Over the many years that I have advised investors, I have spoken to a number of people about bonds. The conversation was very different depending on the environment at the time. In 1999, for example, when common stocks were on a tear, I had to explain why anyone would invest anything in bonds. Interestingly, in recent times, I’ve had to talk investors out of investing too much money in bonds.

These are both examples of what Behavioral Economists call “recency.” We tend to place more emphasis (and trust) on more recent data and ignore older data, even if it is more comprehensive.

A more general problem is that investors do not understand the role that bonds should play in an investment portfolio. When you buy a bond you are essentially lending money to an organization, whether it’s a corporation, a state, or a country. In exchange for your “loan,” you are promised a regular payment, usually on a semi-annual basis, plus the full amount of the money you “loaned” returned to you at a given date. Depending on the circumstances, you may or may not realize the promised returns. You should also know that bonds do not reward you for any growth in the economy.

Most serious portfolio strategists view bonds as a way to provide stability to a portfolio. Accordingly, this approach argues for only buying very high quality bonds. The reasoning is that you won’t want a bad economy to affect both your stock portfolio and your bond portfolio at the same time. The whole idea is that, when economic times are bad, bonds should provide a safer haven than stocks.

Investors who mistakenly try to enhance their returns by buying low-grade “junk” bonds can end up doing just the opposite.

Larry Swedroe is the author of several books on investing, including one he co-wrote with Joseph Hempen The Only Guide to a Winning Bond Strategy You’ll Ever Need.

In a recent blog post, Junk Bonds Are Just That – Junk, Swedroe uses Morningstar data to illustrate just how badly some junk bond funds did in 2008. The same conclusions would be reached if considering individual low quality bonds.

Glancing at his tables is very instructive.

Investors who “stretched for yield paid a severe price.”

Losses on the 10 worst taxable bond funds and the three worst municipal bond funds were all worse than the 37 percent loss of the S&P 500 Index in 2008.

There are two lessons you should learn from the experience of 2008. The first is to never confuse yield with return. The second is that credit risk is correlated to equity risk. When the risks to equities shows up, credit risk tends to rear its ugly head at the same time. Thus, credit risk and equity risk don’t mix well together in a portfolio.

Conclusion

I agree with Swedroe’s recommendation of limiting fixed income investments to only the highest quality issues. On the other hand, I believe that it is a mistake for investors to overemphasize bonds in a portfolio, now that stock prices have declined so much. This is akin to locking the barn door after the horses have left.

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 determination of how your portfolio will behave in the future.

To be continued.

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.

You can read Lieber’s article for the details. What is not clear, though, is how much money was involved nor how quickly the irregularities were discovered. Though, from my point of view, they are not the most worrying aspects. What concerns me most is that Mr. Weitzman was a member of the National Association of Personal Financial Advisors (NAPFA).

When a member of the advisory community violates the trust that clients place in him, all clients and advisors suffer. What this country does not need right now is any further deterioration in what little confidence we have left in the banking system, the federal government or our financial advisors.

I have been a fee-only planner since 2003, and whenever possible, I recommend that investors seek out financial planners who are compensated directly by their clients, rather than by commissions. In this way, you will avoid obvious conflicts of interest.

Members of NAPFA all practice a fee-only method of compensation and sign a Fiduciary Oath, which means that they swear to act only in their clients’ best interest. So it is with great discomfort that I heard that not one, but two, former members of NAPFA have been accused of bilking their clients.

What to do? As Ronald Reagan once said, “Trust but verify.” And of course, you should never write checks directly to your advisor, but only to an independent custodian. It is the independent custodian who should be providing you with confirmations of all transactions and trades, and a monthly statement. These are sensible precautions in the age of Madoff.

As Lieber says, “Open your mail. Confirm the accuracy of your trades and fund transfers. Read your account statements. Every month. Every number. Every single word.” I am not sure about reading every number, every word, but I get his drift.

Lieber further recommends that you handle all of your stock transactions yourself. I believe most investors will find this “solution” impracticable, inconvenient and unnecessary. I believe a better solution is for you to sign a limited power of attorney, allowing your advisor to enter transactions on your behalf, but which does not allow him to withdraw your funds. Only you should have the ability to withdraw funds from your account. I am not an attorney, but I believe that this provides adequate protection. (Attorneys, please weigh in.)

