Misbehaving

Almost six years ago, I wrote about my interest in the behavioral sciences, especially behavioral economics and finance.  I further mentioned books I'd read on the topic, notably a book titled Thinking, Fast and Slow by Nobel prize winner Daniel Kahneman.

Since then, I've read many other books related to behavior, including three by former poker player Annie Duke (Thinking In Bets, How To Decide, and Quit), and another by a journalist who became a poker player for a year, Maria Konnikova (The Biggest Bluff).  On the more data driven / less fuzzy side were books by Robert Cialdini (Influence) and another co-authored by Kahneman (Noise).

Now I've just finished a book on this topic that I've enjoyed probably only less than Thinking, Fast and Slow.  It's not a particularly new book (2015) by another Nobel prize winner, Richard Thaler, titled Misbehaving.

Thaler was an early collaborator with Kahneman and his longtime research partner, Amos Tversky.  Misbehaving reviews the early, largely ignored stages of behavioral science, and how it eventually grew to become accepted by all but the most hardcore intellectuals.  

Thaler is more widely known now for a later book he co-authored with Cass Sunstein, called Nudge.  While I also enjoyed reading Nudge (to the point I gifted it to clients), Misbehaving provides many more examples of how people will respond differently to a given set of facts, depending on how those facts are phrased.  This was a prime writing / teaching method of Thinking, Fast and Slow.

Here's one example:

600 people are sick from a disease, and a choice has to be made between two policies:

Would you rather take

A) policy will save 200 people for sure

B) policy will offer a 1/3 chance at saving everyone, but a 2/3 chance of killing everyone

Alternatively, would you rather take

C) policy where 400 people will die for sure

D) policy where there's a 1/3 chance of killing no one but a 2/3 chance of killing everyone

Logic demands that we take either A and C, or B and D, because they are effectively the same thing. But in group tests of this, we don't always do that, because we are not always rational beings.  We also care about things like what seems right, instead of just the logical.

The book reviews the decades-long conflict between the data-only 'econs' and the non-conforming behaviorist 'humans'.  Knowing about this conflict, and the sometimes illogical 'misbehavior' that humans follow, can be a very important advantage to those in a particular field.

Misbehaving has a large section on how this applies within the investing world, so if you're interested in that sort of thing (like me), read it!  Or as I said six years ago, don't read it, and I'll use it to my advantage.

Post #400

This is my 400th blog entry since I started it almost 10 years ago(!)  (I'll have to throw a party in July when the actual 10th anniversary arrives.)  I'm going to do what I've done in past 'century' posts, which is to review some of what I wrote about since my 300th entry.  The time gap between the 300th and 400th is going to expose how I don't write as much as I used to -- it's taken me twice as long as the prior 100.

I wrote about several recurring annual topics, including the Berkshire Hathaway Annual Meeting (soon to be post #410), my advice to graduating seniors, RAGBRAI musings, and things for which I'm not thankful. 

I wrote about how smart people have many advantages in the world, but are disadvantaged by a lack of numbers, and so many stupid people holding them back.

I wrote about new cities and regions of the country I visited, including attending the Rose Bowl.

I wrote about how great social media technology and platforms could be, if not for the all of the people who use social media for evil and not for good.

I wrote more about our country's slow, inexorable march toward decriminalization and legalization of marijuana, which can't come soon enough.

I wrote a few more times about financial issues, and starting my own firm.

I wrote a handful of times about great songs and songwriters, a dying breed with the exception of a few hip-hop and country artists, to which I rarely listen.

Nearly 100 entries apart, I wrote about my observations at the funerals of my father and mother.

I wrote about how religion separates people (and in many cases, harms people) at least as much as it brings people together.

I wrote about the dysfunction and hatred of this decade's politics and politicians, which is in many ways related to the last item.

I wrote about how today's baby boomer parents are ruining not only their kids' lives, but society in general, with their awful parenting.

I wrote a few items of self-reflection, on what happened in the past, and what I might do differently if I knew then what I know now.

400 posts.....bring on the next 100!

A Taxing Occupation

It’s tax time, meaning more work for me both personally and professionally.  This year more than ever, I find myself talking to – and about -- tax preparers.

