While there is more to life than money, having enough of it when you need it most is extremely important.

The end goal of finding the right investment manager isn’t (or at least shouldn’t be) merely to amass piles of money.  It’s to form and adhere to a plan that offers you the best chance for achieving what you most want out of your life, while avoiding too many painful setbacks along the way.  If you look at investing through this lens, it clarifies how you and your advisor can view your wealth management in the same, best light:

Begin at the beginning: create a plan

Are you and your advisor guided first and foremost by a mutually formed plan that defines your unique financial goals and describes a sensible process for achieving them?  If not, what else can you rely on besides blind luck to find your way (and how reliable is that)?

Ensure that your goals drive the process

I recommend that your plan be in the form of a written Investment Policy Statement that you and your advisor have signed, and that you revisit together periodically to ensure that it continues to reflect your evolving circumstances.  By sticking with this approach, you’re investing according to your own goals, rather than the whims of an ever-fickle market.

Find a fiduciary

Financial intermediaries such as brokers expose you to potential and real conflicts of interest.  While some transactions are “perfectly legal,” by definition, they may benefit the broker and not you.  In contrast, a Registered Investment Advisor (RIA) is legally obligated to form a fiduciary relationship with you, which means that the RIA must act in your highest financial interests in managing your wealth.

If someone is determined to break the law, a written agreement isn’t going to stop them.  But, it is beyond me why anyone would open themselves up to the prospect of being legally ripped off (in the form of unnecessarily higher costs or less-appropriate investments), when it is so readily prevented by ensuring your advisor is a fiduciary.

Talk the talk

Have an investment strategy.  A plan is a great start, but, ultimately, it’s only as good as your ability to stick with it.  An advisor’s key role is not only to help you design your plan, but to serve as your constant ally in adhering to it under all market conditions.   He or she should consistently encourage sensible investment activities and remind you what you’re about if you are tempted to stray (such as panic-selling when the markets turn bearish, or chasing hot streaks when the market’s on a tear).

Walk the walk

Last but certainly not least, your advisor should establish his or her business and service offerings to complement rather than conflict with all of the above. Some of the characteristics to look for include: 

• Transparent, fee-only arrangements.  Greg Smith’s Goldman Sachs op-ed piece illustrated all too clearly the conflicts of interest that can arise when your “advisor” is operating in an environment in which portions of his income are in the form of often undisclosed commissions and similar incentives coming from outside sources.
• Arm’s length custody.  Your assets should be held by a separate custodian, who sends regular, independent reports directly to you, so you can substantiate your advisor’s activities on your behalf.  Ideally you should have online access to your account.
• Passive management.  Easily a topic for another post, but the recommended investment solutions within your portfolio should be optimized to help you achieve your personal goals. Briefly, this translates to funds that are “passively” managed to capture available, long-term market risk factor premiums as effectively and efficiently as possible.  A passive strategy helps you avoid the costs and inconsistencies found in attempting to outfox the market through “active” predictions.  The market as a collective, highly informed entity is pretty tough (and expensive) to attempt to beat.
• Go over your results at least once a year.  Find someone you can trust and also verify the results.  You can’t expect to do well every year, but you should at least know your returns.

Conclusion

There is a lot we cannot control: the business cycle, changes in tax policy, political instability and even acts of terrorism.  But we can concentrate on the things we can control.  The proper relationship with a fee-only advisor is your best chance for a positive result.

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.”

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.

Yet, the major U.S. stock market indices avoided a downturn in 2011 after two strong recovery years.  Those who bailed out after any one of the market  tumbles would have missed the year’s many improbable, unpredictable recoveries. 

So, what lessons can we learn from such a volatile year? 

1.  Be humble about making predictions. Even the experts can get it wrong – just ask Pimco’s Bill Gross.

2.  Don’t even try to time the market. That’s difficult even in the best of times and these aren’t those. 

3.  Stay diversified and disciplined; that’s always the best course, regardless of volatility.

4.  Don’t buy into the crisis du jour mentality of the media.  Shock and awe sells; judicious analysis does not.

Weston Wellington, Vice President of Dimensional Fund Advisors, does an excellent job of summarizing the year’s events and the lessons we can learn from 2011.

