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Unlike ”stock picking,” which is about selecting individual securities, asset allocation examines how the various categories of securities—stocks, bonds, alternative investments, etc.—perform as a group.

The result of a well-conceived asset allocation is a portfolio that achieves the required return at the lowest risk.

A common approach amongst investors is to build a portfolio of ”winners.” The most important question is ”What stocks will generate the highest returns?” Following this strategy, an investor attempts to pick the next Apple or Tesla.

Besides being very difficult (even for experts), attempting to pick winners is not a prudent approach to investment. Asset allocation attempts to answer the question, “What combination of assets will help me achieve my objectives?” It requires consideration of three factors, specific to the investor:

Based on the above factors, we can proceed to develop a portfolio that meets the risk-and-return profile of the investors. Below are the principle tools of asset allocation.

By building a portfolio of uncorrelated investments (i.e. investments that do not behave similarly), the gains in some investments in the portfolio tend to offset losses in others. This reduces the risk of the portfolio while preserving the return.

Managing the risk of a portfolio is key to ensuring the sustainability of returns. We do this by identifying, measuring, monitoring, and hedging against the various forms of risk to which investments are exposed.

Not all parts of a portfolio achieve their expected growth. Hence, an asset allocation may deviate from the original blueprint over time. Rebalancing corrects this natural drift and uses gains in well-performing assets to invest in attractively-priced opportunities.

The power of compounding depends on the growth of the portfolio and the passage of time. Reinvesting income, such as dividends, is a straightforward, powerful way to increase growth and enhance the final value of a portfolio.

It is not possible to eradicate fraud or incompetence, but vigilance goes a long way to ensuring that your assets remain secure and available when you need them. Understanding issues such as custody, identity security, and who is charging you for what can prevent you beyond from many kinds of harm.

We’ll explore all of these five areas in more detail in separate articles in this section. Meanwhile, please consult your advisor or contact The Family Office for any questions or assistance.

Since January 2017, David M. Darst, CFA has served as Senior Advisor and Investment Strategist of The Family Office in New York and Bahrain. In this role, he has significantly contributed to the formulation, communication, execution, and monitoring of the company’s asset allocation, investment strategy, and wealth management activities in the Gulf region, North America, Europe, and Asia.

Following a 25-year career with Goldman Sachs in Zurich and New York, David served for 17 years as a Managing Director and Chief Investment Strategist of Morgan Stanley Wealth Management. David was the founding President of the Morgan Stanley Investment Group, and has served for three years as CEO of Petiole Asset Management AG, the Zurich-based asset management arm of The Family Office.

David is the author of sixteen books, including The Complete Bond Book (McGraw-Hill), The Handbook of the Bond and Money Markets (McGraw-Hill), The Art of Asset Allocation, Second Edition (McGraw-Hill) and The Little Book that Saves Your Assets (John Wiley & Sons), which has been ranked on the bestseller lists of The New York Times and Bloomberg Business Week.

This presentation is provided to you by The Family Office Co. BSC(c) (“The Family Office”) for informational purposes only, and contains proprietary information that may not be reproduced, distributed to, or used by, any third parties without The Family Office’s prior written consent.

All information, figures, calculations, graphs and other numerical representations appearing in this presentation have not been audited and may be subject to change over time. Furthermore, certain valuations (including valuations of investments) appearing in this presentation are subject to change as they may be based on either estimates or historical figures that do not reflect the latest valuation. Although all information and opinions expressed in this presentation were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to their accuracy or completeness. The information contained herein is not a substitute for a thorough due diligence investigation. Past performance is not indicative of and does not guarantee future performance. Exit timelines, prices and related projections are estimates only, and exits could happen sooner or later than expected, or at a higher or lower valuation than expected, and are conditional, among other things, on certain assumptions and future performance relating to the financial and operational health of each business and macroeconomic conditions.

The Family Office makes no representation or warranty, express or implied, with respect to any statistics or historical or current financial data, whether created by The Family Office through its own research or quoted from other sources. With respect to any such statistics or data delivered or made available by or on behalf of The Family Office, it is acknowledged that (a) the investor takes full responsibility for making its own evaluation of the materiality of the information and the integrity of the quoted source and (b) the investor has no claim against The Family Office.

