Monday, December 20, 2010

Should Investors Fear A Dismal Economy

By Arianna Capital

We have recently encountered many people in our lives who fear the economic state of the United States. So, we have decided to respond - the reality may be less dismal than it seems.

In this video, Kenneth French explains why lower economic growth may not hinder future stock returns. In fact, history shows that average returns tend to be higher during periods of economic difficulty. The information about a current recession is factored into stock prices, and investors may require a higher expected return to induce them to take higher perceived risk.

Saturday, December 18, 2010

Q: What Is An Index Fund?

A: An index fund is usually a mutual fund or exchange-traded fund that seeks to replicate the movement of a collection of individual stocks. The first known index fund was the S&P Composite Index Fund. Held within this particular index fund are all stocks characterized as US large-capitalization companies, 500 companies in total are held within this index fund, hence the name. Although there are different techniques to "indexing", the most common is traditional indexing. Traditional indexing involves holding a collection of all representative securities/stocks. The weight or how much to own of each security is determined by the ratio of the index being tracked. Furthermore, when a security is either added or deleted the index fund will modify its' holdings as well.

Wednesday, December 8, 2010

Retirement Lessons from the Smartest People I know

By Arianna Capital

I was recently forwarded an article by a friend of mine who knows our company like the back of his hand. He thought Paul Merriman's article, "Ten Retirement Tips from the Smartest People I know" matched our philosophies pretty well.

In our experience, as personal CFOs, for the families that we steward several of the tips ring true. I will comment on five of his tips and add in some of my own.

Lesson one: Happiness in later life is not a direct function of how much money someone has.

There seem to be many reasons to be happy and many seeming sources of that happiness. Emotional intelligence and emotional control is a huge part of it - along with the relationships that are currently in your life.
However, another portion is having a life plan that a financial plan fits into. We call this the peace of mind plan. Having a successful plan that reaches your goals is a gigantic part of being able to forgo worry and relax when spending time with those people you have wonderful relationships with.

Lesson Two: Wealth Comes from Choices People Make Not Changes People Take

When choosing a financial adviser make sure there are no conflict of interests. I have seen to many broker/dealers sucking money right out of peoples' accounts with no value added. Also, use a fully diversified low-cost index fund or DFA based investment strategy instead of hiring an "active manager."

Most importantly, however, hire an adviser who is committed to being your personal CFO. This means that they are interested in managing your risks - investment, insurance, et cetera, and in getting you to your goals through wealth preservation, tax mitigation, wills, estates, trusts, and anything else that fits your needs.

Lesson Three: Those Who Plan Prosper

Many folk do not understand the relationship between the money they have present and how this relates to their goals be it retirement, a new home, college savings, or more. As such, it is pertinent to learn or have someone help you identify where you are and what it is going to take to get you to where you want to go.

Lesson Four: Don't Wait to Start Saving

Starting young is the best option. Saving through your employee retirement plan is a great way to defer costs - assuming the plan has decent investment options.

Lesson Five: Retirement Belongs to Those Who are Still With Us.

Your health is an extremely important asset. And it does not just include physical health. Taking care of mental health and the health of relationships is also extremely important. Life is for enjoying, so make sure to make healthy choices and build integrity for your life.

If you would like to read the other five tips the link to the article is posted at the top. I have a few tips of my own, besides the comments above that should also be considered for your financial health.

Lesson One: Think Wisely when Considering Alternative Investments

After the recent recession many investors are looking for other places to put their money. Make sure to educate yourself on these alternatives so you do not end up making the same mistakes we have seen by a few unsuspecting people.

Lesson Two: Annuities Are Superfluous

After the recent recession many people not only turned to alternative investments, but billions of dollars went into annuities. I understand the psychological reaction, however, if their advisers had properly diversified their portfolios and their risk appetites were properly analyzed there would be no need for fear.

Even the death benefits of annuities are a poor argument. One of our prospective clients was spending enough on his old annuity that he could have garnered a 20 million dollar life insurance policy instead of his 2 million dollar death benefit.

Other downfalls to annuities are their conflict of interest by the seller, large costs, actively managed funds, huge front end load, surrender charges, inability to correctly measure individual risk, et cetera.

It is possible to reach your goals without annuities using diversified low-cost index funds - give us a call for a free consultation.

Lessen Three: Gold Does Not Belong in Your Portfolio

Gold makes sense as a portfolio asset only for investors who also get the consumption dividend from gold, since this "dividend" lowers gold's expected capital gain. Thus, for investors who do not get the consumption dividend, the expected return on gold does not cover its risk as a portfolio asset. Most people do not get the consumption dividend and should just get their exposure to precious medals through an index fund that happens to have gold in their index.

Tuesday, December 7, 2010

10 Easy Steps to Enriching Your 401(k) Experience

It seems as if the topic of 401(k) investing is surfacing quite often. The young are starting to establish a plan with their employer and the "old" are beginning to worry if their 401(k) is working in the best way possible for them. Truth is, a lot of individuals don't get the most out of their plan. Either, they are too afraid to invest in equities so they let the funds accumulate in the money market account available within the plan or are way too aggressive by investing in one segment of the market.

Ironically, people spend hours upon hours researching their next car (depreciating asset) or the new, coolest computer. What if that same time was spent educating yourself about your 401(k)? You could use your knowledge to not only make your investments work better for you, but to educate the trustees responsible for servicing the plan to get a better one - now we're talking!

You worked hard for that money, you earned every single cent of it. How come I see 401(k)s that are half of what they were ten years ago, or just simply haven't moved? It has nothing to do with the market, the market certainly provided healthy returns over the past 10 years.

Simply put, people just aren't educated about investing, especially within their 401(k). The beauty of it is, the warehouse worker can become more educated than the CEO, creating a better investment experience for him/herself just because the warehouse worker did a little bit of homework. This research, in most cases, can be a difference of millions of dollars. Yes, millions, for a little bit of time and know-how! My plan is to give EVERYONE several easy steps that they can utilize within their 401(k)...for FREE! Put that in your back pocket. Here we go.

1. Participate. Your company is without a doubt giving you a great deal! If you don't participate, you don't reap the benefits. You should contribute as much as you can afford, especially if your employer matches - it's free money. Also, you can usually set it up so that automatic deductions are taken out of your paycheck and put into your 401(k). You don't even have to think about.

2. Invest the funds appropriately. Here is where we see the biggest mistakes made. You want to find the lowest cost funds. Academic studies show that the funds with the best performance have the lowest expense ratios - duh! Do not invest in a fund that has an expense ratio over 1%. Try and find funds that have expense ratios in the .08% to .6% range. Once you have found low-cost funds, you should begin to put the puzzle together. You want to find these asset class (what markets they are invested in):

US Large-Cap, US Large-Cap Value, US Small-Cap, US Small-Cap Value

International Large-Cap, International Large-Cap Value, International Small-Cap, International Small-Cap Value, and Emerging Markets.

Just make a check-list and cross them off as you find each one.

If you can find funds with "index fund" within the name, perfect, these are your best bet! Ideally, your plan will most likely not have all of the aforementioned funds (poor plan). To do something about this see Step #8.

3. Determine your allocation.
Simply said, how much will you allocate to equities and bonds. Equities will earn you a greater return, but with more risk. Bonds, the opposite. To determine your allocation here is a quick rule-of-thumb: Take your age, subtract the number from 110, the number you get is about the percentage you need to invest in all of your equity funds. Obviously, a much younger investor (21), could handle putting all of their funds in equities. Like I said, this a quick rule-of-thumb.

An example: You are 40 years old. You subtract 40 from 110, equaling 70. Roughly 70% of your overall funds should be invested in equities. Now, half of that 70%, 35%, we will split up equally among your 4 US funds mentioned in Step #2. The other 35% will be split up equally, five-ways into your International and Emerging Markets funds. Obviously, the other 30% of the overall plan will be put into the bond fund. You are almost off to the races!

4. Rebalance your funds once a year. Generally speaking, since you have your percentage or allocation figured out via our quick rule-of-thumb, this number should be your target every year. In our previous example, our target should be to maintain a mix of 70/30 (Equities/Bonds). The individual funds you invest in will move, up or down. Each year, rebalance the funds so that your allocations are appropriate, both your equity/bond allocation, and your allocations within the equity funds. This quick exercise will keep your assets aligned and on the way to your goals. Plus, some plans even allow you to select an auto-rebalancer. Even better, you don't have to check it, unless of course you get older, in which case your equity allocation will go down.

