Who Will Guard Your Nest Egg?

 ”Make no mistake about it, you are engaged in a brutal zero-sum contest with the financial industry — every penny of commissions, fees, and transactional cost they extract is irretrievably lost to you.” – William Bernstein.

Previous posts have discussed the advantages of using a fee-only financial planner and also the possible conflicts of interest that may arise when working with a commission compensated planner.

Certainly, Wall Street investment firms spend a lot of money on advertising, making it seem as though their interests are aligned with yours. So, it is understandable that the majority of consumers are unaware of the difference between a fee-only planner and someone who calls himself/herself a financial planner but who is actually a salesperson.

In Saturday’s Wall Street Journal, Jason Zweig delineates the nature and extent of the confusion.

Brokers must recommend only investments that are “suitable” for clients.

(Registered Investment) Advisers act out of “fiduciary duty,” or the obligation to put their clients’ interests first.

Most investors don’t understand this key distinction. A report by Rand Corp. last year found that 63% of investors think brokers are legally required to act in the best interest of the client; 70% believe that brokers must disclose any conflicts of interest. Advisers always have those duties, but brokers often don’t. The confusion is understandable, because a lot of stock brokers these days call themselves financial planners.

Brokers can sell you any investment they have “reasonable grounds for believing” is suitable for you. Only since 1990 have they been required to base that suitability judgment on your risk tolerance, investing objectives, tax status and financial position.

A key factor still is missing from FINRA’s (Financial Industry Regulatory Authority) suitability requirements: cost. Let’s say you tell your broker that you want to simplify your stock portfolio into an index fund. He then tells you that his firm manages an S&P-500 Index fund that is “suitable’ for you. He is under no obligation to tell you that the annual expenses that his firm charges on the fund are 10 times higher than an essentially identical fund from Vanguard. An adviser acting under fiduciary duty would have to disclose the conflict of interest and tell you that cheaper alternatives are available.

If brokers had to take cost and conflicts of interest into account in order to honor a fiduciary duty to their clients, their firms might hesitate before producing the kind of garbage that has blighted the portfolios of investors over the years. (Emphasis added.)

Conclusion

Panicking and pulling out of the stock market following a steep decline, concentrating your investments within a narrow range of options, and too much trading and too little long term holding are some of the more common mistakes investors make. Any and all of which will likely result in a reduction of your investment returns.

Understand, though, that high costs can absolutely kill your investment returns, whether from the high fees of a variable annuity or 403(b) plan, high (and often hidden) expenses and fees of some mutual funds, or the opaque mark-up on bonds sold to unsuspecting investors. Your best protection is to ask your financial advisor to sign a Fiduciary Oath. To find a fee-only planner near you, view the NAPFA (National Association of Personal Financial Advisors) web site.

It is encouraging that the issue of who is working in your best interests has been brought front and center by Jason Zweig, a respected author and columnist. Now, let’s see if the Securities and Exchange Commission Chairwoman, Mary Schapiro, proposes changes in legislation that will benefit consumers. The stakes are extremely high, as Wall Street firms make billions from unsuspecting customers.

Entrenched interests never give up power or lucrative business practices easily.

Is Buy and Hold Not Working? Part 3

“Being a buy-and-hold investor today makes as much sense as it ever did. The point of sticking to sound, fundamental strategies, after all, is to keep you from making big mistakes in moments of crisis. And abandoning the market now could turn out to be a very big mistake.” – Jeremy Siegel.

Roger C. Gibson, the author of Asset Allocation: Balancing Financial Risk was recently interviewed by Morningstar Advisor to offer his perspective on the turbulent stock market of the last year. Gibson is an expert on portfolio construction and investment management. His observations are worth considering.

No Place to Hide in 2008

Morningstar’s data base includes approximately 4,000 mutual funds that invest in either stocks or real estate (U.S. or international). All but one had losses in 2008.

“Of 1,730 bond funds–both taxable and municipal–68% lost money, which surprised us. Those that didn’t were (U.S) government or short term bond funds.”

“I’ve never seen losses like 2008, but it wasn’t something completely unthinkable. And when you have absolutely horrible, panic-driven significant losses, they’re usually not just confined to a particular asset class. In 2008, panic fed on itself.”

Volatility

Gibson tabulated the number of days the Standard and Poor’s 500 gained or lost 5% or more. Between January 2008 and August 2008, there were no 5% days. Between September and December there were 18 days when the market moved 5% or more, or one out for five! This is unprecedented volatility.