Amounts in currencies other than the US Dollar are translated using prevailing market rates as calculated by The Family Office or its service providers and may differ from the rates used by banks. The rates are indicative only and do not reflect the rates at which The Family Office would be prepared to enter into any transactions with other parties.

Certain information contained in this presentation constitutes “forward-looking statements,” which can be identified by the use of words such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “plans,” “estimates,” “intend,” “continue,” or “believe” or the negatives thereof or other variations thereon or comparable terminology. To the extent this presentation contains any forecasts, projections, goals, plans and other forward-looking statements, such forward-looking statements are inherently subject to, known and unknown, significant business, economic, competitive, regulatory and other risks, contingencies and uncertainties, most of which are difficult to predict and many of which are beyond The Family Office’s control and may cause actual performance, financial results and other projections in the future to differ materially from any projections of future performance, results or achievements expressed or implied by such forward-looking statements. Investors should not place undue reliance on these forward-looking statements. The Family Office undertakes no obligation to update any forward-looking statements to conform to actual results or changes in The Family Office’s expectations, unless required by applicable law.

The Family Office makes no representation or warranty, express or implied, with respect to any financial projection or forecast. With respect to any such projection or forecast delivered or made available by or on behalf of The Family office, it is acknowledged that (a) there are uncertainties inherent in attempting to make such projections and forecasts, (b) the investor is familiar with such uncertainties, (c) the investor takes full responsibility for making its own evaluation of the adequacy and accuracy of all such projections and forecasts so furnished to it and (d) the investor has no claim against The Family Office.

This presentation represents a summary of certain information, the full terms of which are contained in a Private Placement Memorandum that should be reviewed for a more complete understanding of the investments and their risks. In addition, this presentation does not constitute an offer to sell, or a solicitation to buy, any instrument or other financial product, nor does it amount to a commitment by The Family Office to make such an offer at present or an indication of The Family Office’s willingness to make such an offer in the future.

The Family Office is a Category 1 Investment Firm regulated by the Central Bank of Bahrain 

.53871 dated 21/6/2004. Paid Up Capital: US$ 10,000,000. The Family Office only offers products and services to ‘accredited investors’ as defined by the Central Bank of Bahrain.

Asset allocation is the architectural blueprint for your investment portfolio. Rather than a chaotic collection of securities acquired over time, it is the result of a holistic, systematic process built around your preferences and needs.

Asset Allocation

Asset Allocation With David Darst

The American baseball catcher, Yogi Berra, once said, “It’s tough to make predictions, especially about the future.” This is why good investors do not depend upon predictions but build a portfolio capable of surviving the unpredictable.

Diversification is among the most effective tools to future-proof your investments. This article summarizes how it works and why it is important.

A diversified portfolio consists of a range of “uncorrelated” assets that do not all behave the same way.

We purchase securities because we are reasonably confident that the underlying company or government is stable or likely to grow. But specific circumstances or events may cause the value of a given security to decline. With a diversified portfolio, other assets that are unaffected by the same circumstances offset their effect, or at least diminishes it.

For example, during the pandemic, airline and hospitality stocks suffered while the technology and pharmaceutical sectors were resilient and certain sub-sectors grew strongly (e.g. remote working tools, medical devices, etc.).

Without dwelling on mathematical concepts, the principles of diversification are based on two premises:

The rule of risk and return still applies: the greater the expected return for a given security, the greater the risk. But a diversified portfolio of assets protects returns and reduces risk.

Diversification is not about sacrificing potential gains to limit potential losses, it is about increasing risk-adjusted returns.

A common example of diversification is a portfolio of stocks and bonds. The two asset classes have fundamentally different profiles. Stocks flourish in a strong economy with stable inflation, whereas highly-rated bonds (e.g. prime corporate and government bonds) perform relatively well during recessions or deflationary environments.

Similarly, high inflation benefits certain assets and diminishes others. For example, floating rate asset-backed loans benefit as interest income rises while their risk is reduced by the growing value of the underlying collateral assets. Technology companies, on the other hand, may suffer lower revenues as inflation-strapped consumers and advertisers reduce non-essential spending. Regardless of the situation, investors must be ready to take advantage of attractively-priced securities (e.g. during a stock market crash or a credit squeeze).