My mother always said “A promise is a promise.” Unfortunately, there are always people who will promise one thing and do another. It’s disappointing to have your expectations dashed.

I don’t know about you, but I expect firefighters to be brave, judges to be moral and rabbis and priests to comfort the troubled. Yet, there have been judges who, instead of upholding the law, bend it out of shape for personal gain. And there have been priests and rabbis who have preyed upon our young and betrayed our trust.

Lieber says, “I’ve always believed that advisers in the (NAPFA) association were plenty smart and morally upright, but it’s hard to recommend them now without at least including an asterisk.”

In my experience, NAPFA members have the highest standards in the profession. But like every profession, there may be individuals who choose to violate the trust of clients they serve.

It’s not easy to protect yourself against out and out theft, but you can take some small comfort from the fact that if financial advisors break the law, they are subject to prosecution by the regulatory authorities.

In my opinion, a great majority of investors will lose countless dollars because of the continuance of “Standard Operating Procedures” at Wall Street investment firms. Every day these firms peddle ill-conceived, hard-to-understand, expensive investments, because it is profitable for them to do so. Investors will lose more money in the ordinary course of business than they will ever lose due to outright fraud.

Unfortunately, what is legal on Wall Street is bad enough.

And so, I will continue to heartily recommend NAPFA members, because the fiduciary standard is the right way to do business.

And yes, monitor your accounts. Remember, “Trust but verify.”

A previous post sought to debunk the notion that anyone can consistently outperform the market by superior stock selection and/or stock trading, better known as active management. It’s worth continuing an examination of this approach, because so many investors, through their investment advisers, are essentially chasing a chimera. They are trying to beat everyone else by choosing mutual funds that have done well. This approach has been shown, time after time, to fail.

I concluded with this statement: “It would be wonderful if we could find really good stock pickers, the ones who consistently beat the average, but that is impossible.”

Actively Mismanaged Funds by Scott Woolley in the April 13, 2009 Forbes Magazine reinforces my conclusion.

Here are the relevant quotes:

For years William Miller’s name appeared atop lists of the world’s most successful stock pickers. His Legg Mason Value Trust outperformed the S&P 500 every single year for a decade and a half through 2005, an astonishing streak regularly cited as evidence that a smart fund manager can consistently beat the market. Customers flocked to this hot hand. Assets in the fund climbed to $12 billion, representing $200 million a year in management fees for Legg Mason. (Emphasis added.)

That’s when the gravy train came screeching to a halt. Value Trust’s 6% gain in 2006 was only half as good as the market’s. The fund has lost money ever since, including a 6.7% decline in 2007, 55% in 2008 and 20% through February of 2009. Each of those numbers was worse than the broader market’s return.

Another way to look at Value Trust: Investors paid Miller and his underlings $2 billion in management fees to destroy wealth.

Value Trust is an exceptional case of outsize gains followed by outsize losses, but the phenomenon of active managers creating wealth only for themselves is no fluke. What makes this especially searing to investors these days is the implication by many active funds that they’re worth a premium because they’ll rescue you from nasty bear markets while “dumb” index funds abandon you to a mauling.

The facts indicate otherwise. Last year, during the worst stock market drubbing since 1931, the average active stock fund lost 40.5%, versus a 37% loss for the market-tracking Vanguard S&P 500 Index, according to Morningstar. Stretch out the time frame and active management looks no better. According to Standard & Poor’s, 69% of actively run large-company funds, 76% of funds buying midsize companies and 79% of funds buying small companies underperformed their indexes in the five years through last June.

Especially humiliating lately is the performance of the largest funds, including Fidelity Magellan, in Peter Lynch’s day the grand master of actively managed vehicles. The fund lost 52% in the past year.

While Magellan has been a disappointment to investors, it has done very well for its manager, Fidelity Investments (in which the family of billionaire Edward Johnson owns a large stake). The fund’s 0.73% annual expense ratio on $41 billion in average assets added up to $295 million in fees last year. Investors could have stuck their money in Fidelity’s Spartan 500 Index at one-seventh the cost and earned more over the past one-, three-, five- and ten-year periods.