Year-End Review

Equity investors around the world had a disappointing year in 2011 as thirty-seven out of forty-five markets tracked by MSCI posted negative returns. The US did well on a relative basis and was the only major market to achieve a positive total return, although the margin of victory was slim. Total return for the S&P 500 Index was 2.11%, and the positive result was a function of reinvested dividends—the index itself finished the year slightly below where it started.

Throughout the year, investors seeking clues regarding the strength of business conditions or the prospects for stock prices were confronted with ample reason to rejoice or despair. Optimists could cite the strong recovery in corporate profits and dividends, the substantial levels of cash on corporate balance sheets, low interest rates and inflation, a booming domestic energy sector, continuing strength in auto sales, and record-high share prices for leading multinationals such as Apple, IBM, and McDonald’s. Pessimists could point to persistently high unemployment, slumping home prices, tepid growth in retail sales, worrisome levels of government debt at home and abroad, and political gridlock in both Congress and various state legislatures.

Although the broad market indices showed little change for the year, there were opportunities to make a bundle—or lose one. Among the thirty constituents of the Dow Jones Industrial Average, thirteen had double-digit total returns, including McDonald’s (34.0%), Pfizer (28.6%), and IBM (27.3%). But losing money was just as easy: The three worst performers in the Dow were Hewlett-Packard (–37.8%), Alcoa (–43.0%), and Bank of America (–58.0%). If nothing else, the substantial spread between these winners and losers discredits the argument we often hear that all stocks are now marching in lockstep and that diversification is ineffective.

Achieving even modest results in the US market required more discipline than many investors could muster, since investor sentiment fluctuated dramatically throughout the year and the temptation to enhance returns through judicious market timing often proved irresistible.

For fans of the “January Indicator,” the year got off to a promising start as stock prices jumped higher on the first trading day, pushing the Dow Jones Industrial Average to a twenty-eight-month high. Bank of America shares jumped 6.4% that day, the top performer among Dow constituents. With copper prices setting new records and factory activity worldwide perking up, the biggest worry for some was the potential for rising prices and higher interest rates that might choke off the recovery. “Overheating is the biggest worry,” one chief investment strategist observed. By April 30, the S&P 500 was up 8.4%, reaching a new high for the year.

Stocks wobbled through May and June but strengthened again in July. On July 19, the Dow Jones Industrial Average had its sharpest one-day increase of the year, jumping over 200 points, paced by strong performance in technology stocks. Just a few days later, however, stocks began a precipitous decline that took the S&P 500 down nearly 17% in just eleven trading sessions. The century-old Dow Theory—a sentimental favorite among market timers—flashed a “sell” signal on August 3, and on August 5, Standard & Poor’s downgraded US government debt from AAA to AA+. As investors sought to assess the implications of sovereign debt problems in both the US and Europe, stock prices fluctuated dramatically, with the S&P 500 rising or falling over 4% on five out of six consecutive trading days in early August. Rattled by the sharp day-to-day price swings, many investors sought the relative safety of US Treasury obligations in spite of the rating downgrade, pushing the yield on ten-year Treasury notes to a record low. Stock prices hit bottom for the year on October 3 as some market participants apparently lost all confidence in equity investing. A Wall Street Journal article cited a number of individual investors as well as professional advisors who had recently sold all their stocks and did not expect to repurchase them anytime soon. “I feel like a deer in the headlights,” said one.

As it turned out, the article appeared in print on the second day of a powerful rally that sent the Dow Industrial Average surging over 1,500 points during the next 19 trading days, putting it back into positive territory for the year.

What can we learn from a difficult year like 2011? As Dimensional founder David Booth is fond of saying, the most important thing about an investment philosophy is that you have one. Many investors (as well as some allegedly professional advisors) apparently decided to switch from a buy-and-hold philosophy to a market timing strategy in the midst of an unusually stressful period in the financial markets. We suspect few of those adopting the change would have been able to clearly articulate their investing beliefs and why they had shifted.