It is quite amazing how investors have become accustomed to 5% fluctuations in a single day. According to Gibson, “Over the last 50 years, these kinds of moves probably only happened once a year and, already, investors have almost gotten numb to this volatility.”

What can we learn from 2008?

“During times of excessive optimism, people overshoot markets on the high side, and during times of extreme fear and panic, markets overshoot on the downside. In 2008, people panicked and dumped securities, which sets the stage for higher-than-normal rewards for people holding on.”

Regarding asset allocation and diversification, “Strategic asset allocation isn’t broken and never promised to sidestep a year like 2008, but what it will do is make the portfolio as a whole have less average risk. That’s mathematically driven. And it will cause a portfolio to have a higher compound return than the average return of its asset classes. That said, it doesn’t mean you can’t get into a scary environment.”

Conclusion

In previous posts, I have written about the futility of trying to predict the near term direction of the stock markets. It just can’t be done successfully on a continuous basis, neither by you, on your own, nor with the help of a market strategist. I’ve also written about the near impossibility of improving your overall results by pulling out of the market and waiting until you think it’s a better time to invest. Finally, I have outlined the evidence for the failure of market selection – finding underpriced securities.

Given what does not work, what is the recommended approach? In my opinion, it is a diversified, low cost, buy-and-hold portfolio matched to your time horizon and risk tolerance.

To be continued.

Is Buy and Hold Not Working? Part 2

My last post addressed the proper response to a stockbroker’s claim that the “Buy and Hold” approach to investing has not worked. My answer was, “compared to what?” I explained that, in determining when you should and should not invest in stocks, the probability is low that you’ll guess right.

By the way, have you noticed that the question of whether “Buy and Hold”  works only comes up after a steep market decline? Why doesn’t it ever come up when stock prices are hitting new highs?

Since we have covered the issue of when to buy, up next is what to buy, or more specifically, what approach to use in investing for the long term.

Active Investing

A perennial debate (actually, only since the 1970’s, but you get the drift) among investors is which is better, active or passive investing. Wall Street (stockbrokers) must convince you that active investing is superior, or they have little to sell. Their sales pitch is usually that their experts can do better than average. Think about it. All stockbrokers and active money managers say the same thing. How is it possible that they all claim to achieve better than average returns? Do they live in Lake Wobegon?

What they are claiming is that, through superior stock selection, they can outperform the market. The strategy is for an investment manager to buy something that is underpriced and will do well. After it has outperformed, sell it and then buy something better. This approach is certainly good for the stockbroker, who earns a commission on each and every trade, or the mutual fund company, which can charge higher fees for active management.

But there is no evidence that anyone can actually do it profitably on a consistent basis. Let me rephrase that a bit, there is no evidence that a stockbroker can do it consistently and profitably on behalf of an investor. Certainly, the stockbroker consistently profits from the commissions he earns while actively trading on an investor’s behalf.

Regarding mutual funds, remember that active trading has costs; the cost of research, trading, and taxes, for a taxable account. Therefore these mutuial funds have to overcome the higher costs before their investors benefit at all from active management.  That is true in good times and bad. In fact, many actively traded mutual funds have had a really rough time in this bear market, underperforming stock indexes.

For a witty (though somewhat wonkish) take on the active versus passive debate, consider a transcript of Rex Sinquefield’s opening statement in a debate with Donald Yacktman at the Schwab Institutional conference in San Francisco, October 12, 1995.

For a more recent comment on the issue, one professional investment management firm that manages billions of dollars and uses the asset class mutual funds of Dimensional Fund Advisors, summarized it well.

“Let’s be very clear: this bear market has been witness to the spectacular failure of active management. Index funds have handily outperformed active managers in a market where conventional wisdom would have you believe the active approach would add value. When (you) read that now it is more important than ever to be tactical, it begs the question that if active management didn’t help you avoid this bear market, then why would you expect it to outperform going forward?”

Conclusion

When an active investor attempts to identify and buy a stock or bond that is underpriced, what he or she is really saying is that everyone else is wrong. That’s because the current price is the best estimate of what everyone thinks it should be. It’s true that prices can be wrong, and that they can and do eventually change, but the question is whether you, or anyone else for that matter, can identify and take advantage of any mis-pricings in advance of their correction.

The same applies when choosing a successful mutual fund investment manager. It would be wonderful if we could find really good stock pickers, the ones who consistently beat the average, but that is impossible. You may find that sometimes (about 25% of the time) a mutual fund has beat its benchmark. Unfortunately, you cannot identify such winners in advance.

To be continued.

