Personal Finance

Investors face many kinds of risks:

Exogneous Risks – Risks that are external and common to all investors
1. Market risk – Risk which is common to an entire class of assets
2. Interest rate risk – Risk that value will change due to a change in interest rates
3. Reinvestment risk – Risk that future proceeds will have to be reinvested at a lower interest rate
4. Business risk – Risk associated with the unique circumstances of a particular company
5. Liquidity risk – Risk that security cannot be sold quickly
6. Default risk – Risk that company or individual will not be able to meet contractual obligations.
7. Industry risk – Risk which is common to a specific industry
8. Deflation risk – Risk of contracting (vs inflating) volume of money and credit relative to available goods. Considered the most dangerous risk to an economy because consumers stop spending and hoard cash. This triggers a vicious cycle of increasing unemployment and declining economic activity which is difficult to reverse.
9. Inflation risk – Risk of expanding (vs. deflating) volume of money and credit relative to available goods. Also called “purchasing power risk”.
10. Uncompensated risk – Risk for which the investor receives little or no reward because the risk can be diversified away.

Endogenous Risks – Risks that are internal and specific to the individual investor
1. Longevity risk – Risk of outliving your money
2. Unemployment risk – Risk of no income
3. Morbidity risk – Risk of disability or need for long term care
4. Mortality risk – Risk of premature death
5. Cash flow risk – Risk of insufficient cash to meet living expenses
6. Default risk – Risk of not being able to meet contracted financial obligations
7. Decision making risk – risk of suboptimal decisions triggered by emotions, lack of knowledge, bad information or bad advice from media or incompetent advisors. Evidence suggests this is the greatest risk faced by investors.
8. Fraud risk – Risk of being defrauded by criminal activity of advisor (Madoff, etc.)

The three Commandments for Successful Investing
1. Thou shall not take any risk that thee dost not need to take
2. Thou shall not take any risk for which there is not commensurate reward
3. Thou shall not risk any money thee cannot afford to lose.

Off course you can!  Most people underestimate their ability to grow both their income and their wealth.  Most people do not create a written plan to increase their income and wealth.  Do you believe you can double your net worth in five years?

The four primary areas of increase where average people build their net worth are:

1. Savings
2. Portfolio return
3. Real estate (home) appreciation
4. Debt reduction/amortization

There are five major inputs or “levers” by which you can control the four sources of increase.  These include:

1. The growth rate of your income
2. Your savings rate
3. The rate of return on your investment portfolio
4. The rate of appreciation on your home
5. The rate at which you pay off debt

You have the most control over your income, your savings rate and your debt reduction rate.  You influence your portfolio rate of return with your asset allocation.  You have the least influence over the rate of your real estate appreciation.  However you influence the return on your investment or equity in real estate through leverage or the size of your mortgage debt and the rate at which you pay it off.

Start now!  For the next 30 days, when you get up in the morning and before going to bed at night, ask yourself the question: “How can we increase our income?”

It is extremely important that you believe your plan is achievable.  90% of achieving financial goals is mental, not financial.  “Whether you think you can or can’t, you’re right.”(Henry Ford).  Belief determines behavior.

For example, you can reject your Financial Plan because it does not fit your belief systems.  Or you can change the Financial Plan until it fits your belief systems.  Or you can work on changing your belief systems.  Helping people change their belief systems is the work of therapists, psychologists, ministers, educators and financial planners.  The purpose of all human communication is to change belief systems.

There are many ways to change your belief systems which are beyond the scope of the work of a Financial Advisor.  I believe the primary way to influence your belief system is through education.

If I were a prospective client, here are the steps I would take to reduce the possibility of hiring a financial advisor or being defrauded by him if he is tempted to take money from my accounts.  Each step increases my Peace Of Mind, but also reduces the number of potential advisors.

Step I: Choose Fiduciary standard of care OVER Suitability standard of care.  Why?  It provides you with highest legal standard of care under federal law, converts personal trust into a legal right, places advisor under growing body of fiduciary law & principles governing money management, increases risk of criminal prosecution for advisor and severity of penalties, including prison. It also increases the probability of restitution for investor losses.

Step II: Choose a FEE-ONLY advisor with a preference to flat fee compensation OVER Commissions and fees from sale of products, fee-based combination.  Why?  It reduces conflicts of interest between investor and advisor.  It also creates greater alignment between investor and advisor interests.