Legendary investor Benjamin Graham offered the following observation nearly forty years ago: “There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he himself is a part.”

Good advice then, good advice now.

By Weston Wellington, Vice President of Dimensional Fund Advisors

Sources

---

Mark Gongloff, “Investors’ Forecast: Sunny With a Chance of Overheating,” Wall Street Journal, January 3, 2011.

Jonathan Cheng and Sara Murray, “Stock Surge Rings in Year,” Wall Street Journal, January 4, 2011.

Matt Phillips and E.S. Browning, “Tech Sends Stocks Soaring,” Wall Street Journal, July 20, 2011.

Steven Russsolillo, “‘Dow Theory’ Confirms It’s an Official Swoon,” Wall Street Journal, August 4, 2011.

Damian Paletta, “U.S. Loses Triple-A Credit Rating,” Wall Street Journal, August 6, 2011.

Tom Petruno, “Investors Stampede to Safety,” Los Angeles Times, August 19, 2011.

Kelly Greene and Joe Light, “Tired of Ups and Downs, Investors Say ‘Let Me Out’,” Wall Street Journal, October 5, 2011.

Benjamin Graham, The Intelligent Investor (New York: HarperCollins 1949).

The S&P data are provided by Standard & Poor’s Index Services Group.

MSCI data copyright MSCI 2011, all rights reserved.

Yahoo! Finance, www.yahoo.com, accessed January 3, 2012.

Yes, Virginia, bubbles do exist.  Years ago my professors downplayed the importance of speculative bubbles, but I think the evidence is clear.  In the last 15 years I would argue that we have had (at least) four separate bubbles.  Two of those bubbles have already popped, and of those I am sure there will be no disagreement.  Bubble #1 was technology stocks (remember all of the dot-com companies?) of the 1990s and bubble #2, housing prices, which from 2001 – 2006 went sky high, simply because people fell in love with the sure-fire benefits of owning them. 

Now, I cannot prove it yet, because prices are still high, but I believe we have had a bubble in gold, and to some extent, silver prices.  (I wrote about this last November.)  The phrase “as good as gold” has a long history and a certain charm, but I would not bet my own money, nor my clients’ money for that matter, on whether gold will continue to do so well. 

A Bond Bubble?

I believe that we have also had a bubble in bonds.  Admittedly, bonds have done extremely well in the past, but you don’t win a race by looking backwards.  Are too many people flocking to the supposed “safety” of bonds?  We will see.

Diversification works, but not always.  It is foolish to concentrate your investments in a narrow selection of securities.  Because we cannot predict the future, we diversify.  But in a crisis, when investors are panicking, most assets fall, in lock step.  

There have been some exceptions; we can count on cash to be stable, and money market funds have been a safe, if not very profitable, bet.  U.S. Treasury bonds usually rise when other riskier assets are falling, but even this may change at some point in time.

A fairly quick recovery of the economy usually follows a recession, but not if it is caused by a financial crisis. This is something Carmen Reinhart and Kenneth Rogoff demonstrate in their book: This Time Is Different: Eight Centuries of Financial Folly. We are living through a very slow recovery, which should not surprise us, given the financial crisis that started the Great Recession.

Decisions by the Federal Reserve are very important but not a sure thing and, certainly, not always the right thing.  The Fed can influence interest rates, the economy and people’s expectations.  They can slow the economy down when it is overheated, and they can give it a boost when the economy is not growing, but there are limits to just how much they can accomplish. We will learn more about this in the next few years, as events are still unfolding and history is still being written. And, speaking of history, it has shown us (witness the Great Depression) that the Fed’s decisions are not always the right ones. The hope of course, is that they, and other central banks, have learned from past mistakes.

Those in the know, don’t always know.  Economists are not very good at predicting anything useful: the growth in the economy, interest rates, exchange rates, stock prices.  Top management of a publicly traded stock may be buying their company’s shares like there is no tomorrow, but they can be wrong.  Hedge fund managers who have had spectacular results can make bets that turn out spectacularly wrong.  Investment “experts” are right some of the time, but are wrong frequently.  (See this post.)

