Can You Trust Wall Street?

For anyone who is a movie buff, this bombshell can be compared to the classic scenes in Tom Cruise’s Jerry Maguire and his career-killing “mission statement.”  Except this time, it’s not fiction, it’s for real. When executive Greg Smith quit his job on March 14th, he declared, “The environment (at Goldman Sachs) now is as toxic and destructive as I have ever seen it.” 

And this was no internal memo in which he aired his grievances.  As most are now aware, he went public (very public) in his now-viral New York Times op-ed, Why I Am Leaving Goldman Sachs.

Time will tell whether Greg Smith ends up honored as a game-changing hero, cast aside as a “whiner,” or largely forgotten, like that JetBlue steward who departed his career via the emergency exit.   But Smith’s observations are spot on. “If clients don’t trust you, they will eventually stop doing business with you. … People who care only about making money will not sustain this firm — or the trust of its clients — for very much longer.”

He may not enjoy lasting personal fame, but I fervently hope that the message he delivered ends up spurring a much-needed cultural shift within the financial industry.  Smith’s condemnation of the leadership changes he saw during his decade at Goldman Sachs struck most of us as illustrative of a global epidemic rather than a problem at only one Wall Street firm. 

It really shouldn’t be that complicated.  As Susan John of the National Association of Personal Financial Advisors (NAPFA) commented in InvestmentNews, “I think clients want to know that whoever is working with them has their interests at heart, and that there’s more loyalty to the client than to the firm.”

It seems to me that this sort of dedication to investors’ best interests should be a no-brainer — regardless of a firm’s business model, fee structure or service offerings.  It seems equally clear that, at least among Wall Street’s behemoths and likely far more widespread than that, it’s all too frequently not.  (This blog contains a series of posts on the “dark side” of Wall Street.)

How do we make meaningful progress toward eliminating financial service environments in which, as Smith alleged, his former colleagues “push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals”?

Legislation can help, up to a point. But one need only look to Bernie Madoff to know that laws will only get us so far when someone is determined to break them. What’s required is an attack on all fronts.  As individuals — financial professionals and investors alike — we must share a common passion for championing continued cultural, legal, procedural and educational improvements in all that we do with our investment activities.

My first recommendation is that you insist that your financial advisor promise in writing that your highest interests will come first.  In legal terms, this is known as a fiduciary relationship between you and your advisor.

If your advisor won’t agree to this legally enforceable relationship with you, I would suggest you respond with a quote from another movie character, Howard Beal, excellently portrayed by Peter Finch in Network: “I’m as mad as hell, and I’m not going to take this anymore.”

30 Kidney Transplants, a Reason for Hope

Despite plenty of disheartening news in the world, one masterful act can restore my faith that there are always reasons to be hopeful, even optimistic. A recent case in point: The New York Times article, 60 Lives, 30 Kidneys, All Linked, relates a chain of anonymous kidney transplants among 30 donors and recipients. Why would I, a financial planner, write about this?  Besides being a magnificent example of the human spirit, I see intriguing connections between the process, and the way our markets frequently overcome challenges the way they do.

The article is so breathtaking that it takes time to appreciate its impact and implications. While I recommend that you read the entire piece, here is how the Times summarizes the two-page story: “A record chain of kidney transplants resulted from (a) mix of medical need, pay-it-forward selflessness and lockstep coordination among 17 hospitals over four months.” The article also mentions Garet Hil, who was inspired by his own daughter’s kidney transplant experience to found the National Kidney Registry, which was behind the successful chain of events.

In financial planning, we do not know what medical expenses might be. This story merely hints at how complicated that can be. In addition, bad things happen to good people, and as much as we can plan for the future, there will always be unhappy surprises and setbacks. That’s why we buy all kinds of insurance: car, life, umbrella, and long-term care. It’s also why we should have wills and other estate planning documents.

Ever since I studied economics in college and graduate school, I have been curious about when markets work beautifully and when they don’t. Milton Friedman (and other free-market economists) argued that central planning doesn’t work very well compared to the decisions of millions of people acting in their own interests. (See the Power of the Market – The Pencil) 

But by law there cannot be a market in body organs; you cannot legally pay someone for his or her kidney.  (I’ll leave it to the bioethicists to argue why that should be.)

