Investment Theory for Physicians

This article is an updated version of one from August 2011 written by Jason M. O’Dell, MS, CWM, David B. Mandell, JD, MBA, and Kim Renners, MBA.

If you are like most investors, you have significant concerns about the global economy. Even though our stock markets have come back and broken new highs, the financial crisis of 2008 remains fresh in the minds of affluent Americans. Sluggish growth has inhibited job creation and the recovery has been slower than anticipated.

Central banks and governments throughout the globe have implemented an array of measures to stimulate growth in their respective local economies. The financial markets have responded favorably to a four-year trend of government spending. However, the days of artificial stimulus will have to come to an end at some point in the near future. Once the market’s safety net is removed, volatility will return and global economies will have to stand on their own.

For these reasons and many others, it is crucial that well-informed investors, including physicians, adjust their investment behavior accordingly. This article touches on a few ideas.

Investment theory for physicians

Most savvy doctor investors understand that portfolio diversification is a key consideration to reducing some of the risk of loss in a portfolio. In historically volatile markets, mitigation of loss is not a luxury — it is a necessity.

Though most educated investors who thought they were “adequately diversified” still lost nearly half their portfolio value in 2008 and 2009 — how did this happen? Most investors were diversified within the stock market with holdings in various sectors. What these investors suffered was “market risk.” The entire market came crashing down, so did all investors within the market.

Affluent individuals should approach investing with the goal of diversifying risk through non-correlated assets, allowing their funds to compound over time by achieving positive returns net of taxes and inflation with reduced volatility. This strategy does not suggest opportunity should be ignored, it simply states that risk must be properly managed and allocated.

Generally speaking, this strategy is suitable for physicians of all ages for different reasons. An established physician less than 10 years from retirement has likely accumulated significant assets and now needs to limit the range of possible outcomes for his or her established wealth. A young or middle-aged physician’s greatest asset is his or her ability to generate future earnings. While a higher risk tolerance is appropriate for a doctor in this demographic, the income earned will be significant enough that with proper savings and risk management, the younger physician has no need to participate in speculative investments. Consistent after-tax returns and proper planning will be sufficient to allow a young physician to retire comfortably and maintain an appropriate standard of living.

What investors should understand is that diversification need not be limited to securities like traditional stock and bond investments or bank deposits. Proper diversification must be across investment classes and not just within a class (such as securities or real estate) — especially in volatile markets that return periodically throughout an individual’s lifetime. A balance of domestic and foreign securities, real estate, small businesses, commodities and other alternative investments would prove to be much less risky than holding the majority of your investments in real estate and securities (which is what most doctors do).

Most doctors who contact us are either affluent and want to fine-tune their planning or they are getting more involved in their financial planning and want to know the secrets of the more financially successful. Subsequently, many of our physician clients have taken a more active interest in surgery centers, medical office buildings and other health care related real estate.

This strategy contradicts the idea of achieving portfolio diversification, by having a disproportionate amount of capital dependent upon the success of a single industry. One strategy of portfolio diversification for doctors is to avoid all health care-related investments. The theory is that doctors already have a large portion of their income related to health care.

Alternative Investments

According to results of Capgemini and Merrill Lynch’s World Wealth Report 2011, the allocation of the world’s high net worth individuals by investment class is expected to be as follows in 2012: 38% equities, 29% fixed income, 15% real estate, 11% cash and 8% alternative investments. A key benefit of alternative investments is the low correlation to broad equity markets. Non-traded alternative investments can provide a variety of roles in a physician’s portfolio.

Certain categories of alternatives have successfully served as a hedge in client portfolios in the past. In 2008 when multiple stock indices declined by nearly 50% from their peak values, a majority of managed futures strategies offered positive returns. Although, past performance does not provide assurance of future success, a hedging technique that successfully minimized damage during the worst financial crisis most of us have experienced in our lifetime certainly warrants consideration.

For doctors who can’t build or participate in surgery centers or other profitable health care investments, a popular investment strategy is to take advantage of different investment programs that are not traded on a public exchange. Non-Traded Real Estate Investment Trusts (REITs), Leasing Funds, and Oil and Gas Drilling programs are a few examples. As with any investment, there are pros and cons for each type of offering.

Given recent market conditions, many physician investors have been attracted to non-traded programs because they offer a sense of stability. Most of these programs are available to investors at a flat price, for example $10 per share, during the offering period. An advantage to these programs is that their performance is not correlated with any particular market or index, making them an additional form of diversification. Holding non-correlated offerings may help reduce the “volatility rollercoaster” of a traditional portfolio. They should be an additional allocation in your portfolio, not a substitute for proper allocation.

Another significant benefit for physicians in the higher income tax brackets is the potential tax benefit an alternative program can offer. Some programs offer tax deductions on the initial investment. Others pay tax-efficient dividends. Some programs offer both. For example, there are oil and gas drilling programs that offer tax deductions on the initial investment due to intangible drilling costs AND tax deductions on the program’s cash flow due to depreciation and depletion allowances. REITs’ and Leasing Funds’ dividends are often only partially taxable to the investor. These tax efficiencies vary by program and from year-to-year.

Word of caution

It is important to note that one of the advantages of a non-traded offering is also a disadvantage. There is typically no market for shares of these programs. As an investor, you are expected to hang on to the security for the life of the investment, which can be as long as four to 10 years. This makes your investment essentially illiquid.

In addition, these programs are not without risk. You could invest in an oil and gas drilling program that finds no oil. You will get a deduction, but you may not get much of the initial money back. Like any other investment class, some offerings are more aggressive than others, and none make any guarantee about future performance. As with any investment, you run the risk of losing the principal investment — make sure you understand the investment and how it fits within your portfolio before committing to the strategy.

The time is now

There has never been a better time to focus on investment risk management and tax reduction planning. For physician-investors seeking ways to diversify traditional stock and bond portfolios and reduce portfolio volatility while possibly reducing unnecessary taxes, non-traded investments are an attractive alternative.

Jason M. O’Dell, MS, CWM, is a financial consultant and an author of a number of national books for doctors, including For Doctors Only: A Guide to Working Less & Building More, as well a number of state books. He is a principal of the financial consulting firm OJM Group, where Andrew Taylor, CFP, is a portfolio manager. They can be reached at (877) 656-4362 or odell@ojmgroup.com. You can also call for a free (plus $10 S&H) hard copy For Doctors Only: A Guide to Working Less & Building More. If you would like a shorter free E-book download of our “highlights” version, you can download it here.

Disclosure:

OJM Group, LLC. (“OJM”) is an SEC registered investment adviser with its principal place of business in the State of Ohio. OJM and its representatives are in compliance with the current notice filing and registration requirements imposed upon registered investment advisers by those states in which OJM maintains clients. OJM may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. For information pertaining to the registration status of OJM, please contact OJM or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).

For additional information about OJM, including fees and services, send for our disclosure brochure as set forth on Form ADV using the contact information herein. Please read the disclosure statement carefully before you invest or send money.

This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.