Investor behavior is more important than investment returns.  To get the long term returns that stocks have delivered over time, you cannot periodically panic, sell your stock investments, and “go to cash.” If your strategy is to “get back in” at a safer time, you will undoubtedly miss the rebound in stock prices. (If you were out of the stock market in 2003 or 2009, you cannot get those large returns back.)  Just because the media and your friends are telling you how terrible things are, don’t go along with the “end of the world” story.  (See this post.)  If you do panic, you will almost certainly hurt your results. 

Conclusion

I am thankful that I learned Micro Economics, Macro Economics and Monetary Economics from some wonderful professors.  Knowing what incentives drive producers and consumers and how markets work is very helpful. But it is not enough. 

In graduate school, I loved studying Modern Portfolio Theory.  MPT was so new that we read the original groundbreaking work, before it was even in textbooks.  But I am always looking for practical ways to implement it. 

Understanding risk premiums and historical returns of various investments is useful, but it is not sufficient.  Mathematical models are helpful, but they are not foolproof.  To me Portfolio Optimization is a useful framework in theory, but not very practical in application.

We should always remember that people and events are not as predictable as we would like to think.  Economics is a social science not a physical science. Psychology frequently plays an important and changeable role.  We should not forget that our crystal ball is always cloudy.  

I believe that individuals and couples will learn something from the experience Anonymous shares, his honest assessment and changed behavior.

Money Challenges for a Conscious Couple

Like Roger, I am a Certified Financial Planner (now retired, however) and have an MBA in Finance.  For several years, I have been very involved in The Mankind Project, a men’s organization which is dedicated to improving the world by helping each man achieve his full potential.  My wife is a therapist who counsels people on developing effective communication, especially with their primary partners and family members, and learning to live life to the fullest. 

You might imagine, then, that we, a happily married couple, would be very effective at communicating with each other about any and all matters that arise in a marriage, including those issues with a financial aspect.  Unfortunately, that is not the case; the issue of managing our finances has been far and away the major point of contention in our marriage.  Embarrassing as they may be, I will relate our struggles with the hope that, by sharing this, you can learn from our mistakes.

One thing that we have never had to worry about, fortunately, is having enough money.  I was an executive at several different banks; I earned a good salary, received stock options, had a 401k, and I now receive a small, but entirely adequate, pension.  Just as important, I did not marry until I was in my 50’s, and my then wife-to-be had no children.  Thus, as a childless mature couple, we avoided the major expenses of child rearing and college.

When we got married, my wife was an independent, intelligent businesswoman from New York City who made good money in a commission-based job.  I moved into her NYC apartment afterward, and was, I admit, pretty unhappy.  Having lived in that apartment for over 20 years, my wife essentially “owned” it; The apartment was filled with “her” things, top to bottom, and I missed having my own stuff around me. 

Life Events Caused a Re-evaluation

I got laid off from my bank job in 2001- the fourth lay-off in ten years, as banks went through one round of layoffs after another.  That was the last straw; I examined my life hard and decided that, in order for me to be happy, I had to quit the corporate game, and move back “home” to the Washington, DC area.  I had enough money saved so that both of us could stop working full-time, if we so chose.  My wife, understanding that I was just not happy in NYC and open to a change, agreed to give up her established career and move to the DC area.

Once settled back in the DC area, my wife attempted to re-create the success she had had in NYC by doing the same type of work—helping people find jobs (attempted being the operative word.)  For whatever reason, and in spite of her incredible work ethic and outgoing, buoyant personality, she just could not replicate her NYC success.  (And with all due respect to Frank Sinatra and the lyricist who wrote the words to that wonderful old song, New York, NY, “If you can make it there, you can make it anywhere” simply did not apply in my wife’s case.)  So, she became dependent upon me and my savings to live.  Of course, I didn’t mind her being financially dependent on me, but I also didn’t think it unreasonable for me to assume that I would be the one who would control our finances.  In my mind, it made perfect sense; I was the financial expert, after all.  I believed that she should be grateful, not just for my generosity but for enabling us both to retire at relatively young ages, and for my willingness to take control of the finances.  I truly thought she would not mind relinquishing financial control to me. 

