October 1, 2002
by Barry McNulty
Recently, one of my friends mentioned that a colleague of his had the perfect solution for dealing with the turmoil in equity markets. This man had simply decided to stop opening his monthly investment statement! At first, I thought this solution was akin to an ostrich hiding its head in the sand to avoid danger. However, when I gave it more thought, it occurred to me that perhaps he was on to something.
After all, once he received his statement what could he change? If he sold, he’d most likely be locking in his losses. (It’s a documented fact that the majority of investors buy high and sell low.) If he put more money into the market to average down his pricing, he might end up throwing good money after bad, especially if the market continued to decline. To make matters worse, there’s a lot of conflicting advice in the media these days as to what investors should now be doing. So, how can this man decide what to do when the experts can’t even agree on a course of action?
In fact, most people who claim to know about these things didn’t predict when the markets would start to decline. Why should this man (or other investors) expect that anyone will be able to predict when stocks will recover? By not opening his statement, this fellow is really making a decision to “ride it out.” So, depending on his portfolio structure, overall financial circumstances, risk tolerance, time horizon and other variables, he may well have chosen the best strategy.
Dental practitioners must also ride out ups and downs
Like my friend’s colleague, many dental practitioners are unfortunately faced with similar dilemmas, such as extraordinary market volatility, accounting and conflict of interest scandals, and the prospect of a “double dip” recession.
Throughout the 1990s, with its bullish market and unprecedented growth in equity markets, many dentists believed that the most effective way to create wealth was investing in stocks. Double-digit returns became the expected norm. Unfortunately, with hindsight it’s become clear to most practitioners that such expectations are not realistic. Historically, markets always seek their mean.
While this may seem like a gloomy forecast, there’s an old expression that, “Every cloud has a silver lining.” So, what’s the silver lining with respect to declining markets? Permit me to suggest that it’s what all this market volatility can teach.
Markets go up, markets go down. Economies expand, economies contract. In 1837, a famous British aristocrat and economist described economic cycles this way. He said the economy moves from “a state of quiescence” through “growing confidence, and overtrading” to “convulsion and distress” and finally “again to quiescence.” The world may be more complex today, but this simple statement continues to apply.
There are many examples confirming that history, from an economic point of view, tends to repeat itself. The conditions we face today are likely to be repeated in the future. Of course if you knew exactly when these changes were going to take place, your future would be made. But the real lesson here is that you don’t know–and neither does anyone else.
In my view the biggest risk an independent dentist faces is the risk of not having their money when they need it. Therefore, investing to obtain a high return could mean that you’re facing the risk of not having your money when you need it. In other words, it’s not the return on your money that should be your main priority in creating wealth. It should be the return of your money that counts.
There is a vast difference between wealth creation and wealth management. Creating the relative level of wealth that you’ll need is a practice activity. I have never seen a passive investment that has a greater return than what you can make through your practice. In a financial sense, this is your greatest strength.
Creating wealth involves strategic planning
To create the relative level of wealth that you need from your practice takes strategic planning. First, you must assess where you are today in a financial sense. That means understanding your resources and quantifying your long term goals. By quantifying goals, I mean working out what specific wealth you’ll need. Everyone is different. Financial security to you may be having sufficient assets to pay for a lifestyle that can be financed today for $75,000 per year. Someone else may financially require much more or much less to sustain a satisfactory lifestyle.
Let me illustrate by describing a case. After analyzing his circumstances, we determined that Dr. Smith (not his real name) needed to save an additional $35,000 per year, over and above RRSP contributions, to meet his long-term transition and retirement objectives. I call this building his pension plan (it’s not a formal pension plan but the idea is the same: to build an asset base that will supply an income stream upon retirement). Dr. Smith was spending most of his practice income, so to build what would amount to his pension, it was necessary to create practice strategies that would generate the required savings amount. It’s difficult if not impossible to design strategies to address an annual objective such as this unless we first break down the figure to “digestible bites.”
The best way to do this is to calculate what additional production will be needed, on average, on a daily basis. Then, strategies to meet this additional production can be explored. These strategies could involve increasing hourly production rates, improving recall, scheduling, increasing marketing efforts to name just a few. In Dr. Smith’s case, he worked 240 days per year. His marginal tax bracket was approximately 47%. Variable expenses in his office ran about 18% of gross production. By dividing the $35,000 by 53% (the amount left over after paying tax on this incremental income) and then dividing this figure by 82% (1-18%) we arrived at the total annual practice production needed to have $35,000 left over for creating the so-called pension. This figure is $80,533. Now by dividing $80,533 by days worked or 240, we arrived at the required incremental daily production amount of $335. This is a workable figure for two reasons. First, after analyzing unique practice circumstances, it’s possible to decide whether or not strategies can be designed to meet it. Second, assuming such strategies can be created, it’s a figure that can easily be monitored.
Naturally, it’s important to determine whether strategies are on target, or whether they’ll need fine-tuning before getting next year’s financial statement. By then it’s obviously too late to do anything remedial. That’s why I recommend monitoring either monthly, on a ‘days worked’ basis, or at a minimum, quarterly. This way, you’ll either be encouraged that you’re on plan, or you’ll have an opportunity to make necessary adjustments.
After going through the above calculation for your own situation, you may find that you can’t create strategies within your practice to generate the additional gross production ($335 per day in our example).
In this case, your strategic solution will likely involve one or more of the following:
Reducing your present lifestyle expenditures. In my experience this is not a good solution. In working with dentists for more than 20 years on the management of their financial affairs I’ve found that the most successful strategies involve either increasing gross income or options described below.
Reorganizing your affairs. Typically this involves tax planning and or debt reorganization, but there are situations where the sale of redundant assets is necessary.
Changing your goals. This means that, in your individual circumstances, reasonable strategies can then be adopted.
Let’s go back to our case study. Would Dr. Smith have a reasonable expectation of earning the extra $35,000 per year after tax from his investment portfolio? In my view, the answer is no. Increased returns bring increased risks as mentioned earlier. If you lose money on your investment portfolio it takes too much time and effort to make it back.
That’s why I believe the role of wealth management, as opposed to wealth creation, is to protect the integrity of your capital. It takes too much effort to make the money to risk losing it. While there are never any guarantees, there are ways to minimize investment risk. Typically these involve being well diversified in a manner that complements your long-term strategic plan at a risk tolerance level that is appropriate to your circumstances.
Overall, my advice is to look to your practice to create the wealth you need, and to put a solid wealth management plan in place. Remember that it’s vitally important that your strategy emphasize the protection of your capital. After all, when you work hard to make your money, you should also work hard to keep it.
Barry R. McNulty CFP, RFP, CIM, FCSI is a financial advisor with Assante Capital Management Ltd. which is a member of CIPF. The opinions expressed by the author are not necessarily those of Assante.