There are so-called investment managers, they manage portfolios in a wild and risky fashion that I term “portfolio cowboys.” In contrast, there are high quality investment professionals who manage portfolios carefully based on time-tested principles of long-term wealth management. These high-quality wealth managers must compete with portfolio cowboys for clients — and they often lose. The reason that clients are attracted to portfolio cowboys is that cowboys are more enticing than wealth managers. Here’s why portfolio cowboys should be avoided and how to spot them:
Portfolio cowboys prefer concentrated positions in a few stocks; wealth managers diversify. For every concentrated holding that beats the market, (when the portfolio cowboy bets on the “right” stock) there must be an investor whose portfolio cowboy picked a stock that underperformed. Diversification is the one true free lunch – the opportunity to reduce risk without reducing expected return. Investors should diversify most or all of their wealth.
Cowboys engage in market timing; wealth managers maintain steady risks. Similar to concentrated positions, for every cowboy that beats the market, (by timing into stocks prior to a bull market and timing out prior to a bear market) there must me a cowboy whose client lost out. Wealth managers maintain risk levels that change significantly only when the client’s circumstances and goals change.
Wealth managers tend to buy-and-hold assets for their clients. Portfolio cowboys trade frequently. Therefore, clients of portfolio cowboys pay lots of commissions and other trading costs such as bid-asked spreads and SEC fees. Also, frequent trading usually wreaks havoc with tax planning. Clients of portfolio cowboys are stuck with lots of adverse tax consequences as they sell at short-term gains and hold onto long-term losses. Wealth managers transact conservatively with a careful eye on minimizing adverse tax consequences.
Portfolio cowboys can always show off particular accounts that did fabulously over particular time intervals because even the worst portfolio cowboy gets lucky. Wealth managers can never show truly exceptional short-term profits for an entire portfolio because they maintain well-diversified portfolios with steady risk exposures.
Wealth managers may not dazzle, but in the long-run they deliver.