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Finance

Modern Portfolio Theory

I’m not going to reiterate my disclaimer with every post other than this: You are reading what amounts to financial advice from a guy who has no credentials and no expertise–it’s just what I’m finding in reviewing my own financial situation. View it as a wake up call and nothing more.

Modern Portfolio Theory (MPT) is a lot like Political Correctness. or Progressive Policy–a marketing  label that sounds like a blanket endorsement. Or in more direct parlance–bullshit. Oddly enough, Modern Portfolio Theory was developed in the 1950’s, which makes it as modern as avocado-colored refrigerators. But in recent years it’s become the accepted tool for financial managers and wealth advisors. Maybe it took that long for them to understand it. Or maybe it just fits the current market mood. Wikipedia has a very technical definition of the concept, which says in part:

Modern portfolio theory (MPT) is a theory of finance that attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize for the theory,[1] in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics.

As a sidebar, the Nobel Memorial prize is NOT a Nobel Prize. Financial advisors selling MPT  go on a bit about the Nobel prize aspect. I’m not discounting the theory when I say that there’s a big difference in winning the Nobel Prize and a Nobel Memorial Prize, which is actually awarded by a Swiss bank. Here’s a wikipedia reference on the difference: http://en.wikipedia.org/wiki/Nobel_Memorial_Prize_in_Economic_Sciences.

Here’s what I think–MPT is a reasonably safe way to invest. But paying someone to do it for you is like paying someone to be your friend. It’s pretty easy to do it for yourself, but having a “wealth advisor” do it for you is a more than a bit nutty–believe me, I know, I’ve done that for the last six years.

I say reasonably safe, because when everything goes to hell–which is the crisis mode mentioned in the full Wikipedia entry–it probably won’t do you a lot of good. There are some trading strategies that make more sense, but they are much harder to implement, and if you get scared and pull out of them, your investments will probably get hosed. We’ll talk about those later.

Without getting into the math and a lot of examples, MPT basically says that no one really knows how to time the market, and mutual fund managers don’t outperform the market over the long term, so you’re better off owning a representative bits of the entire market and diversifying between stocks, bonds, and alternative investments purchased in index funds, or funds that approximate an index.

The proportions of the asset classes chosen are intended to balance out risk in the timeframe of the investment. So, for example, if you are eighty, you’d own a lot more bonds than if you were thirty. But you probably wouldn’t own actual bonds, you’d probably own bond funds which are broad samples of the total bond market, or samples of particular bond classes, like tax-free munis, or treasuries, or perhaps TIPS, which are inflation-adjusted treasury bonds. Because broad diversification, by owning a little of everything, is one linchpin of the strategy.

MPT is good because:

In theory, it takes away the emotional trading that kills portfolios. People tend to buy when the market is going up–which intrinsically means they buy when stocks are expensive, and they sell when the market goes to shit–which means they sell when stocks are cheap. Do that a few times and your nest egg goes away. This isn’t just something stupid people do, the Nobel Prize aspect involves long-term research that found that most investors do exactly that. Professional mutual fund managers might seem like they’d have more discipline, but they can’t afford to. If they stay the course with an investment that’s going south their fund results will suck, and they’ll only earn six figures instead of seven.

By emphasizing careful re-balancing of asset allocations the strategy tends to buy stocks when the market has cratered, and to buy bonds when the market is booming. It’s an approach that cries out to be automated, and a lot of companies are doing exactly that.

MPT sucks toads because:

It’s fundamental tenet is buy and hold, no matter what. Like all strategies based on statistics, it assumes that the impossible case can’t happen. But it does. The possibility that you exist is trillions of trillions to one when you look at the statistical likelihood that all your ancestors, going back to slime mold, would be the ones that survive to reproduce, and produce exactly the line that yielded you, and yet here you are. backward-looking strategy is not predictive, it’s just history. there might be better strategies that help you remain solvent after a financial meltdown. But really, who gives a damn. It will take a lot of your personal attention to go short on the survival of the species. I’m not sure it’s worth it. MPT has the benefit of being easy, and if things don’t go to hell, it probably works.

Next time we’ll talk mechanics and toss in Robo Advisors–some easy ways to implement MPT that might work well for you. We’ll also probably get to Vanguard, a remarkable company that does what you’d like an investment company to do–they don’t steal your money. Makes them almost unique.

 

 

Categories
Finance

The Retirement Trap

What would your savings look like if you spent the last 30 years unemployed? I know mine would be very zen–like the sound of one hand clapping. And yet that’s what you’re planning to do as you consider retirement. If you retire at 65 it’s not out of the question that you’ll live to 95. More likely that you’ll live to 85, but do you really want to be scrambling for bucks at 90? The simple reality is that retirement is a concept rooted in the turn of the last century, codified in the USA by the social security act in 1935–when the average life expectancy was 61.7 years. You were supposed to save for retirement, with a pension from the big manufacturing company you worked for all your life, sweetened by savings and a little social security to help anyone that fell through the cracks. Then die shortly after retirement. In fact more than half of the prospective retirees were supposed to die in the traces, a couple of years before they were booted out at 65.

