Investors Seek Objective Advice

“In the aftermath of the financial-market crisis, investors are leaving Wall Street to sign on with independent investment advisers.” – Wall Street Journal.

A perennial topic for articles in the mainstream press (and, subsequently, in this blog) is how individuals do, and also, should, choose a financial advisor.

Wary Investors Are Seeking Out Objective Voices in Wednesday’s Wall Street Journal is the latest installment on that subject.  They report that “registered investment advisers brought in more than $108 billion of net new assets into the three largest custodians” while “the four major Wall Street brokerage firms saw an outflow of $8 billion in 2008.”

While an individual investor may find it difficult to identify with billions and billions of dollars, that’s still good news; it means (in my opinion) that the good guys are winning.  Recall as I said in previous posts that registered investment advisors must act in the best interests of their clients, while brokers follow a less stringent rule.

More and more prospective and actual clients are getting that message, as the article reports that “investors seeking to repair their damaged nest eggs say the chief lure of independent advisers is more-objective guidance.”

The subhead of the article is a somewhat wordy, “Independent Advisers Are In Demand, but Picking One Means Homework.”  If not for that, the article would have been suitable for a Twitter post!  Nevertheless, the writers offer some good advice, which I summarize below.

…while most independents call themselves “advisers,” they aren’t all required to adhere to the same fiduciary standards.  As a result, the degree to which each must put a client’s interests before his or her own can vary.  The upshot, says Marilyn Dimitroff, chairwoman of the board of directors of Certified Financial Planner Board of Standards Inc., is that “the public is so confused.”

“To hire an independent who suits your needs, you should consider how much you have to invest, how much you can afford to pay and whether you want someone to oversee your entire financial life, or just pieces of it. It’s also important to probe the potential conflicts of interest your adviser may face.

Here are some questions to consider:

What type of adviser do you need? As with their counterparts on Wall Street, independent advisers come in two basic flavors: brokers, who typically focus on investment advice, and registered investment advisers, or RIAs, who may help you with everything from saving for college and retirement to tax and estate planning.

What are the potential conflicts of interest? Brokers’ income depends on commissions from client trading. As a result, they have a financial incentive to steer clients to products that pay them the most, such as variable annuities or mutual funds with high sales “loads.”

Still, many independent brokerage firms receive so-called revenue-sharing payments from mutual-fund and other financial-services companies.  In return for making such payments, fund companies may be given opportunities to promote their products to a firm’s advisers.

Investors wary of such potential conflicts may want to consider an RIA.  RIAs not only generally refrain from accepting commissions but are held to a higher “fiduciary” standard—a legal requirement that they act in clients’ best interests.  Brokers follow looser “suitability” guidelines, which means they can’t put clients in inappropriate investments. (A recent Obama administration proposal would require brokers to operate under the higher fiduciary standard.)

What are the adviser’s credentials? To find an adviser with specific skills, look for certain credentials.  A Certified Financial Planner must complete courses in investments, taxation, estate planning and insurance.  They also must pass a two-day exam, have at least three years of experience, and comply with ethical standards that require them to put a client’s interests ahead of their own.

To be continued… (as always)

Brokers May Have to Change

“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.” – Jason Zweig.

If you are confused by the difference among these titles: Financial Planner, Stockbroker, and Registered Investment Advisor, you are not alone.  The “Name Game” in the financial services industry is downright confusing.  How does your financial advisor operate?  How does she get paid?  What are the advantages and disadvantages of each arrangement?

Many people believe that they are getting financial planning from a stockbroker, when in fact financial planning is usually only an incidental part of what a stockbroker does.  Similarly, many people are not aware that a stockbroker does not have to act in the client’s best interests.

A June 19th Wall Street Journal article Big Change in Store for Brokers in Obama’s Oversight Overhaul brings home this point.

According to the article, stockbrokers might have to change the way they do business; they might have to act in their client’s best interests, the way a Registered Investment Advisor already does.

Wow!  What a concept.

Here are the relevant quotes:

Buried in President Obama’s proposed regulatory overhaul is a change that could upend Wall Street: Brokers would be held to a higher “fiduciary” standard that would compel them to place their client’s interests ahead of their own.

Currently, brokers are only required to offer investments that are “suitable,” which means they can’t put clients in inappropriate investments, such as a highly risky stock for an 80-year-old grandmother. The move could change the way products are sold and marketed and even how brokers are compensated.

Many investors don’t even know the difference between the two standards, believing their brokers already are acting in their best interests.

