Fees, Wealth and Value

When it comes to fees, people often think that higher rates mean better value/performance, and that's simply not true. It's to the point where charging low adviser fees borders on a competitive disadvantage as people assume the adviser must not be worth it. The amount you pay in fees has no positive bearing on your performance, and is likely a negative, as fees eat into returns. And fees can take lots of forms, you can pay them to an adviser, to a fund or to both, if you use an adviser who also uses funds, as most do. 

[For the record, most advisers charge fees @ 1.00% of assets under management. As for funds, you can get simple index funds for as low as .05%.. There are some good funds that charge more, but there are also funds that are essentially index funds but charge well over 1% in fees.]

There also seems to be a perception among some that you have to be wealthy to get access to good financial advice. This is sort of true. If you have a small amount of money, it won't be cost effective for most advisers to work with you (and you might not want to pay out any of that money to an adviser anyway), so you get shut out of "the game". But, that doesn't mean the advice gets super-fancy as you creep towards the 6 or 7 digits. It's just that the options increase (most people would shove a $5k account into one fund, but probably wouldn't do that for a $500k account). 

But, any small thing that an adviser does to "juice" returns on a modest account is going to pale in comparison to you saving more money, so don't waste too much time trying to maximize return on an account that's barely worth enough to buy a very used KIA. If you have only a few thousand bucks, the best advice is to save more, save consistently and invest in one or two simple low fee funds. Then, if you want your hand held by an adviser as your account gets bigger and there are other corners of your finances to consider (greater insurance needs, financial planning, small business retirement plan options, etc.), hire one. Or maybe by that point you feel confident enough to do it continue doing it yourself.

And once you turn that into more money, you admittedly have a few more options. But the principles will remain the same: watch your fees, be consistent, stick to your plan. By and large, the world of sophisticated financial advice doesn't suddenly open up to you because you have some wealth. You get a few more tools in the toolbox, but you can also potentially stab yourself with them. The rich are subject to many of the same constraints as the rest of us. Being wealthy means one thing: you have money. It doesn't necessarily mean you are smart and may not even mean you are good with money. It it definitely doesn't make you immune from bad returns or being swindled.

As to those options available to wealthy investors, as I said,  a few things do open up. First, if you meet certain income/net worth standards, you  become an "accredited investor". That means that the government then assumes you are knowledgeable enough to handle some riskier investments in securities not regulated by financial authorities, such as hedge funds. The problem is that, while we can make some broad assumptions about returns in the "vanilla" stock market, the returns of these hedge funds and other pseudo-private investments are all over the map. So, as is the case in many areas, the government's assumptions are often wrong.

And hedge fund returns have been downright ugly as of late. Of course, periods of under-performance are a certainty with any investment, but the problems with hedge funds could be structural as long as they continue their high fees. Historically, these funds have charges 2% of the assets under management and 20% of the profits, but the smart funds are bringing fees down. 

And, of course, people with a higher net worth can also invest in real estate without needing excessive leverage, which can work out very well. But again, those returns vary by location, experience and luck. And, remember, I'm not a real estate adviser, so I won't go out on any limbs here. This is often more about how you are at the business of real estate than how you are as an investor. And business and investing are not the same thing, though the line can get blurry.

So, it's not so much that only rich people can afford good advice, it's more that poor people generally can't afford advice and/or don't need it yet. If price equaled value when it came to investing, we'd see hedge funds as a class have consistently superior performance. Also, we'd see the high fee, actively managed mutual funds with similar success. But, most don't beat the indices, and you generally have to pay for this middling performance. There are ways to attempt to improve on the index returns, but often they can be implemented with tactically using inexpensive index funds or using mechanical, algorithm-based funds that still charge much less than 1%.

Most successful investing is simple, and the simplest investing is essentially index investing, give or take. Are there things you can possibly due to improve upon that and/or mitigate the ups and downs? I certainly believe so, but they won't be as essential as the amount you save, your consistency of implementation and of course, how much you pay in fees.

More Thoughts on "The Quants"

As mentioned in one of last week's posts, I was reading a book called The Quantswhich is basically about how a bunch of nerds climbed to the top of Wall Street and then proceeded to get shot in the foot, both by themselves and other people. I will spare the reader a proper book review (there is only so many ways to say "very readable" and "I liked it") and instead throw out some takeaways and reactions.

Most of us understand that bad stuff can happen in the markets, as we've lived through it. However, it seems we tend to comfort ourselves by saying that those times are in the past and that they were the result of greedy gunslingers. I think one of the big things that was reinforced to me by this book was that this stuff still happens when people "get their math right". Sure, these guys took some risks and a lot of them were greedy, but many of them did this in the context of dotting their "i's" and crossing their "t's". Things like the crisis of 2007-2008 were only modeled to happen once in a few thousand years, and probably not even that  frequently. Clearly, the impossible happens a lot more often in world of finance than we would like to acknowledge. And recent college football endings like Auburn's "Kick Six" or the 2015 Michigan State win over Michigan prove the impossible seems to happen often more than expected in other domains, as well.

