Featured Wealth Management Article
Even the Most Successful Among Us in Venture Capital and Start-ups Are Subject to Cognitive Errors in Financial Planning
by Robert M. Cheney, CFA, CFP® Dated 3/30/2016
There are numerous cognitive and behavioral challenges that we as human beings face in our financial planning. The flows of deposits into and distributions out of mutual funds indicate that the investing public is generally buying when financial markets have appreciated and are selling when markets have declined. The investing public is showing a recency bias error; they believe that the trend they most recently experienced will continue into the future. If the market is dropping, recency bias will cause many people to believe that their investments will continue to drop and and lead them to think they should sell their investments. The same bias leads many people to believe their investments will continue to rise when they have most recently experienced market increases.
If people were entirely rational, they would do the opposite. If someone is interested in a refrigerator and they suddenly hear about refrigerators on sale by 40%, they would rush to buy such a new refrigerator. However, with the stock market and investments, our disproportionate fear of loss, along with our recency bias, cause us to refrain from buying when faced with a similar discount in the stock market.
Many believe that it is only the relatively unsophisticated, average investor who is susceptible to such biases. However, the truth is that cognitive biases affect even highly sophisticated Silicon Valley venture capitalists, start-up founders, and early-stage employees. One bias I repeatedly encounter is known as mental accounting.
Mental accounting leads many investors to view their assests as falling into separate buckets, with separate objectives. For exmaple, they often contemplate their investments as falling into one risky bucket and one safe bucket despite the fact that there may be a single financial objective. This mental accounting often has a detrimental effect on their portfolio by failing to recognize that every dollar has identical value and potential and that by failing to imagine more than two buckets or categories, those investors overweight their liquid portfolio to low-return assets and the risks of those limited asset classes.
Silicon Valley is teaming with financially successful people. Many of these individuals have highly concentrated wealth, for example, entrepreneurs and start-up employees whose net worth is made up predominately by the illiquid, private stock in the company where they work, or private equity and venture capital partners whose net worth is concentrated largely in the illiquid investment partnerships of the firms where they work. These individuals are often wealthy in terms of net worth on paper, but the majority of that wealth is often not liquid and the value of it moves in tandem with public small capitalization growth stocks, a relatively volatile, risky asset class. With much of their current net worth and human capital (future income stream) tied up in this single, risky asset class, the inclination of many of these individuals is to put the remainder of their liquid wealth into “safe” assets such as cash, municipal bonds, or other bonds. With their net worth separated into one higher-risk bucket and one safe bucket with cash and bond investments, they often believe that they have created a neutral, diversified or “safe” overall portfolio.
The real result, however, is an insufficiently diversified porfolio. This “barbell” allocation of one risky and one safe set of investments fails to meet the definition of a fully diversified portfolio under widely-accepted Modern Portfolio Theory. A sufficiently diversified portfolio should have representation from many more publicly traded asset classes.
In financial planning, we generally want our clients to keep a savings buffer in cash of 6 months of living expenses for a single-wage earner family. For someone in a particularly risky early-stage start-up company, that savings buffer may need to be even higher. For remaining liquid assets not needed for the next ten years, we generally want to have those funds invested in a diversified global portfolio appropriate to the risk tolerance of the investor.
I regularly encounter individuals in Silicon Valley with concentrated wealth who have no identified goals for their liquid assets within ten years but still concentrate their liquid savings to safe asset classes such as cash, municipal bonds or other bonds “just in case.” Sometimes these individuals have even done this under the guidance of professional wealth advisors who may be appeasing the client’s own bias, or who make commissions on bond trades. This is unfortunate because the client not only has an undiversified portfolio exposing them to undue risk in a single liquid asset class, but they have also missed out on the substantial potential returns from a diversified portfolio.
These individuals were likely not informed that since the time of modern indices in 1972, a 65% equity, 35% bond global portfolio has never had a negative rolling 10-year period, a timeframe that includes the second worst bear market on record. In fact, the worst return for the 65/35 portfolio in any rolling 10-year period in that duration was +2.6% annualized, a rate much more appealing than current savings accounts.1 There is no certainty that any investment strategy will be profitable or successful in achieving your investment objectives but the historical performance of a diversified portfolio gives promise. Even if concentrated wealth investors have already accumulated enough liquid savings to meet their expenses over their lifetime, a sophisticated wealth advisor can help them assess the benefits of a long-term, fully diversified portfolio for purposes beyond their lifetime such as helping children or charities.
Concentrated wealth investors using a “barbell” approach have given up significant returns and are exposing themselves to risks which they may not be fully aware of. By keeping liquid funds in cash, we know that our savings is not going to keep pace with inflation or retain our purchasing power at the current yields of savings, CD’s, or money market accounts. Municipal bonds or other bonds have had the wind at their backs for the last three and a half decades with declining rates since the early 80’s. However, rates are currently very low historically and as rates eventually increase, bondholders may experience a period of time while bond prices decline and their total return from these investments is negative. This is a very strong argument for being broadly diversified into other public asset classes. Their concentrated wealth may justify that the liquid portfolio should exclude small capitalization growth equities as they are already represented through their concentrated portfolio at work but there are other public asset classes of a global, diversified portfolio that should be included (e.g. , domestic value equity, domestic mid-cap growth equity, domestic large-cap growth equity, foreign equity, emerging markets equity, domestic fixed income, global fixed income, real estate securities, etc.).
Even if there does end up being an expense need for these individuals such as a capital call for their investment fund or an additional round of fundraising required for their start-up, sophisticated advisors can offer private banking services to implement lines of credit or mortgages using their investment portfolios as collateral. This allows these clients to stay invested even if a liquidity need does arise and particularly at a time of weak financial markets.
Mental accounting is a natural human inclination and may cause us to feel that we have a safe or neutral portfolio overall when in fact it is certainly not a fully diversified portfolio. The lesson here is that even concentrated net worth investors can significantly benefit from the objective advice and behavioral coaching of a competent wealth advisor to help them achieve a truly diversified portfolio and higher potential returns over the long-term.
Source: Morningstar Direct 2016