Step III: Choose Passive management investment philosophy OVER Active management investment philosophy.  Why?  It removes expectation for advisor to “beat” the market by speculating with investor money in an economic “zero-sum game”. Frees advisor to focus on areas where he has much higher probability of delivering value, such as goal setting, tax planning, retirement planning, wealth building, risk management, values clarification, conflict resolution, estate planning, asset protection, etc.  An advisor who simply helps client harvest market returns with index funds or passively managed portfolios is MUCH less likely to lose money in speculative investment activities. 

Step IV: Run a background check OVER using gut feeling, “we like him”.  Why?  It removes advisors with criminal backgrounds, previous securities violations and history of compliance problems

Step V: Give a Limited Power Of Attorney (POA) for trading or View/Read only POA only OVER Custody of your account.  Why?  Advisor does not have power to execute trades.  You can execute trades recommended by the advisor.

One of the biggest reasons investors underperform the market is that they try to beat it. Since the early 1970s there have been two competing theories on how to get better investment returns. Active Management is the oldest and still most widely held. The goal of active management is to “beat the market”. The last time I checked about 93% ($6.5 trillion) of all mutual fund dollars were actively managed.

Passive Management is the relatively new theory which is gaining acceptance among a growing number of academics and institutional money managers. The goal of passive management is to “capture market returns” by simply investing in a statistical sampling of the whole market and eliminate all the costs of trying to beat the market. About 7% ($500 billion) of all mutual fund dollars were passively managed.

Active management begins with the assumption that stock and bond prices do not always reflect their “true” or “intrinsic” value. Active managers spend billions of dollars on research to find the “mispriced” securities. Using fundamental analysis, technical analysis and market timing, professional money managers actively trade (buy & sell) securities in search of higher investment returns.

Passive management begins with the assumption that free markets, while not perfect, are a very effective mechanism for setting prices for anything, including publicly traded companies and bonds. In other words, the the capital markets are just as efficient as the free markets for automobiles and toothpaste. Proponents of passive management like to say that the only people who don’t believe free markets work are the Cubans, North Koreans and believers in active money management.

The “market” is all investors together, functioning like a super computer processing all the information about a company and calculating the best estimate of the intrinsic value of a company at any particular moment. This estimate is called the “fair market price”. Investors who try to beat the market, believe they know something the supercomputer does not. I like to compare passive management with the game of golf. Instead of trying to beat the golf course by scoring birdies and eagles, investors who adopt passive management are satisfied with par. Instead of trying to beat the golf course, they are satisfied with beating 99% of all other golfers (active managers) who spend billions of dollars and make a lot of mistakes trying to overcome almost insurmountable odds.

Can information be bad for investors? Prof. Paul B. Andreassen from Harvard University, compared the investment performance of four groups of investors. Two groups managed a volatile growth stock like Google. The other two groups managed a stable value stock like Sears. In each pair of groups, one group was fed a steady stream of news reports about their stock, while the other group received no information. In both pairs, the group that received no news performed better than the group that was given a steady stream of information. In fact, the investors who received no news and traded the volatile growth stock performed twice as well as the investors who received regular updates on the company’s performance!

How can this be? How does easy access to financial news and the ability to track portfolio values harm investors? Researchers in behavioral finance observe that when investors receive new information there is a natural tendency to “do something” in reaction to that information. It turns out the human brain is programmed to act on new information.

In most cases, acting on new information is good. But when it comes to implementing a long term investment strategy, it’s usually disastrous. Information stimulates emotions which in turn increase the urge to act. So a steady stream of information about losses, moves investors to sell. Later, a steady stream of news about market gains, induces investors to buy. Without realizing it, most investors have abandoned their strategy, if they had one in the first place (See previously posted Mistake #1). Driven by natural urges to act on information, investors unintentionally implement a strategy of selling low and buying high.

Watching daily movements in your investment portfolio is like watching paint dry. Imagine a paint job with a one-hour drying time and checking it every minute by touch to see if it’s dry. Sixty fingerprints can ruin a great paint job.

Assume your portfolio has at least a ten (10) year time horizon. Checking the value every day is like touching the paint 3600 times an hour to see if it is dry. One of the worst things we can do after creating and implementing our investment strategy is to touch the paint. Treat all the daily headlines like static on the radio. Ignore them. Because information can be harmful to investors, we recommend the discipline of an annual investment review.

From 1988 thru December 2007, investors underperformed the stock and bond markets by -7% and -6% respectively.  It is an empirical fact that individual investors sabotage their own portfolios because they have no strategy.  If you think you are an exception, you should have what professionals call an Investment Policy Statement that describes your strategy by answering questions like the the following:

What is the target return for your investment portfolio?   4-6%?   7-9%?   10-12%?   

