ELITE ADVISOR BEST PRACTICES

Active Versus Passive Investing

Nailing down your investment philosophy and mastering 4 key skills for success

By Guy Baker

Key Takeaways:

  • Understanding and conveying your philosophy is integral to success in the financial services business.
  • High-performing investors understand volatility, market cycles, portfolio expenses and tax mitigation.
  • It takes a lot of hard work and discipline to be a successful “passive” investor—but the rewards are worth the effort for your clients.


When I was a young boy, my mother bought me 100 shares of Heublein, Inc. It was a growth stock in the food, wine and spirits industry. I watched it grow and split several times through the years. Owning stock got me interested in how the market worked and motivated me to learn how to pick stock portfolios by watching the earnings, profits and sales of prospective companies. I learned rather quickly the power of diversification and why putting all your eggs in one basket could be hazardous to wealth. I watched stocks gain value and then lose it with no apparent reason. I soon determined that the insiders were the ones who really had the best chance of profiting in the market.

I finished graduate school in business and went full time into the financial services business. One of my first accomplishments was to qualify for a securities license. But I never used it because I could not figure out how to sell what appeared to be commodity mutual funds. In the parlance of renowned author and financial advisor Nick Murray, what happens if raindrop A beats raindrop B one year and loses the next? Which raindrop (mutual fund) do you pick? Why?

I determined that I did not want to be selling basically hot money. I could find no rhyme or reason for how to build a portfolio or a way to make solid recommendations to clients. Everything seemed based on the reputation of the funds and their track record. I needed to have a story to tell and to provide a reason for clients to do business with me. But I could not find my “value add”—my unique selling proposition. So I decided to ignore investments and concentrate instead on risk management, tax planning and wealth strategies.

Enter MPT

That was until 1992 when I attended a seminar on Modern Portfolio Theory. The speaker extolled the virtues and benefits of index funds as well as the reams of research that led to the 1990 Nobel Prize earned by Markowitz, Miller and Sharpe. As I sat there mesmerized, I listened to the presentation and was dramatically impacted by the science and mathematics of MPT. Here was a strategy I could emulate and trust—something I could believe in. So I immediately decided it was time to start offering money management to my clients. I was tired of watching them lose money and listening to their complaints about their wirehouse brokers and financial advisors. I figured I could lose their money just as effectively and get paid for it (just joking).

As providence would have it, a young advisor showed up in my office right after I made the decision to offer money management services. We talked over our vision for money management and decided to build a company together. We formed our RIA in 1993, and I started gathering assets. Now, nearly 20 years later, I look back and feel this was a great decision. The investment clients who chose to follow our process have done very nicely, even through the rough years of 2000–2010.

4 key skills

What was the turning point? I will go into the details in future columns, but looking back, there are four important skills investors must master to increase their probability of success in the stock market. First, they need to understand the dynamics of volatility. There is an astounding correlation between IRR and standard deviation. Second, they must understand how to build a portfolio that is able to suppress the “downs” and capture most of the “ups” in the market. Third, investors should understand the disclosed and undisclosed expenses in their portfolio and how to calculate them. Finally, if this is nonqualified money, they have to learn how to minimize their taxes.

Conclusion

I have learned that if I communicate these principles effectively to my prospects, I have a high probability of capturing their assets for management. In my next column I will write about philosophy and how important it is to have a philosophy that you can communicate to your clients. Without a philosophy, you are a ship without a rudder and your clients have no captain. Understanding and conveying your philosophy is integral to success in the financial services business.


About the Author

Guy Baker, MBA, MSFS, CFP® is a financial advisor to business owners. He works to help owners find ways to reorganize their planning to achieve tax-efficient solutions to their succession, retirement and estate planning problems. Guy is a 34-year member of Top of the Table and recognized by Worth magazine as one of the top 250 financial advisors. For more information, you can contact him at guy@bmiconsulting.com or through www.bmiconsulting.com.