Is Buy and Hold Not Working? Part 1

Recently, my son-in-law got a cold call from a stockbroker. “Jim,” the stockbroker exclaimed, “Buy and hold isn’t working!” James, intelligent man that he is, begged off with the response that his father-in-law is a financial advisor and that he was “all set.”

While I certainly appreciate my son-in-law’s loyalty, the stockbroker’s statement had me thinking. If you had been the recipient of that cold call, how would you have responded to the statement: “Buy and hold isn’t working any more.” My suggestion is that you ask, “Compared to what?”

Well, I suppose one answer would be compared to a strategy which keeps you out of the stock market when it’s going down. Unfortunately, no such strategy exists. If it did, pension funds with billions of dollars would be using high priced managers to implement it.

An October article in Fortune magazine, Is Buy-And-Hold Dead and Gone? had these useful observations on this issue.

You can’t time the market.

The evidence shows that most investors get it wrong over and over again. According to a study called the Quantitative Analysis of Investor Behavior by financial research firm Dalbar, over 20 years through the end of 2007, the average equity-fund investor earned an annualized return of just 4.5%, vs. the S&P 500’s 11.8% return. Why? In large part because investors, chasing performance, shift money out of lagging funds and into hot ones at the wrong times. We buy high and sell low repeatedly.

Need more evidence? Go back to the dot-com bubble. In the first quarter of 2000, according to Morningstar, investors channeled $97 billion into equity funds – nearly double the total of the previous two quarters – right before the S&P 500 peaked on March 24, 2000. And in the third quarter of 2002, they withdrew $41 billion from stock funds just before the market bottom on Oct. 9.

(Emphasis added.)

Conclusion

No one can accurately or consistently predict the short term direction of the stock market, but selling stocks, or refusing to buy them now, because they have gone down in price, is not likely to be a winning long-term strategy. Historically, stock markets have had sharp increases following a bear market. The difficulty is identifying when that move is for real. Bear market rallies, bear traps, etc. tend to keep investors gun-shy, so a sustainable bull market rally will only be identifiable in hindsight.

Nevertheless, individuals who keep their investments in cash or Money Market funds will miss out on most of the move.

To be continued.

Brawl Street: Jon Stewart vs. Jim Cramer

The Daily Show With Jon Stewart	M – Th 11p / 10c
Jim Cramer Unedited Interview Pt. 1
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Daily Show Full Episodes Economic Crisis Political Humor

I’m not a fan of the financial advice dispensed by CNBC’s talking heads. The “advice” is contradictory, often based on someone’s guess, and certainly not geared to your individual situation.

I find Jim Cramer, of Mad Money, particularly difficult to watch, and it’s not just the bombast. I believe that none of his recommendations make any sense. He is telling viewers which stocks will do well and which will do poorly, which is impossible to do.

Guessing which stocks to buy is not investing; it’s speculating. The public needs to understand that. So I was pleased that Jon Stewart of the Daily Show took Cramer to task. Since I believe that Jim Cramer’s infotainment gives viewers the absolutely wrong framework for successful investing, I think he got off easy.

ABC This Week with George Stephanopoulos had a roundtable discussing, among other things, whether CNBC fell down on the job covering the financial and business world.

Right at the end of the session, George Will nailed the real issue with his general rules in life.

• Don’t play poker with a man named Slim.
• Don’t buy a Rolex from someone who is out of breath.
• Don’t take financial advice from people who are shouting.

Amen.

The Scream of the Lizard

Bob Veres writes a well-respected newsletter for financial planners. Recently Russ Thornton posted one of Mr. Veres’ articles, The Scream of the Lizard.

I loved this article, because I believe that Veres captures, so perfectly, the fear that is motivating, not just many inexperienced investors, but himself, as well. What’s interesting is that, while he has a very well developed and rational understanding of what investing in the stock market sometimes entails, he is still gripped by the fear of the “roller coaster ride” and the scary (but unrealistic) feeling that we are about to fall into the abyss.

Even though he knows better, he still can’t help the way he feels, because of what he refers to as “the lizard-like part of the back of (the) brain” which screams “against all logic and against many things I (know) to be true.”

If you are extremely fearful and cannot possibly imagine that there is a bottom to the stock market, give yourself a little understanding and possibly a little more TLC. You are not alone; in fact, you are in good company.

I recommend that you read the whole article, but here is the conclusion.

I’m one of those financial media types, and also a pundit on occasion, and I can tell you that I can hear the lizard’s scream echoing across the financial landscape, so loudly that it’s hard to remember that stocks are on a fire sale now and they are certainly a hell of a lot less risky than they were last August, and that these rides are seldom fatal to those who stay in their seats, and they are usually at least harmful to those who panic, unhook their seatbelts and jump over the side toward the distant anthill below.

