Ashvin Chhabra, the president of hedge fund Euclidean Capital and former chief investment officer and head of investment management and guidance at Merrill Lynch Wealth Management, has noticed that rich people tend to make a lot of mistakes with their money. They violate the basic tenets of good portfolio management, seeking out risky investments and failing to diversify.
And often, these mistakes make them a lot of money.
Chhabra, who has a doctorate in applied physics from Yale, studied that paradox and wrote an influential paper in 2005 titled “Beyond Markowitz” that changed the way many money managers thought about personal finance.
Chhabra grew up in New Delhi, where his father owned a large newspaper and his mother was a well-known journalist who later took an interest in public affairs and served as India’s deputy minister of health.
Chhabra earned his undergraduate degree in physics at St. Stephen’s College in New Delhi, India, in 1982. After earning a master’s at the University of Georgia, he did his Ph.D. in applied physics at Yale.
Early in his career Chhabra was head of quantitative research at J.P. Morgan Private Bank. He joined Merrill Lynch in 2001 and gained recognition as a leader in the fields of investment management, risk and asset allocation, and risk management.
Chhabra directed wealth strategies and analytics at Merrill Lynch from 2001 through early 2007 at Merrill Lynch before it was absorbed by Bank of America. At that time he left the brokerage company to manage endowment funds at the Institute for Advanced Study in Princeton. He returned to Merrill in 2013 and departed earlier this year for Euclidean Capital.
Now Chhabra has written a book, “The Aspirational Investor,” that brings his theories to a mainstream audience. He will discuss his latest work at a Monday, November 16, meeting of the Princeton Roundtable, an invitation-only group for high-level investment professionals. For more information, visit www.princetonroundtable.org.
In his book he examines why the conventional theory of diversified portfolios may not be enough good enough for most investors:
‘Money will not buy you happiness, but wealth does provide safety and comfort and, more important, it creates choices and opportunities. Whether your goal is to grow your wealth or simply to preserve it, how wisely you invest your assets will play a significant role in teh quality of the life that you and your loved ones will lead.
Unfortunately, most investors, even those who are otherwise smart and successful, lack a basic understanding of financial markets. This causes them to make poor investment decisions. The problem is compounded by the fact that a great majority of us either do not realize our incompetence in financial matters or are simply unwilling to admit that it has a negative impact on our relationships and personal life.
Many investors do recognize their limitations and hand their money over to a professional advisor. Yet the process of delegating to a professional is fraught with peril. Most individuals have little understanding of what can (and cannot) be achieved through investing. After suffering through a market disaster, such as the Great Crash of 2008, irate investors will fire their advisors and find someone else.
In the next market downturn, the cycle repeats.
The investment world has hardly helped matters. Despite more than 60 years of debate and research, academics and the financial services industry alike remain divided into two broad camps: the so-called efficient market camp, which holds that most investment managers simply cannot outperform the market, especially after taxes and fees are paid, and offers index investing as a prescription, and the active management camp, which seduces investors by pointing to track records of extraordinarily successful investors like Warren Buffet.
The average investor’s results turn out to be quite dismal. Their portfolios under-perform not only the standard market benchmarks but also the individual funds they are invested in. We will explore this sad finding in detail.
The exciting and comparatively new field of behavioral finance highlights the role of psychology and emotion in investing. So far, however, research in that field has uncovered a lengthy list of psychological biases that lead many of us down a faulty path, but it offers little insight into why these “mistakes” are so persistent and hard to correct.
Meanwhile, the 24/7 news cycle and the plethora of financial news websites mean that even casual viewers are constantly updated on every world event, big or small, and its supposed impact on financial markets. This abundance of information and analysis serves to alternately entertain and confuse, amplifying the noise and adding yet another barrier to sound financial decision making.
No wonder investors seem to lack the tools to succeed.
Your financial advisor may well be compounding the problem. If you work with a professional on a regular basis, chances are your meetings are animated by a variety of full-color graphics: pie charts detailing the allocation of your liquid assets and different ways to measure performance. The central focus is likely to be your returns over the past few quarters or the most recent calendar year. Time and again, the conversation with your financial advisor probably focuses on the investments that did well, the fund managers that under-performed and may need to be fired, and other changes to make based on predictions about what the investment climate might look like over the next few years.
So what’s wrong with this picture?
The problem is this focus on liquid investable assets that, by the way, may account for only a portion of your total net worth and (short-term) investment performance, anchors the traditional advisory relationship to the wrong set of questions. The emphasis becomes “How can I increase my returns or consistently beat the market?” instead of “How can I achieve my major life goals with some degree of certainty?”
The grand debates in finance, particularly the clash between indexing and active management are focused on a series of false choices. If the markets don’t really care about you, as they surely do not, why should you spend all your time and effort trying to beat them? You certainly do not want the great successes of your life to be dependent on the future performance of financial markets.
And what about those so-called behavioral “mistakes?” Perhaps they are not errors at all. As we shall see, concentration and leverage — two of the biggest mistakes in finance theory — turn out to be the building blocks of substantial personal wealth for many entrepreneurial people. When smart and successful individuals constantly violate what seem to be straightforward guidelines of sound investing, such as diversification, there is clearly something more to the picture.
This book offers an entirely new approach to managing wealth — one based not on the markets but on achieving personal goals and carefully managing risks. The approach, which I call the Wealth Allocation Framework, begins with the idea that a truly comprehensive wealth management strategy must accommodate the dual need for financial safety and wealth creation, while also enabling you to maintain your standard of living through measured exposure to financial markets. The primary focus is around defining your personal objectives, then optimizing your financial assets and your human capital, or earning potential, around those objectives.
Conventional portfolio theory, ironically called modern portfolio theory, is a theory about optimizing risk and return from financial markets through optimal portfolio construction. What is needed is a theory that shifts the focus from portfolios and markets to individuals and objectives. I call this more useful and contemporary approach objective portfolio theory.
Intuitively, this objective-driven approach makes sense. We no longer live in a world of bountiful social safety nets, so exposing your entire net worth to the risk from financial markets in a quest for outsized returns is hardly a sensible strategy for achieving what is important in your life. Pensions and defined-benefit plans seem headed for extinction, and the future of Social Security benefits in their current form is in doubt. Secure company pensions have given way to the 401(k), which shifts the risk of running out of money from companies and the public sector to individuals. The traditional company job for life no longer exists. People are starting work much later, and living longer, at a time when health care costs continue to skyrocket. The reality is that, for most people, personal financial assets are no longer a supplement to a pension but represent everything they will have to live on.
Today all of us bear the burden of investing wisely.”