Nassim Taleb talks of a conference in Las Vegas he attended in which the concept of risk management in casinos was discussed. The owners were focused on cheaters and the actual games, but he felt that this was the exact wrong approach. Casinos are a sterile (figuratively, not literally) and closed environment in which the returns often matched probabilistic expectations, mostly because there are set rules and casinos have gotten pretty good at catching cheaters. These days, it's what happens outside the games that kills you. His theory was played out in the ensuing years when the casinos had to deal with issues like IRS troubles brought about by negligent employees, the kidnapping of a casino owner's daughter (which caused him to raid the casino coffers for ransom money) and the Siegfried and Roy tiger attack (which cost that casino about $100 million). The math took care of the slot machines and blackjack, they needn't worry about that.

That's what the markets are like, in that real life keeps getting in the way of models. We aren't completely helpless, though. Some things that might aid us.

1) We can avoid esoteric derivatives. Standardized instruments such as options and futures can cut deep enough as it is, but the collateralized debt obligations that brought about the crisis where a whole new breed. Luckily, they were out of the reach of average investors, but unluckily, their decline still effected the average investor. As for the fancy quant hedge funds who got burned? For many of them, their mistake was not that they directly invested in these CDOs, its's that they underestimated the impact that their implosion would have on more regular stocks and access to credit (a necessity in the hedge fund world).

2) Diversify outside of stocks and bonds. Cash, home equity, a small business, permanent cash value life insurance (if it is a good policy and you have a realistic idea of possible returns) are no guarantees of protection against bad things. However, if there ever comes a time when ALL of these types of assets get hammered, having almost all of your wealth in stocks instead would have likely been close to as bad, if not worse. If you can stand a risky strategy such as having all of your net worth in equities or highly leveraged real estate, those options offer the hope of the best returns, but also the biggest chance of ruin. 

3) Avoid leverage. This is closely related to the first point. As a book such as The Quants indicates, it's impossible to completely escape leverage in our economy (this could come back to bite us, but that's a bigger argument for smarter people-and they probably won't get it right, anyway). No need tempt the devil by borrowing to invest in things like stocks, options or futures. Obviously, a mortgage is borrowing, also. But, you can live in a house, you can't live in 100 shares of Google, so it's not a complete apples-to-apples comparison. But, even in real estate, not all mortgages are created equal. The quality of the property, the ratio of debt (are you putting 3% down or 20%?), your experience in real estate and the use of the property (investment vs. residence) can all factor into whether or not to use debt.

Having the math right is great, but remember, our models are an attempt to reflect the real world, not a means for controlling it. Markets will do what they are told, but their master is all of us, and not a formula. Quantitative research and analysis is fantastic and can be a great tool, but it is always imperfect and only as good as the assumptions used to create it.

Roth Versus Traditional

Executive summary: It kind of depends.

Much ink has been spilled over the Roth IRA versus traditional IRA debate. To a degree, I think this is a tempest in a teapot because I don't know how many investors agonize over the decision. The very act of saving/investing is more important than the tax structure. That is assuming, of course, that the way you are saving offers some type of tax benefit. Things like 401(k)s and both forms of IRAs have tax advantages, as do real estate and and to a different degree, cash value life insurance. From a tax perspective, these things all offer advantages over just stashing your money away in a vanilla taxable account. Now, the taxable account generally offers more control and easier access to funds than these other things, so it is up to the investor to assess how and when to use taxable savings/investments.

But, back to the point at hand: Roth vs. traditional. We can torture the data enough to tell us either one is better. A lot of it depends on what your tax rate is now and what it will be in the future. As you can see from this Nerd Wallet study, Roths generally do better than traditional IRAs. This is even true in the most apt comparison: the one that takes tax savings from the Traditional and invests it. In that scenario, it is close, but the general tendency still benefits the Roth. Now if you go to the chart (the first one on the above link), you will see the Traditional tends to do better at the bottom left (low future tax rate and high current tax rate).

To play devil's advocate, here is an article at Financial Samurai which tears the Roth a new one. He raises a lot of good points, but I think the gist comes down to this: taxpayers are unlikely to have higher tax rates in retirement, so it is better to defer taxes until later.  Probably true, but remember this: personal finance is often more personal than finance (also, projections generally stink). Some people like getting their taxes out of the way. If it is worth it from a behavioral/psychological standpoint, that has value. The important thing is that you are saving and getting some tax benefit from it. We can game plan all day, but we won't know the optimal solution until it's history.