5. Don't invest your plan assets in the company you work for. This step is fairly obvious, but I have seen people's fortunes get wiped out for making this mistake (Citigroup, Enron, etc.). No matter how big, tough, and great your company is, do not invest in your own company. This is called double exposure or career risk - you wouldn't stand on top of a hole you are digging right?

6. Do not borrow against your 401(k) savings. Some plans allow individuals to borrow against their funds for certain situations. This is not a good idea.

For an example, if for any reason you cease to be an employee at your company, the entire balance of the loan becomes due and payable immediately. If you don’t pay, you will have to pay taxes (plus a 10 percent penalty if you are under 59 ½ years old) on the loan balance. This means that if you are laid off, you will suddenly have to pay back this loan – just at the time you may be the least able to afford it. This among other reasons, show that it is unwise to borrow against your savings.

7. Know thy plan.
Reading your plan documents doesn't sound like fun, especially when Monday Night Football or the Victoria Secret Fashion Show is on. But again, your education will earn you a substantial amount of money over the long haul. Get to know what you can and can't do within the plan. Who is in charge? What are the fees? Knowledge is power here! If you can't figure out what a term means, ask H.R. at your company.

8. Educate the trustees of the plan.
Again, it is your money. If the investment options I mentioned are not available, your plan is not good enough. Try and persuade the plan trustees to include low-cost index funds in the plan. Keep in mind, the trustees usually have their assets in the plan as well, so what helps you, helps them. You are a tribe. Refer the trustee to our website or blog so they can become educated. Remember, from reading your plan documents you will know who is in charge and responsible. The trustees usually hold a fiduciary standard to the plan. So, if you point out that the current plan is sub-par and they can get better, and they don't get a better plan - Uh oh...somebody may be in trouble, just saying.

9. If you do leave your employer, get your moolah.
Tax laws will hurt you if you aren't familiar with what happens when you leave your workplace. Bottom line: Once you leave your job get your money within 60 days, roll it over into a Rollover IRA (a professional advisor can help you here). Two things: You will have better investment options within a Rollover IRA and if you don't roll it over and instead, decide to go shopping with the money, you will be taxed by the IRS 20%, and possibly a 10% penalty. All at your current tax rate - not fun!

Example: If you have $60,000 in your IRA when you leave your job and ask for the money in cash, the employer pays $12,000 to the IRS and gives you a check for $48,000. You can invest that $48,000 into a Rollover IRA, without tax consequences. But unless you also invest another $12,000, the IRS will tax you (and possibly also penalize you 10 percent) on the $12,000 that you had withheld. It doesn’t seem right or fair, but that’s the law.

10. Upon retirement, create a plan. You have made it this far, you need a plan to maintain your standard of living after work. A professional will be able to help you in this area. The professional can transfer the funds to a better investment solution for you. Take this part seriously. Find a fee-only, independent advisor. Someone who will take fiduciary responsibility for your money. The advisor should only be paid by you, no one else. Are they going to sell you a product or choose the best solution for you? Make sure to ask them these questions. Again, important decisions will translate into millions earned or lost. The last thing you want to happen is to realize you do not have enough to support your lifestyle and end up having to go back to work. Talk about a loser.

That's it! Any person can follow the 10 steps. They are easy and simple. If you put in the time to read this article, you will be successful at maintaining a disciplined approach. Do not try and time the market within your plan. Stick to your guns (funds) and rebalance - that's it. This a portion of your life where you have complete control, whether it is taking the time to read your plan documents or persuading your CFO for change, the decision is a vital and a beneficial one. Please help others and pass this article along. In 10 to 30 years people will thank you for enriching their lives, both financially and emotionally.

Friday, December 3, 2010

The Cocktail Party Fallacy

By Eugene Fama Jr.

"What do you think of the market?"

I usually shrug, "It's . . . a market." I don't know what to say to this. People should probably be in the market.

Then they ask, "What do you think is a hot stock?" This translates to: "Which company do you think has the best chance for future profitability and earnings success?"

Most investors think glamorous, profitable companies like, say, Intel (Nasdaq: INTC), have higher expected returns than beleaguered, poorly earning companies like, say, JC Penney (NYSE: JCP). If someone on the plane asks for a hot stock tip, they want to know the next Cisco (Nasdaq: CSCO) or the next Microsoft (Nasdaq: MSFT). They don't want to hear you say "JC Penney" or "Marvel Comics Group" (NYSE: MVL). They might walk away or turn you down to share a cab.

And yet, poorly managed, distressed companies have the highest expected returns.

Why is this opposite to everyone's intuition? It's possible that people confuse the well being of their human capital with the well being of their investment capital. The receptionist at Intel is better off than middle managers at JC Penney. Since healthy companies are better places to invest our work effort, they feel like better places to invest our money. But buying stock is not analogous to working for, partnering with, or even owning, a company. It's more like lending money to a company.

The 1990 Nobel Prize in Economics recognized Merton Miller of the University of Chicago for his research into the "cost of capital." When markets work, the cost of capital to a company is equal to the expected return on its stock. This is a simple but profound notion. It means that companies use stock, like bonds, to fund operating capital. If a company sells off 10 percent of its stock, the buyer has a claim on 10 percent of the company's future earnings. The return the investor receives is the return the company forgoes when it sells the stock. The expected return is therefore the "cost" the company pays to obtain capital. Investors provide capital in exchange for an expected return in exactly the way a lending bank provides capital in exchange for an expected interest rate.

Well, if both Intel and JC Penney went to the bank for a loan, which company would pay the higher interest rate? JC Penney would, to compensate the bank for its poorer earnings prospects and greater risk of default. The stock market similarly expects a higher return from JC Penney than from Intel. This induces investors to buy JC Penney even though Intel is healthier. If Intel had a higher expected return, or even the same expected return, nobody would buy JC Penney. People buy the stocks of distressed companies because the market sets the discount rate so that these stocks have higher expected returns.

Over the long term, investors in unhealthy stocks are rewarded. The stocks of distressed companies have outperformed the stocks of healthy companies on average since the dawn of recorded time in the US,1 and by more in other markets around the world. It should be mentioned that individual stocks have a lot of "noise" in their returns, which means there will always be individual distressed stocks that perform terribly and individual healthy stocks that perform well. In diversified portfolios, distressed stocks are expected to outperform healthy stocks over the long run.2

So next time you're at a cocktail party and some hotshot investor recommends a glamorous growth company with strong earnings prospects, proceed with caution. Don't go rushing to sell it short, but don't expect its great earnings to translate into equally spectacular investment returns. Markets wouldn't work if healthy companies had to pay more for their capital than distressed companies. By the time a guy at a party tells you about some stock or sector's glowing earnings prospects, the expected return is likely to be low. By the time you see it plastered across magazine covers and chatted up by televised investment gurus, the "hot" stock's cost of capital, and its expected return, have probably cooled to a chill.

Thursday, December 2, 2010

Don't Believe the Hype

By Dan Wheeler

Case in point: The popular financial press. It's almost impossible these days not to stumble across a newspaper column, magazine, television show, or even an entire TV network devoted to the topic of investing. Investment advice is literally everywhere. The question your clients must learn to ask themselves is whether all that advice is any good.

In a previous Investment Advisor column ("House of Games," October 2004), I explored the incentive system that motivates brokers and other transactional-based members of our industry, and showed the many ways in which that system is flawed—that is, it is designed to benefit the person and the firm doing the selling, not the client with the money to invest.

Much of the financial press also operates with incentives which may not be in the interest of investors. Publications such as Money and Smart Money have an agenda your clients will understand with a little education from you. Like any business, their goal is to increase their revenue. They do so by running stories that will maximize their audience and, accordingly, their advertising revenues. What types of stories do that? All too often it is some version of "The Best Five Stocks for the Coming Year" or "The Next Microsoft"—headlines that will motivate a reader to buy the publication in order to learn how to make a killing in the market.

In my opinion, this type of investment advice can be more dangerous than the stuff you get from a salesperson. After all, the SEC and other regulators might come down hard on financial services firms that don't operate in their clients' best interests. But there is no one around to hold the financial media accountable for its actions when it steers investors into making poor decisions with their money. When "The Best Five Stocks" turn out to be a poor investment, does anybody care about the retired couple that followed that advice and had their retirement funds depleted? Apparently not.