I can hardly wait to look back on those charts and wonder what the hell we were thinking getting so panicky about a blip, and I know at that time that the lizard will be giving me a different message: that if only I’d had the sense to buy when everybody else was selling…

This too shall pass, and 99% of your brain knows it. The market belongs to the lizard now, and I am ashamed to admit that I, the pundit, the media guru, still feel that sense of panic on the way down, irrational as I know it is. I feel it so much that sometimes I can barely hear the rational part of my mind over the screaming that echoes that are calling up from a deeper part of my consciousness. I would curse the designer of this roller coaster, as I did the fiend who put that damn thing up at Sea World, but I’m afraid this time it is us, collectively, who designed our own fear machine.

CNBC Financial Advice

The Daily Show With Jon Stewart	Mon – Thurs 11p / 10c
CNBC Financial Advice
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Daily Show Full Episodes Political Humor Healthcare Protests

Last week Jon Stewart of the Daily Show ridiculed the usefulness of financial predictions made on some CNBC shows.  Stewart exposed the theatrics and general silliness of many CNBC commentaries, not to mention the shameful sucking up to CEOs.

Remember that the Daily Show is on Comedy Central, so have a good laugh. This is not meant to be fair and balanced.

Yes, CNBC has had some very good interviews with the likes of investor Warren Buffet, author John Bogle and PIMCO executive and author Mohamed El-Erian. But remember that many CNBC shows are essentially infotainment; they are meant to keep you watching so that CNBC can sell ads.

By the way, keep watching the show to see a humorous but also enlightening interview with New York Times columnist Joe Nocera.

Nobody is Buying Stocks?

“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.” – William Feather.

As stock prices have declined this week, I have noticed some sloppy journalism. According to newspapers and TV programs, there is so much pessimism about the economy that no one is buying stocks. Clearly if everyone else is selling, you would be foolish to be a buyer.

To get a sense of this interpretation, take a look at today’s New York Times article Slump Humbling Blue-Chip Stocks, Once Dow’s Pride by Jack Healy.

Here are some relevant quotes with my comments:

“With so much uncertainty, investors are parachuting out of companies like banks, retailers and utilities, and abandoning stock markets everywhere from Asia to Europe to Wall Street.” (Parachuting? Nice metaphor.)

“No one is taking a back-seat approach. Everyone is just selling.” – Peter I. Cardillo, chief market economist at Avalon Partners.  (Everyone?)

“Nobody wants to be invested, that’s the problem. I don’t believe we’re at the bottom yet.” – Eric Ross, director of research at the brokerage firm Canaccord Adams. (Nobody?)

A similar story was portrayed in an article in the Wall Street Journal, Stocks Hit ‘97 Level, Signaling Long Slump, on March 3, 2009 by Tom Lauricella and Annelena Lobb.

Here are a few quotes with my comments.

“It’s like an unending nightmare” – Kent Engelke, managing director at Capital Securities Management . (This is an exaggeration and seems to suggest prices will continue to drop.)

“The relentless decline is pushing investors to the sidelines.” (Not really. See explanation below.)

“I want to wait for a firm turnaround, and be as safe as possible,” Bijon Mishras, a financial-services consultant in New York. (Whoa, Nelly. Remember this quote and see how it turns out.)

“Nobody wants to buy a market today that they think is going to be down 2 or 3% tomorrow,” says Michael O’Rourke, chief market strategist at brokerage firm BTIG LLC. (Nobody?)

A Reality Check

Yes, the economic news coming out of everywhere is very bad, and yes, stock prices have had steep declines. But guess what? Every single time that someone sells a stock position, someone is on the other side of that transaction. Every single time. What do we call such a person? Insane? No. How about “buyer.” Sellers and buyers must be equal!

For every person who sells because he or she doesn’t like the prospects for the future (a.k.a a “pessimist”), there is someone who is buying (a.k.a. an “optimist”). That person thinks the investment is at a great price. Those two groups of investors or participants in the market have to be in equilibrium at all times.

When you look at it from that perspective, you don’t get the overwhelming sense of doom that the media creates — that there’s only one way for prices to go, and that is down. If that really is the case, then there are a lot of crazy people who are buying now.  I don’t think so.

The fact that prices have been going down does not mean that they will continue to go down. Just as in 1999, the fact that prices had been going up did not mean that it was a good time to buy stocks.

Risk/Reward

No one knows what tomorrow will bring, but unless capitalism ceases to function, stockholders will be rewarded in the long term for owning stocks and for taking risks. Yes, there is risk in owning stocks, as we have recently experienced. Since we’ve already seen the risk, how about staying around for the reward?