Nerds Flying to Close to the Sun

I'm reading a book called The Quants by Scott Patterson. Basically it's about the run up from the 1960s to 2008 when Wall Streets old guard of jockish, gut-feeling-based, egotistical traders was usurped by nerdy, algorithm-based egotistical traders. In both cases, overconfidence ultimately did them in. The jocks underestimated the nerds and got taken to the cleaners and the nerds underestimated risk and achieved a possibly worse result.

I think there is absolutely a ton to be said for algorithmic, rules-based investing. It really permeates our investing lives, whether we know it or not. As Cullen Roche points out, the S&P 500 index is really just a rules-based investing system. That is good, but the problem is that the system is only as good as the people who buy and sell it. So, a person who is constantly in and out of and S&P 500 index fund is really overriding the rules based on their own judgment. It's like have an awesome constitution that is only selectively followed by the judiciary, not that any of us would know anything about that.

The point here is that these "quants" felt they could completely subdue risk with math, which is  fool's errand. Investing is full of surprises, the only surprise would be if we didn't continue to get surprised. Simple works better and the most basic methods have tended to be the most enduring, but even these rarely offer a smooth and risk-free path to success. Want to buy and hold? Awesome, just be ready for a possible 50%+ decline in your portfolio. This number sounds hairy,  but can be offset partially by regularly (and mindlessly) adding to you portfolio.

The reasons that a mortgage can work so well for our net worth isn't because real estate is such a bulletproof asset (it's not), it's because a mortgage requires regular payments and is cumbersome to get in and out of. It has consistency and rules. These are more important the the actual return on our investment, which is important, but tends to take care of itself when  consistency is present and rules are obeyed. These things tend to tame risk better than fragile and complex algorithms.

And, while personal finance loves consistency and rules, it tends to punish hubris, as many of the math experts discovered.

As a final plug, remember that all assets are not created equal. The mortgage crisis hit mainly because of the over-reliance on derivatives, which are notional investing instruments that "derive" there value from an underlying asset (examples include futures and options). There is certainly a place for these in the modern economy, but they can lead to outsized bets equal to many times the net worth of the investor. When these go bad, it's like being upside down on a home, but with potentially many more dollars at play. And also, there's the fact that, as depressed as home values can be, it makes for much better shelter than an options contract. Our economy is modernizing, but we can't let our obsession with  new technology and complex financial instruments and  cloud the fact that the building blocks of economies are tangible things and services. 

 

 

 

Why This Bull Market Stinks

Actually, if it's making you money (and some of that money remains after the inevitable correction), it doesn't stink. But, perception is reality, sort of, and the current eight year run up of the stock market hasn't been fully embraced with the folly and euphoria that we normally see. Generally, at this point in a bull market, the ideas that the good times will last forever and that we have reached a new era in investing/the economy start to take hold.

As an aside, take note of that. Because everyone has been waiting for the other shoe to drop, it's taking longer for the other shoe to drop. Don't be surprised if the bull market chugs along longer until we REALLY leave sanity behind or our economic situation  becomes so stark and dismal that even our guarded optimism proves too optimistic.
 

Josh Brown of The Reformed Broker lays out a good case as to why the this bull market is so disdained. Technology and algorithms are taking over and automation is a threat to the careers of many in the industry. So, the professionals fearing for their jobs is poisoning Main Street's feelings about the markets. Do I have strong feelings about where the market is headed? Well, it will come down sometime. When or how much is impossible to know. However, I do have strong feelings about trying to predict the markets. Don't. It's ok to have misgivings about the market, just don't let it be due to Wall Streets career worries and don't let concern paralyze you.

As another aside, Brown mentions the overarching trend towards quantitative, rules-based investing. While this is an improvement upon "gut-based" investing, let the buyer beware. Simply having an algorithm is no assurance of success. It must be robust, simple and able to survive markets that are constantly adapting. Some of these programs will likely deliver superior results, some will be serviceable and some will blow up. Control what you can control, kick the tires on your methodology, play it safe and follow your plan.

Fiduciaries and Fragility

In case you haven't noticed, the much talked about (in some circles) Dept. of Labor Fiduciary Rule has gone into effect. What does it do? Well, basically, it's going to elevate most people in the financial services industry to the level of fiduciaries. Being a fiduciary means acting in the best interests of the client. Many people (including this author) already operate under this standard, as opposed to the lower "suitability" standard used by many brokers and people in the insurance industry (who aren't also investment adviser reps-which would make them subject to the fiduciary standard).

There's little things people in the financial services industry like more than looking down on other people in the financial services industry, so I won't throw dirt on anyone's grave. There are some excellent and knowledgeable people in all corners of this business, and being a "fiduciary" is all well and good, but at the end of the day, it just gives a bad actor one more rule to break in pursuit of your money.