How much risk are you willing to take in order to get that return?   Are you willing to lose 40% of your portfolio one out of every five years in order to have a 65% chance of averaging 12% over 20 years?   How much risk is acceptable as defined by the “volatility” or “variablity” in your annual returns?

What is the time horizon for your portfolio?   When do estimated withdrawals from your portfolio exceed the contributions and earnings?  Ten years from now?  Twenty years?  Fifty years?

How many asset classes do you use?   Three?  Five?  Seven?  What is your target allocation for each asset class?  What are the band limits?  When do you rebalance?

Have you chosen an active or passive management philosophy for security selection?    

If you have chosen active management for the equity (stocks) asset class, what strategy have you selected?   Do you buy growing companies or beaten down value companies?  Do you use a buy and hold, momentum or market timing strategy?

Achieving investment goals requires a plan and a strategy.  One of the most frequent mistakes investors make is they have no written plan or strategy to address some of these most important questions.

There is a difference between investor and investment performance.  In 2008 the US stock market, as measured by the S&P 500, lost 37.7%.   But investors did even worse by losing 41.6%.    The US bond market, as measured by the Lehman Aggregate Bond Index gained 5.2%, but bond investors actually lost 11.7%.   In other words, the stock market as an investment outperformed investors by 3.9% and the bond market beat investors by 16.09%.  

This is not just a one year phenomenon.   Every year the Dalbar company measures how investors performed compared to the capital markets themselves.   For the 20-year period from 1988-2007, the US stock market, as measured by the S&P 500 returned 11.81%, but equity investors only earned 4.48%.  For the same period, the US bond market, as measured by the Lehman Aggregate Bond Index, gained 7.56%, but fixed income investors earned only 1.55%.   In other words, over the past 20 years the stock market outperfomed investors  by 7.33% and the bond market beat investors by 6.01%.   If we’re not shocked, we should be.

What are investors doing wrong?  How do they unintentionally sabotage themselves?

These are ten broad categories of mistakes that we have seen investors make:

1. They have no strategy
2. Their strategy is to beat the market  (Market Failure Theory)
3. They don’t hold themselves accountable (No Benchmarks)
4. They listen to the media more than the math (The Loser’s Game)
5. They don’t count the impact of costs (SEC Cost Calculator)
6. They let emotions overrule numbers (Behavioral Economics)
7. They don’t understand or set a portfolio time horizon
8. They don’t define long term (Speculators vs Investors)
9. They don’t understand all the risks
10. They measure risk tolerance instead of risk capacity

Most investors believe they are the exception, but it’s pretty easy to prove they are not.   People’s Financial Advisor offers a Financial Checkup that will estimate the cost in your personal portfolio from just one common mistake.  In future postings we will explore each of these mistakes in greater detail.

The simplest and best way to protect your investments from advisor fraud, is don’t give the advisor opportunity.  In other words, don’t give him custody of your assets.   Don’t give your advisor power to buy and sell securities without your permission.  Give him a limited power of attorney to execute trades with your signed permission only.   Don’t authorize your advisor to pay himself (deduct his fee) out of your account.    Ask for an invoice and pay the fee with your credit card or a check.    The more control you give the advisor over your money, the greater the risk of being defrauded.

If keeping control creates too much work for you, then at the bare minimum require the advisor to use an independent financial institution to hold your investments.   Such an institution is called a custodian because it provides custodial services for advisors and their clients.  An independent custodian gives you an extra layer of protection because it, not the advisor,  generates the reports and values your assets.    You should be very nervous if the only report you receive is the one prepared by your advisor or a custodian controlled by our advisor.

If the independent custodian is not a well-known name like Schwab, TDAmeritrade or Fidelity, you will have to do some additional background checking.   Get the firm’s name and contact information.   Call and ask for evidence that  custodial services are provided to other advisors.   Request copies of reports from an independent auditor.  Visit the physical office.  I’ve read that Bernie Madoff’s custodian had a small office in a remote location, with just a couple employees and no independent auditor.   Do a Google search and check the yellow pages.   Verify to your satisfaction that the custodian is truly independent and trustworthy.

Finally, I believe you can greatly reduce the risk of being defrauded by abandoning the strategy of active management altogether.  There is no evidence that an active money manager can beat the market.   Read the all time best seller ”A Random Walk Down Wall Street” by Professor Burton Malkiel or  ”Winning the Loser’s Game” by Charles Ellis.    I can’t prove it, but I suspect that most, if not all the Ponzi schemes and acts of fraud were committed by advisors who believed they could beat the market, even after subtracting their expenses.   An advisor who sells his ability to predict the future (ie. pick winners and losers) has created almost impossible expectations (and pressure) for himself and his investment performance.