 Diversification can also be made by industry (e.g. Financial vs Technology), geography (e.g. emerging markets vs developed markets), company size (large cap vs small cap) and company stage (value vs growth).

Diversification is a complex process that must be customized to each investor’s situation. Investors whose wealth is heavily concentrated in their home country or a specific asset class (like real estate) should seek diversification internationally or in other asset classes whose performance is less correlated.

Diversification does not eliminate all risk. “Systematic” risk, for example, cannot be diversified away. These risks are inherent to the entire market and arise from a mix of factors including economic, socio-political and market-related events, such as war, recession, and natural disasters.

The aim of diversification is to lessen the impact of non-systematic risks related to specific businesses or sectors. These may include the departure of a CEO, changing regulations, disruptive competition, etc.

There is no single rule book on how to diversify. Diversification is partly art and partly science. Over-diversification, for example, may lead to excessive transaction costs. But the most important aspect is judging the true level of correlation between assets and build a portfolio accordingly.

The financial plan you develop with a financial advisor should include the construction of a diversified portfolio that delivers the required return at an optimal level of risk. Your advisor will also help to update the asset allocation as your situation changes and market events emerge.

Diversification

David Darst | Diversification

Investments that promise ultra-high returns tend to be riskier, leading to losses that may exceed your risk tolerance. Risk management is key to portfolio management. Your goal as an investor should be to manage risk prudently and not eliminate it entirely.

Risk is about uncertainty. The higher the risk, the lower the certainty of the promised return.

Government bonds denominated in its domestic currency are often considered “risk-free.” The promised coupon payment is practically 100% guaranteed as the issuing government can simply print the money to meet its obligations.

On the other end of the risk spectrum is for example a technology start-up raising capital. If it becomes the next Facebook, the returns could be exponential, but the likelihood of a loss is very high.

Risks fall into many categories and the below are by no means comprehensive. Some risks affect the entire market.

Market risk is the possibility of loss due to factors that affect the performance of financial markets, such as a drop in investor confidence.

Interest rate risk is the possibility that a change in interest rates would reduce the value of bonds or other fixed-rate investments.

Event risk is the possibility of loss due to unforeseen occurrences such as war or natural disasters.

Other risks are specific to a firm, sector, or product.

Credit risk is the possibility that an entity is unable to meet its obligations when due.

Legal risk includes the possibility of loss due to a legal action.

Prepayment risk is the possibility of reduced returns on bonds or loans due to a borrower prepayment or bonds being called.

Liquidity risk includes the possibility of loss arising from a distress sale of an asset when there are not enough buyers.

The list of risks is indefinite, and the risk factors depend on your exposure to specific industries, companies, products, and geographies.

While risk management is a complex task, it consists of four basic steps:

The first step in risk management is understanding the risks—external and internal—to which your investment portfolio is exposed. Some risks apply to all investors, while others relate to where your capital is deployed. It is also important to understand the investor risk tolerance level (i.e., willingness and ability to take risk) and manage the portfolio accordingly.

The next step is to identify the data pertaining to the key sources of risk. This could be publicly available economic data or a private database by a commercial enterprise. Some data may need to be estimated based on expert opinion.

The data must be synthesized to give an ongoing, quantitative assessment of how key risks in a portfolio are developing, and whether they are within acceptable limits. This may include calculating and updating prices for illiquid assets where the market price is not available. The estimated risk level should be measured against the investor risk appetite and rebalancing might be necessary when this is exceeded.

Certain risks can be reduced through hedging instruments (e.g., covering a long position with a short position, buying put options to limit the downside of holding a stock, converting a floating rate loan to fixed rate loan through an interest rate swap, using currency options and forwards to mitigate exposure to foreign currencies, etc.). However, the cost of hedging may reduce returns and the risk manager must evaluate an optimal strategy carefully.

Risk is unavoidable and inextricably linked to return. Seeking only “safe” investments to minimize risk may not create sufficient returns to meet your goals. Risk management is about optimizing risk and return within the risk tolerance. Having a professional wealth manager that optimizes your risk-adjusted return is clearly an advantage.