An old Wall Street proverb is that “Nobody rings a bell at the top or the bottom of a market.”

Are you waiting for that bell to ring? Don’t.

Searching for a Better Investment Guru

U.S. stocks declined yesterday to the lowest prices in more than 12 years. The Standard and Poor’s 500 closed at 700. You would think that now would be a very good time to have a reliable investment guru offer sage advice and words of wisdom. Times are tough, the economy is tanking and there is panic in the streets (Wall Street and Main Street, both). What is an investor to do? Should she buy, sell, hold? “Surely,” you think, “the ‘experts’ must know.” Unfortunately, you’d be thinking wrong; the correct answer is that he or she really doesn’t.

Last month, in an article titled Why the Experts Missed the Crash, Money Magazine published an interview with UC Berkeley Haas Business School professor Philip Tetlock. The professor has spent his career evaluating experts and authorities in a variety of fields, and he is not at all surprised that the vast majority of financial “gurus” failed to predict the recent steep market decline.

Here is a summary of the article:

Despite everything, we can’t shake the belief that elite forecasters know better than the rest of us what the future holds.

The record, unfortunately, proves no such thing. And no one knows that record better than Philip Tetlock, 54, a professor of organizational behavior at the Haas Business School at the University of California-Berkeley. Tetlock is the world’s top expert on, well, top experts. Some 25 years ago, he began an experiment to quantify the forecasting skill of political experts.

Tetlock has analyzed “not just what the experts said but how they thought: how quickly they embraced contrary evidence, for example, or reacted when they were wrong. And wrong they usually were, barely beating out a random forecast generator.”

Why did so many experts miss the economic crash?

The people intimately involved in packaging [financial derivatives like] CDOs must have had some sense that they were unstable. But their superiors seem to have been lulled into complacency, partly because they were making a lot of money very fast and had no motivation to look closer. So greed played a role.

But hubris may have played a bigger one. … In this case the biggest source of hubris was the mathematical models that claimed you could turn iffy loans into investment-grade securities. The models rested on a misplaced faith in the law of large numbers and on wildly miscalculated estimates of the likelihood of a national collapse in real estate. But mathematics has a certain mystique. People get intimidated by it, and no one challenged the models.

Money has written about human mental quirks that lead ordinary folks to make investing mistakes. Do the same lapses affect experts’ judgment?

Of course. Like all of us, experts go wrong when they try to fit simple models to complex situations. (“It’s the Great Depression all over again!”) They go wrong when they leap to judgment or are too slow to change their minds in the face of contrary evidence.

An Alternative to Finding a Better Forecaster

A good part of the article explores the question “What makes some forecasters better than others?” Professor Tetlock has a detailed answer, which makes interesting reading. He recommends looking for “self-critical, eclectic thinkers who were willing to update their beliefs when faced with contrary evidence, were doubtful of grand schemes and were rather modest about their predictive ability.”

But my answer to the same question is radically different. I believe that it is futile to rely on gurus who have been right more often than others. Various “experts” will be right or wrong at different times, and you cannot, regrettably, know in advance when that will be. So if in essence, the future is unknowable, and experts are so unreliable, you need to have a strategy that does not depend on “accurate” forecasts.

No one, yes no one, knows how markets will behave in the short term. Accordingly, my recommended approach has been and continues to be a disciplined long-term strategy. To understand why, it is absolutely necessary to have perspective on financial history:

• There have been many financial crises in the past; none have proven fatal.
• We have experienced a dozen other Bear Markets since World War II.
• Stock prices have rebounded from all previous declines, even steep ones.
• The stock market goes up in roughly 3 out of every 4 years.
• Stock market losses are temporary; stock market gains are permanent.

Furthermore, waiting for the “right time” to invest doesn’t work for most people, most of the time. The likelihood is that you will miss out on the really strong rebounds that happen when you least expect them. In other words, don’t wait until it looks safe to invest in stocks.

Accordingly, I leave forecasting to the “experts” who according to Professor Tetloc “barely beat random guesses – the statistical equivalent of a dart-throwing chimp – and proved no better than predictions of reasonably well-read nonexperts.”

I do believe in controlling what I can:

• Costs (through low cost mutual funds)
• Risk (through global diversification and sensible asset allocation).

I believe in staying the course so as to participate in the eventual and inevitable recovery.

In short, I do not have a forecast; I have a philosophy and an approach. It’s not perfect, nothing in this world is, but experience shows that it works better than any other approach.