The best defense is a good offense!

Recently, independent investment research firm BCA Research published a weekly bulletin (available by subscription only) with the subject of "Wealth Preservation."

In it, author Chen Zhao noted that he has found from his conversations with ultra-wealthy investors and their advisors that they are often "natural bears."

"As one gentleman put it," the bulletin relates, "their job is to be worried. They need to make sure that the family money is passed on to the next generation, hopefully with an expanded capital base. Many families have lived through wars and social upheaval over the last several decades, and they want to make sure their money is not robbed by people like Madoff, lost in financial crisis or confiscated by governments. Therefore, wealth preservation is always a big topic for this group."

The report notes that these wealthy families and their advisors are often looking for 5% to 6% returns without much volatility.

While this may seem like an "un-ambitious goal," the author correctly notes that it is actually very difficult to find such returns. We ourselves have long held that the decline in overall bond yields during the late 1980s and 1990s (and through the current time) from the double-digit yields that prevailed during the late 1970s and 1980s played a big role in the huge explosion in hedge funds, as investors with the mindset described above looked for someone who could give them the kinds of returns they could no longer obtain with a straightforward bond portfolio. The dismal performance of many of these hedge funds, especially during the recent financial panic, has caused investors to realize that they are often the wrong prescription for the kind of returns wealthy families seek.

We would also note that the desire among wealthy families for this kind of steady return no doubt contributed to the fraudulent practice of the aforementioned Bernie Madoff, who offered just such steady "un-ambitious" returns to his victims. We have discussed some important lessons for investors from the Madoff scandal in previous posts, such as this one.

The report also points out that bonds lately have not presented much of a solution either, with very low yields on governments, and very high volatility on investment-grade corporates. Junk bonds (or "high-yield bonds," as brokers often euphemistically call them) can provide even higher yields than investment-grade bonds but at risk levels that make them unacceptable for the goals articulated wealthy families and their advisors.

We believe this issue is a very important one to consider. We even agree with the general conclusion reached by the author from BCA, when he says: "In the end, the best defense is probably offense. I have found that many of these 'super rich' investors are highly entrepreneurial and extremely industrial. They have been involved in all kinds of very innovative projects and exotic ventures all around the world to extract returns."

However, he then concludes that "asset allocation has to become more imaginative and dynamic to obtain 'excess rent.' The trick to sustaining and preserving wealth is to take risks when the time is right." The remainder of the bulletin discusses whether it is time to shift capital from US equities to global equities, from small cap to large-cap, from dollars and yen to euros or other currencies or gold, from the debt of the US to that of other nations, and so forth.

We would argue that the author's observation about the fact that many wealthy investors are very entrepreneurial is right on -- in fact, we have noted many times before that most of the wealthiest families in America became that way precisely by being entrepreneurial (see for example here, and here, and here).

Given that important observation, however, why would one argue that they should now abandon investment in innovative and entrepreneurial companies and instead entrust their wealth preservation to an attempt to time the market moves of one sector versus another, one currency versus another, one style or capitalization band versus another, and so on? These kinds of guessing games, which we have previously classified under the broad heading of "sector rotation" (under which we could group countless variations and permutations), are more properly understood as speculation. While it may seem that they have superficial similarities, they are actually very different from the kinds of entrepreneurial activity mentioned as being so central to the stories of many successful and wealthy families.

We agree wholeheartedly that in the current environment, the best defense is a good offense, and that to achieve satisfactory returns (even "un-ambitious" returns of 5% or 6% per year), investors must expose themselves to investments that may be seen as more aggressive than the bond portfolios of past generations. We have discussed this very idea in previous posts, such as "Panning for gold in unfriendly business climates" and "Return of the 1970s, part 2," among other places.

However, we would argue that the proper prescription for the "good offense" is to allocate capital to carefully selected, innovative, growing businesses. While this may seem to be just as aggressive as the speculative strategies outlined above, the opposite is more likely true over time, as we have explained before. This "aggressive" capital can be balanced with more conservative strategies, including cash itself (accepting the lower returns it offers as the price of stability).

In spite of this point of disagreement, we believe that Mr. Zhao's discussion of "wealth preservation" and the issues he uncovers -- as well as his insightful comment that "the best defense is probably offense" -- are all incredibly important subjects for investors to consider and to understand.

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