Tax preparers are a little bit like financial advisors, in that some are better than others, and credentials matter.   If you need help doing taxes, you probably get what you pay for.

Alternatively, though, most tax preparers are alike in one major way.  That is, they are concerned with minimizing their clients’ taxes in the current year.  Seems like a good idea for everyone, right?

The thing is, not everyone should be worried about minimizing taxes now; they ought to be worried about minimizing taxes later.  While always subject to change, it’s a fact that the current tax law expires in 2026.  Without changes, this means tax rates will go back to the higher 2017 brackets.

In this environment, tools like a Roth IRA can be of great use, where you pay taxes now in return for not paying taxes later.  Unfortunately, when tax preparers do suggest an IRA, it’s almost always a traditional IRA, since they want the immediate tax deduction.

Part of this is that some tax preparers are compensated in part by the amount of refund they generate.  Gosh, imagine that, doing something that’s better for them than for the client.

This is why many people would be better served by a credentialed, fiduciary, financial / tax planner instead of the run-of the-mill tax preparer. 

Thinking, Fast And Slow

For the past month or so, I've been concentrating on reading books and articles broadly related to behavioral science.  More specifically, I'm interested in how and why people make the decisions they do, with a concentration on macro-economics and finance.

This is a field I've been interested in for some time.  Over the years, I can think of several books I've read that are generally related to behavioral science.  These include the Freakonomics trilogy of books:  Freakonomics, Superfreakonomics, and Think Like A Freak, by economists Steven Levitt and Stephen Dubner.  (In the past year I've also become a regular listener to the Freakonomics podcast, which has kept me interested during thousands of miles of travel.)

I'd also include the books The Tipping Point and Blink by Malcolm Gladwell in that list.  Those books are more about social science, but they provide real insight about way people behave the way they do.

The most recent book I've read is called Thinking, Fast And Slow by Daniel Kahneman, who previously won a Nobel Prize in Economics.  I thought the book would be good, but it was better than good.  It was a tour-de-force about how our brain works, and the many biases that affect it.

How the brain works is basically a matter of two 'systems' that Kahneman called System 1 (instinctive and emotional) and System 2 (deliberative and logical).  But after a few chapters about the science of that, the rest of the book focuses on psychological aspects of thinking -- the cognitive biases.  These include terms / effects like loss aversion, framing, anchoring, overconfidence, and sunk-cost theory.

Once you read about what these biases are and how they affect thinking, it becomes clear how economic / financial decisions (or are they gambles?) are made and why.  This is a good thing to know for me, both personally and professionally.

Thinking, Fast And Slow by Daniel Kahneman.  Read it.  Or don't, then I'll use it to my advantage.

2017

It's time for my annual review of the list of things I wanted to happen the prior 12 months, and give my list of things I want to occur in the next 12 months.  Here's the 2016 list, with comments in ALL CAPS:

-At least some progress, not regress, on medicinal marijuana legalization in Iowa.
NOPE TO DOPE AGAIN, BUT AT LEAST THERE WAS A BILL ON WHICH TO VOTE.

-Chris Christie versus Hillary Clinton for president, with ? winning.
HILLARY LOST THE PRESIDENCY, WHILE CHRISTIE LOST HIS POLITICAL CAREER.

-A higher stock market.
AFFIRMATIVE, BUT IT DIDN'T LOOK GOOD ON FEBRUARY 1ST.

-Just one actual, even very minor piece of legislation to make it slightly more difficult to buy a gun.
DESPITE MORE VIOLENCE, WE'VE NEVER BEEN FARTHER FROM THIS HAPPENING.

-The personal, financial, and political implosion of Donald Trump.
THE OPPOSITE HAPPENED THIS YEAR, BUT IT WILL EVENTUALLY HAPPEN.

-A way to charge devices without a wire.
NO, BUT WIRELESS HEADPHONE HAVE GONE MAINSTREAM.

-An à la carte option for cable and satellite TV channels.
THANKS TO PRESSURE FROM STREAMING SERVICES, SEEING SMALL PROGRESS.

