Wall Street's Wealth Machine Is Broken

03/04/2009 12:00 pm EST

Focus: MARKETS

Bruce Weininger

Principal, Senior Financial Advisor, Kovitz Investment Group, LLC

Bruce Weininger of Kovitz Investment Group, an independent Chicago-based investment management firm, tells why Wall Street’s money managers failed their biggest test.

The wealth management practices of the Wall Street firms and big banks are broken. Again.

Regardless of which particular investment was the flavor of the month, the common theme that was heard over and over again for the past 25 years was that by dividing your assets among many different categories, you were going to reduce the risk of the overall portfolio.

This premise seemed to have some validity until October 2008, when virtually every category got caught in the same downdraft. With one exception, that is: high-quality short/intermediate fixed-income investments.

[That’s when] the Wall Street wealth management model failed its biggest test. Investors who were told that they were diversified suffered losses of double or triple the magnitude of what they were told to expect during a tough year.

What went wrong? The wizards of Wall Street had convinced their clients you could shed some of these boring old high-quality bonds, because they could help you earn higher returns via a combination of “fixed-income substitutes” and diversification among classes of risk-based assets (commodities, real estate, hedge funds, private equity, etc.).

Wall Street firms and the big banks were all too happy to create “structured products”—pools of asset-backed securities—chop them up, and then generate large fees and commissions by selling them off to yield-hungry investors. [Investors] were all too willing to buy something which promised high yield and looked like AAA credit that, in hindsight, they didn’t fully understand. Nor did their advisors or those selling these securities.

For too long, Wall Street has dreamed up products with marketing sizzle versus looking for far simpler products to [help] investors meet their goals. It’s far less sexy to tell someone to invest one-third of his or her assets in bonds and buy a basket of high-quality companies (or an index fund) with the other two thirds—[and] it’s less profitable.

Wall Street and its biggest cheerleader, the 24/7 television news media, have over time convinced investors that ”is now a good time to invest?” is the key question that people should be asking (ad nauseum).

The implication is that they are going to help the investor time the market and their seers will somehow help ascertain when to jump between stocks, bonds, and cash based on what they see in their crystal balls. [That] game, no matter how it gets dressed up, is market timing. And market timing is a loser’s game.

High-quality bonds shouldn’t be used as a placeholder until the investor is ready to jump into equities. Rather they should be a fixed percentage of an investor’s portfolio derived from a thoughtful assessment of the investor’s volatility tolerance and the need to assume volatility in order to meet investment goals. Note the use of the word “volatility” here instead of the more common term “risk.”

Though modern financial theory would equate the two, Warren Buffett, for one, disagrees. In his mind, and in the minds of many Graham and Dodd investors, risk relates to the potential permanent loss of principal—not how much a portfolio zigs and zags over any given month, quarter, or year. We agree.

Here’s hoping that investors finally wake up to this game and get serious about what percentage of their portfolios belong in high-quality fixed-income securities and then find inexpensive, transparent ways of implementing that strategy.

If investors get that piece right, the next time we have a year like 2008, there will be far fewer surprises. And we will have taken one large step toward restoring genuine safety to the art of investing.

Bruce A. Weininger CPA, CFP, is a principal in the Kovitz Investment Group and can be reached at bweininger@kovitzinvestment.com. A longer version of this article originally appeared in FA-mag.com  which has given MoneyShow.com permission to reprint it.

Related Articles on MARKETS

Keyword Image
Seasonal Trading in Oil
7 hours ago

Oil companies typically come into favor in mid-December and remain so until late April or early May ...