Investors often focus on returns, overlooking risk - the other “R.”

Risk Management

Risk Management: Asset Allocation With David Darst

The investment portfolio must be managed actively to address market changes and provide optimal risk-adjusted returns that achieve long-term goals within the investor’s risk tolerance.

Rebalancing keeps your investment portfolio in line with your investment plan as the value of assets fluctuates over time.

For example, if stocks grow rapidly and the value of the stocks in the portfolio increase from 30% to 50%, the asset allocation must be restored by selling some stocks and using the proceeds to purchase other assets.

Rebalancing enables the portfolio to stick to the investment objectives. 90% of the portfolio risks and returns over time are based on the asset allocation strategy.

Movements in the value of securities are often exaggerated by fleeting investor sentiment rather than underlying fundamentals. Selling securities that have grown sharply in value and buying those that have fallen in price maximizes returns by realizing profits on overvalued securities and investing in undervalued ones that promise more growth.

 Those who remain dispassionate and “buy the dip” benefit when the sentiment passes and the price recovers, avoiding bubbles or manias.

The most basic rebalancing strategy is based on defined time intervals—quarterly semi-annually or annually. This approach requires minimal effort as market movements are ignored between the rebalancing intervals which can reduce transaction costs.

Another approach is based on market movements to ensure that no asset category deviates beyond a defined tolerance range (e.g. +/- 10%). This addresses errors in a more timely manner but can incur higher transaction costs.

Regardless of whether rebalancing is based on time or market movements, it is generally prudent to revisit the portfolio at least once or twice a year.

Not all declines are due to market sentiment. Buying assets that have fallen in value due to genuine underlying fundamentals may reduce returns.

 Depending on the jurisdiction, tax treatments may need to be considered. Some jurisdictions levy a tax on unrealized gains while others treat capital gains on assets that are held for a specified period more favorably.

Another factor is human psychology. A 1985 study of mutual fund performance by Hersh Shefrin and Meir Statman documented the “disposition effect,”

 where investors tend to ignore timely rebalancing by holding losing stocks too long and selling winning stocks too soon, leading to negative results.

Given the above complexities, investors are advised to work with a well-informed, objective financial advisor to maximize the benefits of rebalancing against the irrationality of markets and the human mind.

Previous articles discussed the importance of a long-term investment strategy to achieve investment goals within the risk tolerance of each investor. This entails an investment plan with an asset allocation strategy that diversifies the portfolio across uncorrelated asset classes.

Rebalancing

Rebalancing: Asset Allocation With David Darst

The occasional losses that arise from active trading in stocks may wipe out years of returns overnight. The best returns accrue to those who invest with a long-term perspective.

In our separate article on compounding, we show how investing over a longer period enhances the growth of your portfolio. Reinvesting your income can further boost this growth dramatically.

For example, assume that stock A pays an annual dividend of 3% of the share price and appreciates 5% annually. If you invest $1000 in stock A for 20 years, your portfolio would grow to $2,653 in value and you would have collected $992 in dividends. This is equivalent to a total return of 264.5% or 6.7% per annum.

If you reinvested the 3% dividends in more shares of stock A, your portfolio would grow to $4,595, equivalent to a total return of 359.5% or 7.9% per annum over 20 years. A 1.2% increase in annual returns may not appear much, but the growth in the final value of the portfolio would increase from 27% to 73% by reinvesting the dividends.

 The chart below shows the effect of reinvesting 50% and 100% of the dividends, respectively, on the value of the portfolio over 20 years.

Investment decisions must consider the power of reinvestment within the context of your aims and wider portfolio. Income-generating assets may not be the best choice for all investors.

Also, the income from some assets may not be sustainable. For example, a company that does not generate profit may borrow money to maintain dividend payments. In this case, the dividend income to the investor will be offset by the loss of value over time. Reinvesting in such a company create no value.

Reinvestment is a tool, not a goal. The starting point is a clearly documented investment strategy that sets sensible parameters for various exposures to determine your needs for short-term income and long-term capital appreciation. Working with an advisor will help you create an intelligent approach to income-generating securities while mitigating risks. Please consult your advisor or contact The Family Office for any questions or assistance.

