Personal Finance

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.