It’s obvious that the situation has changed completely. There’s simply no way that saving at the typical rate for Americans working at a typical middle class job can support that person in retired splendor, walking with their elegantly aged, active, slender, vibrantly healthy wife on a secluded beach for 30 years. First, most of us would go nuts staring at waves and gulls for more than five years, and second, those beaches would be very crowded. Worse yet, for most Americans, retirement means scaling back on activity, accepting the “limitations” of aging, and eating junk while staring at the boob tube. The dirty trick of an extended lifetime for most people is that it’s just a lot longer time to be old and sick.

So lets accept the premise that retirement is not really going to work for many people. How are you going to avoid the trap that confronts a huge number of people? Keep working? For a lot of people that’s not an option. They either have jobs with a mandatory retirement age or they work in a job with physical requirements that get harder to meet as they age.

Save more? Well, that’s a good start, but as many people discovered in 2009, saving in the way that most people do, by stuffing as much money they can into an IRA or 401K can be pretty disappointing.

Spend less? Another good start, but Alpo sucks, and some of the biggest expenses you have are either invisible to you or are hard to avoid.

Work at something else? It’s very likely that anything else you do is going to pay less than what you do now. Going from a position and expertise you spent 30 years acquiring to something new is not a recipe for instant success.

This paints a grim picture, but your reality doesn’t have to be grim. I think the key to retirement success is to plan well for it, and be very realistic about every decision you make. Plan everything–income, expense, activity, interests, where you live, how you save, how long you will work–with a clear understanding that you are looking at 30 years of a very different kind of life than you are living now.

The next article in this series will look at all the elements in detail, but here’s a basic index to what I will be writing about:

Saving and investment–Every element of this matters. You can’t just turn your money over to someone else and expect good things to happen to it. The cost of your investments is as important as their performance, and tax issues are critical.

When To Retire–You probably want to recalibrate your thinking on this. We’ll step through some options.

Activity and fitness–Nothing will kill your savings faster than illness. And medicare won’t bail you out. You need to stay physically active and fit. If you aren’t fit now, it’s time to start. The cost of obesity is not the food you eat, it’s the toll on your body.

Post retirement earning–Uncle Sam might penalize you if you start collecting Social Security and then rejoin the workforce.

It’s not what you make, it’s what you spend–Changing your lifestyle to suit your cashflow.

Here’s the basic, basic, bottom line rules:

1. Your total draw on your savings can’t be more than 3% per year. This includes the expenses of investment but not taxes. If your financial advisor is charging you 1.5% to manage your money and they invest it in mutual funds that have an average expense ratio of 1.5%, then there’s no money for you. Fire them and invest the money yourself in stock and bond index funds that have an expense ratio of less than .2%

2. You can’t owe anything. No loans, no mortgages, no credit card balances. It makes no sense to have loans at rates that exceed the return on your investments. The only exception could be a locked in mortgage at a crazy low rate.

3. Keep sufficient liquid, low risk funds to last you two years.

4. Don’t buy individual stocks, alternative investments, or any risky investment.

5. Don’t have a broker.

6. If you need financial advice use someone who charges an hourly fee. No long term charges. A CPA can be more useful than a financial planner.

7. Funds should be held by an independent custodian. If you use a financial manager (DON’T), never write checks directly to them.  The fund family must be reputable and low cost. I like Vanguard, but any company with a similar size and operating principles may suit.

 

There’s a lot more detail of course, but that’s a good start. Build a budget, have a plan, get in shape, pay off your house, invest wisely, and work as long as you want. And maybe a little longer.

 

Categories
Finance

Zero Sum

Here’s my disclaimer again:  Anyone taking financial advice from me without checking every concept for themselves is simply nuts. So please, consider what I say here to be at the very most an index for your own investigations. If you take my “advice” as some kind of intelligent and actionable wisdom, then you are making a foolish, terrible, and likely very expensive mistake.

Picking individual stocks is just gambling. It’s not a plan for the future. My Dad used to say “If you don’t know who the fool in the game is…  …it’s you.” The worst thing that can happen to you is that you get it right the first time and make a nice wad of money. There will be ups and downs in your stock-picking career after that, but you can be certain of one thing–sooner or later you’ll lose badly. Its a rare person who can learn from a big loss that their initial luck was a fluke. Most people will keep betting, expecting the game to turn around. You know how that ends. I had a friend whose wife made some money in the stock market. He was impressed and encouraged her. Six months later their entire nest egg and the kids college funds were gone. She had some losses, got panicked, and kept trying to “fix it” without him knowing. How would you like to explain that to your significant other.