But requiring brokers to operate under a fiduciary standard could force them to offer products that are less costly and more tax-efficient. They will have to disclose any potential conflicts of interest, such as any fees they may get for favoring one product over another. That could mean clients will be offered fewer proprietary products if the broker can find a lower-cost option elsewhere.

For example, a broker couldn’t put you in a mutual fund with higher fees — or one he gets a bigger commission for selling — if he could get a comparable fund with lower fees elsewhere, says Tamar Frankel, an expert on fiduciary law at Boston University School of Law. (Emphasis added.)

The article implies that some stockbrokers sometimes put their interests above yours.  Hmm.   This might just be worth investigating.

Luckily, I’ve discussed this topic many times, and in fact I have a series called The Dark Side of Wall Street, which lists all of the relevant posts.  If you start with Choosing a Financial Advisor, Part 1 at the bottom of the page, you can read them in order by following the “To be continued” link at the end of each post.

When Our Brains Short-Circuit

“We have met the enemy… and he is us.” – Pogo.

Have we (i.e. mankind and womankind) developed in such a way that we are prone to making bad long-term decisions?  Is it a matter of evolution?  Is there any hope?

Last week, Nicholas Kristof wrote a column with the eye-catching title, When Our Brains Short-Circuit, that I read with interest.  I believe that the article provides lessons for all of us, as citizens and as investors.

A quick summary of Kristof’s thesis is that, because of the way we perceive risks, our brains are not suited to solving long-term problems.  His column addresses the issue of carbon emissions, global warming and how we are reacting to this threat.  It is not my place to assess the degree of the threat or the comparative advantages and disadvantages of suggested solutions such as a cap-and-trade system versus a tax on carbon, so I won’t even try.

What I would like to do, however, is to point out that our brains can sabotage our individual financial decisions, so the concepts are quite relevant for us as investors.

First, I’d like to recommend Nicholas Kristof’s columns, which are, for me at least, required reading, because he frequently writes about topics that are generally ignored by other columnists.  Sometimes the subjects are quite disturbing – the tragedy in Darfur, human trafficking, and the immense suffering caused by poverty in the developing world.  While it is upsetting to read about such things, he is not just about just gloom and doom.  He also writes inspiring stories about courageous and innovative people who are making significant improvements in the lives of others.  Overall, I find Kristof’s writing riveting.

Here are some quotes from his column.

Evidence is accumulating that the human brain systematically misjudges certain kinds of risks.  In effect, evolution has programmed us to be alert for snakes and enemies with clubs, but we aren’t well prepared to respond to dangers that require forethought.

“What’s important is the threats that were dominant in our evolutionary history,” notes Daniel Gilbert, a professor of psychology at Harvard University.  In contrast, he says, the kinds of dangers that are most serious today — such as climate change — sneak in under the brain’s radar.

Professor Gilbert argues that the threats that get our attention tend to have four features.  First, they are personalized and intentional.  The human brain is highly evolved for social behavior (“that’s why we see faces in clouds, not clouds in faces,” says Mr. Gilbert), and, like gazelles, we are instinctively and obsessively on the lookout for predators and enemies.

Second, we respond to threats that we deem disgusting or immoral — characteristics more associated with sex, betrayal or spoiled food than with atmospheric chemistry.

Third, threats get our attention when they are imminent, while our brain circuitry is often cavalier about the future.  That’s why we are so bad at saving for retirement.

Fourth, we’re far more sensitive to changes that are instantaneous than those that are gradual. We yawn at a slow melting of the glaciers, while if they shrank overnight we might take to the streets.

In short, we’re brilliantly programmed to act on the risks that confronted us in the Pleistocene Age.  We’re less adept with 21st-century challenges.

This short-circuitry in our brains explains many of our policy priorities.  We Americans spend nearly $700 billion a year on the military and less than $3 billion on the F.D.A., even though food-poisoning kills more Americans than foreign armies and terrorists.

Risk Perceptions

All four of Gilbert’s “features” affect people’s perceptions of many aspects of finance, but let’s focus on this one – “we’re far more sensitive to changes that are instantaneous than those that are gradual.”  How does this affect a comparison of risk perception regarding stocks versus bonds?  Remember that all investments have risk. 

Consider the word “bond.”  It sounds substantial, even reassuring; “My word is my bond.”  We believe bonds to be something sturdy and steadfast. Stocks prices, on the other hand, we know to be variable, fluctuating for no apparent reason.

Encouraged by the media, we are all riveted by substantial stock market declines, especially if they occur over a short period of time.  From all media accounts, it seems as though the sky must be falling; certainly the adjectives bandied about by TV broadcasters don’t help: meltdown, disaster, crash. 