Our Background and Baggage

Both my wife and I had come from homes where money was tight, thus a constant issue between our respective sets of parents.  That was the baggage we each carried into the marriage; we both viewed money, not as a tool for enjoyment, but rather as security. 

It’s often been said that money is power, and I recognize that implicitly.  But here is what I failed to recognize:  that the person in power does not have the same “sense” of a power imbalance as does the person out of power. 

I enjoy working with numbers and have more experience with and knowledge of money management than my wife.  So, it was only natural for me to take on the role of Chief Financial Officer for our family, and for many years, my wife had no objections to it.  I paid all the bills and made all the investment decisions and we did just fine. 

Having gotten married for the first time when I was 54, I was used to making decisions on my own, without consulting anybody else.  Even after getting married, I didn’t really see the need to change my behavior and consult with my wife, especially in areas where I felt supremely confident, namely with respect to money management.  After all, she couldn’t possibly add any value to the decision making process, given her lack of knowledge.  I didn’t know it then, but my wife was very hurt at how easily I could make financial decisions on our behalf, but without consulting her. 

Mauled by the Bear Market

The Great Recession of 2008-2009 presented us with a particularly challenging time.  As with so many others, our nest egg suffered a major hit, and we lost over 25 % of our savings.  One major bone of contention was my investment philosophy; I was (am) basically a “buy and hold” kind of investor and was more than willing to leave our asset allocation alone.  My wife, on the other hand, had told me, even prior to the downturn, that we should get out of the stock market, because she “did not have a good feeling.”  I was the financial expert so I dismissed her “feeling” and overruled her. 

We stood pat and watched our net worth go down, and down again.  Never giving up, my wife would regularly lobby for us to get out of the stock market and, as usual, I would resist.  It wasn’t until near the absolute bottom of the market, that my wife’s constant lobbying (and I admit now, grudgingly, my own annoyance for not having listened to her in the first place much earlier), persuaded me to finally really listen.  She wanted the mortgage on our house paid off, so I sold off enough stock from our portfolio to pay off the loan balance.  In truth, to me, paying the mortgage off didn’t make sense – smart investors buy low and sell high!  But the majority of people do the opposite.  Much to my chagrin, we later joined the masses in buying high and selling low.

Preparing to be a Widow

A couple of years ago, the husband of one of my wife’s dear friends died after a long bout with cancer, and his wife had to learn how to handle the family’s financial affairs.  Unfortunately, she was not well-prepared to take on this task, and struggled with the burden of it, in spite of her husband’s well-detailed instructions on what to do with each account.  It was my wife’s observance of her friend’s struggle that was the wake-up call that she, too, should become more knowledgeable about our finances. Now.

My wife insisted that I make no financial decisions without consulting her first.  I hated the idea, but acquiesced once I realized how strongly she felt about it.  It took me some time to get used to the idea of it, but now we have regular meetings to discuss how our finances look and what we should do or changes we should make.  My wife has assumed responsibility for monitoring our expenses, using the free on-line tool, Mint.com.  She has become disciplined in reviewing each and every expenditure on that system and assuring that it is correctly categorized.  I calculate our net worth on a monthly basis and evaluate our asset allocation.  As a result of our most recent look at our asset allocation, we decided to change our portfolio allocation, together.

My Advice for Couples

To those couples who argue over money (and really, who doesn’t nowadays!), I suggest the following:

• Understand that both money and knowledge are power. 
• Share the three major tasks of managing your money, i.e., paying bills, monitoring expenses and investing.
• Monitor your expenses on a monthly basis.  The free on-line tool, mint.com, is a wonderful way to understand what you are spending money on and how much by category.
• Determine what asset allocation you are comfortable with and rebalance your portfolio so that you stick to your target.  Take on only the amount of risk that you are comfortable with and that you need to achieve your goals.
• Monitor your net worth on a quarterly basis. 
• Have regular financial meetings to discuss expenses and investments.