Not only is it foolhardy to try to find stocks that are going to make you a lot of money, but it’s equally dangerous to try to buy the general market when it’s low and sell when it’s high. There is plenty of well documented research and endless charts and graphs (I won’t be showing them here, this is summary information, if you’re looking for proof to convince you, look elsewhere) that shows the market as a whole grows in fits and starts, driven more by emotion and chaos than anything else. Probably the strongest predictor of market changes is the price to earning ratio, and that information is historic. For individual stocks at best it’s accurate once a quarter, and probably not then.  Even people who claim a great deal of market knowledge and understanding get the timing wrong. Generally that means they buy when stocks are going up and sell when they’re going down. In other words they’re buying when it’s expensive and selling when it’s cheap.

If you try to make investments in a zero sum game someone has to lose for you to gain. Why would you think that the wind will blow your way? Perhaps you’re counting on being the smartest, best informed, most decisive, fastest acting, most brilliant investor of the billion people investing. Or having someone who is willing to make you money who has all those attributes. Sorry, if they were that good, they’d be very careful to never tell anyone, and they’d be incredibly wealthy.  That’s not even Warren Buffet–he doesn’t claim to be that fictional character. And if you think it’s you, or that you have access to that talent, then we know who the fool in the game is.

So the bottom line here is that anyone who is selling their services on the strength of their brilliant choices is simply lying to you.

So how do you win in a zero sum game? The simplest strategy I’ve seen that makes sense to me is to own a little bit of the whole market and benefit from economic growth. In other words, buy the whole market–stocks, bonds, and alternatives, and then pray that economic growth happens. There are other strategies that look interesting, I’m reading books and digging into websites. They look like a lot more work, but they might be a place to put part of your funds to hedge on the kind of disaster that 2009 delivered to investors. We’ll get to that eventually.

That brings us to index investments, which are simply funds of stocks, bonds, or whatever that represent the majority of the value of a given segment. We’ll talk mostly about stock indexes since that’s the most familiar concept.

The notion of an index in this case has been broadened to be more than just all the stocks represented by a tracked index, like the Dow, or Standard & Poor. They can include all the major stocks in a segment or geographic market. Buying them feels a lot less like gambling, since you’re betting on the performance of the entire sector represented. But since stocks represent a pretty substantial risk, and the market as a whole rises and falls somewhat in unison, you need other investments that aren’t strongly coupled to market fluctuation–ideally they’d hedge the market, fluctuating in the opposite direction to compensate.

There are indexes for stocks, bonds, and alternative investments. Since the composition of the index fund is established by some algorithm or definition relative the the size or value of the companies comprising it, there’s not much for the fund manager to do. In fact the trade volumes and percentages can be largely automated. That means they can be low cost. But here’s a catch. There’s not going to be some magical gain that’s several times the gain of the general stock market. The recent gain of most indexes is somewhere around 4-5% per year.

The research that supports the theory that buying indexes is the prudent way to invest is substantial. Any broker or financial advisor that starts talking about academic theory of investment is talking about indexes, pure and simple. Unfortunately they leave out the crucial part of index investing and many will put you into managed funds that mirror indexes but are supposed to have some kind of secret sauce. They might cost 2% per year on top of the 1.5% the advisor is charging you to manage you money. At 3-4% cost for a 4-5% gain plus taxes there isn’t anything good that’s going to happen to your money. The secret sauce is mayonnaise and ketchup. You can make your own.

Here’s a simple way to find out if your financial adviser is working in your best interest. If they rattle on about index funds and academic investment, but the expense ratio of your funds is more than .2 percent, then there’s something amiss. If it’s more than 1 percent, then either you’re being sold out or your advisor is not very sharp. If it’s more than two percent they’re totally screwing you.

If you have been investing on your own, or most of your investments are through IRA or 401K contributions, you still need to look at the kind of “expense ratios” that the funds you invest in are charging. If you accept the fact that fund managers can’t beat the long term (or even mid term) performance of the market, then the kind of return an index fund provides is probably all you can expect. So what are you paying for? The average expense ratio of mutual funds is about .75 percent, but I suspect that number is fudged. The most popular mutual funds are the ones with strong historic performance, and from what I’ve seen they are a lot higher. You don’t need an advsor to get hosed, you can do it all on your own.

I hesitate to provide this link, because the writing style in NewsMax triggers my bullshit detector, and the “groundbreaking new research” mentioned is hardly new, but it’s right in the wheelhouse of what I’m writing these posts about. The simple fact that the kind of compounded growth you count on to grow your retirement nest egg won’t happen if you give all the gain away in fees. Here’s the link, keep your bullshit detector turned to eleven and don’t buy anything from these guys.