The press has an acute understanding of how most investors think—that you need to know the future in order to invest successfully. Therefore, they focus on making forecast after forecast. Traditionally they've done so by having their writers pick up the phone and call sources who profess to have a crystal ball. Often these sources are Wall Street analysts and brokers—the very same people who focus on making sales instead of giving solid advice.

This arrangement is so obviously conflicted. Financial reporters—often fresh out of journalism school—go out seeking an honest, objective viewpoint for the story they've pitched or been assigned. Yet they head right for the Wall Street salesmen who have massive agendas. The result, of course, is that the journalist ends up adopting the source's agenda and communicating it to thousands of readers looking for investment information. In such a scenario, the journalist's needs are served—he got a story—and the Wall Street source's needs are served—he got to promote his own firm or a company he covers. The only losers are the readers, who desire the "fair and unbiased" reporting that many promise but few deliver.

So why does the media go to these industry sources in the first place? There are several reasons. For starters, the enormous growth in the number of people participating in the capital markets has created a huge demand for financial news (how else do you explain multiple cable networks devoted to financial markets?). And magazines hire journalists, not investment experts. Journalists rely on their sources for knowledge and expertise—and if they believe their source is credible, they write what they are told. Unless you have actually worked in the financial services industry, the chances of you being aware of all the conflicts is remote.

The media also has to fill up space, based in part on how much advertising they sell. If there's a three-page (or three-minute) gap, you can bet that someone at the magazine or network will generate a story to fill it—even if the "advice" the story provides comes from a Wall Street salesperson with a separate agenda.

Perhaps the most pervasive reason the media loves to court these sources is because they offer "sizzle"—commentaries that are designed to lure readers in, get their pulses racing, and encourage them to buy the magazine. Commenting on these sensational stories, Jane Bryant Quinn of Newsweek referred to them as "investment pornography—soft core, not hard core, but pornography just the same."

These are the media-hyped stories that you must educate clients about. Help them understand what's really going on when magazines print headlines like "The 20 Best Stocks for the Next Year." The fact is, these stories are always designed to grab clients' attention—and very rarely meant to offer the type of advice that will give them a successful investment experience.

The good news for you is that it doesn't take much effort to prove this fact to clients. Advisors are always asking me for the right wording and the best examples to help them discuss important topics with clients. When it comes to the media, there's no shortage of examples of conflicted—or just plain bad—advice. When I speak at conferences on this topic, I usually just stop at the airport newsstand and pick up the current issues of the most popular magazines or watch CNBC for a few minutes. Inevitably, I find an example to give to advisors that day.

One of my colleagues collects these stories and revisits them in a few months to assess the damage done by the "advice." A quick review reminded me of some of my all-time favorites.

  • "Don't Just Sit There...Sell Stock Now!" August 1997 Money. Market timing, anyone?
  • "Everyone's Getting Rich," May 1999 Money. Actually, those readers who took Money's advice in August 1997 and sold stock probably weren't getting rich!
  • "Bearish on America," July 1993 Forbes. This one is tough to beat—Morgan Stanley's Barton Biggs dressed up in a bear costume on the cover of Forbes, imploring readers to sell U.S. stocks and buy emerging markets (which, by the way, performed terribly for the next three years).
  • "The Death of Equities," August 13, 1979, Business Week. OK—this one wins. The magazine tells us that "the old rules no longer apply" and the "the death of equities is a near-permanent condition." I almost don't need to point out that this call was made essentially on the eve of the greatest bull market in history for stocks.
I could fill this entire column with similar headlines, but the point is this: Once again, we see that trying to predict the future is a loser's game. The screaming headlines prove that even the biggest names in the industry don't have an accurate crystal ball. But the magazines and TV networks will always keep putting their faces out there for one reason: Forecasts and hype about the riches to be gained sell magazines—and that makes the advertisers very happy indeed.

It's even more interesting to see the almost covert endorsement of passive or indexed strategies by media professionals. It's pretty obvious that headlines like "Buy and Hold!" or "Best Bet: Do Nothing!" don't titillate readers or help sell magazines—a scenario that makes advertisers very unhappy indeed. And yet, in a past issue of the now-defunct Worth (cover headline: "The World's Highest Yields"), we find an article noting that "the index fund is a truly awesome invention (that) should constitute at least half your portfolio." Even better, a former mutual fund reporter admitted in Fortune that "by day we write 'Six Funds to Buy NOW!' By night, we invest in sensible index funds...unfortunately, pro-index-fund stories don't sell magazines." Bingo! Straight from the horse's mouth.

Wednesday, December 1, 2010

A Decision Costing People $894,000 Every 10 Years

I was chatting with a friend in regards to helping out his family with their finances. After speaking with family members their response was "we already use someone and it would be too much of a hassle to change." I responded with "that's an expensive decision."

To illustrate the loss of wealth or opportunity cost of that decision we should lay out a few facts.

First, looking at our own client's returns (before we retained them) over the past 10 years, ending 12/31/09 the average annualized return was 2.04%.

Secondly, according to the Dalbar (QAIB) the average of all equity investor's returns was -0.55%.

Additionally, a low-cost, globally diversified with Arianna Capital with a mix of 60% stocks and 40% equities achieved 6.29% annualized.

And lastly, inflation over the same period was 2.67%.

As we can see, the average equity investor was beaten by inflation. Additionally, before we retained our current client's their return was also trumped by inflation. Also, if a client would have chosen to retain Arianna Capital at the beginning of 2000, the client would have outperformed inflation and some.

So now let's do some math to illustrate how expensive this decision is under the aforementioned facts. The obvious solution would be to hold a global portfolio compensating investor's for taking appropriate market exposure, this can be found through Arianna Capital - $1,000,000 would have grown to $1,840,000. Let's compare this number to both, our client's past returns and the average equity investor's returns. Respectively, they are $1,224,000 and $946,000. Take whichever number you like to do your arithmetic. The net result is a difference of $616,000 to $894,000. A significant amount of money over just a 10 year period. Considering a 30-year old will be in the accumulation phase for 30-35 years, the difference can be staggering, even for a 50-year old.

We often find that when individuals respond with this decision, they usually have grown "attached" to their current advisor through golf outings and/or fancy dinners. Likewise, Do-It-Yourself investors become confident (epistemic arrogance) in their own abilities (active management). Both parties usually suffer from a lack of transparency - in which past returns, fees, and risk are unknowns. Similarly they don't know how to measure those three variables or end up inappropriately measuring.

The point is, the current relationship, whether it is with your advisor or your own money is usually extremely costly. In this case ranging from $616,000 to $894,000.

Monday, November 29, 2010

Don't Try to Pick Up Quarters Off the Street

I was walking on the street this weekend when I noticed a quarter on the ground. My initial thought was to pick it up...but then my knowledge about the stock market immediately kicked in. I suddenly couldn't decipher if I was having a deja vu, dreaming, or actually experiencing this! I thought to myself: If the world of walking the streets of Dallas is anything like the stock market that quarter shouldn't be there. Furthermore, even if it really was there, the action of bending over and picking it up would not overcome the costs (in this case energy and time) of receiving 25 cents. I quickly snapped out of my mental intuition and rightfully picked up the quarter. Oh well...

On the other hand, individual and professional investors believe they are all good at picking up quarters off of the ground or picking the next Microsoft or predicting interest rates or figuring out that international stocks will beat domestic. But they fail to realize two things, 1) those free quarters or opportunities do not consistently exist and 2)the cost of trying to find those quarters will dig you a deeper hole.

When talking to individual investors some feel they are the next stock picker dejour. Again, they fail to realize that there never was and never will be a stock picker dejour - someone who can predict the future and position their portfolio appropriately for the next 20-30 years, beating a portfolio of low-cost, diversified index funds.

One of the biggest mistakes an investor can make is believing that they have the "skill" or "knowledge" to outperform the market (perform better). Usually this conviction arises by looking in the rear view mirror while driving forward. Investors plow into funds after strong performance and depart after weak performance. Just because a fund has had great performance in the past does not mean it will continue to do so. Furthermore, once you invest in a fund you do not instantly achieve the past returns of the fund. If investing worked that way everyone would be rich.

An active manager attempts to outperform the market (index) by assembling a portfolio that is different than the market. They construct their portfolios through innumerable methods: account records, earnings, the CEO, rating services, the alignment of the stars, literally anything their brain can trick them into believing that a pattern or rationale exists for.

