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Big picture investing
Consider net worth when investing

There are lots of cliches that aim to educate people on the basic principles of investing. But nowhere, during my education, had I ever encountered anything detailing a method that makes perfect sense - a net worth approach to investing.

The goal of diversification

In the context of investment portfolios, diversification is usually obtained by selecting a combination of many assets that don't all move the same way. Hence, when the total value rises, it's the result of some parts rising and others falling in value - and vice versa. The values of individual components move in different patterns.

The benefit isn't necessarily a higher growth rate (though that's possible to some extent). Rather, the biggest benefit of diversification is to arrive at the same destination (i.e. reaching a stated goal), while making the ride along the way much smoother than it would be otherwise (i.e. reducing risk).

While most investors look only at their investments in isolation, it would be wise to broaden the scope considerably.

The net worth approach

The essence of what I call the "net worth approach" to investment management is really what could be termed "net worth" or "total wealth" management. After all, for most of us, our investments and savings don't make up our entire net worth.

I would argue that the most valuable asset that working people have is their ability to earn an income. This steps into financial planning territory and the need for disability insurance. But the logic should be extended to the source of income and what can affect the sustainability and variability of that income.

From there, a great deal of insight can be obtained by closely examining the specific makeup of an individual's net worth. For instance, someone with one of today's ever-popular floating rate mortgages will be more significantly impacted by rising rates as compared to her neighbour with a fixed rate mortgage.

In the broadest context, this approach speaks to the job of managing the net worth. It can be broken down into two parts: a) diversify the value and variability of the assets, and b) managing the liability side of the balance sheet to offset variations in values of assets.

There are many factors to consider and many of them will not be products at all. Rather, the focus is on specific circumstances and desires - a definite financial planning twist on the art and science of structuring investment portfolios.

Factors to consider

There are numerous factors to consider - too many to list in this space. The more common relevant factors to examine, aside from those noted above, include vested pension plan assets, private business interests, and employer stock ownership.

While this may make intuitive sense, there are good reasons not to use this method. For instance, some pension assets may be viewed as a type of fixed income. Using this method may result in holding a disproportionately large amount of stocks in the investment portfolio.

This is dangerous for two reasons: a) many people can't handle the risk of investing almost exclusively in stocks; and b) it's simply not a good idea to hold so much in stocks since pension plans can get in trouble (despite the guarantees) when stocks really take a beating.

Also, a portfolio may have a very specific purpose (i.e. providing a set level of cash flow for a period of time) that will override the principles of this approach.

Otherwise, it's a sound way of building and managing investment portfolios. I use it myself.

Next week: we'll look at a couple of case studies to illustrate the application of this method.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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