March 17, 2016 (Beijing, China) – How do individuals and family businesses manage wealth? Nobel laureate in Economic Sciences, Robert C. Merton, gave his insights on wealth management and capturing global market value in an investment portfolio at Peking University, Guanghua School of Management. Associate Dean and NCFR director, professor JIN Li gave the opening remarks at the event, which was attended by over 500 students and friends of Guanghua.
Merton’s 3 Wealth Management Insights
1: DIVERSIFY, DIVERSIFY AND GLOBALLY DIVERSIFY
“You mix the best performer with a market portfolio, which is diversification, that combination gives you a line [return on investment] that is even better than either one.”
The old financial adage goes, “Diversify, diversify and diversify,” but typically this adage refers to the diversification of stocks within an investment portfolio- common knowledge to the average investor. However, Merton takes this advice a step further. He says that it is actually having a globally diversified portfolio that is key.
Why?
Merton showed us a chart of Hong Kong’s performance from 1993-2015. The chart, which is shown below, has three lines: Hong Kong’s forecasted market performance, actual performance and the world’s performance. Merton argued that even though Hong Kong outperformed predictions, it still did worse than the global market.
Thus, Merton recommends the following investment portfolio mix:
High performing country investments + World market diversification
In fact, he argues that even if you assume a high level of sophistication and deep expertise about a particular market, if you only invest in one country, your investment portfolio will still underperform in comparison with the global market. This is the case, he points out, even if cases you invest globally with no such expertise.
2: CUT RISKS
The investment process should not look at the investments in the company [family business] and outside the company separately. They are separate, legally and otherwise, but from a risk and portfolio point of view, they should be integrated…You can only decide on what’s the right mix of the choices [for the company], decide how much debt, by considering those risks.”
Merton explains that one of the constraints for private companies, and particularly family businesses, is access to capital. For a private company, Merton says that the ability to borrow depends on the risk of the assets that the company is borrowing against.
Merton explains, “Anytime you have a value with risks, whether its adding value or it's a neutral value (like holding the S&P 500), your creditors are going to hold it against you on how much capital to give you.”
How do you increase your ability to raise capital?
Merton says that cleverly managing your risks is key. Simply put, “If your portfolio is low risk, they’ll [banks] lend you a lot, if its high risk they’ll lend you a little.”
Merton advises that the best way to lower the risk of your company’s portfolio is strip out all of the risks from non-value investments and invest in a globally diversified portfolio, while also investing in your core business.
Invest in Core Business + Cut Risks of Non-Value Investments + Globally Diversified Market Portfolio
Why does this work? Merton argues that it follows the same logic behind “Diversify, Diversify and Globally Diversify.”
3: TRUSTWORTHINESS+ COMPENTENCY = TRUST
“Financial services, like most of medicine, cannot be transparent. Then, the only thing that works is trust.”
Switching gears a bit, Merton gave us his take on the future of wealth management.
Trust in finance, he says, is key. Merton defines trust as having two parts: the first, trustworthy and the second, competency. He makes the point that neither the first, nor the second work on their own. He gives this example, “My son, I would trust with my life. I believe he would always make decisions in my interest. He is trustworthy. But I would not let him do open heart surgery on me. He doesn’t have the competency.” For this reason, Merton believes that the fee-only financial advisor model is the future of the wealth management industry.
Merton, then, talks about disruption in the financial industry. He points out that trust plays a huge role in this space, as well. Financial processing offered by tech companies, Merton argued, can disrupt the financial industry, as they decrease the costs of transactions and are quick. However, financial advice, he argues, cannot.
Robert C. Merton
Robert C. Merton received his doctorate degree in economics from the Massachusetts Institute of Technology in 1970, under the guidance of first Nobel laureate in Economics, professor Paul Samuelson. In the early 1970s, together with Fisher Black, Myron Scholes, Professor Merton proposed an option pricing model. For the first time, the scientific pricing model is widely used in financial derivative products and laid the foundation for the prosperous development of financial derivative products. He was the George Fisher Baker Professor of Business Administration (1988-98) and the John and Natty McArthur University Professor (1998-2010) at Harvard Business School. Merton served on the finance faculty of MIT’s Sloan School of Management until 1988. He is currently Resident Scientist at Dimensional Fund Advisors, where he is the developer of Managed DC, an integrated retirement-funding solution system with global application that addresses the deficiencies associated with traditional defined-benefit and defined-contribution pension plans. His target retirement solution has been widely adapted in many companies in US, Canada, Europe and Africa, and greatly improved investors’wealth management efficiency. He served as an independent director on the boards of the Dimensional Funds from 2003-2009.
Merton received the Alfred Nobel Memorial Prize in Economic Sciences in 1997 for a new method to determine the value of derivatives. He is past president of the American Finance Association, a member of the National Academy of Sciences, and a Fellow of the American Academy of Arts and Sciences.
