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wealth management

For small investors, it might be reassuring to know that even millionaires make basic – and potentially costly – mistakes in managing their money by failing to manage risk.

One of the biggest and most common errors is failing to plan. David Kaufman, who advises wealthy investors, outlines a scenario where a client might be at a cocktail party or golf course when a friend mentions a wonderful fund manager who has done great things for her.

"The next thing you know, they're saying, 'Great, I'll put a quarter-million dollars into that fund because the guy sounds like a good manager,'" says Mr. Kaufman, president and chief executive officer of Westcourt Capital Corp., which advises clients with $1.5-billion in combined assets.

By simply acting on the friend's tip, the millionaire in the example has made a basic mistake by investing before taking the time to plan. The investor could unwittingly end up with risks she doesn't understand and does not want. It could jeopardize her wealth by making it excessively vulnerable to a single market, region, industry, asset type or investing style, Mr. Kaufman says.

"It should be ready-aim-fire rather than ready-fire-aim," says Mr. Kaufman, whose clients generally have $5-million to $100-million to invest. "The order of operations that makes sense is to start with the articulation of the goals of the investor, and the constraints of the investor."

Working with a wealth manager to review and analyze investment priorities, income needs and risk tolerances to produce the "investment policy statement" is a process that can take months. That's homework that many people – wealthy or not – simply ignore.

"Many investors spend more time planning their vacation than planning their retirement," Mo Lidsky, a principal at Prime Quadrant LP, told an investing conference this month.

RBC Wealth Management, Canada's largest manager of assets for individuals with at least $1-million to invest, is spending $25-million a year to help clients who do care about their homework by hiring more than 200 tax planners, estate planners, lawyers, accountants and actuaries.

Canada has 298,000 such high-net-worth individuals, with combined savings of $897-billion (U.S.), according to the World Wealth Report 2013, produced by RBC and Capgemini and released in June.

"We're seeing a lot more high-net-worth clients take advantage of our wealth-planning capabilities," says Mike Scott, managing director of RBC Wealth Management Canada. "We put a big focus on providing planning to our clients. That's a huge commitment for us, and we're not going to change that."

Failing to plan is just one of the mistakes investors make. Once a plan is drawn up, wealth advisers and money managers focus on managing risk as a central part of managing wealth. That usually means diversifying assets in various ways to spread the risk, from the safest to the most speculative bets.

"We are big believers in cash," says Mr. Lidsky, whose typical client has between $20-million and $50-million. "We insist that every client have at least two years of living expenses in cash, and in some cases, more than two years."

Having part of one's wealth in cash typically requires returns on the non-cash portion to exceed 8.5 per cent, generally achieved by investing with hedge funds and other so-called alternative strategies, Mr. Lidsky says.

Simpler strategies may also work to diversify holdings and boost returns. Merely investing in the S&P 500 index, a benchmark for U.S. equities, would have returned more than 40 per cent in the past two years, more than four times the return for Canada's S&P/TSX composite index. Canadian millionaires have almost 30 per cent of their shareholdings in U.S. stocks, almost three times the level of smaller investors, according to data by RBC.

Analyzing investments by their risk profile is a smarter way to allocate and diversify assets than the traditional classes of cash, stocks, bonds, real estate and alternatives, Mr. Kaufman says.

Investment strategies using the traditional classes can lead investors astray because a speculative penny stock on the TSX Venture Exchange and a blue-chip company such as Rogers Communications Inc. would both be classed as "equities," despite having very different profiles, Mr. Kaufman says. Similarly, debt issued by the U.S. Treasury and by a company with a "junk" rating would both be classed as "bonds" or "fixed income." Having such different securities in the same bucket can skew perceptions of risk and return.

"We prefer to look at the kinds of risk and reward that you get out of different types of investments, rather than what they're called," he says. "There's no such thing as no risk. Risk is not something that you always try to avoid, it's something that you try to manage."

"The biggest thing for high-net-worth clients is risk control," RBC's Mr. Scott says. "You need to put planning very high on your list of to-dos."