Your Human Capital

An interesting article in the Wall Street Journal today highlights the part that you as an income-earner play in your overall investment diversification strategy. I have not read the article thoroughly, but am familiar with the concept, as the CFA Institute published a monograph on the topic about 3 years ago. The idea makes sense, and we use the concepts routinely in working with clients.

The bottom line is that a persons career can resemble either a risky or riskless asset at various stages of life. For example, a 22 year-old college graduate in a first-year sales position may have a lot of career risk and income volatility. Depending on this person's overall financial situation, he or she may not want to take on a lot of investment risk in their 401k or savings program. We typically advise new graduates to invest in safer, less-risky assets until they have the necessary liquidity, emergency and "house down payment" funds established.

A research scientist or tenured educator may have a lot of career stability, but maybe not the potential for outsized income, like the salesperson may have at various times. So the more stable income-earner may want to take more risk in her investment portfolio, even though they mentally may not be a risk-taker.

Therefore, you may personally resemble a stock or a bond, depending on the stability of your career and your income (as well as a few other factors, such as the adequacy of your life insurance, investment assets, etc.). If you resemble a stock, the case can be made to lighten up a little bit on equities in your investment portfolio. If you resemble a bond, perhaps growth assets like stocks should have more of a weighting.

Don't overlook your career situation when implementing your investment strategy.

--Doug

More Wirehouse Monkey Business

Surprise!!!! A major Wall Street brokerage house is the subject of an article in today's Wall Street Journal. The article is on page C1, to be exact, and Merrill Lynch is the offender du jour. This time, they are being accused of selling CDOs (collateralized debt obligations) to improperly-informed "accredited" investors. Understand that some of these investors lost millions, and at one point were told by a Merrill Vice President that they should put even more money in these CDOs, as they had "zero risk".

Merill's defense is basically that these high-net worth investors have lots of money and therefore should know better...that's kind of like saying that someone who can afford an expensive luxury car should be prepared that it's possibly a piece of junk and may fall apart as you are driving at 85 mph on your family vacation, scattering parts and people in every direction. Imagine an auto manufacturer using THAT in their advertising campaign.

Even more damning about this situation is this quote from the article:

"It was common practice for Merrill to pitch retail clients (i.e. you and me) the lowest-rated CDO slices - a permissible transaction under the SEC rules - while it sold the higher-rated tranches to larger institutions, according to people familiar with the matter."

Back to our car analogy. This is like BMW selling their best, road-tested, highest quality-controlled cars to their "best" customers and pushing the lemons onto the unsuspecting, uninformed first-time buyer. Fortunately for all of us, auto manufacturers don't engage in such practices.

So when Sally Krawcheck talks about how investors prefer to work with large, stable institutions like hers (Merrill Lynch), a large grain of salt is in order.

Perhaps Merrill Lynch should decide who they really want as clients, and stop trying to have the public believe they are something they are not.

Conventional Wisdom Is Neither Conventional Nor Wisdom

I can't believe that it's almost been a year since I posted here. I'm having a hard time staying on a writing schedule. Possibly impacting me is the fact that I'm not really promoting this blog yet, so I feel like I'm writing to myself. I do have a few thoughts however, mostly having to do with assumptions that investors and advisors share about the markets and money management.

The system that we have all been accustomed to seems to share the following beliefs, some of which are detrimental to your wealth:

1. Modern Portfolio Theory (diversification of assets designed to limit risk and smooth returns) is reliable, makes returns predictable, and will enable you to sleep at night.
2. The most visible and highly-advertised mutual funds and financial products are the ones that will make you successful.
3. _______(insert your investment choice here) is/are safer than _______________.
4. _______(insert your investment choice here) will appreciate better than________.
5. All types of investment advisors and brokers will look out for your interests equally.
6. The big investment firms are safer and more reliable than the independent custodians / Broker-Dealers.

My thoughts are as follows:

1. Modern Portfolio Theory has been misunderstood and misused by many in the investment management profession. Slick computer programs designed to evaluate your "risk tolerance" spit out beautiful graphs and charts which are primarily designed to give the investor confidence so that he or she moves his accounts to the advisor armed with these tools. I don't dispute the value of diversification, as our clients would not have weathered the economic downturn nearly as well without their bond positions. However, statistics have a way of lying, and these tools have to be taken with a grain of salt. Adding infinite asset classes does not help manage risk, either. You don't need more than a handful of low or non-correlated asset classes in your portfolio.

2. Rarely are the most visible and advertised investment products the highest-performers, or the most consistent. We prefer managers who are good at what they do, have a track record, and preferably do not spend a lot on advertising and entertainment. Some of the best managers are ones you've probably never heard of. Don't forget you are buying talent, not a slick brochure.

3 and 4. No one asset class is the highest performer or lowest risk at all times. Sometimes bonds are overvalued relative to stocks and other assets, and sometimes the reverse is true. Everything is relative. Beware of absolutes.

5. Only a NAPFA-Registered financial planner (Purely Fee-Only) or a firm that is strictly a Registered Investment Advisor act as fiduciaries (put your interests first) for their clients. Period. End of story. Always find this out before hiring one.

6. Really? Wasn't Merrill Lynch rescued from bankruptcy by a government-backed buyout by Bank of America? Wasn't Citigroup (Smith Barney) against the ropes? Interesting that Fidelity, TD Ameritrade, Schwab, and a host of smaller firms had no threat of going out of business during the credit crisis.