I have asked dozens of investors why they believe they have more information than millions of other market participants. I ask why they think they can outperform the market even though the odds (2 out of 10 each year) are against them. I ask why they think quarters are free. I have never gotten a response to this question.

Wednesday, November 17, 2010

Can You Beat the Market? It's a $100 Billion Question

Investors collectively spend around $100 billion a year trying to beat the stock market. That’s the finding of a rigorous effort to measure the total costs of Americans’ efforts to surpass the returns they would have received by simply holding a stock index fund. The huge price tag helps explain why beating a buy-and-hold strategy is so difficult.

The study, “The Cost of Active Investing,” began circulating earlier this year as an academic working paper. Its author is Kenneth R. French, a finance professor at Dartmouth; he is known for his collaboration with Eugene F. Fama, a finance professor at the University of Chicago, in creating the Fama-French model that is widely used to calculate risk-adjusted performance.

In his new study, Professor French tried to make his estimate of investment costs as comprehensive as possible. He took into account the fees and expenses of domestic equity mutual funds (both open- and closed-end, including exchange-traded funds), the investment management costs paid by institutions (both public and private), the fees paid to hedge funds, and the transactions costs paid by all traders (including commissions and bid-asked spreads). If a fund or institution was only partly allocated to the domestic equity market, he counted only that portion in computing its investment costs.

Professor French then deducted what domestic equity investors collectively would have paid if they instead had simply bought and held an index fund benchmarked to the overall stock market, like the Vanguard Total Stock Market Index fund, whose retail version currently has an annual expense ratio of 0.15 percent.

The difference between those amounts, Professor French says, is what investors as a group pay to try to beat the market.

In 2006, the last year for which he has comprehensive data, this total came to $99.2 billion. Assuming that it grew in 2007 at the average rate of the last two decades, the amount for last year was more than $100 billion. Such a total is noteworthy for its sheer size and its growth over the years — in 1980, for example, the comparable total was just $7 billion, according to Professor French.

The growth occurred despite many developments that greatly reduced the cost of trading, like deeply discounted brokerage commissions, a narrowing in bid-asked spreads, and a big reduction in front-end loads, or sales charges, paid to mutual fund companies.

These factors notwithstanding, Professor French found that the portion of stocks’ aggregate market capitalization spent on trying to beat the market has stayed remarkably constant, near 0.67 percent. That means the investment industry has found new revenue sources in direct proportion to the reductions caused by these factors.

What are the investment implications of his findings? One is that a typical investor can increase his annual return by just shifting to an index fund and eliminating the expenses involved in trying to beat the market. Professor French emphasizes that this typical investor is an average of everyone aiming to outperform the market — including the supposedly best and brightest who run hedge funds.

Professor French’s study can also be used to show just how different the investment arena is from a so-called zero-sum game. In such a game, of course, any one individual’s gains must be matched by equal losses by other players, and vice versa. Investing would be a zero-sum game if no costs were associated with trying to beat the market. But with the costs of that effort totaling around $100 billion a year, active investing is a significantly negative-sum game. The very act of playing reduces the size of the pie that is divided among the various players.

Even that, however, underestimates the difficulties of beating an index fund. Professor French notes that while the total cost of trying to beat the market has grown over the years, the percentage of individuals who bear this cost has declined — precisely because of the growing popularity of index funds.

From 1986 to 2006, according to his calculations, the proportion of the aggregate market cap that is invested in index funds more than doubled, to 17.9 percent. As a result, the negative-sum game played by active investors has grown ever more negative.

The bottom line is this: The best course for the average investor is to buy and hold an index fund for the long term. Even if you think you have compelling reasons to believe a particular trade could beat the market, the odds are still probably against you.

Tuesday, November 16, 2010

China, Ireland, Spain, Greece - Uniquely Looking at the World Map

How should we view the world economy? The rise of China and decline of the United States seems to be prevalent in the news recently. Fears of Ireland are a hot topic. Months ago Greece was worrisome. Spain's fate was in question at sometime as well. Statistics don't help either. Population growth, GDP, trade balances, etc. - how can we determine what the world map looks like?

Viewing the world map by relative market capitalization illustrates the importance of building a globally diversified portfolio and avoiding biases that may arise from attention to other economic statistics.


This cartogram depicts the world not according to land mass, but by the size of each country’s stock market relative to the world’s total market value.

Population, gross domestic product, exports, and other economic measures may influence where people invest. But the map offers a different way to view the universe of equity investment opportunities. If markets are efficient, global capital will migrate to destinations offering the most attractive risk-adjusted expected returns. Therefore, the relative size and growth of markets may help in assessing the political, economic, and financial forces at work in countries.

The cartogram brings into sharp relief the investible opportunity of each country relative to the world. For example, China and Spain have a slight larger market capitalization than Microsoft! Greece is virtually non-existent. The world map avoids distortions that may be created or implied by attention to economic or fundamental statistics, such as population, consumption, trade balances, or GDP.

By focusing on an investment metric rather than on economic reports, the chart further reinforces the need for a disciplined, strategic approach to global asset allocation. Of course, the investment world is in motion, and these proportions will change over time as capital flows to markets offering the most attractive returns.

Monday, November 15, 2010

What Is the Investment Impact of Our Federal Deficit?

By Larry Swedroe

One of the widespread concerns I keep getting asked about is the impact of our federal deficit on investments. A new study by Marlena Lee of Dimensional Fund Advisors demonstrates that the impact isn’t what you would think.

Before we discuss the study, it’s important to note that the fact that our deficit (and the resulting debt) is a major problem is just that — a piece of information and nothing more. What you have to understand that it’s not information you should use to alter your investment plan. The reason is that if you know the information (and it’s not insider information), you can be 100 percent sure the big institutional investors that do most of the trading and therefore set prices also are aware. Thus, that information (and the risks it brings) is already embedded in prices.

It’s critical to understand that it doesn’t matter if news is good or bad, only if it’s better or worse than already expected. We see this all the time when a company reports earnings down 20 percent (clearly a bad number), yet the stock price increases because the market expected an even worse figure. The reverse is true when there is good news, but the stock price falls because the news wasn’t as good as expected.

Federal Deficits and Debt
We begin by noting that the U.S. — with a debt-to-GDP ratio of about 90 percent — isn’t the only major industrial country with a deficit/debt problem. The 28 countries in the Organization for Economic Cooperation and Development have debt-to-GDP ratios ranging from 23 percent (Australia) to 199 percent (Japan), and more than half the countries have deficits in excess of 70 percent.

Interest Rates
In her study “The Economics of Fiscal Deficits,” Lee concluded that today’s deficits don’t provide us with valuable information about either future yield curves or future bond returns. In other words, today’s interest rates already incorporate information about fiscal policy.

Economic Growth
It turns out debt has very little impact on economic growth until it exceeds 50 percent of GDP. However, even at as much as 70 percent of GDP, debt levels only explain about 12 percent of the variation in GDP growth.

Equity Returns
While deficits/debt negatively impact economic growth, there’s actually a negative relationship between a country’s growth rate and its stock returns. The explanation is similar to the reason value stocks produce higher returns than growth stocks despite producing much lower growth in earnings: Markets don’t price growth, they price risk!

For developed MSCI countries from 1971 through 2008:

  • High-growth countries (average real growth of about 1 percent) produced equity returns of 12.9 percent
  • Low growth countries (average real growth of about -4 percent) produced stock returns of 13.5 percent.

For emerging market countries from 2001 through 2008:

  • The high growth countries (average real growth of about 2.5 percent) returned 19.8 percent
  • The low-growth countries (average real growth of about -5 percent) returned 24.6 percent.

Remember this the next time you are tempted to jump on the China or Brazil bandwagon.

While the talking heads from Wall Street and the financial press continue to produce dire forecasts based on the deficits, the historical evidence demonstrates that today’s deficits and debt levels don’t provide any valuable information about the future returns to either stocks or bonds. Thus, you should stick to your well-thought-out plan and ignore the noise designed to get you to act when doing nothing is in your best interests.

Thursday, November 11, 2010

Faced With the Decision of Selling an Inherited Asset?

Thanks to my favorite writer Larry Swedroe, I thought it might help to provide an explanation of the right way to consider whether you should buy, hold or sell investments. No, I am not advocating to try and time the market.

Put yourself in the following situation: You’re a wine connoisseur and purchase a few cases of a new release at $10 per bottle to store in your cellar to age. In 10 years, you learn the wine is now selling for $200 per bottle. Do you buy more, sell your stock or continue to hold it?

