The Wealth-Builder Model

August 5, 2014

by C. Thomas Howard, PhD

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Portions of this article are excerpted from the case written by Dave Turner of Cascade Financial Management that appeared in my book Behavioral Portfolio Management: How Successful Investors Master their Emotions and Build Superior Portfolios, recently published by Harriman House.

Success in building long-term wealth is largely determined by the simple idea of compounding, or earning as much as you can for as long as you can. For example, if you start with $1 million and earn 9.7% per year (the stock market average) for 20 years, you end up with $4.6 million.

If you invest for an extra 10 years, you end up with $10 million. If you earn an extra 4% per year instead, you end up with $10 million. If you do both, you end up with $30 million, or six times the wealth!

While the math is straightforward, building wealth can be difficult. But if you use an approach based on the principles outlined below, the accumulation of real wealth is within reach.

It’s not easy to stay invested

Over the last 20 years, investors have experienced and had to navigate a number of challenging markets. We have seen entire regions collapse financially (the 1997 Asian contagion), world powers default on their sovereign debt (1998 Russian crisis), the brink of the collapse of the U.S. financial markets (1998 Long Term Capital Management implosion), the dot-com bubble bursting, terrorist attacks in America, the near collapse of the U.S. financial markets (2008 global financial crisis), the threat of default of the U.S. on its sovereign debt and the 2013 shutdown of the U.S. government. Yet in that time period, the S&P 500 generated a total annual compound return of 9.5%, approximately equal to the long-term average for the stock market. Earlier eras all have their own events that seemed just as daunting and yet produced remarkably similar results.

The lesson of history is that investing in the markets works over time. The key to being a successful investor is to have a comprehensive investment strategy that provides the liquidity, cash flow and security needed, so the component of the portfolio allocated to stocks (capital-growth assets) is given the time it needs to work. Clients need to be able to stay invested through the trials and tribulations of the marketplace, allowing them to extract the benefit of their investments.

Thus, building wealth necessitates focusing on long-term results, while simultaneously avoiding the distractions of emotional short-term volatility. In this regard, a major challenge for investors is to avoid myopic loss aversion (MLA), in which investors feel twice as bad about a loss than they feel good about the equivalent gain (this is called 2:1 loss aversion) and choose to focus on short-term performance over a year, a quarter or even a month at a time. The combination of 2:1 loss aversion and a short attention span produces the hard-wired cognitive error of MLA. As a result, long-horizon wealth suffers. MLA permeates every aspect of wealth-building, from portfolio construction to selecting investment managers to selecting individual investments to managing over time.

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