Planning Pitfalls High Net Worth Investors Should Avoid

Far too many high net worth individuals suffer the consequences of pathetic advice and live to
regret it. A combination of time constraints, financial ignorance, and quite possibly egos often impede a wealthy individual’s ability to make rational economic decisions. And let’s face it, not all of Wall Street’s ‘finest’ have your best interest at heart.

Having extensive experience working with wealthy families, I have seen the financial carnage that
occurs first hand. The symptoms are always the same: inappropriate strategies, excessive costs,
exaggerated risk, portfolio churning, liability exposures, lack of integrated planning and failure to meet reasonable goals.

If you are tired of fattening up other people’s wallets at the expense of your financial growth,
empower yourself to make better financial decisions.

Wealthy professionals, because of their high incomes and high visibility, are often easy targets for bad advice. When hiring an advisor, a considerable amount of thought and research should be dedicated to the process. After all, it’s only your money. Here are some things you should ask when engaging a financial professional:

• How are you paid?
• Are your recommendations in any way influenced by compensation?
• Do you have a clean regulatory record?
• What are your credentials?
• How much experience do you have?
• How much authority will you exert over my accounts?

The Certified Financial Planner Board of Standards offers some great (free) online guides on how to choose a planner. Check out their site at http://www.cfp.net/learn/library.asp.

In your quest for an advisor, the more informed you become, the better your outcome should be.
Here are the underlying factors that often jeopardize a sound financial plan.

Inappropriate strategies

Wealthy individuals are often successful business owners or professionals exercising a high
degree of rationalization. The same practice should be executed with your money.

Successful portfolios are based on research and reasonable expectations, not intuition. Illogical investors attempt to guess which manager, stock or asset class will have tomorrow’s best performance. That’s why so many have consistently failed. Successful, rational investors excel because of a clear methodology and, of course, discipline. What type of investor are you? What type of investor do you want to be?

For the past fifty years, modern finance has been exploring the most efficient methods of achieving
global market returns. The findings have been a boon for individual investors who have put forth
the effort to learn about them.

The single largest driving force behind investment results is the policy decision allocating between stocks, bonds and cash. Roughly 94% of the variations in returns are explained by asset allocation. The factors that most investors assume contribute the most to investment returns, like individual stock selection and market timing, contribute less than 6% to the result.

Also, by mixing risky asset classes with low correlations together, the resulting portfolio will have higher rates of return, but with lower risk than the average of the individual parts.

Excessive costs

Here’s a quiz. Besides inappropriate diversification, what is an investor’s worst enemy? Answer: excessive costs. Costs are mainly comprised of the following categories: commissions, taxes, and
fees

Commissions

Many financial advisors are nothing more than glorified salespeople. The investments they sell
have a direct correlation with the compensation they receive. Given those dynamics, what are the
odds that you will receive objective advice?

Commission based advice serves only the broker and the brokerage firm. Stay away from
investments that charge your front end or back end loads or surrender charges. Commission
based compensation includes “fee-based” compensation which is a particularly evil label referring to both fees and commissions. Don’t be fooled.

Fee-only compensation (non commission driven) eliminates the exploitation of investors, where
quality objective financial advice is the product, and the advisor sits on the same side of the table with the client.

Taxes

I don’t know of one high net worth investor who is not burdened by hefty income taxes. Add to that the additional drag of investment related taxes and your problem is further augmented.

A rational investor should not necessarily seek tax avoidance, but it makes sense to pursue the
highest after tax return possible. The excess turnover of actively managed funds, will no doubt
lead to higher tax bills (whether or not your have a gain in the position). One of the most effective ways to manage this problem is through tax efficient investment vehicles like index funds. Tax managed funds that harvest fund gains against fund losses may also be a suitable alternative. Also, consider allocating positions with higher turnover and distributions in tax-deferred accounts
where possible.