This probably isn't a bad thing, but I don't know how much help it will be. At the end of the day, it will result in more documentation and work for the adviser, but likely little advantage for the consumer. I'm not a Randian free market fetishist and  wouldn't pretend to think that no regulation is needed in the investment industry, but we are way past that point. From our overly-complex tax code to dizzying investment adviser laws to our arcane farm subsidies, our top-down economy is looking extremely fragile as it is poised to choke on itself.

This isn't me predicting "The Big One". After the 2007 crash, I was sure the next big market move was farther downward, and that simply wasn't the case. But, I would implore everyone to have their heads on a swivel, though, and realize the limits of laws and regulations while having an investment plan that doesn't lean on predictions and can survive both a good and bad economy. The odds are that laws such as the DOL will be ineffective at best, and at worst, will sap your adviser's time with more admin work. As usual, the client must remain informed, because your finances can't be completely outsourced any more than diet and exercise can.

Lastly, here's a good summary of what the DOL Fiduciary Rule.

The Calm Before the...?

Anyway you slice it, volatility is low these days. Per this article (with pretty charts) from Pension Partners, by a lot of different measures, the stock market is overwhelming stable and consistently higher than its historical averages. Do this mean that stocks have become less risky?

Well, actually, be grateful that stocks are risky. After all, risk drives the returns. If stocks start to look like bonds, be ready for bond-like returns. However, it's doubtful that stocks are less risky, but, as a whole, we will likely start to believe they are, settle in for nice, consistent positive returns and then we will get steamrolled by a market dive. The article quotes the one and only Nassim Taleb: "Don't confuse lack of volatility with stability, ever."

History's least favorite bull market is now over 8 years old. No one thought it would last this long, and while the party can't last forever, I'm not going to be the one foolishly attempting to predict when it will end, nor will I extrapolate these returns indefinitely into the future. Don't cash out and run for the mattress just yet, many have lost out on great returns by predicting doom and gloom. Just have a plan that can survive the bad times...and the good times, as well. No two market cycles are the same, but that doesn't mean the rules have altogether changed. The markets go up, then they go down. We just don't know when or by how much. So, expect the unexpected.

Managing the Excesses

Knowing that crazy things happen in the market and living through them with your portfolio intact are two very different things.

One of my favorite bloggers, Ben Carlson, points out that everything is obvious in retrospect. He really nails it here. There's a certain snide aspect to our writing about past market overreactions, positive or negative.  Ex post facto, we seem to take it on face value that "obviously, the market will come back" or "clearly the high valuations were unsustainable", but few of us actually put our money where our mouth is in real time.

Correspondingly, seeing a mathematical model of the returns over a time period isn't the same as experiencing the ups and downs in real time. As Michael Batnick points out, it's the difference between seeing a map and making the actual trip.

Every time the market experiences a wild swing, we weigh the possibility that this is just another example of the normal ebb and flow vs the possibility that something has fundamentally changed. The vast majority of the time, it's the former, but the latter theory is seductive, and that's why we fall for it.

What is Smart Beta?

Some of you casual investors might have come across "smart beta" (or "factor investing") lately and wondered what it is. Here's your chance to learn. I will take it easy on equations and math.

Basically, a couple of academics named Eugene Fama and Kenneth French built on some previous research (the first building block being the Capital Asset Pricing Model) and figured out that the biggest factors influencing returns are:

1) Beta-a measure of the volatility of a stock compared to that of the market as a whole.

2) Size-small companies tend to outperform large ones in the long run.

3) Value-stocks that are "out of favor" tend to offer the best chance for superior returns.

These aren't all of the factors. In recent years, people have discovered quality, momentum, etc., but the three above seem to be able to account for the majority of equity returns, so they are the most popular. The theory goes that superior stock performance isn't a mystery, it is a function of one  taking on excess risk by exposing a portfolio to various factors that offer the corresponding chance for greater return.

So, how is this done? More or less, you (or more likely, a mutual fund or ETF) "tilt" the portfolio by exposing it to one of more factors. So, maybe the fund only invests in companies that are below a certain size. Or maybe below a certain size AND out of favor. You get the idea.

Of the companies that have brought this idea to market, perhaps the best known and one with the longest track record  is Dimensional Fund Advisers. It  was started by some former students of Fama's (he and French both still serve as advisers to DFA), but they are far from the only player these days. 

The rubber is about to meet the road as there are now a variety of potential factors (the so-called "factor zoo") being exploited by a host of companies. How well will this perform in the future? It is impossible to say for sure, but this much we know: the more people who employ a strategy, the tougher outperformance becomes. But, if the people who are rushing into the strategy aren't going to stick around for the inevitable rough times, then maybe what we will see is a bubble bursting as people jump off the bandwagon, followed by performance in line with historical norms (which would be slightly above that of the indexes), as the reward to those who stayed the course. That's no prediction, only a scenario.