Is it stretching the point too much to suggest that Garet Hil created a “market” by forming the National Kidney Registry?  It may not depend on buyers and sellers using prices to allocate scarce resources, but the ability to coordinate 60 (or more) anonymous donor/recipients toward a common cause is a comparable, if not greater challenge.  Certainly Mr. Hil’s computer programming prowess was complemented by his ability to convince hospitals to accept his better way for finding matches for kidney transplants.  People (mostly) responded to understandable incentives although a totally selfless donation started the whole process this time.

As an ex-Marine and M.B.A. from the Wharton School, Mr. Hil is worthy of a book or article by Michael Lewis. Brad Pitt, are you free to make a movie in 2014 ?

And personally I am always amazed and inspired when someone experiences adversity or loss and then resolves to change the world so someone else does not have to suffer the same fate.  (It’s worth noting that Hil’s daughter did find a donor, but not without some touch-and-go moments that Hil felt should have been avoidable.)

So what did it take to accomplish this particular “miracle”? (1) someone had the idea of transplant exchanges and wrote a journal article in 1986; (2) someone else witnessed suffering first hand and had the motivation, financial resources and expertise to do something about it; (3) there have been amazing changes that computers and information technology make possible; (4) doctors and hospitals had to get over the “not invented here” syndrome; (5) altruistic individuals wanted to make a difference and were willing to undergo surgery and some suffering to accomplish that; (6) trust was needed that people would honor their commitments; (7) coordination, logistics and persistence all played their part; (8) and finally old-fashioned chance and luck contributed to the final result.

If you take a moment to view Friedman’s short pencil-example video, you’ll find it succinct and persuasive, but isn’t the “60 Lives, 30 Kidneys” story so much more powerful?  It is, especially if you happen to know someone who needs a kidney transplant.

Admitting Ignorance

“After more than a quarter-century as a professional economist, I have a confession to make: There is a lot I don’t know about the economy.” – N. Gregory Mankiw.

The well-kept secret that the media won’t tell you is that, in spite of the fact that they do it all the time, economists find making predictions fairly tough, and they’re really not very good at them. 

I’ve commented on this before, and past posts are grouped under the Series: The Cloudy Crystal Ball.

If You Have the Answers, Tell Me

In this Sunday’s New York Times column, Harvard professor and economist N. Gregory Mankiw admits with some humility what he doesn’t know.  And he doesn’t know a lot, apparently.  That list includes the very things we care and worry about as consumers, investors, Americans; things such as the future direction of the U.S. economy and unemployment, the future amount and impact of inflation on consumer spending and business investment, and how long the U.S. government will be able to borrow money at such low interest rates.

How refreshing for a professional economist to be humble.

Professor Mankiw’s column is brief and well worth reading.

He concludes with this, “If you find an economist who says he knows the answers, listen carefully, but be skeptical of everything you hear.”

Larry Swedroe has, for many years, expressed similar skepticism about the ability of forecasting to add value.  Mr. Swedroe is director of research for The Buckingham Family of Financial Services, author of several books that I have read with great pleasure, and he is my absolute favorite blogger at Wise Investing.

Never In Doubt, Often Wrong

Here is something he said in 2002.

The track record of economists is dismal (perhaps that is the real reason it is called the dismal science). The track record of market strategists is equally dismal. Despite this, the press and media focus on forecasts (though rarely holding the forecasters accountable, for accountability would end the game) and investors pay great attention to them; allowing the forecasts to influence or even determine their investment strategy.

Buckingham’s Swedroe on Housing, Oil, Investing

In a recent interview aired on Bloomberg TV, which is well worth viewing in my opinion, Swedroe said emphatically, “There are no good forecasters.”

Not merely offering a criticism of forecasters and prognosticators, he also discusses the “right way” to invest.  Specifically, Mr. Swedroe advises controlling risk by widely diversifying, keeping costs down and keeping taxes low.  And, of course, by not buying actively-managed mutual funds. 

Amen.

Freedom from the Press

While freedom of the press is crucial to a well-functioning democracy, reading the financial press may be hazardous to your wealth.

One of the worst things investors can do, right now, is to pull out of the stock market because (they think) “the end of the world is upon us.”  The truth is that many people “throw in the towel” at just the wrong time.  And, certainly, the media, all too frequently, plays into (and plays up) that irrational fear, and usually at just the wrong time.