 Humans, …are hardwired optimists. To our detriment as investors, we tend to overestimate our ability to pick winning stocks and stock pickers, like Bill Miller. (Emphasis added.)

The other problem is that funds are often sold rather than bought. The sellers are in it for commissions. Those are easiest to skim off actively managed funds that charge fat fees in exchange for the prospect (but not the probability) of knocking out the lights or the protection offered by “professional management” in troubled times.

Franklin Templeton’s ads boast that its flagship Growth Target Fund has “weathered the ups and downs of the market for over 50 years.” That included some rough sailing in 2008, when Growth Target, a supposedly conservative mix of stocks and bonds, lost 31% of its value and lagged its index by six percentage points, according to Morningstar.

American Century enlisted pedaler Lance Armstrong to evoke his successful battle against cancer as a template to “provide for a secure financial future.” Ultra, American Century’s largest fund, lost 41.7% last year, lagging the S&P 500.

Investors are learning

The crash is making investors rethink their faith in funds that try to beat the market. Last year they yanked out $222 billion while adding $18 billion to their index holdings, according to Lipper. That left $3.2 trillion with active managers at year’s end, compared with $672 billion in passive mutual funds and exchange-traded funds.

That shift from actively managed funds to passively managed mutual funds and exchange-traded funds is definitely a move in the right direction.

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

No Place to Hide in 2008

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

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

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

Volatility

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

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

What can we learn from 2008?

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

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

Conclusion

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

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

To be continued.

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

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

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

You can’t time the market.

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

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

(Emphasis added.)

Conclusion

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

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

To be continued.

In my last post, I recommended what I consider to be two very helpful books for those investors who have decided that they want to engage a financial planner to manage their investments. Reading either or both of these books before you have your first consultation with the prospective advisor, will provide you with a checklist of the right questions to ask him or her.

The knowledge you will gain will also arm you against misleading claims some advisors may make; for example, that the funds they recommend “outperform” the market. There is no evidence that anyone can consistently “beat the market.”

Suppose that, after realistic introspection, you have decided that you definitely want to manage your own investments. Perhaps you do not want to give up the control to someone else. Or you are convinced that you can do a better job yourself. If that is indeed the case I suggest that you start by educating yourself. To that end, let me suggest several books that will help you become your own investment advisor.

Obviously, I won’t waste your time suggesting any book that purports to have a strategy to consistently outperform the market or promises to avoid losses, and you should be very skeptical of any such claims.

Here are three books that are a very good place to start.

The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William J. Bernstein

The Only Guide to a Winning Investment Strategy You’ll Ever Need: The Way Smart Money Preserves Wealth Today by Larry E. Swedroe

Live It Up Without Outliving Your Money! – Getting the Most From Your Investments in Retirement by Paul Merriman

These books all reach similar conclusions, primarily about the need for diversification and risk management, though they obviously present their authors’ differing perspectives. To some extent, these are overlapping, but all are useful. If I had to choose just one book, it would be Bernstein’s. It covers the Theory of Investing, the History of Investing, the Psychology of Investing and the Business of Investing; all-in-all, a well-rounded, intelligent read.

Some Cautionary Notes

Keep in mind that designing a portfolio is just the beginning. You will still need to implement your investment plan and to monitor it regularly. And you will need to keep up with changes in tax policy as it affects your investments.

Often, the most difficult aspect of being your own investment manager is the psychological part – namely, sticking with your plan. It’s too easy to second guess yourself, and you will not have a behavioral “coach” to help you avoid big (i.e. costly) mistakes.

Nevertheless, taking the time to read these books will not go to waste. As my wise mother used to say, “Knowledge is a light burden.”

In my last post, I suggested that a great many investors would benefit from a financial advisor who could help them create and implement a comprehensive financial plan and who can manage their investments. Whether or not you heed my suggestion depends on whether you consider yourself a do-it-yourselfer or a delegator.

To handle your own investments, you must first know yourself. Be honest. Do you have the time, inclination, and emotional fortitude to do this right?  Successful investing takes both knowledge and discipline.

Do you understand risk management, asset allocation and asset location? Are you capable of writing and sticking to an Investment Policy Statement?