The reality is that there is a lot of good data behind factor investing, but markets are dynamic, so they are constantly adapting. That doesn't mean that there aren't some underlying constants due to human nature and economics, but it does make it impossible to optimize the future. There is a great deal of promise behind this type of investing, but they only thing we know for sure is that it, like all types of investing, will take discipline through the ups and downs as we try to determine whether we are in a cyclical decline or something about the strategy's prospects for future success has changed. That's the risk, and be grateful for it, because without it, there is no reward.

Book Review: The Incredible Shrinking Alpha by Larry Swedroe and Andrew Berkin

If you bore easily, this book is for you, because this book doesn't give you time to get bored. If it were any smaller, I might have to worry about this review being longer than the actual book.

The book is built around a pretty simple premise: alpha (the returns above and beyond an appropriate risk adjusted benchmark) is harder and harder to get. The reason? Well, there's a few of them. First, people are doing more passive investing these days, so their are fewer "suckers" to get taken but the often false promise of active management. Also, the competition is better, so more informed and more educated people (compared to generations past) are duking it out and negating each others advantages.

Swedroe and Berkin also lay out a few methods for individual investors to avoid investment minefield through passive investing and being hawkish on fees. They don't reinvent the wheel, per se,  but they do give you some of the past data on the wheel. It has several appendices with data on models, active management and simple investing. If you like this book, move up a few levels in complexity and try Your Complete Guide to Factor Investing: The Way Smart Money Invests Today by the same authors. Packed with stats and theory. Quick and inexpensive.

How Much Do I Need for Retirement?

Here's the liberating answer: no one knows. And as is generally the case in situations where no one knows, opinions seem to only get stronger.

As blogger Ben Carlson pointed out, retirement is kind of a new concept. People used to work until they died, which tended to be early because...people worked until they died. So, in the last 125 years or so, we've had the advent of the idea of retirement, the onset of social security, the overextension of social security, skyrocketing health care costs and the lengthening of life spans. Given all the constantly changing variables,  much like the guarantees on the box in Tommy Boy, these rules may only serve to help us sleep well at night.

That being said, here's some thoughts in the subject:

First, Mr. Money Mustache examines the old 4% rule and lays out his case why having about 25 times your annual spending is a good number. Also, note the first few comments at the end regarding risk. Don't plan for a 100% success rate, because it's an illusion. A couple my parents knew (acquaintances from high school or something)  always took separate planes when they traveled, so if one crashed, the other would be alive for the kids. Tragically, they both died in the 1980  MGM Grand fire in Las Vegas. Heartbreaking irony, and I honor their attempts to protect their kids from being orphans, but it's proof positive that you can only do so much before life steps in.

Second, the above mentioned Ben Carlson talks about uncertainty and the retirement issue and how this results in the need for continual monitoring.

 

The Step of Faith

I recently had a chance to hear Westin Wellington of Dimensional Fund Advisors speak (among many other people from the company). He handles a good deal of public facing communications for the firm, and it's easy to see why. Part of his presentation was a walk through the various market prognostications of the last 45 or so years, whether foolishly exuberant or apocalyptic. While few of us likely bought into all of these theories, I think most people could probably cop to being effected by one or two of them. So, listening to his talk was little bit like going through a photo album or one's worst haircuts.

One part of Wellington's talk really struck a chord with me. He spoke of the period around an infamous "The Death of Equities"  magazine cover in 1979. At this point, stocks suffered from years of underperformance. Little did anyone know that equities would soon go on a two decade tear. At this point in time, Wellington said (and I'm paraphrasing) that sticking with stocks would have required something more than data-driven discipline. It required a kind of "intuition" (his word) that capital markets worked. This could also be thought of as a step of faith. "Leap of faith" sounds a little extreme, given all of the data supporting the long term success of stock market investing.

This basically represents a type of investing first principle that would have served someone very well throughout the last 100 or so years. The idea of a first principle (whether in investing or more importantly, life in general) is kind of foreign in this day and age. Many of us go from issue to issue without a guiding ethos, or almost as bad, with an ethos that eventually collapses in on itself. Then, we argue with data that can be twisted or has so many layers that it is almost impossible to find the truth. I would argue that many of my most important beliefs were ahead of the science and data. But, I'll try to keep it to money here.

Author and "adviser-to-financial advisers" Nick Murray once wrote "optimism is the only realism". With respect to money and investing, I don't know if this is 100% true, but 1) it's probably closer to true than many of us realize and 2) it's probably a lot more useful to the opposite of this belief-that pessimism is the only realism.

I wish I could tell you that I didn't find pessimism interesting, especially as it relates to politics and the markets. There's something about contrarianism and pessimism that makes us feel smarter or better informed than others-and I like few things more than feeling smarter or better informed. The problem is that, in investing, pessimism involves a fair amount of being wrong in the form of missed opportunities. Don't get me wrong, pessimists will eventually be right. The question is, on balance, will this serve them well? Missing the 30% stock market correction isn't that great if you also missed the 200% run up that preceded it.

