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.