Some investments provide a steady flow of income, such as stock dividends, bond coupon payments or property rentals. This article discusses how you can unlock the power of compounding (covered in more detail in a separate article) by reinvesting the income inflows from your investments.

Reinvestment

Reinvestment: Asset Allocation With David Darst

But keeping our assets safe is just as important. Taking additional, needless risks with our hard-won gains makes no sense. Here we look at four ways you can minimize these risks.

When you graduate from a saving account in a bank to investing with a fund or advisor, you can easily lose sight of where your assets are held. If you do not know who controls your assets, you are open to fraud or other unwelcome surprises in an unexpected event (such as a market crash).

When you entrust your portfolio to an intermediary, that intermediary will (or should) entrust your funds to a qualified third party custodian, whose primary role is to keep the funds safe for you.

his clients’ assets—he kept them under his own control. This enabled him to bankroll an illegal investment scheme without scrutiny for many years.

Besides fraud, customer funds can be at risk without their knowledge. Some broker-dealer custodians do not fully segregate consumer funds but use them as collateral for other trades. This puts funds at risk if the institution runs into trouble.

Ensuring that your funds are segregated and in the hands of a large and reputable custodian gives you peace of mind. You can also ascertain additional information such as whether, and up to what amount, your money (if kept as a deposit) is insured against loss (a legal obligation for custodians in many countries).

Online transactions are convenient and cost-effective for investors and financial institutions alike. The pandemic accelerated the trend towards online banking and investing, as face-to-face interaction became either impractical or impossible.

Unfortunately, this has opened a new avenue for identity fraud. Scams and frauds focus on obtaining personal information and credentials (passphrases, birthdays, social security numbers) to gain access to funds online and withdraw money before the victim detects anything unusual.

Careless errors (such as leaving a password taped to a computer screen) can be avoided with common sense. But more sophisticated scams rely on impersonating a family member or a trusted institution (e.g. via an official-sounding call or email).

In case of being defrauded, you can still protect yourself by preparing a response plan (e.g. police report, locking your credit file). Your advisor and/ or bank can help you with this. As fraud continues to evolve, the best protection remains constant vigilance.

Fees are often less transparent than they should be. Some financial products are designed to be opaque, and a good financial advisor will help you avoid them.

Understanding fees can be a daunting task as there could be many different fees charged based on the services provided. Advisory fees are what an advisor will charge you for helping you build and maintain your investment strategy (including asset allocation, manager selections, etc.). Management fees relate to the ongoing management of underlying investments or assets (sourcing, evaluating, executing, monitoring, exiting). Performance fees are paid to the investment manager once the underlying investment meets or exceeds a minimum return per the private placement memorandum (PPM). Other small fees include custody fees, legal fees, and audit fees that are generally immaterial to the investment performance.

The complexity of these fees can vary widely depending on investments. Lower fees are not necessarily better, but lower 

 fees leave less room to hide. Your advisor should help you understand these fees. Transparency is practiced as one of the core values at The Family Office.

As your trusted advisor, The Family Office strives to place your investments with the best custodians with full transparency on fees, being always the trusted partner of our investors.

The main risks that investors fear are the investments themselves. This is natural, as our financial goals depend on meeting our target return.

Asset Protection

David Darst | Asset Protection

According to legend, a wily craftsman tricked the emperor of China into promising an impossibly large payment for a chessboard he had made for him. The craftsman requested the emperor to place one grain of rice on the first square of the chessboard, then double the number of grains for every subsequent square until all 64 had been filled.

By the end of the first row, the total number of grains were only 255. By the end of the second row, the number had grown to 65,535. By the 41st square, the number was over a trillion. According to legend, the king turned the tables by insisting that the craftsman count the grains to ensure the payment was correct, thus making payment impossible (as it would take nearly 300 billion years to count the grains).

The legend reveals two important lessons for investors. The first is that the effect of compounding can be astonishing. The second is that the human brain often underestimates its effects.

The chessboard example showed the effect of repeated doubling (100% return). Let’s look at the effect of a more realistic 7% annual return.