-More time for eating right, less time for exercise.
ENDED UP DOING MORE OF BOTH, WHICH WAS A GOOD THING.

For 2017 I'd like to see:

Again:  At least some progress on medical marijuana in Iowa,

Some type of institutional or legal control over fake news / social media.

Related to the above, more critical thinkers, fewer idiots who believe everything they hear.

GPS technology used in major sporting events, e.g. to mark the ball in football games, and for the strike zone in baseball games.

More working from home by me.

The return of popular mainstream rock bands and rock music.

Implementation of the fiduciary rule, and the demise of commission-based financial advice.

The resignation or impeachment of an unqualified president -- no names, any one will do.

Saying No To The Book

I'm a financial planner.  I've been doing this for going on 10 years now, after more than 20 years of working for financial organizations.  I have great clients and my practice has had great growth, at least by my standards.  I'm content.

But based on the writings of many successful financial planners ('the book' as I call it), I should be trying to ramp up by adding staff and other advisors, and marketing more heavily.  I need to turn my financial planning 'practice' into a 'firm' and if I don't, I'll be ruined.  I'm supposedly not doing it right.

The thing is, based on 'the book' I shouldn't have been able to build a fairly successful practice.  If fact, if I hadn't followed 'the book' when I first became a financial planner, I'd believe I'd be much better off now than I am.  (It's occurred to me more than once that perhaps one of the reasons 'the book' says to add staff is, the so-called successful advisors who wrote it weren't smart enough to know how to do their own paperwork, or make their own decisions.)

So I have two possible paths now.  One, to slow down growth, and enjoy the practice and the balance it provides to my life.  Or two, pursue more growth, probably make more money, work longer hours, and end up managing other support staff, advisors, and the headaches that go with a large firm.

Choosing option #1 is easy for me.  My kids are grown and independent, and I live a comfortable if not affluent life. My focus is much more on health and having time to enjoy life more.  I want my practice to be something I can and want to manage.

It's easy for me to ignore 'the book' now, to say yes to life, and no to more money and more work.  The hard part was knowing when not to listen to what people / 'the book' tell you to do.

Saving Investors From Themselves

One of the smartest financial journalists I follow is Jason Zweig.  He isn't a media darling, but he's fairly well-known for writing a column for the Wall Street Journal, and he's also authored books and operates his own web / blogging site at jasonzweig.com.

I was looking at his blog archive recently, and came across a gem from three years ago called, "Saving Investors From Themselves."  He's writing about financial journalists, but he could just as well be writing about financial advisors.

Here's an excerpt -- if you don't want to read it all, at least read the last sentence.

I was once asked, at a journalism conference, how I defined my job.  I said:  My job is to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself.

That’s because good advice rarely changes, while markets change constantly.  The temptation to pander is almost irresistible.  And while people need good advice, what they want is advice that sounds good.

In practice, for most of the media, that requires telling people to buy Internet stocks in 1999 and early 2000; explaining, in 2005 and 2006, how to “flip” houses; in 2008 and 2009, it meant telling people to dump their stocks and even to buy “leveraged inverse” exchange-traded funds that made explosively risky bets against stocks; and ever since 2008, it has meant touting bonds and the “safety trade” like high-dividend-paying stocks and so-called minimum-volatility stocks.

It’s no wonder that, as brilliant research by the psychologist Paul Andreassen showed many years ago, people who receive frequent news updates on their investments earn lower returns than those who get no news.  It’s also no wonder that the media has ignored those findings.  Not many people care to admit that they spend their careers being part of the problem instead of trying to be part of the solution.

My job, as I see it, is to learn from other people’s mistakes and from my own.  Above all, it means trying to save people from themselves.  As the founder of security analysis, Benjamin Graham, wrote in The Intelligent Investor in 1949: “The investor’s chief problem – and even his worst enemy – is likely to be himself.”

From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics:  Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.

But humans perceive reality in short bursts and streaks, making a long-term perspective almost impossible to sustain – and making most people prone to believing that every blip is the beginning of a durable opportunity.

