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.

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.

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?

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.

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.)

Gold
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.

Dollar
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.

Inflation
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.

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!