Personal Finance

Imagine going to the doctor for headaches that have been increasing in pain and frequency for the past 2 years.  What would you expect in terms of your treatment and how the doctor is paid?

PAYMENT – The first doctors were travelling medicine men who sold magical elixirs out of the back of a wagon.  The first dentists were barbers.  The first financial planners were life insurance agents and stock brokers.  Like doctors, dentists and lawyers, we believe professional financial planners should be paid for their expertise and their services, not for the financial products they sell.  They should be paid by so they are loyal to you, and not to the insurance or investment company by whom they are employed.

PROCESS – You would expect the doctor to ask questions and perhaps conduct tests to determine the cause of your headaches.  After the diagnosis, you would expect a plan of treatment.  You would expect the recommendations to depend on the diagnosis and range from stress management to chemotherapy.  In the 21^st century, you should expect the same kind of professional standards for treating your financial issues.  The Certified Financial Planner® Board of Standards has defined a six-step process for giving financial and investment advice.

The 6-step process for creating your financial plan is similar to the process for creating a medical plan of treatment for your headache.  Dispensing investment or financial advice without a process and plan is like writing a prescription without a diagnosis and plan of treatment.

Here is the Six Step Process as defined by the CFP® Board of Standards:

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.

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.