Several articles, had they been taken seriously, might have scared you right out of the stock market.  If you had followed the very typical story line of “now is a very risky time to be investing in stocks” you might have missed out on the best September since 1939.  In that single month, the Standard & Poor’s 500 Index gained 8.8%!

Here are just a few of the recent articles that could have led you astray.  (And note, please, the usage of the word “flee” in the title of the first two articles; I can’t help but relate the word “flee” to those old Godzilla movies, where everyone is haphazardly running for their lives.)

Small Investors Flee Stocks, Changing Market Dynamics, Wall Street Journal, July 12, 2010

“Many individual investors were tiptoeing back into stocks in the spring. Now, they’re running for cover again.”

“Individual investors were important market pillars in the 1990s, but their flight from stocks is changing the market dynamic.”

The article actually pictured a smiling couple who “sold the last of their stock holdings on May 20, moving the money to bonds, certificates of deposit and bond-like annuities.”  What unfortunate timing!  I’d be curious to see if they’re still smiling.

In Striking Shift, Small Investors Flee Stock Market, New York Times, August 21, 2010

Renewed economic uncertainty is testing Americans’ generation-long love affair with the stock market.

Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year, according to the Investment Company Institute, the mutual fund industry trade group. Now many are choosing investments they deem safer, like bonds.

The New York Times and The Wall Street Journal were not alone in trumpeting doom and gloom.  There have been similar articles in USA Today and Fortune.  Even The Atlantic weighed in with a fabulous title: The Great Stock Myth.

For an astute analysis (and a thorough debunking) of the Atlantic’s article, read Larry Swedroe’s August 30^th post, Are Stocks Really Doomed?

Conclusion

What can we learn from reading (and then completely disregarding) such inflammatory articles?  We learn that they are not at all helpful for long-term investing.  Articles of these types almost always appear after periods of low returns and/or increased volatility of stock prices.

What we know is that, yes, stocks are risky.  And, yes, prices fluctuate.  And, (a very emphatic) yes, we are all facing serious economic and political challenges.  And, perhaps some people should have a significant amount of their money invested in fixed income securities. 

But your portfolio should depend on an individual assessment of your goals, your time horizon, and your ability and willingness to accept risk.

Your long-term investment strategy should definitely not depend on – nor should it be influenced by – what you read in the media.

Wall Street Greed and Delusion

Derivatives (complex financial instruments) are time bombs and “financial weapons of mass destruction” that could harm not only their buyers and sellers, but the whole economic system.

“Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years.”

Warren Buffet (2003)

After seeing Michael Lewis on both 60 Minutes and The Charlie Rose Show last week, I had to read The Big Short: Inside the Doomsday Machine, the just released book by Lewis about the subprime mortgage disaster. Lewis is a fabulous story teller, and I cannot recommend this book enough.

He tells how the subprime mortgage market was created, who benefited, who lost, the cons, the dupes and the dopes and “how some of Wall Street’s finest minds managed to destroy $1.75 trillion of wealth in the subprime mortgage markets” and created the worst financial crisis since the Great Depression.

Essentially billions of dollars were lent to people who had very little chance of ever paying it back. And Wall Street firms earned billions of dollars creating, packaging and betting on complex financial instruments whose raw material was the risky mortgage loans they created. And that was just the beginning.

Tremendous leverage (using borrowed money to magnify possible returns) increased the risk of destroying entire firms.

Lewis follows a few very colorful individuals who gradually figured out just how corrupt the entire risky mortgage system was. These investors made billions by betting against the subprime market by selling short.

Note that “selling short” is an entirely legal transaction, but generally considered a high risk one that involves betting against something, i.e. a stock, bond, or currency, for example, which isn’t “actually” owned by the investor. Selling short requires astuteness, foresight, excellent timing and staying power. Being “right” too soon can be both nerve wracking and very costly, because until the market agrees with your assessment, you are at risk of losing a great deal of money. (Disclosure: I do not sell short.)

In reading Lewis’s gripping story, I alternated between nodding my head in recognition of the self-serving greed that categorized Wall Street to shaking my head in disbelief that Wall Street bankers could have been so deluded that they ended up believing their own lies, I mean “models.” As I read, I found myself laughing out loud more times than I can count – truly, Lewis has a way with words.