A person at the age of 20 who invests $50,000 at an average annual return of 7% would have $1,050,123 by the age of 65. But what happens if the investment is delayed by 10 or 20 years? 

The table below shows that reducing the investment period by 10 years almost 

 the final value of the investment, although the period has decreased by far less half (from 45 years to 35 years).

The effects of compounding appear slow at first but accelerate over time. The investors who begin later—at age 30 and 40—miss the rapid growth in the final 10 years enjoyed by the investor who begins at age 20. This rapid acceleration is often discounted by investors as it happens further into the future.

Warren Buffet is among the world’s most successful investors with a net worth of over $100 billion. 97% of Warren Buffet’s wealth was accumulated 

The good news is that anyone can access the power of compounding by starting to invest today. Of course, much depends on the ability to maintain a steady rate of return. This is why an advisor is an important part of achieving your financial goals. A professional will help steer you to the right investments and help you stay the course.

Albert Einstein is reported to have described compounding as “the eighth wonder of the world.” The power of compounding is real, but it is not intuitively obvious. For investors, it makes a significant difference to one’s net worth. 

The Effect Of Compounding

Most of us do not have the bandwidth or the desire to manage assets full-time, so 

 do we assess and select a manager to help grow and preserve our capital?

David Darst, Analyst and Investment Strategists at The Family Office, lists key criteria that one should consider in selecting a potential wealth management partner.

Ethics is more than just following regulations. It is about intellectual honesty. If you sense that your advisors do not believe their own recommendations, you should seek the advice of those who do.

Success in any business requires clear focus. For an investment manager, this means a coherent “investment philosophy.” This could take many forms and there is no fixed template. But if the advisor cannot clearly define it to you in a sentence, or you cannot clearly summarize it yourself, it is a red flag.

To justify charging a fee, a manager must add value. Typically, this means an ability to outperform the market. There are various ways to do this—such as leverage or deep sectoral expertise—and a manager should articulate and demonstrate this ”edge” to you in your initial meeting.

Investment management is both an art and a science, but the scientific element is essential. A good manager will have a clearly documented methodology (e.g. for screening, selecting, and divesting securities) and analytical tools (e.g. proprietary models) that make their “edge” sustainable. If neither methodology nor tools are in evidence, you may be dealing with a gifted storyteller rather than a competent investor.

Many reputable firms consist of a multi-disciplinary team, and the names of these individuals are typically displayed on the website or else accessible by request. Basic research on background and credentials can be done on the internet. A deeper dive—requesting references from previous employers—may also be worthwhile. 

Request data on how a fund or team has performed relative to its objectives and on a risk-adjusted basis. This is a great way to verify claims about focus, expertise and competence. Past performance does not guarantee future returns, but the willingness to share data is a good sign that the team stands by its history and has delivered adequately on its promises to former clients.

An honest manager will be open about mistakes and missed opportunities, and—more importantly—will share what they learned from them. No team is perfect, but the fund managers who can correct course and avoid past errors are the best prepared for an uncertain future.

Ultimately, the net returns (i.e. after fees) of the fund will accrue to your portfolio. Knowing your fees and where they are stated in the paperwork gives you a full picture of what you are receiving. Also, understanding how fees are structured gives you comfort that your interests are aligned with those of the fund (for example, knowing if the manager participates in both the upside 

It is worth also probing a fund manager on the highlights of their professional career, and encouraging them to share their most difficult experiences. A good fund will often prove itself during difficult times (e.g. a market crash or panic), and understanding this will give you a sense of how it will fare during future crises.

You can also ask them to define more generally what they believe the success factors are for a fund (for example “passion,” “discipline” or “integrity”). This is another way of revealing the team’s values, and whether they align with your own.

The purpose of the above is to cut through the common marketing and jargon in the asset management industry and establish the only two things that matter for a successful relationship: competence and compatibility.

The above points should give you ample data on which to make your decision. Given the importance of this relationship, it is better to err on the side of caution and listen to your instincts as well as the words you are hearing.

Individuals and institutions entrust their funds to a dedicated wealth management firm for many reasons. The main reason is that investing is a full-time job that requires a distinct set of skills and experience. 

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