Consider
net worth when investing
There are
lots of clichés that aim to educate people on the basic principles of
investing. But nowhere, during my education, had I ever encountered anything detailing
a method that makes perfect sense – a net worth approach to investing.
In the
context of investment portfolios, diversification is usually obtained by
selecting a combination of many assets that don’t all move the same way. Hence,
when the total value rises, it’s the result of some parts rising and others
falling in value – and vice versa. The values of individual components move in
different patterns.
The benefit
isn’t necessarily a higher growth rate (though that’s possible to some extent).
Rather, the biggest benefit of diversification is to arrive at the same
destination (i.e. reaching a stated goal), while making the ride along the way
much smoother than it would be otherwise (i.e. reducing risk).
While most
investors look only at their investments in isolation, it would be wise to
broaden the scope considerably.
The essence
of what I call the “net worth approach” to investment management is really what
could be termed “net worth” or “total wealth” management. After all, for most
of us, our investments and savings don’t make up our entire net worth.
I would
argue that the most valuable asset that working people have is their ability to
earn an income. This steps into financial planning territory and the need for
disability insurance. But the logic should be extended to the source of income
and what can affect the sustainability and variability of that income.
From there,
a great deal of insight can be obtained by closely examining the specific
makeup of an individual’s net worth. For instance, someone with one of today’s
ever-popular floating rate mortgages will be more significantly impacted by
rising rates as compared to her neighbour with a fixed rate mortgage.
In the
broadest context, this approach speaks to the job of managing the net worth. It
can be broken down into two parts: a)
diversify the value and variability of the assets, and b) managing the
liability side of the balance sheet to offset variations in values of assets.
There are
many factors to consider and many of them will not be products at all. Rather,
the focus is on specific circumstances and desires – a definite financial
planning twist on the art and science of structuring investment portfolios.
There are
numerous factors to consider – too many to list in this space. The more common
relevant factors to examine, aside from those noted above, include vested
pension plan assets, private business interests, and employer stock ownership.
While this
may make intuitive sense, there are good reasons not to use this method. For
instance, some pension assets may be viewed as a type of fixed income. Using
this method may result in holding a disproportionately large amount of stocks
in the investment portfolio.
This is
dangerous for two reasons: a) many
people can’t handle the risk of investing almost exclusively in stocks; and b)
it’s simply not a good idea to hold so much in stocks since pension plans can get
in trouble (despite the guarantees) when stocks really take a beating.
Also, a
portfolio may have a very specific purpose (i.e. providing a set level of cash
flow for a period of time) that will override the principles of this approach.
Otherwise,
it’s a sound way of building and managing investment portfolios. I use it
myself.
Next
week: we’ll look at a couple of case
studies to illustrate the application of this method.
Dan Hallett, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling
Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.