To give you some background info, in the “old” days, a bank lent money to a home buyer and they held the mortgage. The bank was very serious about getting repaid, so before they agreed to fund the loan, they did some rather basic things like verify the borrowers’ creditworthiness, check their employment and salary history and retain an appraiser to assess the value of the property being bought. A good credit history, a stable job and a property value that would support the loan were enough incentive for banks, back in the “old” days, to grant a loan request.

But when banks started selling the mortgage to a Wall Street firm who repackaged the loan and then sold the package to investors, the incentives became very different. It was like the Wild West before the Marshall came to town to establish law and order.

The acronym IBGYBG came into being. The brokers who made more money than they ever imagined said, “I’ll be gone, you’ll be gone” so let’s not worry about the suckers who will probably lose their homes or the gullible institutions that bought the crappy investments in the purposely opaque financial instruments. And it was easy to rationalize the sleazy behavior, because, after all, it was possible that this will all work out, if home prices keep rising. That was a big IF.

It was really a mammoth legal Ponzi scheme, or as Lewis called it a “mass delusion.”

The individual characters’ stories are fascinating, but I will not try to summarize them. Instead, here are some observations that emphasize the need for fundamental financial regulation of Wall Street firms.

1. No one goes to Wall Street investment banks to make the world a better place. “Greed on Wall Street is assumed – almost an obligation. The problem was the system of incentives that channeled the greed.”
2. People see what they have an incentive to see. Wall Street employees, managers and CEOs had an incentive (i.e. huge bonuses – surely, you’ve heard about them) not to see the truth.
3. When Wall Street firms were partnerships and the principals had their own money at risk, they had a sane long-term approach to their business operations. When these same firms became publicly traded corporations, risk was transferred to the shareholders. But, of course, huge bonuses were paid to successful traders based on one year’s results. In the short term, traders had every incentive to take large risks. “Heads I win, tails someone else loses, perhaps some time in the future.”
4. The fixed income (bonds) world dwarfs the equity (stocks) world in size. The stock market is transparent and heavily policed. On the other hand, “bond salesmen could say and do anything without worrying that they would be caught. Bond technicians could dream up ever more complicated securities without worrying too much about government regulation – one reason why so many derivatives had been derived, one way or another, from bonds.”
5. The world of mortgage-backed securities (pooled investments backed by mortgages) and derivatives (financial instruments created by Wall Street) were intentionally difficult to understand, so no one even bothered to try. The book describes the nature of asset-backed securities, tranches, collateralized debt obligations, credit default swaps, etc. You, dear reader, can safely skip those portions if you want to. The horse is already out of the barn.
6. It’s difficult to appreciate the amount of backstabbing, mistrust and cynicism that is endemic at Wall Street firms. “Wall Street doesn’t care what it sells.” Investment banks exploited their institutional customers (pension funds, mutual funds, banks). The same firm that is advising them on what to invest in (the sell side) also has an in-house operation that is trading for its own account. Why is this blatant conflict of interest allowed?
7. While there may have been some criminal behavior, in the end, group think, mass delusion and incompetence were more important factors. Wall Street firms did not understand the money-making machine they had created or the risks they had taken.
8. When lenders ran out of customers who would qualify for a normal mortgage, they dreamt up new ways to lend to people who could not afford to pay the old fashioned way. Hence the introduction of “interest-only negative-amortizing adjustable-rate subprime mortgages.” Translation: you don’t have to pay any principal or any interest on your new mortgage; we’ll just keep adding that to the amount you owe.
9. Amazingly enough, Wall Street firms convinced bond ratings agencies (Moody’s, S&P) to give such garbage a Triple A rating. That credit rating agencies are “educated” by and paid by the issuers of the bonds is quite a conflict of interest! And it still exists.
10. Lewis asserts that today “nobody believes that Wall Street knows what it is doing.” He understands why Goldman Sachs and Morgan Stanley, for example, want a say in how they are regulated. He wonders why anyone would listen to them.

Conclusion

The greed and miscalculation of Wall Street firms caused the near collapse of the world economy. Governments around the world felt forced to commit trillions of dollars to resuscitate the banks.

