Maui Millionaires

In this eLetter I want to talk with you about how the wealth industry keeps you in the dark about your real rate of return.

Sadly, most people with 401k's or investment accounts are misled about the returns they are really getting.

The wealth industry has grown rich by providing ever expanding financial services for its clients. While many of these services can be useful, unless you as a wealth consumer actively and intelligently take control of your own wealth building, you are virtually guaranteed to get sub-par results.

Take the example of how the wealth industry lays out your financial information on performance. Since the most common investment via the wealth industry is publicly traded securities let's start there.

My friend showed me his Merrill Lynch monthly statement which had column after column of "results" for his portfolio. But all of it was laid out in such a way to impress, especially to impress upon my friend how much he needed them to keep track of all this complicated information.

The truth is that they report actually hid or ignored the two most important markers to measure the performance of his portfolio: the real rate of return and each investments performance against an appropriate benchmark for that risk category of investment.

Let's look at each of these in turn.

First there are the returns that his statement showed. The return did not share the AFTER TAX, AFTER FEES rate of return on the investment, but rather the pre-tax, pre-fees rate of return.

Empowered wealth builders know that they need to look at the real rate of return on their investments which means the after tax, after fees view of how well their investments performed.

Second, his statement never compared his returns to a suitable benchmark that was appropriate to the risk category of the investment. He had no way to know how well he was doing in an objective way, instead, all he saw was his isolated performance with no way to see how well the market as a whole was doing.

Without this information it is impossible to know how much of his results were augmented by the financial services he was paying for, and how much was just passively driven by the marketplace.

And if this wasn't enough, there was the area of "asset allocation" which on his Merrill Lynch account was neatly represented on a pie chart in three distinct sections: Equities, Dividends, and Other Assets. He was given a wealth plan which said he should use these three categories to determine the ideal composition of his portfolio. This is woefully inadequate and in fact is very misleading.

First, the above divisions treat all stocks as if they were the same risk category, and treats all "dividend" investments as if they too were of the same risk category. This is fatal to your wealth building. A stock like Coca Cola is much less risk than some specialty stock in a focused niche about which you have no real expertise or advantage, even though both are equities. A short-term AAA rated bond cannot be compared to a junk bond, even though both generate dividends.

When you lay out your asset allocation you need to consider which risk classes you want what percentage of your net worth first. Then it is your job as a savvy investor to find the highest return possible per each of those risk categories.

Second, his portfolio was being run for him in a way that over time put him at great risk. What do I mean by this? He had professional management that he was paying for coming, going, and on every layer in between. He had his "wealth advisor" being paid to manage his choice of investments, including many government securities that needed no real active management, and his mutual funds that he was already paying the for his fractional proportion of management costs.

In essence he was paying for professional management at two levels: at the mutual fund level and at the wealth advisor level. This meant that he immediately LOST 3-6% of his total return depending on fees he was being charged. Considering that the average market return for stocks over the past 50 year is about 12% that means his fees cost him 25-50% of the total market return. If that isn't risky I don't know what is!

And we haven't even factored in the other frictional costs from a strategy like this like the turnover costs to the portfolio at either the mutual fund level or at the meta-wealth advisor level (can you say brokerage commissions!) Nor have we factored in the tax costs of an actively turning portfolio.

As Warren Buffet shared in a recent letter to the stockholders of Berkshire Hathaway, the FRICTIONAL COSTS of all this management eats away at the real returns most investors get (these frictional costs also include the turnover costs of actively trading securities in your portfolio.) As Buffet suggests, and I agree with, for those investors who want to invest in securities but don't want to invest the energy to become skilled themselves, and would rather pursue a passive strategy of investing and holding, they would do much better to invest in the market via index funds that have so much less expense associated with them (between .2-.4 percent or 5-10 times less expense!)

The bottom line to all this is to take a sharp look at your brokerage statements and calculate your after tax, after fee REAL return. Are you happy with that?