While I probably always knew this to some degree, I still was way too bearish after 2008. Perhaps it looks like a sign of weakness to admit this, so I will risk admitting that to the reader as he/she searches for an adviser who has never been wrong. But be careful, the adviser who has never been wrong is often actually just the adviser who has never admitted they were wrong. And the adviser who never admits he was wrong is the one who isn't learning, so I welcome this attitude, as long is it's the competition who is adopting it and not me.

I'm somewhat comforted in this by a few things, First, Prof. Eugene Fama, who has served as an adviser/board member/spirit animal to the above mentioned Dimensional Funds, has had to do a fair amount of modifying to his theories throughout the years. Now, an academic being wrong isn't unusual at all. What is unusual is admitting the deficiency of your theories and still being able to make money for yourself and others throughout the process of discovery. Most academics in the financial/economics field have to lose all of someone's money before they admit they aren't gods.

Does this mean we throw 100% of our net worth into a stock fund and ride out the storm? No. Most people's guts can stand that, so self-knowledge is key here. Know what you can stand, diversify your holdings accordingly. Just remember a few things. First, stocks involve risk. Limit your exposure to what you can stand to see cut in half (or possibly more). It happens. And it will happen again.

Second, know the true pluses and minuses are of those other assets you own as diversifiers, such as cash, bonds, gold, real estate, hog belly futures, your wine-vending machine business, Green Lantern comic books, etc. You've got to know enough that you won't shoot yourself in the foot or expect an asset with a 5% long term return to give you 10%.

Doing something always involves risk. So does doing nothing. Pick your poison, develop a plan and execute it.

Sticking to Your Guns

I always feel the need to qualify the fact that I'm not a Warren Buffet acolyte, for some reasons beyond the scope of this blog. But, I'd be a fool not to learn from him when appropriate. He clearly knows a thing or two.

Meb Faber points out (in this article from a year go) that many investors could simply ride Buffet's coattails through  Berkshire Hathaway's B shares. That would result in a good overall return, but would also mean sticking through some periods on underperformance to get there.

DIY Personal Finance for Doctors

I just finished a very good book called The White Coat Investor by Dr. James Dahle, which shares a name with his website. The author tired of shoddy financial advice that doctors get and set out to learn as much as he could on the subject, and has made a pretty good go of it. 

The book covers a good deal of financial items specific to doctors, such as medical student loans and malpractice insurance, but it also covers a fair amount of material that is relevant for any small business owner. This would include corporate structure, taxation, retirement savings and asset allocation. And he also has a lot to say about living within your means, a subject that is important to us all.

Dr. Dahle achieved financial independence at a pretty young age and managed to turn his story and expertise into a side business. It's pretty impressive how much he has managed to learn about finance as a sideline gig, but that's the power of "want to". Personal finance is like exercise-you can pay someone to help you, but at the end of the day, you've got to be responsible for the results and some things simply can't be outsourced. 

Some people may not have a choice in the matter, but for many people, their financial situation can be as simple or as complex as they want to make it. But, the good news is that money is one of those subjects where one can learn a great deal through individual reading and experience. Now, some things are going to be too hard to master solo while thumbing through a book on the beach, but there's a lot to learn before you hit that wall.

Dahle has a good deal of less than glowing things to say about financial advisers, but at the end of the day, such opinions generally have an element of truth to them and I am in no position to argue with an individual's experience. Many of his complaints fall into one of these categories:

1) Lack of transparency

2) Cost

3) Misaligned incentives between practitioner and client

I would also say those elements are also present in the healthcare industry, but I won't quibble right now. When and if I  become enough of an expert on the subject to write my book about the medical field (don't hold your breath) I can expound on that. Bottom line is that  any professional that followed the advice outlined in this book would be well on their way to success, as they will be a few steps closer to figuring out what he can do alone. Also, since the realm of personal finance includes everything from investing to insurance to taxes to estate planning, there's going to be areas where people need help. No one (amateur or professional) can completely do it by without help. For times such as those, this book will leave the reader much better armed to find the right expert at a fair price.

The Importance of Persistence...Again

Ben Carlson's (not Carson's) website is one of the better in the financial world. Substantive content, easy to understand, delivered in a matter-of-fact manner with no inflammatory hot takes. I read his book (like his website, titled A Wealth of Common Sense) last summer and enjoyed it. It is full of good content, but one part in particular is worth re-visiting.

[Note: These numbers aren't audited. I used his data as a starting point and extrapolated some more myself with the help of Excel. I make no warranties, but since he is a Charted Financial Analyst and I majored in math, I am hoping we are at least in the ballpark.]