Regulation of firms and people which have fundamentally the wrong incentives will not be easy. Regulatory reform of institutions that are too well connected to fail will not be easy. Change is never easy. But it is absolutely essential or we will all be at risk of a repeat performance of the last financial crisis. Without reform, the investment banking system can crash again, taking with it jobs, savings and U.S. tax payer dollars.

Investment Pornography, Part 1

Caught your attention, didn’t I?  Please don’t be offended by the title of this post, and please don’t snigger over it.  This is serious business, after all. Also called “Financial Pornography,” investment pornography consists of (1) alluring magazine cover headlines promising juicy riches, (2) articles featuring exciting ways to capitalize on supposed opportunities and (3) outlandish claims and predictions that may, in fact, be bad for your financial health. Finally, it has no redeeming value whatsoever (except that it is good for a laugh).

When I go to conferences held by Dimensional Fund Advisors, one of the best run and most respected mutual fund companies, the lecture known affectionately as “Investment Pornography” generally gets the most attention and the most nodding heads of recognition. The presentation consists of articles from popular finance magazines followed by a quick analysis of what actually happened. Punchline: They were spectacularly wrong, time and time again.

Future posts will cover articles that are way too optimistic and were written simply to get you riled up enough to buy a magazine, newspaper or investment newsletter. Today’s topic is of the other kind of Investment Pornography, the alarming article that promotes fear. This is the other side of the outlandish approach to getting your attention.

Sympathy and Recognition

I feel sorry for a journalist who covers the stock markets. A writer typically takes the financial news of the day (which is, more often than not, pretty muddled), and tries to make some sense of it by quoting various people who at least sound as though they know what they’re talking about.

The fact is that sometimes stock prices go up and sometimes they go down, and sometimes they don’t do anything. And no one can predict what is going to happen next. That’s why it’s best to be a buy and hold type investor. But, really, who would read that story over and over? Would you?

So although writers try to be accurate, relevant and interesting, they frequently stray into making predictions. In my opinion, trying to predict the future is futile, and can be downright dangerous. Sometimes a writer will positively mislead you and convince you to do something you will regret.

Fear Mongering

A year ago, on March 6, 2009, I took the New York Times to task for fear mongering at (possibly) just the wrong time. By coincidence the stock market hit its actual bottom a year ago on March 9th, the next business day. Read that post for an egregious article that, if followed, would have cost you dearly.

While, in general, I love the New York Times’ reporting, here is a recent example of fear mongering from the January 25th article, Volatility and Politics Spark Fears of Market Correction, by Javier C. Hernandez.

Here are some questionable quotes with my comments:

“Brace yourself for another wild ride on Wall Street.” (Sounds scary, doesn’t it?)

“Worries about the strength of the global recovery and proposals from Washington to clamp down on banks have sent fresh jitters through financial markets, prompting chatter among traders that stocks could be poised for that rare but alarming phenomenon: a correction.” (Rare and alarming? Not really; it happens more often than you’d think.)

“Over three tense days last week, stocks tumbled nearly 5 percent; the Dow posted triple-digit losses on Wednesday, Thursday and Friday, ending the week at its lowest level since November.” (So? Five percent declines are quite common and mean nothing. Three days should definitely not make anyone “tense.”)

“Some analysts believe the downward momentum may continue.” (True, but other analysts don’t.)

“A confluence of all those headwinds creates a perfect storm of uncertainty on a market that had already been a bit vulnerable to a pullback,” said Quincy M. Krosby, a market strategist at Prudential Financial. (“Perfect storm”- nice phrasing; I sure hope that it didn’t convince you to abandon a well-thought out plan, though.)

“A severe decline in the market is far from assured. There are no certainties on Wall Street, and stocks have been known to bounce back after similarly turbulent periods.” (Thank you, thank you, thank you! I couldn’t have said it better myself.)

“In the near term, an unusual degree of uncertainty may bring more losses to the stock market.” (Yes, and then again it may not.)

Fast Forward Five Weeks

By contrast, after the market had gone up, the New York Times had this March 5th article: Markets Find the Upside of the Jobs Report also by Mr. Hernandez.

