Invest: Financial planning, portfolio management and wealth management

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Financial planning, portfolio management and wealth management  are often used interchangeably, but they are actually different disciplines in finance.

How are they different? Let’s take a closer look.

What is Financial planning?

As the name implies, Financial planning is a process where you plan out your finances, first, you come up with financial goals that you want to achieve, for example, 

  • Save for a house down payment by age 30
  • Pay for children’s college
  • Retire at 40
  • Etc.

These goals should have a dollar amount  attached, estimated to the best of your abilities. They should also have a deadline. In effect, all of these goals can be translated into a statement of the form:

I want to have $X by year Y.

Once you have your list of goals, you’ll effectively have a list of net worth dollar amounts that you’ll need, by certain years.

The next step is to take stock of what your assets are, right now. You should be able to then assess the viability of your financial plan, by just applying aggressive assumptions for your assets, for example, 15% annual growth year over year, every year. You should also factor in your expected annual income from a job, trust, allowance, etc., as well as your annual expenditures, again, use aggressive assumptions – your income will grow 2-4% a year, your expenditures will only grow 1.5-3% a year, etc.

If your financial plan fails even with the aggressive assumptions, i.e., you miss one or more goals even with such aggressive assumptions, then your goals are likely unreasonable, and you should re-evaluate the goals and try and make them more reasonable. For example, maybe delaying retirement by a few years?

Finally, you need to figure out how much risk you need to take on, and how much you need to increase your income by, also how much you need to limit your expenditures by, in order to give your financial plan the highest probability of success. This is important! You are not trying to maximize the return of your assets or investments, but rather, under the set of goals, you are trying to figure out what is the least risky way for you to achieve it.

The last step is where you start making more conservative assumptions. Is 15% annual growth in investments reasonable? There certainly are stocks that grow 15% or more a year for long periods of time, but how likely are you to identify them ahead of time? Also, these stocks tend to be more risky – either small / mid caps, highly levered, etc. also how likely are you to get a 2-4% raise every year? How much harder will you have to work to achieve that? Are you willing to work that much harder? And how much will you have to sacrifice in terms of living standards to keep your expenditures low? Are you sure you can maintain such low expenditures for long periods of time?

These are all questions you need to ask yourself honestly, and answer honestly. Make the necessary adjustments to what kind of risks you are willing to take with your investments, how much  you are willing to put into your job to try and achieve the raises you target, and how much you are willing to forsake in current standards of living in order to meet your goals.

Remember always, that you are trying to maximize the probability that your plan works! Yes, if you work 20 hours a day, you may get a 6% raise every year. But is that reasonable? What are the chances that you work yourself into serious health issues, and then have to take months or even years off of work to recover? Think about all these issues, then ask yourself, is it reasonable to expect yourself to work 20 hours a day for 2 years? 5 years? 10 years? I think not.

As you are probably thinking now, this is an iterative process. As you figure out the kind of sacrifices, risks and adjustments you’ll have to make, you’ll find that perhaps you are willing to trade off some goals to reduce the amount of sacrifices, risks and adjustments you’ll need to make, which in turn will likely increase the probability of success.

After a few rounds of adjusting goals, making more conservative assumptions, you’ll have a better picture of the tradeoffs that you need to make – either reducing your goals, or increasing your risk, sacrifices and adjustments. 

And once you are done, once you are happy with the final result, you’ll have a financial plan.

Portfolio management

Portfolio management is the curation of your investment assets. For example, let’s say you have a financial plan in place, and you have devoted $100,000 to investing. What assets should you buy? In what ratio? Should you have excess cash lying around to opportunistically time market downturns? Or will you stay 100% invested at all times? Or will you even lever your position to be more than 100% invested?

These are all questions that you’ll answer when you are managing your portfolio.

In order to answer these questions, though, you’ll need to have an idea of the different asset classes. Largely they are:

  • Cash
  • Equity (stocks, or ownership of private businesses)
  • Bonds (or other types of debt-like instruments such as loan, preferred equity, etc.)
  • Real estate
  • Commodities (such as precious metals, agricultural products, energy commodities, or more likely derivatives of these)
  • More exotic forms such as fine wine, rare art, etc.

Each of these behave differently in different environments. For example, in inflationary environments, commodities and real estate tend to do well, equity decently, but bonds and cash tend to suffer. In reducing interest rate environments, bonds and equity tend to do well, real estate decently, commodities and cash maybe not so much, etc.

Figuring out what to invest in, and in what ratio, is non-trivial! Happy, for most people, the answer need not be very nuanced. A 60/40 portfolio of 60% equities and 40% bonds, with maybe a few percent taken out of each to invest in real estate will generally be a fairly good trade off between risk undertaken and potential reward. However, if you are willing to spend more time on the topic, you may be able to gain more return without increasing risk or reduce your risk without reducing your return. Unless you have a substantial amount of assets under your care, you may find the results are simply not worth the effort.

Remember that when you are planning  your portfolio, you are effectively aiming for some goal from your financial plan – say you need to get 10% returns every year. This goal may severely hamper the choice of assets that you can invest in! If you aim for 10% returns every year, for example, leaving your portfolio entirely in cash is unlikely to work.

Finally, unlike financial planning, where the focus is mainly on trying to maximize the probability of success (i.e., reducing risk), portfolio management takes a more balanced approach and looks more at expected returns of assets, before figuring out how to reconcile that with expected risk (i.e., trading off risk vs return).

Wealth management

Wealth management is generally spoken of as a service provided by a professional, a wealth manager. It’s not really something someone does for themselves.

In effect, wealth management is a service which combines aspects of financial planning and portfolio management. The wealth manager will work with you to figure out what you are comfortable doing for yourself, and what you would prefer professional help with, and then work through the financial planning and portfolio management process with you. At the extreme, you may simply give the manager power of attorney over your assets, and they will then manage everything towards the goals you’ve discussed, and perhaps send you a regular stipend for living expenses.

In practice, wealth management services tend to be very expensive, as they involve a lot of risk for the manager (legal and liability risks mostly), which need to be defrayed with increased fees. Also, ongoing portfolio management and financial planning services tend to be labor intensive, while also requiring fairly specialized skills, again pointing to high fees. So, in general, wealth management services are typically only offered to those who are wealthy, and for most managers, the minimum assets a client must have is generally in the 2-10 million dollars range.

How are they intertwined?

Financial planning  can be thought of as your “life’s goals”, finance-wise. It is the target that you’d like to hit, if you think of your financial life as a business. Portfolio management is, then, the actual steps you’d take to achieve those targets (though focusing only on investments, while a financial plan often involves incomes and expenditures as well).


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