Know Where Your Money Is?

How many stock certificates do you have sitting in a drawer forgotten? How many mutual fund statements have you put in a “to read eventually” pile that grows taller each month?

To put it another way, how would you identify your investing style? Are you content with achieving an average return, or do you want something more?

There are two ways of handling your investments - passively and actively. As you might expect, I prefer taking a more active role.

Passive fails

Investing runs on a continuum, with total passivity at one end and speculative activity (day trading) at the other. A prudently managed portfolio probably lies somewhere in between.

In the textbook sense, passive investing means composing a portfolio to match the return of a certain benchmark (such as Standard & Poor’s 500). Active investing means managing a portfolio in an attempt to beat that benchmark.

In passive investing you’re either going to purchase a stock or bond index fund, or - if you’re a big enough investor - have somebody put together a portfolio of stocks and bonds that will attempt to match your chosen index. In reality, passive investors rarely match the index, because of the costs of investing (management fees, etc.). Passive investors are content with doing about as well, or nearly as we ll, as everybody else.

Investing by inertia

As a financial adviser, I’ve seen several cases of people losing their savings because they assumed an investment that was good when they bought it would stay that way forever. It’s a terrible idea to think that you can put a stock or bond certificate in a safe deposit box and forget it.

In the Baltimore area where I live, we’ve had a couple of hard lessons recently in what happens when you don’t keep an eye on what’s going on. Before the early 1990s, USF&G insurance was considered a blue chip stock in Baltimore. This hometown firm had been around for 100 years - it was the oldest insurance company in the U.S.

I know of one woman whose family had owned the stock for years; she herself had 90 percent of her savings invested in USF&G. She never looked at it or thought about it.

That’s called a buy-and-hold strategy, in which an investor buys a stock and then just hangs onto it, ignoring market indicators, analysts’ views, financial reports, and all the other information investors need to guide their decisions. It’s one of the most reliable strategies I know for losing your shirt.

Well, right around its 100th anniversary, USF&G started having some serious financial difficulties and the company’s stock plummeted. By the time The St. Paul Companies bought USF&G, this woman had lost almost all of her money. She died broke, and without leaving her children the legacy she had hoped to pass on.

There are many reasons for this kind of passive investing. Some people just never get around to looking at their holdings. They have good intentions, but don’t follow through. They’re immobilized by inertia.

Other investors don’t want to pay the expenses associated with trading stocks and bonds; they’d rather sit on a stock then pay someone else money to sell it. (An excellent example of being penny-wise and pound-foolish.)

Finally, some investors are attached to certain stocks for emotional reasons. I had one client whose husband had died earlier than they expected. Almost all of the couple’s savings was tied up in stock and stock options for the company where her husband had worked for many years. It took a lot of persuasion to convince her that she needed to sell some of that stock and diversify her portfolio. On some level, selling that stock seemed to her like a betrayal of her husband.

Get active

Active investors, as you might expect, take more responsibility for their investments, either personally or by hiring an investment expert to assist them. They’re knowledgeable about what they own and what they hope to accomplish. They’re ready to make changes when it’s appropriate to do so.   People who actively manage their portfolios know their strengths.   If they have areas of special insight or expertise, they add value to their portfolios by making decisions about which stocks or bonds to buy or sell in those areas. In other areas - for lack of interest, qualifications, or tools - they are content with matching the index, assuming a more passive position. Most institutional portfolios are constructed this way.    

Active investing includes the concept of personalizing a portfolio to your needs. You don’t hold onto a stock or a bond because 30 years ago your favorite uncle died and left it to you. You are re-examining, on a frequent and regular basis, your investment strategy, deciding how much money you’re willing to invest, how much income you need, and when you need the money back. You think about the risk return on the various funds (and your ability to tolerate risk). You consider the tax implications of the funds you choose.

With active management, you can structure your portfolio to take taxable gains at a time of your choosing, whether that means taking them this tax year or deferring them until the next.

Two words of caution on active investing, however: as Clint Eastwood once said, “A man’s got to know his limitations.” Just as no physician is expert in everything - you wouldn’t go to a thoracic surgeon for a knee replacement - no one person can be an expert in every area of the market.

Actively manage those parts of the portfolio where you or your portfolio manager has an edge. In areas where you’re less knowledgeable, your best option is probably to try to match the average return (be passive or use an index fund). That’s OK, as long as you’ve gone through an active process of deciding on that strategy.

Also, keep in mind the caution that you read on every investment prospectus: “Past results are not guarantees of future earnings.” If you find a fund with a manager who has had a superlative record in the last five years, the data show that they’re not likely to repeat. Remember, active investment doesn’t mean following the same path that everyone else is following. It’s using some differential insight that allows you, or your investment adviser, to see something in the market that others do not see and using that insight to your advantage.

Managing for others

Most physicians have the largest part of their assets in qualified plans such as pension plans or profit-sharing plans. In many cases - when they set up a 401(k) for office employees, for example - they may also have fiduciary responsibility for these funds.

If you have this responsibility and in some way are not actively managing (or at least actively monitoring), you could be opening yourself to a lawsuit if you lose money, or even if you don’t earn as high a return as someone invested in the plan thinks you should have.

The Employment Retirement Income Security Act of 1974 (ERISA) spells out your responsibilities as a fiduciary. You must have an investment policy statement and you have to monitor results compared to an index that you have chosen as a benchmark. Total passivity doesn’t cut it when other people’s money is involved.

And it really shouldn’t cut it when it’s your money, either.

A passive investment style guarantees that you will underperform the market. Why would you settle for mediocrity or worse? Most investors want at least the opportunity to have higher, better returns.

If you’re a passive investor - whether it’s because you’re intimidated by investing, too busy to get around to it, or simply not interested enough to take the time to do a good job - I urge you to seek professional advice. Working with a good investment adviser will provide the discipline you need to become an active investor. You’ll be given the structure and the guidance necessary to identify your needs and objectives, to think about your risk tolerances and tax preferences, and to have all of these factors reflected in your portfolio.

You’ll have someone else reminding you when it’s time to rebalance and fine-tune your portfolio. You will be an involved and active investor, and that’s a good thing. Trevor C. Lewis Jr. can be reaced at editor@physicianspractice.com.

This article originally appeared in the October 2004 issue of Physicians Practice.