And most importantly, never assume anything with respect to your partner’s feelings about money management- have the tough discussions early on to make certain you are both on the same page.

- Anonymous

Postscript by Roger Streit

Many people are not motivated, or do not have the time, to analyze and monitor their financial situation.  A good financial advisor should be able to help you assess your goals, discuss your risk tolerance, set up a sensible portfolio, and even help you unpack your feelings about money.  Do-It-Yourself is not right for many people.

At base, the increase in market volatility is an expression of uncertainty. The sovereign debt strains in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading market participants to apply a higher discount to risky assets.

So, developed world equities, oil and industrial commodities, emerging markets, and commodity-related currencies like the Australian dollar are weakening as risk aversion drives investors to the perceived safe havens of government bonds, gold, and Swiss francs.

It is all reminiscent of the events of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction. This time, however, the focus of concern has turned from private-sector to public-sector balance sheets.

As to what happens next, no one knows for sure. That is the nature of risk. But there are a few points individual investors can keep in mind to make living with this volatility more bearable.

* Remember that markets are unpredictable and do not always react the way the experts predict they will. The recent downgrade by Standard & Poor’s of the US government’s credit rating, following protracted and painful negotiations on extending its debt ceiling, actually led to a strengthening in Treasury bonds.

* Quitting the equity market at a time like this is like running away from a sale. While prices have been discounted to reflect higher risk, that’s another way of saying expected returns are higher. And while the media headlines proclaim that “investors are dumping stocks,” remember someone is buying them. Those people are often the long-term investors.

* Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was last this bad—the S&P 500 turned and put in seven consecutive of months of gains totalling almost 80 percent. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.

* Never forget the power of diversification. While equity markets have had a rocky time in 2011, fixed income markets have flourished—making the overall losses to balanced fund investors a little more bearable. Diversification spreads risk and can lessen the bumps in the road.

* Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. As the IMF noted recently, while advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving.1 A globally diversified portfolio takes account of these shifts.

* Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

The market volatility is worrisome, no doubt. The feelings being generated are completely understandable. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value will re-emerge, risk appetites will re-awaken, and for those who acknowledged their emotions without acting on them, relief will replace anxiety.

Jim Parker, a Vice President of Dimensional Fund Advisors, wrote this essay.  It is posted here with permisson.

On Friday evening, the Standard & Poor’s debt rating agency  downgraded all U.S. government debt with more than a year of maturity, from the top AAA rating down to AA+.  To put that in perspective, now only 17 countries enjoy the AAA rating on their government bonds.  Typically, that means that they are considered the safest havens for cash, and therefore are able to pay the lowest interests rates on their borrowing. 

Here’s the list, and I’ve included the current yields on each country’s 10-year government bonds in parentheses.  This lets you see what the top-rated countries pay on their debt, compared with the 2.5% interest the U.S.  government has to pay on its 10-year U.S. Treasuries: 

France (3.41%), Germany (2.83%), Canada (2.93%), Australia (5.75%), Finland (3.19%), Norway (3.29%), Sweden (2.82%), Denmark (3.06%), Austria (3.30%), Switzerland (1.53%), Luxembourg (NA), Guernsey (NA), Hong Kong (2.29%), the Isle of Man (NA), Liechtenstein (NA), the Netherlands (3.17%), and Great Britain (3.11%). 

The first thing to notice is that the U.S. government is still borrowing at very attractive rates compared with the triple-A nations, and Treasury rates actually got better during the angry debate in Washington, as investors continued to beat down our doors to lend money to our government.  Why?  The downgrade and recent weakness in the stock market have made bond investors nervous, which usually causes them to buy the safest paper they can find.  The United States still offers the deepest and most liquid bond market in the world.

The second thing to understand is that, despite the high levels of government debt, there is really no crisis in the government finances or in the economy.  S&P officials made it clear that they were more influenced by the recent messy debate in Congress than the fundamentals of government finance.  They may have been particularly rattled by public statements by key members of Congress that it might not be a bad thing if the U.S. government defaulted on its sovereign obligations to its global lenders–sort of like one of us telling the bank that we’re thinking seriously about not making any more mortgage payments.  