Faced with this type of decision, very few people would sell the wine, but very few would buy more. (Of course, given the appreciation in the wine’s value, you might choose to save it to drink on special occasions.)

The decision not to sell or buy isn’t rational. This is known as the “endowment effect.” The fact you already own the wine shouldn’t impact your decision. If you wouldn’t buy more at a given price, you should be willing to sell at that price. Since you wouldn’t buy any of the wine if you didn’t already own any, the wine represents a poor value to you. Thus, it should be sold. The same thing is true of any investment you currently hold: In the absence of costs, the decision to hold is the same as the decision to buy.

The endowment effect often causes individuals to make poor investment decisions. For example, it causes investors to hold assets they wouldn’t purchase.

The most common example of the endowment effect is that people are often reluctant to sell stocks or mutual funds they inherited. I have heard many people say something like, “I can’t sell that stock, it was my grandfather’s favorite and he’d owned it since 1952.” Or, “That stock has been in my family for generations.” Or, “My husband worked for that company for 40 years, I couldn’t possibly sell it.” Another example would be stock accumulated through stock options or some type of profit-sharing/retirement plan.

Financial assets are like the bottles of wine. If you wouldn’t buy them at the market price, you should sell them. Stocks, bonds and mutual funds aren’t people — they have no memory, they don’t know who bought them, and they won’t hate you if you sell them. An investment should be owned only if it fits into your current overall asset allocation plan. Thus, its ownership should be viewed in that context.

You can avoid the endowment effect by asking this question: If I didn’t already own the asset, how much would I buy today as part of my overall investment plan? If the answer is, “I wouldn’t buy any,” or, “I would buy less than I currently hold,” you should sell. That is true of a bottle of wine, a stock, a bond or a mutual fund.

David Tepper Wants Us to Believe It Was Easy to Beat the Market

Stay tune. I have asked several experts to try to explain his Hedge Fund’s 30%/year return for a 17 year period. Before you rush out and try to get into his fund, read this very carefully (click the title):

Also, Read this Article Titled - "'Hedge Fund Liars"

And, for even more information, contact us at Arianna Capital for a white paper on why hedge funds often fail.

Hebner, Mark. "David Tepper Wants Us To Believe It Was Easy To Beat The Markets." Index Funds Advisors Blog. Word Press, 9/26/2010. Web. 11/11/2010. .

Tuesday, November 9, 2010

You Might be Misled by the Lipper Average (as Seen on T.V.)

Q: When I hear financial companies advertising on T.V., they mention the fact that their funds have beat the 10-yr Lipper Average, what is that and what does it mean?

As Larry Swedroe points out, there are many misleading ways to report performance. The Lipper Average is simply the average level of performance for all mutual funds, reported by Lipper Inc. But let's take a closer look at what data Lipper uses.

In 1986, Lipper reported that 568 stock funds had an average return of 13.4 percent. However, in 1997, Lipper showed the 1986 return to be 14.7 percent. This happened because 134 funds from the original batch disappeared, and their returns were removed from the database. This skew happens by showing the performance of only those funds that are currently in existence. This is known as “survivor-ship bias.” Funds that have poor performance disappear, most often by merging a poorly performing fund into a better performing one. Fortunately, we now have publicly available databases for mutual funds that are free of survivor-ship bias.

Beware, mutual fund companies use other tactics to misled individuals. Including comparing returns to inappropriate benchmarks. For example, a private equity fund, hedge fund or even a value fund might compare its returns to the S&P 500 Index. Each of these funds takes on much greater risk than that benchmark, including the use of leverage. Thus, their returns should be compared to more appropriate, risk-adjusted benchmarks. Many investors have been fooled by this trick.

Also, there’s a third, less well-known bias in mutual fund reporting called incubator bias. Here’s a hypothetical example: A mutual fund company uses its own capital to seed multiple small-cap funds. Each fund might own a different group of small-cap stocks. The fund family incubates the funds, safe from public scrutiny. After a few years they bring public only the fund with the best performance. Magically, the poor performance of the other funds disappears, never to see the light of day.

Unfortunately, the SEC allows fund families to report the pre-public performance of these incubator funds. Thus, we have the potential for a huge distortion of reality, as only successful fund histories make it into the public databases. This is a real problem since the historical evidence is that the past performance of mutual funds has proven not to be prologue.

The bottom line is mutual fund companies attempt to deceive investors through advertising. Of course, there’s a very simple way to avoid the tricks: Just follow the advice you find here and never invest in actively managed funds.

Monday, November 8, 2010

Is the Grass Grenner on the Other Side - 401(k) or Joint Account?

Q: Would it be better to invest my money with a wealth manager offering lower cost, passively managed funds or contribute to my 401(k), where I have expensive, actively managed funds?

The obvious advantage with the 401(k) is the tax-deferment of pre-tax contributions. If you choose to contribute to a Joint account rather than a 401(k), the Joint account would be funded with after-tax dollars, in which you would take quite a hit comparatively. I realize most 401(k)'s are poor, offering expensive, under-performing funds - along with high management fees. Unless the 401(k) has an outlandish wrapper/management fee of 5-6%, at which point your account would never grow, it would not be worth it to fund a Joint account as opposed to your 401(k).

Although the investment choices are most likely more prudent with your wealth manager, the performance may not overcome the taxation of these dollars once the account is contributed to. Eventually, providing the 401(k) fees are high enough and fund performance low enough, over the long-term the Joint account may overcome the 401(k) value. But this "strategy" would rely on superior investment performance, although this could happen, it is not a chance I would suggest taking given numerous other factors e.g., offering of a better 401(k), rise of taxes, etc.

Portfolio Endurance

The need for retirement planning doesn’t end with the onset of retirement. A new retiree’s focus shifts from building wealth to managing and preserving it. One major challenge is to make the investment portfolio supply cash flow for the duration of life — and through different economic and market conditions.

Experts have studied portfolio longevity or endurance to help retired investors reduce the odds of depleting their wealth too soon. The studies evaluate how a portfolio might endure under the stress of changing markets and spending levels. The resulting models estimate portfolio survival in terms of statistical probabilities.1 While the technical details are beyond the scope of this article, the general conclusions are more intuitive.

Three main factors drive portfolio endurance: asset mix, spending level, and investment time frame. Certain aspects of these factors are within an investor’s control while others are not. Let’s briefly consider them.

Asset Mix
Asset mix describes the ratio of stocks to bonds in a portfolio. This determines risk exposure and expected performance, and is one of the most important decisions investors of all ages can make. Historically, stocks have outperformed bonds and outpaced inflation over time. This return premium reflects the higher risk of owning stocks. Consequently, the larger the equity allocation, the greater a portfolio’s expected return—and risk.

Keep in mind that risk and return go together. A higher allocation to equities increases the risk of experiencing periods of poor returns during retirement. But if you can handle the risk, having more equity exposure in a portfolio enhances its return potential. Growth can bring higher cash flow, inflation protection, and portfolio endurance over time. This is why most advisors believe that most investors should have an equity component in their portfolios, with actual weighting depending on one’s time frame, risk tolerance, and spending flexibility.

Spending Level
Portfolio withdrawal is typically described in terms of a specified dollar amount (e.g., $50,000 per year) or a percent of annual portfolio value (e.g., 5% of assets each year). Neither method is ideal, however—and for different reasons. Briefly consider each one:

· Specified dollar amount: withdrawing a fixed amount each year and adjusting it for inflation can provide a stable income stream and preserve your living standard over time. But the portfolio may survive only if future withdrawals represent a small proportion of the portfolio’s value. One academic study quantified this amount. It found that a retiree with at least a 60% stock allocation can withdraw up to 4% of initial portfolio value (adjusted for inflation each year), and enjoy a high probability of never running out of wealth. Choosing a higher withdrawal amount is not likely to be sustainable, especially if the portfolio faces an extended period of negative returns.

· Percent of annual portfolio value: withdrawing a fixed percentage of assets based on annual asset value makes it unlikely that you will deplete retirement assets because a sudden drop in market value would be accompanied by a proportional decline in spending. But this method can produce wide swings in your living standard when investment returns are volatile.

Retirees who need relatively consistent cash flow may want to combine these two methods. One way is to withdraw cash flow according to a rule that combines past spending (e.g., an average of the past thirty-six months of cash flow) with a payout rate applied to current portfolio value. You can weight these factors to favor your preference for either more stable cash flow or a greater chance of portfolio survival. In effect, you are customizing your withdrawals to smooth out consumption while responding to actual investment performance.

