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.  

The Excitement Continues

The Dow Jones Industrial Average closed down 514 points today, apparently on worries that corporate earnings for the third quarter will be disappointing.  It is now becoming clear to the masses that the expected slowdown in the economy will materialize.

For long-term investors in stocks (the only time frame that applies to stock investments), this volatility and weakness will continue to present opportunities to make investments at reasonable valuations.  We believe that our attention to overall diversification, cash management,  and prudent investing will reward our clients over time, and we encourage you to stick to your plan.

If you are a participant in a corporate retirement plan, where you have the opportunity to "dollar cost average" into a diversified portfolio, consider the fact that everything's on sale, and you are going to load up your shopping cart with a lot more items than you could buy for many years.

If you are approaching retirement, this is a good time to be overweight in cash and bonds.  We tend to take a very cautious approach with portfolios as they reach the retirement years (now  you should really enjoy your bond ladder).  We certainly don't ignore growth investments for retirement, but only after stress-testing your personal situation would we then recommend gradually adjusting to a balanced position between cash, bonds and stocks.

Jason Zweig's WSJ Column on Tuesday

As much as I enjoy providing original thoughts here, I feel compelled to pass along some of the better columns I've read recently regarding personal finance and investing (with proper credit, of course).  I read the Wall Street Journal pretty regularly, and have come to enjoy Jason Zweig's column, "The Intelligent Investor".  

Instead of summarizing, here is the October 7 column.  Enjoy!

So do you feel like quitting yet?

If Monday's 800-point intraday plunge in the Dow Jones Industrial Average made you want to give up and get out of stocks, you're not alone.

Michael Nagle for The Wall Street Journal

As the Dow drops: A trader at the New York Stock Exchange on Monday.

I've written column after column advising investors to buy stocks on the way down, and readers are in pain. "You say not to bail," one reader emailed me over the weekend, "but all funds are down. ... This whole stock market has me so upset, [I feel] like a deer in the headlights." Another wrote: "We are, you see, about to enter another Great Depression, just like the last one only much worse. ... It's way too early to be buying stocks. ... Or I could be really nasty and ask you which brokerage house paid you to run this stupid column now."

Right or wrong, I work only for The Wall Street Journal. But what all of us are feeling is the loss of control we sense when we are faced with anything that is frightening, inexplicable and important.

That lack of control not only makes us feel powerless; it also changes the way we view the world. Very small amounts of fragmentary information can suddenly seem to be fraught with meaning: Did something move on "the grassy knoll" the day John F. Kennedy was assassinated? Will one down day in the stock market lead to another and another?

Even the greatest investors have felt the same kind of fear and pain you are probably feeling. For proof, look no further than "Security Analysis," the classic textbook by Benjamin Graham and David Dodd, which has just been reissued in a commemorative edition. Graham was one of the best money managers of the 20th century, a brilliant analyst and market historian, and Warren Buffett's most influential teacher and mentor.

The new book reprints the text of the 1940 printing, in which Graham addressed the market devastation of the previous decade. Just as the roughly 90% fall between 1929 and 1932 had seemed to be fading, the stock market dropped sharply again in the late 1930s. As market historian James Grant puts it, by the time Graham was ready to finish the 1940 edition, "He had had it."

That helps explain one of the great ironies of market commentary. Graham himself stuck largely with stocks in his investment fund. But at the conclusion of his book, he advised the institutional investors among his readers to shun the stock market entirely and invest in bonds. Graham doubted they could stomach "the heavy responsibilities and the recurring uncertainties" stirred up by stocks.

How does the feeling of being overwhelmed affect investors? Research conducted by psychologists Jennifer Whitson of the University of Texas and Adam Galinsky of Northwestern University shows how it changes our perceptions. In one of their experiments, people were first rattled by a computer that gave them unpredictable feedback on their performance at a trivial task, stripping them of their sense of control. These people became much more likely to perceive shapes in a swarm of random dots.

"When you sense that you have a lack of control," says Prof. Whitson, "you're much more likely to try twisting and pretzeling explanations and seeing patterns that aren't even there."