David Beers, global head of ratings at S&P, said in a supporting statement that the agency was concerned about “the degree of uncertainty around the political policy process.”  A separate statement by the rating agency said that policymaking and political institutional control had weakened “to a degree more than we envisioned.”

Long-term, our government faces some difficult choices.  The question now is whether we’ll get action from Congress or more political posturing.  We’ll get an early look between now and Tuesday, as a new Congressional committee, made up of Democrats and Republicans, will be set up.  The committee will be looking for $1.5 trillion in deficit cuts that have not yet been specified through the debt ceiling compromise.   (A total of $917 billion in cost reductions has already been earmarked).

What should investors do?

What does all this mean for investors?  The investment markets were clearly rattled by the tone and uncertainty of the debt ceiling debate, with the S&P 500 losing 10.8% of its value over the ten trading days of the Congressional standoff.  Early indications are that global markets have been negatively affected by the S&P downgrade.

But a Money magazine report points out that when a country loses its AAA rating, that is not always terrible news for the nation’s stock market.  Canada, for example, was downgraded from AAA status in April of 1993, but the country’s stocks gained more than 15% the following year.  The Japanese government’s bonds were downgraded in 1998, and the Tokyo stock market climbed more than 25% in the next 12 months.

The awful nature of the debt ceiling debate, plus the downgrade, has clearly added fear and uncertainty to an already sluggish economic recovery.  The Treasury debt downgrade is a blow to U.S. pride, and a warning to Congress–particularly those representatives who think the U.S. can simply walk away from its obligations without consequences. 

However, as the decline in Treasury rates made clear, the downgrade is largely symbolic.  Congressional gridlock and partisan posturing could leave us with a long 15 months until the next time we have a chance to vote on their job security.  But it might be helpful to think back to last summer, when concerns about a double-dip recession and mild panic sent the S&P 500 down a long unhappy slide to a low of 1022.58 on July 2, 2010, with a few additional bounces along the bottom until a September rally.  Investors who sold out of the markets at that time missed significant–and largely unexpected–gains through the fall, winter and spring, as people gradually realized that the world was not coming to an end.  (Despite periodic “end of the world” stories promulgated in the press, the world never does end.)

Our Cloudy Crystal Ball

No one can predict stock market prices, because in the short term, emotions can rule the market, and they are visibly tilting toward panic right now.  Longer-term, market prices always tend to return to fundamentals, and it’s helpful to remember that corporate profits remain strong, new jobs are being added and the economy is still growing. 

The Price of Panicking

The U.S. markets weathered much worse than this in 2008, in 2000, during the first and second world wars and a lot of panic-stricken times in between.  Without the ability to see the future, our best prediction is that the Sun will continue to rise each morning, and the U.S. will emerge from this crisis like it has all the others.  In the past, investors who managed not to succumb to the panic like so many did last summer did extremely well.

The alternative is to get out of the market now (after prices have already declined) and wait to get back in, when the economic environment is settled, and things no longer look downright dangerous.  The price you pay for this respite from anxiety is usually very high.  By the time you feel comfortable  being an investor in stocks again, prices will typically be much higher than when you sold.

Selling low and buying high has never been a winning strategy.

These are both examples of what Behavioral Economists call “recency.”   Meaning that we tend to place more emphasis (and trust, appropriately or not) on more recent data even as we ignore older data. 

A more general problem, I’ve found, is that investors don’t understand the role that bonds should play in an investment portfolio.  When you buy a bond you are essentially lending money to some entity, whether it’s a corporation, a municipality, a state, or a country.  In exchange for what is essentially your loan, you are promised a regular payment, usually on a semi-annual basis, plus the full amount of the money you lent returned to you at a given date.  Depending on the circumstances, you may or may not realize the promised returns. 