Categories
Finance

Taking Responsibility

I’m a self-confessed financial moron. Well, I’ve been working hard on that, so I’m all the way up to idiot. Anyone taking advice from me without checking every concept for themselves is simply nuts. So please, consider what I say here to be at the very most an index for your own investigations. If you take my “advice” as some kind of intelligent and actionable wisdom, then you are making a foolish, terrible, and likely very expensive mistake.

How’s that for a disclaimer?

So here’s what I’ve decided so far in my research.

  • Financial advisors are too expensive, often give bad advice, have serious conflicts of interest, and don’t do the work you need them to do anyway.
  • The common notion about the financial benefits of  sharp fund managers and financial experts delivering superior results has been proven to be untrue in the long run.

Who Do You Choose?

Some financial writers claim that fee-only advisors can help you and have no conflict of interest–they are legally barred from having any conflict. That may indeed be true in some cases, but having an advisor collect a fat fee from you is no guarantee that they aren’t steering you wrong to their benefit. You need to understand the difference between fee-only and fee-based. And when you are sitting in a financial advisor’s office you will be sold to–that’s no time to be investigating their fee structure.In theory, you can select a Fiduciary advisor who has specific responsibilities to put your interests first, but even then there’s wiggle room–they must disclose any conflicts of interest. Disclosure represents wiggle room. Your failure to act on full disclosure is not the advisors fault.

More importantly there’s no guarantee that they will pay the kind of attention to your investments that will keep you out of trouble in the future. Theoretically the reason you are engaging an advisor is that they can outperform you. In truth, your selection of an advisor will probably be more influenced by how good a sell job they do on you, or how much your friends and family trust the person, than any clear understanding of their fee structure, real performance, philosophy and integrity.

In other words, good luck, you’re going to need it.

Advice Costs Too Much

Paying the typical fee of one to one and one half percent of investments under management to an advisor might seem trivial, but as we’ll discuss later, if you don’t want your nest egg to evaporate before you die, you should live on about 2-3 percent of your investments. Giving half of that to an investment advisor for mediocre advice and performance suddenly seems pretty expensive. But the reality is that most advisors will be steering you into investments that benefit them, especially if they are receiving commissions that comes from the expense ratio of the funds they recommend. Take a look at those expense ratios and you might find that your advisors are costing you between 2.5 and 3 percent. That’s what you are supposed to live on when you are retired. That’s all of it. If you are also taking, say three percent from your nest egg, then you’re pulling out four to six percent. That moves you well into the territory of people who run out of money before they kaack. I hear McDonald’s may be hiring seniors.

The good news is that following a really well researched path for investment with nearly no fees and very little expense ratio is fairly easy. The bad news is that you have to do the work yourself. I don’t think you’ll find a financial advisor that will take you where you need to go for a modest fee. I could be wrong. In fact I know I’m wrong. For instance, you can use Vanguard’s financial advisers for .2 percent per year. But you can also do it yourself and probably use vanguards free services to do the heavy lifting. If you do everything in the lowest cost way, you could wind up with a total fee and expense percentage of about .09%.  So, for example, if you had one million dollars with a typical financial advisor, and they were collecting fees and steering you into actively traded funds that they collected commissions for, your total expense ratio for funds under management might be 3 percent, or $30,000 per year. If you managed your own investments using something more like a Boglehead (explanation later) approach, your total expense would be $900 (not including taxes).

If your investment advisor was so brilliant that they delivered double the performance of the world market you would just about break even on expense. Except that they would probably be trading a lot, and generating a lot of capital gains. If your advisor isn’t paying close attention to your tax situation with every trade, then the gain will be decreased dramatically. And the simple truth is that no one outperforms the market forever. In fact they very rarely do for more than two or three years.

Do They Really Do The Work?

In my experience, the more senior the financial advisor is (you want to be working with the main dude, right?) the less attention they will actually pay to your account. If you observe their actions carefully, you can usually tell that when you sit down together in that fancy conference room, and your guy opens your folder, that’s the first he’s seen of it since the last meeting. For the most part, people you have never met are working on your stuff, and they’re doing one-size-fits-all work on your account, if they do anything at all. If they aren’t doing much, that’s the good news. Generally if they leave your account alone they won’t be actively damaging your savings. But what are you paying all that money for?

If they’re moving money around they will likely generate some taxable event. You might expect them to pay attention to your overall tax situation, and give you the best strategy for moving money from one entity to another, but often it’s a general decision, and your individual needs are considered only peripherally. I’m sure I’ll get comments that say I’m completely off base, but a financial advisor with a hundred clients is small spuds–how much of their attention is going to be applied to the long and short term tax consequence of their actions. They have your permission to trade without contacting you. They will do so. It won’t always be good for you.

In the next article I’ll talk about alternatives. But in the meantime, Google the word Bogleheads and do a bit of your own research.