Carlson lays out the story of Bob, the world's worst market timer (the story is also found here on his website). Basically, it describes a guy who starts his career in 1970, saves progressively more cash each decade and happens to plow it into the market at the 4 worst times in the last 45 years. No dollar cost averaging. Only bad luck and bad decisions. 

[Note: Carson has the explanations of the funds/indexes used at the bottom of his page.]

Bob does have one redeeming aspect to his investing, though: he never sells. So, largely on the back of that single discipline, he parleys his $184,000 of investments in $1.1 million by the end of 2013. I did some back of the envelope calculations and that's about a 9% annualized rate of return. The annualized rate of return of the S & P 500 during this time was about 10.5%, but he didn't get that because he deployed his capital at the worst possible times.

But, all things considered, that is a pretty good return considering Bob demonstrated zero investing skill beyond a rigid "no sell" discipline. Now, he had to go through hell to get that return, but he did it. Carlson calculates that dollar cost-averaging would have gotten Bob about $2.3 million. 

Now, there is at least one big caveat: these numbers work out so well partly because Bob was 100% in stocks. Probably not a wise idea unless you have a really big appetite for risk. Most other people would have probably mixed in some bonds there, thus dampening returns. 

But, as Carson points out, the biggest takeaways are that 1) it generally pays to be biased towards optimism and  2) think long term. Also, you could probably put in a third item: as he would have been twice as well off had he bought into the market every month, consistency generally trumps guessing.

The Rise of Robo-Advisers

Betterment, a prominent robo-adviser, has decided to add humans....which kind of defeats the point of robo-advisers. But, that aside, if they are trying it, you can bet that another big robo-adviser (I'm looking at you, Wealthfront) will try it , too.

For those of you not familiar with them, a robo-adviser is an online wealth management tool that provides inexpensive, algorithmic investment services  based on individual risk tolerances without a human financial planner. They basically provide cheap, customized passive investing. You enter some data and risk tolerance info, it spits out an appropriate portfolio that doesn't try to beat the market, merely to follow it.

Many see these as a threat to human advisers. I guess they are, if you think an adviser's job is to beat the market (wrong: it's to help you reach your goals). We probably won't know for sure how good these is until it endures a severe bear market. Some people also have problems with how they measure risk, but that's likely an issue for human advisers as well. And there is also the chance that the algorithms could snowball during a sell-off and create a self-perpetuating mess. I admit, this concerns me, but it seems like there is enough algorithmic activity going on in the markets that this possibility is always present in this day and age, with or without robo-advisers.

The point of all this is merely to say that human advisers are certainly using more technology (to make their jobs easier, serve the client better and reduce costs) and now we see that robo-advisers are using humans. Like most things in life, it's not generally an either/or. Sure some investors who have small nest eggs or are price sensitive may prefer the strict robo-adviser without human interference. And maybe some people prefer the old model where you pay 1.5% for the gray-haired guy in a suit in the oak-paneled room. But, many of us will find a balance in the middle. One of my favorite bloggers, Meb Faber, said (and I paraphrase), "The future belongs to advisers who integrate technology seamlessly and provide value through behavioral coaching". In short, a good adviser will keep the computers running and keep you from shooting yourself in the foot. 

To Flip-Flop Or Not To Flip-Flop?

I've been talking with some other advisers lately and getting into the weeds on best practices, hopefully, practices that serve both the business and the client. The two shouldn't be at odds, an adviser can't have a business without clients and they aren't doing their clients any favors by going out of business. And if an adviser is doing his clients a favor by going out of business, then he shouldn't be in business anyway.

During these talks, the subject of change has come up, and this can be a big problem for both advisers and investors. At the end of the day, people are people and a lot of the axioms of investing are pretty rock solid throughout the decades. But, also, the democracy of data and speed at which we have access to it has certainly made its mark. Some strategies that worked for prior generations don't work as well now. Or it could be that the strategy is undergoing a typical period of poor performance, which is pretty much inevitable. So, during the down periods, investors are constantly wondering if  they should just right the storm out, or if something about the markets has permanently changed. Or maybe, the markets haven't changed, but the investor is simply wondering if his initial assumptions had any merit at all.

The question is "when should we change our minds?" As this blog says, "the graveyard of investors is filled with people who refused to change their mind." True, we may know the guy who is still waiting for the whole internet fad to play itself out, but we also probably know someone who sold in 2008, who may well mostly still be in cash, missing out in very real gains. Flexibility is great, spinelessness is not.