Bonds are considered “fixed income;” investing in them generally means that you will not gain as a result of growth in the economy.  Bonds are considered safe and therefore have a lower expected return than stocks.  But bonds have two inherent risks, namely interest rate risk and, more importantly, credit risk/default risk.  Interest rate risk means that when interest rates rise, bond prices will fall, given the inverse relationship between them. 

Default risk describes what happens when the entity has gotten into financial trouble and does not return your original investment.  Take for example, Greece; certainly you have heard how the threat of Greece defaulting on their bonds is playing havoc with markets there and across the globe. 

Portfolio strategists view bonds as a way to provide stability to a portfolio.  Accordingly, this approach argues for only buying high quality bonds, i.e. those with the highest credit ratings.  The reason is that you won’t want an economy which is going through a “soft patch” to adversely affect both your stock portfolio and your bond portfolio at the same time.  The whole idea is that bonds should provide a safer haven than stocks, albeit with a lower expected return.

Conclusion

It is my belief that, as part of a sensible portfolio, fixed income investments must be limited to high quality issues.  I also believe that it’s a mistake for investors to overemphasize bonds in a portfolio, simply because they are afraid of a bad economy or bearish stock market.

Over the long term, stocks have always outperforned bonds.  And over time, it is the erosion of purchasing power that is the biggest risk for most people.  Most bonds do not protect you from the ravages of inflation.

In the long-term, you need both equity investments for growth and bond investments for stability.  How you make that allocation decision is the most important determinant of how your portfolio will behave in the future.

To be continued.

While I do use CNBC’s web site, I hardly ever watch their TV channel. I always recommend that investors shy away from Mad Money, and in fact all TV shows of that ilk.  You know the kind that “shares” “opportunities” for you or makes predictions on interest rates, stock prices, commodities, etc. etc. etc. 

But my advice is to avoid Jim Cramer, in particular, because he convinces people that the right way to invest is to pick individual stocks, to time the market and to trade.  For most people, this is a formula for losing money.  By trying to “beat” the market, they are more likely to underperform. This isn’t just my opinion; it is supported by actual studies of how well individual investors do.

I have chosen to write about Jim Cramer now, because the last few days have been so dramatic.  I think events indicate that he pretends to, but really doesn’t know, what the future brings. 

If case you weren’t paying attention to the day-to-day swings in the stock market (and good for you if you weren’t), here’s what happened.

On Tuesday, May 31^st, the stock markets had a tremendous rally, i.e. stock prices went up worldwide.  That very night on his TV show, Cramer was beside himself with glee, ranting that this trend was very likely to continue.  As he put it, “We haven’t seen this kind of global move for ages!”

You can watch the May 31^st show:

Cramer: It Will Be Hard to Stop This Rally

Well, in the immortal words of Gomer Pyle (I know I’m dating myself), “surprise, surprise, surprise.”  Since that prediction, just a week ago, the stock market fell over the next four consecutive trading days, on Wednesday, Thursday, Friday and Monday.

So what did Cramer have to say about the four days worth of declines on Monday night’s show?  Sometimes “it’s right to be grim about what’s happened.”

You can view Monday’s show:

Cramer: Market Could Continue to Decline

After the stock market had a large rise, Cramer was terribly optimistic.  After the stock market declined, Cramer has a decidedly downbeat view.  This change happened in one week.  Should you take his views seriously?  I would not, but you must decide for yourself.  Do you want to be buffeted by changes in the day to day stock market?  Or would you be better served by having a sensible long-term plan that takes into account your needs, your goals, and your willingness and ability to take risk?

Conclusion

What will happen next week or next month?  I haven’t a clue.  And that’s the point.  No one can know the future; surely, you’ve heard me say that once or twice.  In my opinion, you don’t have to be a good forecaster to be a good investor.  You need to have a plan, and you need to stick to it. 

Where to find a good planner?  I would start with NAPFA, if you want someone to manage your investments and the Garrett Planning Network, if you are a confirmed do-it-yourself investor.  You will still have to do your own due diligence.  (Disclosure: I am a member of both groups.)

 Friends don’t let friends watch Jim Cramer.