What a difference five weeks makes! Now, after the stock market has gone back up, we read “better-than-expected snapshot of unemployment in the United States lifted Wall Street on Friday, reinforcing hopes that the job market — and the broader economy — might be gaining strength.”

Here are more quotes with my comments.

“The fact that unemployment is not getting worse is great news for the market.” (First of all, it is possible that statistically the recession has already ended. Second, the unemployment news tells us only what has already happened, not necessarily what the stock market will do.)
…

“In light of that uncertainty, the question for Wall Street is whether the upward push can endure.” (You are free to guess what the stock market will do short-term, but no one knows.)

…

“The major indexes have recovered from their losses in January, and they are in positive territory for the year. Last week brought strong gains, with all three indexes ending the week more than 2 percent higher.” (Good thing we didn’t bail out and sell after reading that January 25th article, hmm?)

Enough

I am not picking on the New York Times. It is a must read for me every day, for its reporting and also for its opinion columnists. In truth, if I had to give up either reading the New York Times or watching TV, it would be a difficult choice.

And the New York Times is certainly not alone in its fear-mongering role; almost without trying, you can easily find dozens of predictive articles in most, if not all, national publications.   Money magazine has had many silly articles that would have cost you big bucks.  SmartMoney is frequently not-so-smart.   Business Week and Forbes should be ashamed. Time magazine is well known for its lurid front covers of Depression-like photos.

My advice is to ignore such articles, because they are in fact “Financial Pornography.” They attempt to, and often succeed in, getting people riled up, by either pandering to fear or greed. More likely than not, they are heavily influenced by what has already happened.

If they correctly predict what the markets subsequently do, it is merely a coincidence, in my opinion. Save your time and your money. Pay no attention to sensational articles with worrying predictions, or ones that identify sure-fire investments for that matter. By the time you read the story, any relevant facts are already reflected in today’s prices. It is too late to consider what you read to be useful, actionable information.

Do not be influenced by short term fluctuations or worrying articles. It is much better to have a plan and to stick with it.

Wisdom Worth Sharing

As 2009 winds down, I would like to share some wisdom with you from another writer. Frank Sonnenberg is not only a friend, but a marketing maven and strategic thinker. In my opinion, his post on “25 Thoughts for the New Year” has the rare quality of being pithy without being glib, and expresses insights that are wise and helpful, without being too sentimental.

• If you don’t pass your values onto your kids, someone else will.
• You’d think we’d learn something from watching a hamster run around on its wheel.
• Practice doesn’t make perfect if you’re doing it wrong.
• Paradise is not a place; it’s a state of mind.
• Fun shouldn’t be confused with happiness.
• A homeless person wasn’t at one time.
• If work isn’t fun, you’re not playing on the right team.
• Trying to be excellent at everything leads to mediocrity.
• Some people don’t communicate. They just take turns talking.
• Everyone was put on this earth for a good reason . . . what’s yours?
• When it comes to charity, some people stop at nothing.
• Trust takes a long times to develop, but can be destroyed in seconds.
• Anger is a loaded weapon . . . be careful where you point it.
• Lessons in life will be repeated until they are learned.
• Marrying for money is a high price to pay.
• A great start doesn’t always guarantee a great finish.
• It’s better to get called out swinging than called out on strikes.
• Just because it say’s “URGENT” doesn’t necessarily mean that it’s important.
• People often count their pennies yet squander their dollars.
• Half a sandwich shared with a hungry person is more nourishing than the whole.
• Helping people too much only makes them helpless.
• Those who serve arrogance as their main course will eat humble pie for dessert.
• Always give 110%. It’s the extra 10% that everyone remembers.
• We teach children to color inside the lines, and then expect adults to think outside the box.
• Live every day as if it were your last. One day it will be.

My plan for early 2010 is to begin a series of posts on lessons we all should have learned from the “Great Recession” and one of the biggest and sharpest stock market declines any of us have ever experienced. I hope to present these lessons in plain English, and with “real life” stories that you’ll be able to identify with. Ultimately, my goal is to help you to avoid the same mistakes again.

Oh, and if you’re wondering, my favorite thought on Frank Sonnenberg’s list is “Lessons in life will be repeated until they are learned.”

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.