Investment Time Frame
Investment time horizon may be the hardest to estimate, especially if it is the same as your lifespan. In this case, you can only guess how long your portfolio must support spending. If you plan to bequeath assets, your investment time frame may extend beyond your lifetime. This may influence your risk and spending decisions as well.

Time frame forces a tradeoff between the short and long term. Retirees with a longer investment time horizon might choose a higher exposure to equities. But they may have to offset this risk by being more flexible about spending over time. Elderly retirees and others with a short time horizon may choose a less risky allocation or a higher payout rate, although they can experience rising spending levels, too. In any case, retirees should think carefully about equity exposure and avoid taking more risk than they can afford.

Planning involves assumptions about the future—assumptions that may not pan out. Although you cannot avoid making assumptions, you can ask whether they are realistic and consider how your lifestyle might change if future economic and financial conditions are much different than projected. For instance, you may assume an average return based on historical performance. But there is no certainty that future portfolio returns will resemble the past, regardless of time frame. Moreover, short-term results may vary drastically, which could force hard financial choices. Investors should think in terms of probability, not history.

Managing asset mix, payout, and time horizon inevitably involves tradeoffs. Exhibit 1 below illustrates the dynamics. For example, a bond-dominated portfolio with a lower expected return may suit investors with a shorter time horizon, or require them to accept a lower payout rate to increase the odds of portfolio survival. A portfolio with a higher allocation to equities may be appropriate for someone with a long time horizon or a strong desire for a high payout rate, but a higher assumption of risk also results in greater uncertainty about future wealth. Retirees who take this route must be able to handle the risk emotionally, and they should be ready to adjust their lifestyle in response to market downturns. In fact, investor flexibility plays a role in all of the tradeoffs.

Exhibit 1: Basic Tradeoffs in Portfolio Survival

Finally, although you cannot fully control these and other factors involved in portfolio endurance in retirement, having more wealth can improve the odds of having a less stressful financial life. A more substantial nest egg might enable you to take fewer risks, enjoy a higher sustainable spending rate, or extend the productive life of your portfolio.

Wednesday, November 3, 2010

The Amusement Park of Jim Cramer

Jim Cramer is the epitome of "financial pornography". Jim Cramer’s predictions sometimes swing dramatically from optimistic to pessimistic, and back again, over short periods. His army of viewers, a strong 600,000, watch to get their dreams filled with hot air or for just mere entertainment, who knows. One thing is for sure, he knows how to lure viewers in the same way a casino does. Moreover, the show exploits the innocence of investor psychology. In the same manner a casino prevents outside light entering the gambling floor in attempt to control a gambler's internal clock, Jim Cramer's show has fabricated the same fanatical experience.


From the color red to loud alarms Jim Cramer fascinates his viewers with psychological tricks. Who wouldn't be entertained by a circus act? The graphic above gives a list of triggers to look out for - in Mad Money and the investing world in general. Jim Cramer's effect on investors perfectly displays Nobel Laureate, Daniel Kahneman's findings on behavioral biases. A portion of Mr. Kahneman's research concluded that humans are not wired for long-term investment decisions because we tend to try and make create patterns out of random events. Furthermore, our perception flaws our judgment about decisions. Casinos, game shows, and now Jim Cramer play on the psychology of humans.

Mr. Cramer makes hundreds of buy-hold-sell recommendations on individual stocks each month via his show. What have his results been? According to CXO Advisory, his Accuracy Rating is 47%, meaning you would be better off flipping a coin in order to make a decision than listen to the entertainer. You'd be better off spending your time watching Sportscenter.

The Best 529 Plan Goes to... West Virginia!

By Arianna Capital

Saving for college can be quite an endeavor. Luckily, this article will aide anyone looking to pursue a college degree. There are several options like the Coverdell ESA, UGMA/UTMA, or the 529 plan. We will focus on the 529 plan today.

A Little Bit About 529s
Nearly every state has a 529 named for the IRS code that brought them about. The funds can grow tax free if used to pay for higher education qualified expenses. They can also be used to pay for thousands of post-secondary education across the globe. However, not all 529s are the same.

The West Virginia Award

After scouring the nation for the best option to help our clients save for their kids' future payments we found a diamond in the rough - West Virginia 529. It is special for several reasons. First of all it has low fees. This is an extremely important factor when searching for investment options. Secondly, West Virginia offers DFA funds. In previous posts we have written about the academia and science behind these funds. They don't try to offer the next best flavor of the month. Instead, they control what they can control in taxes and fees, and they let markets work for an expected return for providing financial capital. I have yet to come across better funds. Third, they are very simple to use. We all have busy lives. It may happen that we forget to rebalance the portfolio, or the child gets closer to college-age. Enter the age-based portfolio option, like that offered by West Virginia, which automatically does all of this for us.

Other Tips
When selecting a 529 plan there are three other things you need to watch out for.
1. Always buy a direct plan. Advisor sold plan only create wealth for the advisor. West Virginia makes it so easy that an advisor is really not necessary here.
2. Look for a state tax break. If your state gives a tax deduction or credit for contributions, look at home first. If the fees aren’t too much higher than West Virginia's, the value of the tax deduction or credit may outweigh the higher fees. In Texas, this is a mute point.
3. Consider an age-based option. This aids the values of simplicity and diversification.

Investing in 529's is a wonderful idea when planning for college to achieve tax-advantages returns. Make sure you choose carefully and watch out for costs and emotional decision making.

Tuesday, November 2, 2010

The Flaws of Variable Annuities

Ever walked the streets of New York City? Did you experience the snake-oil salesman luring you in with their fake Rolex watches and designer purses? Sounds familiar to the variable annuity market thanks to commissions of 5% or more.

Historically, variable annuities have gone from bust to boom. It seems as if variable annuity providers are in an "arm-race" to construct and sell the sleaziest, most deceiving product. Perfect timing uh? A 100-year event, like the market fall of 2008, can sure get people thinking differently about the complex, costly alien-like products. After all, an astonishing $33 billion in variable annuities was sold across the distribution channels in the fourth quarter of 2009. If only individuals knew what they were getting themselves into.

First, a primer. A variable annuity is basically a tax-deferred investment vehicle that comes with an insurance contract, usually designed to protect you from a loss in capital. Thanks to the insurance wrapper, earnings inside the annuity grow tax-deferred, and the account isn't subject to annual contribution limits like those on other tax-favored vehicles like IRAs and 401(k)s. Typically you can choose from a menu of mutual funds, which in the variable annuity world are known as "subaccounts." Withdrawals made after age 59 1/2 are taxed as income. Earlier withdrawals are subject to tax and a 10% penalty.

Variable annuities can be immediate or deferred. With a deferred annuity the account grows until you decide it's time to make withdrawals. And when that time comes (which should be after age 59 1/2, or you owe an early withdrawal penalty) you can either annuitize your payments (which will provide regular payments over a set amount of time) or you can withdraw money as you see fit.

So, what's the catch? The average expense on a variable annuity subaccount (including fund expenses and insurance costs) is typically one percent more than the average mutual fund expense ratio. Additionally, many variable annuities extract ongoing fees for administration and maintenance on the contract. An annual commission is also usually withdrawn from the account as well.

Proponents of variable annuities may point out the advantages of a death benefit. The death benefit basically guarantees that your account will hold a certain value should you die before the annuity payments begin. With basic accounts, this typically means that your beneficiary will at least receive the total amount invested — even if the account has lost money. For an added fee, this figure can be periodically "stepped-up" or earn a small amount of interest. (If you opt not to annuitize, then the death benefit typically expires at a certain age, often around 75 years old.)

Investors who bought annuities and then happened to pass away within the next two months probably got their money's worth. But considering the fact that over the long term the stock market will deliver positive returns, most folks need this insurance about as much as a duck needs a paddle to swim. While all variable annuities come with a standard death benefit, the average price for additional death benefits is 0.43%, according to Morningstar. On $1 million, if this $4,300 was used to buy a life insurance policy independent of an annuity, a healthy 50-year old man could definitely hold a policy of greater than $2 million, making the benefits of a death benefit a mute point.