In a related experiment, investors who had been stripped of their sense of control by market volatility were convinced that they had read more negative evidence about a company than they had actually seen -- and were less willing to buy the company's stock.

In other words, when our sense of control is threatened, we feel the natural urge to pretend that whatever information we do have is more complete and reliable than it is. Imagining that we know what's coming next (even if we think it will be bad) gives us a slight feeling of comfort.

As an investor, however, it's absolutely vital to separate what you can truly control from what is beyond your control. The only thing you can know for sure is that stocks are steadily getting cheaper. You cannot control whether or not the market will continue to trash stocks, but you can control how you respond.

If we are not headed into a depression, panic hardly seems justifiable.

What if we are?

Even during the Great Depression, the best investment results were earned not by the people who fled stocks for the safety of bonds and cash, but by those who stepped up and bought stocks and kept buying on the way down. A man named Floyd Odlum made millions of dollars putting his cash into battered stocks. His motto throughout the market nightmare of 1929 to 1932 never changed: "There's a better chance to make money now than ever before."

• Email: intelligentinvestor@wsj.com

Late Summer Thoughts

With all of the stock market volatility this summer, we've been spending a lot of time thinking about how to best adopt our long-term strategies to the current economic situation. Obviously, nobody likes to adjust things too often, as that can quickly unravel any sound investment approach.  But certain characteristics of the U.S. economy deserve some attention, such as:

• The return of inflation.  We are glad we started factoring in a significantly higher rate into our projections at the beginning of 2007.  It didn't really feel right at the time, but we felt that higher energy costs would start to affect both businesses and consumers at some point in the near future.  Sorry to say that we were right, but we're glad we took a more conservative approach.
• A significant credit crisis.  The bursting of the housing bubble and the unraveling of various creative and unsound credit vehicles will have a long-term impact on the world economy.  This period feels a lot like the S&L crisis of the 1980's.  We hope it won't get much worse than that.
• Another round of excess brought on by Wall Street "rocket scientists".  It seems that the geniuses responsible for cooking up ever more creative ways to offload risks to the next sucker in line have succeeded again.  The drive for higher and higher profits by publicly-traded investment firms and banks continually create unsound and risky investment vehicles for the public AND institutions.  It's too bad that the average guy and gal on Main Street are going to pick up the tab for this one.  This will create added pressure on our tax system and will probably make for an interesting election year.  
• Significant pressure on our domestic economy brought on by defense, healthcare, rationalizing of certain industries (i.e. automobile manufacturing) and infrastructure demands.  The citizens of the U.S. will have to pay this tab some day, and maybe pretty soon.

On the upside, stocks are now possibly reaching bargain levels, not every company is having a difficult time, gasoline prices are declining, and some of what we are experiencing is the necessary side effect of asset overvaluations (what goes up, must come down).  

As investors, we preach balance in portfolios at all times, and we constantly search for areas of opportunity, whether it's in bonds, real estate, commodities, hedged instruments or equities.  A certain degree of "stay the course" is prudent in times like this, and a more focused approach to investments is in order (in our opinion).  While we like the cost efficiencies of indexed investments, we don't think that you should willy-nilly spread your holdings over very broad markets.  That is certainly a prescription for mediocrity at best, and possibly could lead to significant underperformance due to over-exposure to specific stocks or asset-classes.  

We think that now is a good time to "get back to basics" and adjust your approach to high-quality companies that are well managed and possibly have international exposure.  We favor investment managers who have a long-term track record and who focus on fundamentals.  

Think about companies like McDonald's, arguably the world-leader in fast food and a company that had many operational problems a few years ago, but now appears to have gotten a handle on their problems and are doing quite well.  

Other companies that are well-managed and are quality names:  

• Johnson & Johnson
• Apple Computer
• IBM
• Celgene
• Disney
• GE
• Procter & Gamble
• Kinder Morgan Energy, LP
• United Technologies

You get the picture.  These are companies that have been around for a while, will probably be here for many years, and are good at what they do.  We like to see these companies held by mutual funds and where appropriate, in our portfolios.  We like stocks like these even more if they pay a dividend, but that's a topic for another time.