60 Minutes – The 401(k) Recession

Sunday’s 60 Minutes piece on 401(k) retirement plans was rather shallow, and not at all what you would hope (and expect) from CBS’s popular, long-running show. The template for this type of exposé is generally that there is a problem/scandal and some party has been physically hurt or financially injured, and some other party has to bear the blame.

According to the 60 Minutes portrayal (sadly, all true, by the way), people have lost jobs, their portfolios were destroyed and retirement dreams must now be deferred. Steve Kroft interviewed discouraged job seekers at a job fair, which, if nothing else, provided sympathy and some activity to televise. It’s curious (and quite a coincidence!) how the interviewees just happened to have their 401(k) statements with them.

Naturally, he only interviewed older people, and that’s fine; after all, it’s the older folk who are more severely impacted. In my opinion, younger investors will be fine, as long as they continue to contribute to their own 401(k) plans and invest in stocks. In fairness to 60 Minutes, they did spend about a dozen words on this distinction.

According to my analysis of the 60 Minutes template, we must find victims and we must identify villains. Indeed, they found a very sympathetic woman who not only lost a lot of money in her retirement account, but lost her job as well. She cried on camera. And 60 Minutes made a veteran industry spokesman appear unabashedly unsympathetic, though that may have been the result of heavy editing of his comments.

Actually, the 13 minute piece combined two things: (1) people have lost money, and (2) fees are hidden in 401(k) plans and may be excessive. What they downplayed is that more consumer education is needed. Surely, they could have spared a few more sentences than the paltry few they uttered on that particular, very important, issue.

What can we actually learn from the 60 Minutes segment?

People Lost Money

Well, yes. But, what wasn’t said is that that has been true of other investment accounts as well, not just 401(k) plans. Small business owners have also suffered, as have people who have lost their jobs. Why only claim that 401(k)s have let down participants?

Fees

Yes, high fees can hurt investment performance, so 60 Minutes got it right that high (and hidden) fees can be a big problem in retirement plans. But they chose merely to list the types of fees, not quantify them or put them in a useful context. In my experience, some 401(k) plans are quite good. Some are too expensive. On the other hand, many 403(b) plans have very high fees, yet no one is examining them.

Risk

Defined Benefit Plans (pensions) have been in decline for some time. The old pensions were much better for average Americans, because loyal employees knew (more or less) what they would get, and they didn’t have to worry about making investment decisions. But employers were happy to get rid of traditional pensions to help reduce future costs and to reduce the business risk of achieving adequate market returns. Accordingly, employers have emphasized Defined Contribution Plans and largely dropped pensions.

In essence, investment management and investment risk were transferred to employees, and they were not prepared to make wise choices. In a bull market this was not so noticeable.

The Solution

The nature of defined contribution retirement accounts, such as a 401(k) or 403(b) plan, is that, while they provide a tax-deferred avenue to save for retirement, they need to be managed. Someone has to determine an appropriate asset allocation, based on a number of factors. Moreover, if you have other investments, it is ideal to treat all of your investments as one portfolio. And your allocations should probably change over time. As you get closer to retirement age, you generally will need to be somewhat more conservative in your investments.

The fundamental problem is that people thought that they could simply invest in the 401(k) plan without putting too much consideration into the asset allocation. Or it could be that they chose hot funds based entirely on past performance. The show did not go into any details as to why the participants had done so poorly, only that they had.

Clearly, more consumer education is needed. Fortunately, there are efforts currently under way to provide independent, unbiased support that will assist more employees to make informed decisions about their retirement plans.

Suggestion for 60 Minutes

The producers could have done a much better job. Next time, they should compare and contrast two people. One individual who had read a couple of personal finance/investment books or had consulted a financial planner who explained risk and return, asset allocation and the need to become more conservative as one approached retirement. The second individual would be one who did not understand any of these issues and pretty much just winged it with what amounts to a large part of her net worth.

While this comparison would have been useful and very telling, it would, of course, have made for pretty boring TV.

Rolling over to an IRA account

If you have a defined contribution account – 401(k) or 403(b) – from a former employer you can do a tax-deferred transfer to an IRA account. This would give you more control and more choices, but it should be done carefully. To that end, I recommend that you consult a fee-only financial planner. Otherwise, you may end up paying even higher fees than what you are now paying! You might even, heaven forbid, be sold a variable annuity to put in your new IRA.