Want to get your money back quickly once you invest? Tough luck. The surrender fees typically apply for 5 to 10 years. Withdrawing your funds before this time frame will result in huge fees. The surrender fees usually tier down as the years pass, but getting dinged by a 1% surrender fee in the last years can really eat into your assets. Not only that, but withdrawal before age 59 1/2 will result in a 10% penalty fee.

Gains in variable annuities are taxed at ordinary income tax rates. For most investors, that's a whole lot higher than the long-term capital gains tax rate they pay on their long-term mutual fund gains. And the tax difference can easily eat up the advantage of an annuity's tax-free compounding. Residents of some states may pay even more taxes on non-qualified variable annuity accounts. Some states also add a tax for variable annuities purchased within a qualified account, like a IRA.

Variable annuities continue to be a poor solution for a variety of factors. Some of which are not mentioned, such as estate planning issues and investment options, entailing higher expense ratios and underperfoming funds. Bottom line, ask the seller of a variable annuity how we much they will be compensated and from whom. If a conflict of interest exists, usually the solution wasn't designed with your best interests in mind.

Wednesday, October 27, 2010

How Might a Nobel Laureate Advise You?

By Arianna Capital

Nobel laureates have made lasting contributions to the financial industry. This documentary covers areas of theory, practice, and implementation - ending on a topic that will help investors for years to come. Please welcome this unique opportunity to hear from five recipients of the Nobel prize and learn how this can impact your investment experience of tomorrow.

Dimensional Fund Advisors and the American Finance Association present a new documentary that compares the work and ideas of five recipients of the Nobel Prize in Economics. A brief history of their theories and experiences culminates in a host of insights for today's investors.

Monday, October 25, 2010

Wallstreet and Their 'Special Interests'...

By Jay Franklin

“Wall Street is a place where anything that can be sold will be sold”
– Warren Buffett

“You are just a buyer of Wall Street’s dreck” – Robert Soros

“They [structured products] are horrible investments for retail investors…Simple portfolios of bonds, stocks or the S&P 500 will beat structured products 99.5 percent of the time because of the heavy profit built into the pricing”
- Craig McCann, former SEC economist and founder of Securities Litigation & Consulting Group

Credit to Eduardo A. Repetto and Inmoo Lee of Dimensional

Over the years, Arianna Capital has had the chance to view the portfolios of many different prospects and clients (before they actually became clients). We have seen the underbelly of Wall Street at its very worst, complete with penny stocks, C-Class shares of hyperactive mutual funds, triple inverse Russell 2000 ETFs…well you get the idea. Lately however, there has been one type of product that has been showing up more often than we are comfortable with, structured products. Granted, the name sounds as innocuous as it is vague. To briefly explain, the structured products marketed to retail investors promise either the straight return or a multiple of the return of an index (usually the S&P 500) up to a certain level (say 15%) with partial protection on the downside (e.g., for the first 10% of negative return you are fully protected but for each percentage point drop beyond 10% you lose a percentage point). They are typically designed by the whiz kid quants of Wall Street, the same geniuses who gave us the Synthetic collateralized debt obligations and other monstrosities that nearly took down the whole economy. At first glance, structured products may look very enticing; after all, they offer you some upside and a little protection on the downside. What could be so bad about that? Plenty.

Perhaps the very first principle of investing is that there is no such thing as return without risk. No free lunches. In a similar vein to the First Law of Thermodynamics, risk can never be obliterated; it can only be transferred from one party to another. If your broker is offering you a product that promises partial upside of the market with downside protection, you can be absolutely sure that the party that has agreed to take on the downside risk on your behalf is being paid to bear that risk, so the question you should naturally ask is, “Who is paying this party to take on my risk?” The answer, of course, lies in the mirror, but the costs are not transparent. The cost may show up at the end as a much lower return than what would have been received in a boring index fund.

One of the key points to understand about structured products is that they are constructed out of positions in options (both long and short), Treasuries, and sometimes positions in the underlying index itself. The issuer of the structured product, after collecting your payment, will buy these building blocks at a lower price and pocket the difference as immediate profit, after paying your broker his commission. These products are often designed to help the issuers unwind positions that they have due to trades with other institutions. This brings us to a very important point: Structured products carry default risk of the issuing company. Buyers of Lehman Principal Protected Notes have had to swallow this bitter pill. So even though structured products may appear to provide market-based returns, investors in these products are staking their nest egg on the fortunes of one company. Bad idea! An additional problem with structured products is liquidity.

Like all the other products that come out of the “too big to fail” companies of Wall Street, they are not designed in the best interest of investors, and that alone should be reason enough to steer clear. The complex payoff structures of these products are extremely unlikely to meet the needs of any investor, and they have no special magic that allows them to offer higher expected returns with lower risk. Arianna Capital has consistently counseled investors not to be buyers of Wall Street’s dreck. Rather than incurring the hidden costs and risks of structured products, they should favor transparent, risk-appropriate, low cost portfolios of index funds.

Wednesday, October 20, 2010

Government Intervention and Stock Returns

By Arianna Capital

This is a really cool five minute video that explains how the past can give us an insight into the future. It also attempts to debunk the hype about government intervention being negative for stock market returns and your portfolio.

Video - By Weston Wellington
Should equity investors be alarmed by the prospect of greater government intervention in the US economy?

Monday, October 18, 2010

The Hindenberg Omen... Really?

By Larry Swedroe

Whenever the financial media begins touting some new indicator for predicting the direction of the stock market, my voicemail and inbox inevitably fills up. The coverage of the Hindenburg Omen was no different. Let’s look a little closer at this indicator.

The basic premise behind the Hindenburg Omen is that it triggers when an unusually high number of NYSE companies reach 52-week highs or lows. (You can read the full list of triggers at the Hindenburg Omen page on Wikipedia.)

The reason for the panic is that it supposedly has been triggered prior to every market crash since 1987. According to one poster on the Bogleheads site: The Omen has appeared before all of the stock market crashes of the past 25 years. The first observation was August 12, and this has been confirmed by a second Omen on Friday, August 20. On July 6, the Death Cross appeared, in which the 50-day moving average crossed below the 200-day. After a brief rally, the market is now again on a downtrend and the 200-day moving average is rolling over. Is anybody getting scared yet?

So when the indicator was triggered twice back in August, it sent the financial media and talking heads into a frenzy. In an interview with Bloomberg,

Albert Edwards of Societe Generale noted that the indicator may suggest “a savage equity downturn is imminent.” He warned investors: “Equities are tottering on the edge as increasingly recessionary data becomes apparent. It would not take much to tip them over that edge.”

Whenever such stories appear, I remember a tale I wrote about in The Only Guide to a Winning Investment Strategy You’ll Ever Need that shows the value of reading charts and interpreting data.

In 1959, Harry Roberts of the University of Chicago created a series of random numbers with a distribution that would match the average weekly price change of the average stock (about 2 percent). Since the numbers were randomly generated, there was no pattern and therefore no knowledge that could be obtained by studying a chart of this nature. To make his charts look like stock charts, Roberts placed a starting price of $40 on each chart.

Roberts asked the leading technical analysts of his day for their advice on whether to buy or sell these unnamed hypothetical stocks. He told them that he didn’t want them to know the name of the stock, since this knowledge might bias them. Each technical analyst had very strong advice on what Roberts should do, but since the numbers were randomly generated, the patterns were only in the minds of the observers. I’m sure you’ll never hear this story from a technical analyst.

Even though the study was published in the March 1959 issue of the Journal of Finance (certainly embarrassing the technical analysis “profession”), you can still observe technical analysts dispensing advice on CNBC. Unfortunately, investors still act on that advice, even though the advice is only good for entertainment. Taken any other way, it’s dangerous to your financial health.

If Roberts’ experiment still isn’t enough to convince you that technical analysis such as the Hindenburg Omen is essentially worthless, consider this. On August 20, the date of the indicator’s key second confirmation, the S&P 500 Index closed at 1,072. On Sept. 20, it closed at 1,143, an increase of 6.6 percent. (This means the S&P 500 jumped almost 70 percent of the index’s annualized return in just a single month.) By end of trading on Sept. 24, the S&P 500 had risen to 1,149, putting the increase at 7.2 percent.

The only thing scary about such omens is that people actually pay attention to the financial equivalent of astrology.

Thursday, October 14, 2010

Why Wathching the Financial Media May Be a Waste of Your Time

By Larry Swedroe

This year, I wanted to keep track of some of the predictions made by the financial media at the beginning of the year. In April, we noted that there were five big financial predictions made by investors and commentators for 2010:

  • Gold would rise.
  • Bond yields would rise.
  • The dollar would fall.
  • Inflation would be rampant.
  • Real estate was the asset class to avoid.