Maybe one of the better ways to think about this is to look at one of the lions of modern finance, Eugene Fama. He made his hay off of the Efficient Markets Hypothesis, which basically said that stocks are all priced correctly, so don't bother trying to beat the market. He later modified his views into the Three Factor Model (developed with colleague Kenneth French), which said that a stocks return could be attributed to overall market return, the size of company,  and price-to-book ratio (or value, as in "is this stock cheap?"). It was later expanded to the Five Factor Model by adding profitability and what they call an "investment factor". Defining those isn't important right now. The fact that they modified their opinion is. Also, in the midst of this, Fama and French also came to the uncomfortable (for them) conclusion that momentum (a stock's recent movement) exists, as well. Although, how much merit they place in it is still up for debate.

It's also important to note that to Fama, this isn't merely an academic.question. He also serves as consultant, board member and thought leader for Dimensional Fund Advisers, so real money is on the line here. What he does and says has consequences. He's got every reason to remain entrenched in a position, but he still is curious and intellectually honest enough to modify his beliefs. Furthermore, the fact that he has made past adjustments isn't getting in the way of his acting on his current ideas, and making money for himself and others in the process.

Part of the difference between what people like Fama and French are doing and what the average investor is doing is familiarity with the data. For most, the only feedback they get with regard to investing is their current return. Not to sound like Johnny Cochran, but, if it's bad, they get mad. Then, they change things up at the worst possible time, a fool's errand when investing virtually assures that even the best strategies will give us a pretense to be dissatisfied at one point or another.

Performance alone, or lack of it, isn't a good enough reason to change course. Investors need to look for the reasons behind the performance-the explanatory factors-in order to determine whether  a change is warranted. Results are important, but they don't tell the whole story. At any given time, investing results could be bad. That's life. That isn't a reason for massive change any more than a passing mood is. In the same vein, the 2-3 days a month we generally spend in a depressed state isn't a reason sell the house, quit the job and follow Widespread Panic on the road.

Advisers need to be on guard for this as well. My general rule has been to make changes slowly, although I hope this doesn't prevent me from someday making a quick change if the facts are overwhelmingly obvious. That's where judgement comes in, and that comes with experience and knowledge. If you have these things yourself, you very well might not need an adviser. If you don't, that's where one can help. For all the knowledge that advisers like to think they have, with the proliferation of data and robo-advisers, their best service might merely be serving as a firewall between a client and a bad decision.

Rick Barry's Open Secret

Continuing yesterday's theme on index/passive investing, here is an article on Abnormal Returns about free throw shooting and investing.

The Cliff's Notes version is this:  an episode of Malcolm Gladwell's Revisionist History podcast talked about NBA legend Rick Barry's unorthodox style of shooting free throws: underhanded (or "granny style" or "potty shot"). He had some success teaching it to poor free throw shooters because, from a physics standpoint, it is an objectively superior way of shooting. But few stick with it, because it looks ridiculous.

Although index investing doesn't exactly look ridiculous, some people shun it for similar reasons as they do underhanded free throw: it's not as cool as active management. The bottom line? Whether it is textbook passive investing or something similarly mechanical and boring, forget being cool and seeking action. Go with what works. And with this style of investing, at least you don't have to do it in an arena full of spectators.

Passive Potpurri

This has been dealt with before, but it's worth repeating. A couple of things to keep in mind with "passive" investing (or "index" investing):

-"Passive" isn't exactly the best term. If you decide to invest passively, this still raises a host of questions. Which stock index do you use? What percent do you allocate to bonds? To foreign assets? Any precious metals? You haven't cut out decisions altogether, but you have reduced their frequency.

-To that point, once you decide to passively invest, buckle up for a potentially wide ride. If you put all of your money into a U.S. stock index fund, you could see it cut in half. If you dice it up more ways, you might be able to avoid such a dramatic turn, but you likely sacrifice upside returns.

-If you invest passively, it's unlikely that you will ever been the smartest one in the room, or the dumbest. But, the vast majority of investors fail to achieve index-level returns, so don't confuse "passive indexing" with "average". You would be much closer to the head of the class than the rear.

Passive/Index investing isn't the only way to invest, but it is among the simplest. But you must stick with it for the long haul. Passive investing is patient.

Dividends: Don't Lose the Forest Through the Trees

Meb Faber has a great piece on why dividends are overrated. Now, the "overrated/underrated" debates are kind of cliche, but caring too much (or caring at all) about dividends could be costing you money.

Here's a quick primer on dividends. Stock ABC is trading at $10. It declares a $1 dividend. The investor gets that dollar in their pocket, but the stock drops to $9. It isn't free money. That dollar represents one less dollar that the company can reinvest in itself. And if a company doesn't declare a dividend, anyone who needs income can simply sell enough stock to match the dividend they need/expect, so it's easy to replicate.

Combined with things like debt paydowns and stock buybacks, dividends can be useful (as seen in this book by Faber), but in isolation, they aren't that great of a metric.  It's important to remember, absent taxes, transaction costs and some psychological factors, dividends are a neutral transaction. Don't be fooled by the shiny object. There are things that matter in investing, but, in and of itself, a dividend likely isn't one of them.