Perhaps you’ve shot yourself in the foot one too many times? It happens to a lot of novice (and not-so-novice) investors. Many individual investors tend to be too enthusiastic after market prices have gone up and go into a buying frenzy; conversely, they become overly pessimistic after market prices have fallen and then are anxious to sell.

If you realistically doubt your investment skills, then you are a delegator, someone who will rely on a professional to invest your hard-earned money for you. If that is the case, you should be looking for an investment manager who will listen to your needs and goals and implement an investment strategy that makes sense to you and for you.

In my opinion, and I’ve said this numerous times, you should only work with someone who has your best interests at heart – and that means someone who is a fiduciary.

The most common arrangement in working with a Registered Investment Advisor (RIA) is to pay an annual fee, which is based on a percentage of assets, though some financial advisors do work on a retainer basis.

If you are not clear on what fees you are paying, or if your prospective advisor cannot explain what fees you will be paying, you are most likely working with a stockbroker or insurance agent, i.e. someone who receives a commission. I cannot and do not recommend this approach for two simple reasons: It is not transparent, and there are possible conflicts of interest.

For most individuals, the investment management or retainer fee is well spent, because you will avoid the costly mistakes that most investors make. Since the manager will be both an implementer and a behavioral coach, it is crucial that you understand and accept his or her investment philosophy.

Trusting someone to manage your personal investments is one of the most important decisions you will ever make. Here are two books I recommend that you read in preparation for your search for an investment manager.

Simple Wealth, Inevitable Wealth (3rd Edition) by Nick Murray

Wise Investing Made Simple by Larry Swedroe

Notice that both books have the word “simple” in the title, but don’t let that mislead you, investing is not a slam dunk. As Warren Buffet is quoted as saying, “Investing is simple, but not easy.”

But, if your resolution was and is to make better financial decisions in 2009, I applaud you. It’s an honorable and worthy goal, and one that can be achieved with relatively little pain. Helping individuals to make better financial decisions, so that they maximize their chance of achieving their goals: That’s my professional objective; it’s also another of my perennial resolutions, but one I faithfully keep.

Rather than writing my own killer “Top Ten Things to do to Get a Grip on your Finances,” I did a Google search on what has already been written. There’s an amazing amount of stuff out there on the net, some of which is quite basic – spend less, save more, have an emergency fund – but still apropos. There is one standout among the crowd, The Best Financial Advice Ever by Liz Pulliam Weston.

Assuming you already know the basics, here is an excellent article: 10 Resolutions to Fix Your Finances by Allan Townsend.

Although the last update was more than a year ago, this Money Central article is still a keeper. It definitely goes beyond the basics.

No. 1: Set up a system.
No. 2: Bank online.
No. 3: Take stock of what you own.
No. 4: Get out of debt.
No. 5: Create a budget.
No. 6: Review your 401(k) plan.
No. 7: Check your insurance coverage.
No. 8: Check your estate plan.
No. 9: Don’t give your money to Uncle Sam.
No. 10: Make new goals.

You’ll either find this list “old hat” or quite intimidating. There are links to further information on the various suggestions, and if you’re at all confused by what you’ve read, I urge you to read on.

Conclusion

For most people, developing a financial plan is well worth their time. Just as you plan a vacation, by carefully selecting a destination based on your needs, wants and desires, and determine the best way to get there given your individual situation, your financial decisions should involve the same type of strategic thinking.

After reading Townsend’s article, you may decide that you need help in analyzing your current situation, your required savings, and in developing a long term strategy. Thinking strategically and monitoring your results regularly will let you know if you are on track to reach your goals.  It will also indicate when you need to adjust your existing financial plan to match your new or changing financial situation.

It may not be easy to set up a financial plan by yourself, but you needn’t do it alone. A good financial planner will help you analyze where you are and what you need to do to achieve your goals. For most people, having an experienced financial advisor prepare a comprehensive financial plan is well worth the time and money.

Although you may be very successful in your own field of expertise, you may not have the time or inclination to keep up with changing tax laws and new investment products. There is no shame in delegating these tasks to someone who does them full time. You may also not have the discipline to manage your own investments, and there’s no shame in that, either.

The key is to start immediately. You need to harness your motivation now, create a plan and then begin to take the steps to implement it. A good planner will outline all of the steps required to reach your goals.