Fees

It doesn’t take a neurosurgeon to understand that fees are a dead drag on performance. The
more it costs to run your portfolio, the less you’ll see in your pocket. Risk reward studies indicate that investors are paying too much for what they’re getting. On average, investors in funds with lower fees earn better returns than investors in fund with higher fees, due to the fact that lower fees are being deducted from gross returns

Exaggerated risk

Investors get paid for accepting market risks, that’s true. But taking calculated risks is a far more effective way to achieve your desired returns.

Investors that hold concentrated portfolios are bearing far more risk than justified by the expected return. Concentrated issues include individual stocks, industry, sector and geographic concentrations. There is no separately priced risk element for any of these oncentration issues, and no additional return to be anticipated by bearing these risks.Investors should attempt to spread the risk across various asset classes that include: Large, Large
Value, Small, Small Value, International Large, International Large Value, International Small,
International Small Value, Emerging Markets and Short Term Bonds. Employing these asset
classes in your account will result in true global diversification and tilting toward small and value should enhance returns over time.

Portfolio churning

Whether you or your broker creates the churning, stop it! Technology has made it awfully
tempting and so easy to shoot ourselves in the foot, hasn’t it? Hey, at the click of a button we can move thousands, even millions from one account, fund, or stock to another.
But, excessive trading has a consequence: transactions fees, taxes (in some cases) and missed opportunities. Do yourselves a favor; get your finger off the trigger. Trading for the sake of trading is expensive. Develop a long-term strategy and stick to it. Portfolio turnover should really be limited to rebalancing, distribution requirements and tax planning. Remember, if you want to be a long-term investor, act like one!

Liability exposures

Asset protection planning is an integral part of a comprehensive financial plan. While the level of exposure varies by profession all high net worth individuals risk being sued. Malpractice, and errors/omissions may be the most obvious threats for certain professions (ie. Doctors, attorneys, securities professionals). But, if you think it’s your only exposure, think again.

If you are self-employed and your business sponsors a retirement plan you are exposed to
fiduciary liability as well. Plan sponsors (that would be you) retain a fiduciary responsibility to act with loyalty and prudence, to diversify plan assets, and act in accordance with plan documents. After Enron (et al) the Department of Labor has been hammering down on employers that are not in compliance, or fail to offer appropriate choices and participant education.

Solution: find a competent, objective advisor to oversee the management, education and
administration of the plan. The plan must be comprised of funds with low expenses, a broad
selection of asset classes, and benchmark performance standards. It’s important that the advisor assume partial fiduciary liability with you. Otherwise, the responsibility falls squarely on your shoulders, and you’re right back to where you started.

Lack of integrated planning

Individuals often make the mistake of having a single motive when designing their financial plan. A comprehensive financial plan is a complex structure that should consist of multiple planning challenges. Retirement planning, estate planning, marital planning, tax planning, asset protection, education funding and investment management are among the many factors to consider. If you want a successful result, no individual component of this plan should be mutually exclusive.

There is no one-size-fits-all solution. And many of these strategies can be downright expensive,
inappropriate, embedded with commissions or hidden costs, may be lousy investments or lack
integration with your overall plan.

Let’s use in example using annuities, since many states allow them as creditor exempt assets.
Doctor A buys an annuity with a 5% upfront commission, 1.30 % annual administrative fees, and inside the product holds mutual funds with an average annual expense ratio of 1.19%. Doctor B
buys an annuity with no load (commission), annual administrative fees of 0.60%, and holds index
funds with an average expense ratio of 0.30% annually. Presumably, both doctor’s annuity assets are protected. But, assuming identical market performance (unlikely), which doctor do you think will have accumulated more after 20 years?

The asset protection tail should never wag the dog or exist in a vacuum. Asset protection planning should not come at the expense of the most optimal strategy. Your planning should be cohesive and integrated. The goal, after all, is to preserve AND maximize wealth.

Don’t be a sitting duck. Armed with this wealth of information, you can empower yourself to make
better financial decisions and avoid financial predatory practices. Now that you have a better idea of what to look for, who to look for and what to do, your chances of success should dramatically improve.