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!

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, "...to be fair, I don't think that you'd want to pay much attention to Morningstar's rating system either."

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.

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!