Here is where things stand right now. (For previous updates, see the links at the bottom of the post.)

We began the year with gold at $1,113. At the close of Sept. 30, it was trading at around $1,309.

Bond Yields
The 10-year Treasury note began the year yielding 3.85 percent, and, like gold, it was unchanged in April. As of Sept. 30, the yield was 2.51 percent.

The Euro began the year trading at around $1.44 and fell to about $1.35 in April. As of Sept. 30, it was around $1.37.

The monthly percent changes in the CPI this year have been: 0.3, 0.0, 0.4, 0.2, 0.1, -0.1, 0.0 and 0.1.

Real Estate
The Vanguard REIT Index Fund (VGSIX) was up about 11 percent April, when I first ran an update. For the year through Sept. 30, the fund was up about 16.51 percent.

The message remains the same: The bottom line is that out of five sure things, only one has so far turned out to be right. And, despite all the problems we have faced this year — economic and political, domestic and international — equity markets around the globe have held up fairly well. Despite all the academic evidence demonstrating you’re best served by ignoring the so-called experts, most investors continue to base investment decisions on economic and political forecasters.

Monday, October 11, 2010

Watch Active Management Fail in Real Time

By Arianna Capital

This is a real analysis done by a prospective client in the Dallas/Fort Worth area in Texas. We thank them most graciously for allowing us to use this real data for educational purposes.

This client was with an active manager who practiced tactical and strategic asset allocation while investing in actively manged funds. As we move through this illustration, I hope you get a real idea as to the detriment most people have to overcome before even breaking even in their accounts when practicing active management. If this account had been properly managed in the beginning, this person could have retired earlier and moved on to other dreams.

This first slide illustrates the returns of an active manger vs our asset class strategy.

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As you can see - it really doesn't look that bad. However, review the next slide to get a better indication of what this truly looks like.

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This shows a much better idea of what happened over the long run. First of all let's look at the returns. The active portfolio means 1 million dollars less than the asset class strategy over time. It also can't keep up with inflation. This really affects a client's future goals, like retirement. Now, if one wanted to learn why this occurs turn to the next slide.

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There is a significant negative affect on a portfolio due to fees and taxes. Active management generates these both in extremes. For these and the multiple reasons we have referred to in our previous blogs like the inability to foresee the future and the inability to pick stocks or time markets.

Investing Biases Can Tarnish Your Portfolio

By Arianna Capital

Biases are no new thing - we have handled them over centuries in religion, relationships, business, and much more. It then comes as no surprise to you that they also exist in investing and can severely harm portfolios. It is not just unskilled investors that have them either - it is even professional financial planners and investment managers. So, learn about them so you can make sure your adviser is positioning you in a way that actually serves to accomplish your goals and bring peace of mind to your life.

It may surprise you to learn, however, that financial losses are processed by the same areas of the brain that respond to mortal danger. As such, it is even more important to have discipline in your plan. Wealth managers and advisers can help add discipline as long as they are not subject to the same reactions.

So, what's the solution. First, become aware of these biases, and make sure your adivser is as well. Second, make sure you have a pre-written plan that identifies your investment time line, your goals, and what is being done to get you there. Third, don't time markets or pick stocks. The third one may seem counter intuitive, but I assure you the loads of empirical research and data prove this active style wrong.

This video can help you become more aware of emotional biases in investing - enjoy!

Thursday, October 7, 2010

No Stars For the Morningstar Rating System!

By Arianna Capital

There are two aspects to Morningstar's rating system. The first one is their star system. This one is based on past performance for active managers. The second one is an analyst forecast for the future.

The first aspect definitely deserves zero stars, and here is why.

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This shows that after an actively managed fund reaches the pinnacle of performance it usually does not do so again.

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The same is true for fixed income. So, the five star rating is definitely misleading for investors who invest using these generally high-cost funds.

Our second aspect of the Morningstar rating system is also flawed, but for a different reason. It has been found, that neither individuals that do it themselves nor analysts at institutions can consistently outperform the market by forecasting the future. This is not surprising, however, here is the evidence.
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Even Morningstar's Director of Research, John Rekenthaler says, "We should have more answers. There is suprisingly little that we can say for sure about how to find top-notch stock funds." And, commenting on whether investors should pay attention to mutual fund advertisements he stated, " be fair, I don't think that you'd want to pay much attention to Morningstar's rating system either."

Tuesday, October 5, 2010

Is Your Manager One of the Best?

By Arianna Capital

Although it would be great if we could all hire above average active managers, that only happens in Lake Wobegon. Superior managers may exist, but most investors might as well be picking their managers at random. This video describes the challenge of differentiating luck from skill, and explain how intense competition among investors makes the problem even more difficult.

Monday, October 4, 2010

Create Your Own Annuity

By Allan Roth

Equity investing is risky, unless you have a real safety net. And I’m not talking about those ugly Equity Indexed Annuities, I’m suggesting building your own safety net annuity, bypassing the insurance company and creating far more tax-efficiency. Here’s how you construct this portfolio, using $10,000 as an example.

CDs are the Foundation
Last week, I wrote about CDs to protect against a possible bond bubble. What’s not to love about being paid more to take on less risk? Then, Jason Zweig, writer of the Intelligent Investor column for The Wall Street Journal, contacted me about using this strategy to build your own annuity, which he wrote about last Saturday in Downside Protection has its Downsides.

How it Works

Using Discover Bank’s 3.25 percent APY 10 year CD, you could put $7,263 in the CD, and the remaining $2,737 in a low cost index fund such as Vanguard’s Total Stock Market Index Fund (VTI). I arrived at the CD amount so that in ten years, the CD would be worth $10,000, or the total amount you started with. Thus, you will get your total amount back even if the S&P 500 theoretically closes at 0.00 points, should the US government still be in business.

The amount you ultimately earn depends upon the stock market return. For instance, another lost decade of flat stocks would still yield a 2.45 percent annual return, while a 10 percent annual market gain would earn 5.51% annually.

The real value of this strategy comes from the psychological impact of being able to stay in the stock market throughout all of this volatility, knowing that you will always get your money back, over the ten year period.

Three Annuity Bonuses

Every annuity salesperson knows that the bonuses are the clincher in getting the client to sign on the dotted line. Well the “build it yourself annuity” actually has three bonuses.
Bonus # 1 - Free interest rate option

By using CDs from institutions that have low early withdrawal penalties, one can pay that penalty and buy a new CD at the higher rate, should interest rates spike.

This could be the case if, for example, after two years the experts are proven right and we have a bond bubble where interest rates spike by three percent. Should this happen, you would make more money by paying the penalty and earning the extra three percent annually. Your returns now look as follows:In this scenario, you get an annualized bonus return of between 1.16 percentage points and 2.03 percentage points. Not too shabby!

Bonus #2 - You pay less income taxes

As good as this deal is looking after bonus #1, it gets even better. Ordinary annuities are taxed at ordinary income. The “build it yourself annuity” has the dividends from VTI taxed at a lower rate (at least for now) and defers capital gains, which will be taxed at a lower rate.

The way to minimize taxes is to open the CD in your IRA account and put the VTI fund in your taxable account. In this way, you end up keeping more of the gain.

Bonus #3 - Free Death Benefit Rider

Finally, should you pass away during this ten year period, Uncle Sam will give you a free death benefit in the form of the step up basis on the VTI, thereby eliminating any taxes paid on the gain.

So where’s the catch?

You may be thinking that this “build it yourself annuity” seems too good to be true. It’s not, but there is one catch. It’s not as easy to construct your own annuity as it is to be sold one.To be sold one, all that is required is to write out a check and sign a document saying you’ve read and fully understood the 373 page disclosure. Without that annuity salesperson driving the time-line and telling you this must be signed today, you have to overcome inertia, a powerful force, and set it up yourself.

Why this isn’t too good to be true

Real Equity Indexed Annuities have high costs and commissions. The “build it yourself annuity” pays no commissions and has a weighted average expense ratio of 0.02% annually, approaching the US Government’s Thrift Savings Plan (TSP) costs.

This strategy doesn’t have the endorsement of the National Association of Fixed Annuities (NAFA), and I’m pretty sure no annuity salesperson will like it either. If these two non-endorsements don’t clinch the deal, I don’t know what will!