That's all for now...I hope to be a little more frequent with my posts. Have a safe and enjoyable Summer.

-Doug

Daily Data

Well, in this post-Independence day week, the news is normally pretty scarce, except for this year.  Seems like there's plenty to pay attention to.

Perusing the business news this morning, we find that initial jobless claims fell sharply last week, and this may have been impacted by fewer than expected layoffs in the automotive sector. However, continued claims of people still on jobless aid rose by 159,000 to a record 6.883 million for the week ending June 27.

In addition, stock futures are pointing to a positive open after a better-than-expected earnings report (read: the loss was smaller than expected) which may indicate that the worst of the recession is over.  For stock investors, the focus is now on corporate earnings, and signs of hope shown in improvements in the comparisons.

And, for those of you who watch the annual Nathan's Hot Dog Eating Contest from Coney Island, NY on July 4th, Joey Chestnut defended his title against Takeru "Tsunami" Kobayashi by eating 68 franks in 10 minutes - a new world record.  

Chestnut was quoted in the New York Daily News as saying "I've been practicing hard" and that "I knew it would be hard to beat me."  Kobayashi commented, "I wish I could have done better...it was a real bummer that I lost."

Chestnut is going for 70 hot dogs next year...stay tuned.

I have to admit that in the midst of all of the business, economic, and world news that hits us day-to-day, I'm glad we live in a country where we can still find entertainment value in the Nathan's Hot Dog Eating contest.  Although, I can't stomach watching it.

Independence Day

Here we are, Independence Day 2009 with plenty to reflect on for the first half of the year.  I am writing this from Captiva Island, Florida, where I am vacationing for the week with my family.  

As we pause and reflect on the meaning of this holiday, it's a time for us in the financial planning profession to consider what it is we are meant to do and be in this world.  Yes, our profession is a business, but most of the fee-only planners I know were drawn to it because we derive a lot of satisfaction from helping others achieve their goals and dreams.  For many clients, that means a degree of independence.  Independence from an employer or a job that doesn't excite them any more, independence from the world of work, independence to go live somewhere else, independence provided to their children through a good education, independence in the late stages of life.

The lessons learned from our nation's struggle for independence are applicable to our personal lives as well.  For one thing, our ability to separate from the mother country was no sure thing back then.  Our early leaders staked their lives, reputations, and personal fortunes on the outcome.  Nobody knew whether we would succeed, and when we did, very few had confidence that our republic would continue or thrive.

Yet here we are almost two and a half centuries later, still the beacon of freedom to the world.

Our own personal journeys of independence may not entail such a gamble, or risk.  But we are in a far better position today to succeed.  That is what we do.  We lead our clients through the task of declaring personal independence and ride at the front of the troops to bring them home to victory.  Sometimes the battles are difficult.  The enemies may be fortified.  But we will follow our strategy to achieve your goals.

Happy Independence Day!

Lessons From the Madoff Scandal

You may wonder how Bernard Madoff was so successful in ripping off so many people, including some very sophisticated investors.  In the January 19 edition of Investment News, Blaine Aikin, who is president and CEO of Fiduciary 360 in Sewickley, Pennsylvania (and one of our vendor partners) offered the following observations:

1. Mr. Madoff did not use an independent custodian (such as T.D. Ameritrade Institutional, Fidelity Investments, etc.).  He both directed trades as a money manager and kept track of the funds as a custodian, so there was no third-party oversight on a daily basis.  Additionally, he did not provide his clients with on-line access to their accounts.
2. His firm was audited by a tiny, obscure accounting firm, who did not routinely conduct audits.
3. He produced his own performance reports and wouldn't allow independent performance audits.  
4. His investment results were extraordinary, and didn't match up with reasonable benchmarks.  Furthermore, the results couldn't be substantiated when subjected to fundamental testing of the trading strategy.  
5. The business structure of his fund made little economic sense.  Rather than operate as a hedge fund and charge a performance-based fee, Bernard L. Madoff Investment Securities LLC operated as a commission-based broker-dealer with distribution provided through hedge funds of funds.  By operating as three different types of investment entities, it appears that he fell through the regulatory cracks as a result of confusion.
6. He also showed abnormally high levels of bravado and ego by creating an air of exclusivity.  He rejected and fired clients for asking too many questions and acted above-the-fray when challenged.  His behavior was unusual even for the investment industry.

It's an amazing story, but filled with warning signs.  Caveat emptor.

Our thanks to Blaine Aikin and Investment News for writing a good summary of the Madoff scandal.

Limit Up, Limit Down

The pre-market indications today are showing that U.S. stocks will open at their down limit. That, is the safety mechanisms built into the trading platforms will stop share prices from going lower than the allowable limit.  This means that the DJIA futures won't trade below the 8,224 level and Nasdaq 100 futures won't fall below 1,168.50.  This represents a drop of approximately 400 on each of these indexes.

I also heard an interesting perspective from a floor trader this morning, that it wasn't too long ago, (late 1990's) when limit-up days were pretty common.  It strikes me that it has taken a long time for the market in general to rationalize the high valuations of the late 90's.  I don't mean to imply that all stocks have been overvalued, but broad equity indexes probably have been too exposed to overvaluations.  

If you are a long-term owner / buyer of equities, the stock markets look to be a LOT less risky now.

As always, prudence and balance pay off.