Even something as simple as the phrase, “stocks are declining today” is misleading.  It would be more accurate to say “stocks have declined.”  To say they “are declining” implies that they will continue to go down, which may or may not be true.

Market volatility can be sharp, sudden and terrifying.  And yet we know that the long-term trend of stock market prices is up.  In fact, on a yearly basis, stock market returns are positive in seven out of ten years.  Of course, we cannot know which years will be positive and which will be negative, but we do know that investors expect to be rewarded for taking risks, and they are rewarded, over the long term.

The Real Risk

Consider, on the other hand, what I think is the real risk for investors – the long-term erosion of the purchasing power of the U.S. Dollar. You never see a large increase in prices on any given day, but over time, inflation has been slow, constant and nearly invisible.

In truth, we vastly overestimate the probability that a stock market decline will cause us to suffer catastrophic losses, but we also vastly underestimate the probability that, over the decades of retirement, erosion of purchasing power will grind down our lifestyle.

Wise investors will constantly remember that markets can and do go down suddenly and significantly, but they have never stayed down.  For the long-term investor, the effect of declines has been negligible.

By the same token, prices very rarely go up much in any one year, but they virtually never stop going up. You can observe the cumulative effect by comparing a 15-cent first-class U.S. postage stamp issued to celebrate the 1980 summer Olympics with a brand new 44-cent stamp today.

And yes, I know that currently inflation is not a concern.  But my prediction is that it will be; I just do not know when.

Conclusion

I believe that investors should have both stocks and bonds in their long-term portfolio, and for reasons discussed in earlier posts, I favor mutual funds, not individual securities.  My advice is don’t be so concerned with short-term fluctuations in stock prices.  Remember, the real long-term risk is the erosion of your purchasing power.

For a longer discussion of the real risk of the loss of purchasing power over time, read Nick Murray’s book Simple Wealth, Inevitable Wealth, which also provided the postage stamp example.

From Mozart to Mao

Some of the most memorable evenings in my life have nothing to do with money and numbers, and everything to do with music and theater.  As a child, my mother took me to Broadway plays.  Later, in my twenties, I saw Fiddler on the Roof and A Funny Thing Happened on the Way to the Forum, both with the late great Zero Mostel, and The Apple Tree with a very young Alan Alda, who went on to fame in the television series M*A*S*H.

Over time, I discovered folk music in Greenwich Village, then classical music and jazz, and finally cabaret music.  I am certainly not a connoisseur, by any stretch of the imagination, but I know what I like.

I remember when a friend suggested going to hear Van Cliburn play Gershwin’s works at Lewisohn Stadium, located in what is now the City College campus in Harlem.  Since Gary was always coming up with interesting things to do, I agreed.  And was I glad I did.  What an amazing night!  As I remember it, the audience was so enthusiastic that Cliburn performed three encores.

It was in Rochester where I saw the Alvin Ailey dance troupe for the first time, and I was blown away by the energy, the muscularity, and the joy of the performances.

Some very memorable life cycle events have been marked by equally memorable musical plays.  When my wife Joan was pregnant with our first child, we went to see the original A Chorus Line, which had just opened on Broadway.  It took about eight seconds for me to be totally captivated by the play.  It’s still my favorite musical.  When it finally closed, after the then-longest run in Broadway history, we took our two daughters to see it.

Last week we used Netflix to get an Academy Award winning documentary: From Mao to Mozart: Isaac Stern in China about the famous musician’s 1979 trip to China.  I thought it was a great film, and it captured the impact that a single person can have.  You can witness Stern’s musical genius not only in performing but also in teaching.  And you can see the hunger and enthusiasm that the Chinese performers and audiences had to learn more about Western music, which had been brutally suppressed.  Little did anyone know, at the time, that China was about to change dramatically.

Check out the film and see for yourself. I think you’ll enjoy it, and the DVD extra, Musical Encounters, which tracks Stern as he returns to China, 20 years later. Some of the young musicians in the original film return and reminisce, most of them in fluent English. They are now adults and are successful musicians and teachers.

My brother-in-law likes to say that “there are no coincidences,” but I find it striking that Sunday’s New York Times had a very long article about the effect of Stern’s 1979 visit to China.  After all, we had just seen the documentary a few days ago, and here is this very detailed analysis celebrating the 30th anniversary of Stern’s trip.  You can read the entire article here.

And by all means, rent the DVD documentary from Netflix, Blockbuster or your local store.  You won’t be disappointed.