they tend to be naive about the risks inherent in the markets in which they invest consequently they may unknowingly jeopardize their financial futures lessons are often learned after it's too late but as we have done in this presentation by understanding the natural behavior of the financial markets and our limitations as investors by defining the risks and costs to which we should be unwilling to expose our portfolios and while accepting that market volatility can be an acceptable trade-off for a higher total return potential it is possible with thought and purpose to craft an appropriate and potentially rewarding investment strategy let me illustrate where we are qualitatively and numerically with a table we craft our portfolio by focusing on the levels of risk and volatility to which we are willing to expose our assets the first row is the level of risk of an irreversible portfolio loss the second row is a measure of portfolio volatility and the third row is a projection of the possible rate of return to be earned in exchange for the volatility that the investor might endure now we can highlight several market sectors in which we could invest these market sectors are characterized by the quality and growth attributes of the underlying securities cash deposits of course tend to be very high quality but our slower growth assets they have very low risk of loss they don't fluctuate in value 3% might be an expected rate of return at the bottom of the chart we see that over 20 years a million dollars invested at 3 percent annually would give us an 810 thousand dollar profit next let's add a portfolio of high-quality stocks here again by design the risk of permanent loss was seen to be nominal however we incur much greater volatility in the portfolios value for enduring that motion-sickness the market might pay 10% annually in dollar terms over 20 year period that would amount to nearly a six million dollar profit now let's modify further the types of companies we own instead of randomly buying high quality companies let's focus only on those that qualify as being growth companies as well again by owning an array of companies that are leaders in their fields that have strong balance sheets and healthy income statements it seems doubtful that we'll ever suffer a permanent loss of principle on the other hand because of the nature of growth companies our measure of likely volatility has increased still further what might we get for suffering the greater volatility we would expect a few extra percentage points in average annual earnings at a 12 percent rate over 20 years we'd earn about three million dollars more or nearly nine million dollars as you may recall earlier I mentioned that Dow wealth management typically invests 80 percent or more of a portfolio and high quality securities that still leaves us with up to 20 percent that we have not yet addressed I've added one more column to our chart this column highlights a category of stocks that are of particular interest to us and it's how many of our clients allocate a modest portion of their portfolios aggressive growth stocks are those that are not high quality but whose underlying companies are growing at exceptionally high rates for investors interested in the potential for even more dynamic appreciation than what high quality growth stocks might offer such issues may live up to expectations however as we will notice going back to our most fundamental rule about there being no free lunch for investors such stocks expose the investor to even greater volatility the payoff however for such stocks can be especially good at an assumed 15 percent rate of return compounded over 20 years the investor would earn 15 million dollars but remember our volcano as attractive as that rate of return might appear no darou level of risk also has increased is for this reason that we carefully limit such holdings to a minor portion of an investor's overall situation but now for the all-important question what will our rate of return actually be when we earn 10 percent 15 percent or 25 percent next year or lose 15 percent we cannot know that is the unsatisfying but correct answer that wealth management's approach is to control for risk and volatility in a portfolio then we accept that our rate of return will be dictated by the market in which we're invested what we can say is that if we expose our portfolios to an investment philosophy as I have described directly owning a broadly diversified portfolio of high-quality growth stocks the odds seem much in our favor for doing well in the years and decades ahead so finally let's take one last look at the challenges we face as investors and the strategy that we have designed to address them so here are the eight elements that we need to address for a successful investment experience to continue with our nautical analogy here is a sea that we must navigate and here is the boat that we have designed to provide a safe journey and once seems likely to move us ahead at a good speed and for those who like to supercharge the engines then a modest exposure to aggressive growth stocks offers the potential for making their investment experience
ore dynamic and even faster paced by observing the investment principles discussed you should leave 90 percent of your fellow investors in your wake I wish you fair wins as you navigate your portfolio to ever higher returns I'm Russell Dow thank you for your time you
