As promised, over the next few days I will discuss what I believe are the three aspects of real wealth management – accumulation, protection/preservation and distribution.  Most of the posts and white papers on wealth management deal with the accumulation phase.

Rather than repeat such information, I will just recommend that readers review the post and white papers that are relevant to their situation. In particular, I recommend that readers read the white papers on variable annuities, faux financial planning and the Active Management Value Ratio™ 3.0 (AMVR).

Two of the most important factors in the accumulation phase are controlling costs and risk management. The Department of Labor has estimated that each 1 percent of fees and expenses reduces an investor’s end return by approximately 17 percent over a twenty year period.

The late John Bogle, founder of the Vanguard group, was fond of saying “costs matter,” and “you keep what you don’t pay for.” Two of the most effective and easiest ways to avoid unnecessary investment costs is to only invest in cost-efficient mutual funds and avoid closet index funds. For information on selecting cost-efficient mutual funds, click here. For information on  identifying and avoiding “closet” indexing funds, click here

A good example of the damaging impact of unnecessary cost is variable annuities. A common saying in the investment industry is that “annuities are sold, not bought.” There’s a very good reasons for that saying. The average annual M&E expenses, i.e., the death benefit for variable annuities is approximately 2-2.5 percent. Add in another 1 percent for the annual expense fee for the sub-accounts within the annuity, and an investor is looking at a 51 percent reduction in their end return at the end of twenty years.

Add in another 1 percent for a so-called “rider. Projected loss in end-return over twenty years is now at 76 percent or over a three-fourths loss in end-returns. Finally, if a financial adviser is charging another 1 percent for managing the variable annuity, the variable annuity owner is looking at a  projected 93 percent reduction in their end return.  So much for “retirement readiness.” Bet your financial adviser did not explain those numbers to you. For more information about the “secrets” of variable annuities and fixed indexed annuities, click here.

But even smaller fees can have a decided impact on an investor’s return.  When we perform an audit for an investor or a pension plan, we use three proprietary metrics : the Active Management Value Ratio™ (AMVR™) , the Fiduciary Prudence Score™ and a proprietary stress test. All of the metrics focus on the implicit, or effective, impact of the incremental costs and the incremental returns of actively managed mutual funds

We have publicly shared the calculation process for the AMVR™ ratio, which allows an investment fiduciaries, investors and investors to evaluate the cost efficiency of an actively managed investment. Based upon our own experience, very few actively managed investments can justify their fees, as they fail to outperform less expensive passively managed investments.

Investors often overlook the impact of risk on an investment’s performance.  One of the best known risk management formulas is the Sharpe ratio, named after its creator, Nobel Prize winner Dr. William F. Sharpe.  The Sharpe ratio uses an investment’s return and standard deviation numbers to calculate an investment’s risk adjusted performance.

Another area that deserves mention is the use of misleading marketing schemes within the financial services industry.  Ads touting “we’re number 1” are common in financial publications. What investors need to realize is that such claims are generally based on relative returns. Therefore, if Fund A only lost 20 percent while Fund B lost 22%…Fund A is number 1! At the same time, a 20 percent loss is a 20 percent loss, when the original idea was to increase one’s wealth. When the market does recover, an investor suffering the 20 percent loss will have to use some of the recovery to make up for such losses, suffering what another “loss” in the form of an opportunity cost.

Smart investors know that the real secret to successful wealth management is risk management. The most common form of risk management is efficient asset allocation/diversification.  By effectively diversify their investments, creating a portfolio with investments that behave differently in different market environments, an investor can provide upside potential for their investment portfolio while also providing downside protection against market downturns.  While it is true that such an approach often prevents huge annual returns, it also prevents against huge investment losses.  By preventing huge investment losses, an investor’s portfolio can benefit from the magic of compounding returns.

Successful investing does not have to be that hard. History has shown that 75 percent of stocks follow the overall trend of the stock market, whether the trend is up or down.  So despite what your financial adviser may claim about being a market guru, just remember the popular (or unpopular) Wall Street adage – “Don’t confuse brains with a bull market.”

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This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.