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An ‘active wealth’ plan can maximize long-term financial success

 

In his poem “If,” British author Rudyard Kipling famously wrote that learning to “keep your head when all about you are losing theirs” is part of growing up.

That very statement is also part of growing wealth.

I wish I could go back to March 2020, when some investors froze, and others sold stocks, amid crashing markets. I would have advised them to keep their heads and follow an active wealth plan. It’s hard to overcome emotion and embrace what is needed most in a crisis — discipline, not impulsiveness. Proactivity, not passivity.

Active wealth means taking disciplined action across five facets of an investor’s financial life — investing, borrowing, spending, managing taxes and protecting wealth. These five practices help maximize long-term financial success.

Last year was a stark example of how active wealth practices can grow personal wealth. Strategies involving three activities — investing, borrowing and managing taxes — could have created 20% to 30% more wealth for the investor who followed them, compared to someone with an identical portfolio who allowed inertia — or worse, emotion — to take hold.

While hypothetical, our model scenarios reflect real behaviors and illustrate that wealth growth can accelerate in a volatile market such as 2020:

  • Invest: An investor should have a goals-based investment plan, remain fully invested through downturns and regularly rebalance back to long-term targets. In our model scenario, the active wealth investor did this, sticking with the plan and maintaining target equity exposure through the March 2020 market drawdown by rebalancing the portfolio. The “emotional” investor, on the other hand, panicked and sold equities in March, thus missing April’s recovery. April was the strongest month for equities since 1987.
  • Borrow: When interest rates are low and market growth is rapid, borrowing to make a major purchase keeps assets invested and growing at a higher rate than interest payments. In our scenario, each investor purchased a second home in 2020 equal to 10% of their net worth. Our active wealth investor borrowed the money, while the other sold assets and paid cash. Using debt to keep assets invested could have increased wealth by around 5%.
  • Manage: While managing taxes is always important, its importance was magnified by the scale of the March 2020 sell-off. Our active wealth investor harvested tax losses in March, which were sufficient to offset all year-end embedded taxable gains. Avoiding taxes on significant investment gains could have increased wealth by approximately 4%.

Within BNY Mellon Wealth Management, we expect active wealth practices to generate an additional 2.5% to 5% of after-tax wealth in any given year. The 20% to 30% generated in 2020 shows that a bear market creates an opportunity to accelerate a wealth plan by four to five times what a typical year might offer. Investors who follow active wealth practices in a downturn earn returns that would normally be earned over four to five years or more — a true wealth accelerator.

Having an individual investor proactively codify goals and strategies within an investment policy statement helps them to stay on track by offering a plan to follow regardless of what the market is doing. This is how institutions leverage an investment policy statement to define their investment goals and rely on an investment committee to guide it.

Two keys to an active wealth practice is to plan and not panic, and not to go it alone.

Panic during a downturn erodes wealth. When a bear market occurs, the average market return in the first year of a recovery exceeds 40%, with diminishing returns in subsequent years. The recovery in 2020 was even more dramatic — a 75% return in the first year, measured from the market bottom.

Yet many individual investors missed much of the recovery. Equity fund flows show that investors were net sellers, not buyers, in 2020. They didn’t reinvest until 2021, long after equities had recovered, thereby missing the best returns they are likely to see until the market cycle turns again.

The second key to active wealth is don’t go it alone. I am the CEO of a wealth management firm, yet I value active wealth advice. I benefit from the discipline it provides, which helps to manage my own emotions when markets and my portfolio go down.

As much as we may want to leave 2020 behind, it is a perfect case study for the benefits of an active wealth management approach. When things seem at their worst and those around you are losing their heads, the best thing to do is keep yours.

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