To be continued.

Questions to Ask When Picking a Financial Adviser

An article in the April 13, 2009 edition of the Wall Street Journal entitled Seven Questions to Ask When Picking a Financial Adviser largely misses the boat. Granted, it is a challenge to find a “reliable” financial advisor; however, the article did a poor job of advising you on how to go about it. Reading it may leave you with the conclusion that it is impossible to find a financial planner you can trust. There can be nothing further from the truth.

I take exception with the emphasis of the article and several of its points.

How does the adviser get paid?

Mentioning that there are different methods of compensation, as the article does, is not sufficient.

As I’ve said in previous posts, the key issue in choosing a financial advisor is finding one who will act in your interests. To determine that, you must know exactly how and who compensates your chosen advisor. If an advisor is fee-only, you’re off to a good start.

Remember that a stockbroker must act in the employer’s best interests, and that you are not his employer. A Registered Investment Advisor, on the other hand, must act in a fiduciary capacity, i.e. in the clients’ best interests.

Stockbrokers are subject only to a “suitability” standard. They are regulated by FINRA, which (despite their rhetoric) is dedicated to protecting stockbrokers and their employers, not necessarily investors.

What do the adviser’s clients say?

This may or may not be relevant or helpful.

Registered Investment Advisors are governed by the 1940 Investment Advisor Act, which expressly prohibits providing “testimonials,” which client references would fall under. Of course, a client recommendation or testimonial could easily be concocted anyway.

What’s the adviser’s track record?

The WSJ article didn’t even come close to getting this issue right. Choosing an advisor based on his/her supposed investing track record is the wrong approach on several counts!

Even if you did find an advisor with a “superior” track record, we know that it is meaningless, because, as has been stated before, “Past Performance is No Guarantee of Future Results.” If you’ll recall, Bernard Madoff had a superior track record, many testimonials and lots of personal references and endorsements. And we all know what he did.

Key Financial Solutions does not try to “beat the market.” We are not active managers, because studies show that the added costs offset any possible gains of active trading.  Market timing and stock selection do not work.

Since we are not mutual fund managers, we do not have one uniform documented track record. Real financial planners take into account their client’s needs, financial objectives and tax situation before investing their money.

Because our clients have different risk tolerances and time horizons, they naturally have different portfolios and, therefore, different investment performance.

Financial Planning versus Investment Performance

Understand that beating an index is not a financial plan. What a good financial planner will do is give clients the best chance to achieve their goals.  Because the financial plan sets the parameters of the portfolio, a portfolio is simply a tool to realize clients’ goals.

Don’t get me wrong, we are quite proud of our portfolio design, because we use low cost, tax-efficient mutual funds to build globally diversified portfolios.  I am personally fascinated by asset allocation and portfolio strategy.  I use automated reports and individual spreadsheets to monitor a portfolio and to make changes, when appropriate.  Certainly all of these necessary tasks contribute something to investment performance, but not as much as having a plan and sticking to it.

Real Life Returns

Since investor behavior is a very large component of investment returns, we act as coaches so that clients do not make big mistakes.  For example, we manage how clients respond to the euphoria near market tops and to the panic and despair around market bottoms.

Behavioral advice – coaching clients to continue to do the right thing and to avoid doing wrong things – will have a greater impact on investment returns than attempting to choose next year’s hot sector or mutual fund.

Believing in full disclosure and transparency, we report results quarterly so that a client can see exactly how well his or her portfolio is doing. This report is net of all fees, which are clearly stated, rather than being hidden. But I do not recommend giving quarterly results much importance.

Conclusion

When considering whether to retain an adviser for a long-term relationship, avoiding conflicts of interest should be the first consideration. A strict fee-only method of compensation is the best approach for most people. Members of the National Association of Personal Financial Advisors are strictly fee-only planners who sign a Fiduciary Oath.

NAPFA has always maintained that an advisor who is compensated solely through commissions faces immense conflicts of interest. This type of advisor is not paid unless a client buys (or sells) a financial product. A commission-based advisor earns money on each transaction—and thus has a great incentive to encourage transactions that might not be in the interest of the client. Indeed, many commission-based advisors are well-trained and well-intentioned. But the inherent potential conflict is great.

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