My role, therefore, is to bet on regression to the mean even as most investors, and financial journalists, are betting against it.  I try to talk readers out of chasing whatever is hot and, instead, to think about investing in what is not hot.  Instead of pandering to investors’ own worst tendencies,  I try to push back.  My role is also to remind them constantly that knowing what not to do is much more important than what to do.  Approximately 99% of the time, the single most important thing investors should do is absolutely nothing.

Fiduciary Rules!

Within the next few months, the U.S. Department of Labor is expected to release final rules that will impose a fiduciary standard of care on financial advisors (including insurance agents) working with qualified retirement employer-sponsored plans and individual retirement accounts.  While I'm generally against more regulations, this happens to be of the best and most overdue pieces of federal rule-making ever.

First, let’s clarify the two different rules under which financial advisors currently operate.

Suitability Standard of Care
Most financial advisors, including financial company representatives and insurance salespersons, operate under the suitability standard of care.  Generally speaking, the suitability standard simply requires the advisor to 1) know the client and their financial situation, and 2) recommend products that are suitable for their situation.

Fiduciary Standard of Care
Some financial advisors, including Certified Financial Planner® professionals, must operate under the fiduciary standard of care.  Under this standard, advisors must 1) put the client's best interest first; 2) act with prudence, meaning with the skill, diligence and good judgment of a professional; 3) provide full and fair disclosure of all important facts; 4) avoid conflicts of interest; and 5) fully disclose and fairly manage, in the client's favor, unavoidable conflicts.

While the general public often assumes financial advisors are working in the client’s best interests, in fact, most are not bound to do so.  The new Labor Department rules would change that, making the fiduciary standard the actual standard in financial advising.  It boils down to every advisor following the highest standard of care regarding investment advice and retirement planning.

Seems like a slam-dunk, right?  In truth, large financial institutions (particularly insurers) are spending millions in a lobbying effort to stop the rules from being codified.  There is only one viable reason for this:  Greed.

Big financial institutions use the fecklessness of the suitability rule to sell lots of useless financial products to trusting people who don't need them, thereby capturing huge commissions and other fees.  This is great for the company, while simultaneously terrible for everyone else.  In short, those companies value profits over people.

Let's just hope this fiduciary rule regulation is made final, and comes with the enforcement it deserves.

Be Greedy When Others Are Fearful

“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful."  --Warren Buffett, October 2008

This quote about investing in stocks may be many years old, but it applies like new based on the last 10 days of stock market trading.

A downturn in the investment marketplace creates a natural fear for even the most experienced investor.  When something is cutting away at our net worth, we want to stop it as soon as possible.  We want to do something.

Here’s the problem:  Leaving the markets in that environment is generally a bad idea, because it’s done out of fear.  People make the biggest investment mistakes when they’re fearful.  It’s even more powerful than greed, and there's proof.

Daniel Kahneman is a research psychologist, but he won the 2002 Nobel prize in economics for his work in an area now referred to as behavioral economics.  His research reveals that the response to a price drop generates a much stronger emotion than a response to an equal price gain.  In short, he found that most people fear loss much more than they enjoy success, and this makes fear a powerful enemy of an otherwise level-headed investor.

If we feel the urge to reduce our stock or bond allocation during a market downturn, our challenge is to recognize Kahneman’s observation.  We need to remember that we picked our asset allocation target during a period when we weren't emotional, and did it for good reason.  We must also remember that short-term market movements are of little-to-no consequence if we have a long-term investment horizon.

That said, we should do something during a big market correction -- but not leave the market.  Rather, we should rebalance to our pre-chosen allocation target, effectively buying more stocks or bonds at a time when we may fear it most.  Then later, when those markets inevitably recover, we should try to enjoy our success more!

No Thanks Necessary

Your investments had a great 2014, or so it appears.  Your portfolio went up over 15%, and now you want to go out of your way to thank your investment advisor.

Instead, you ought to be looking for a new advisor.  If your portfolio went up that much last year, it means virtually all of your money was invested in U.S. stocks.  In turn, that means your advisor did not focus on something that should have been of equal concern: Risk.

No doubt, U.S. stocks performed well last year -- but what if they hadn't?  History has taught us that no one can accurately predict the short-term direction of the investment marketplace.  No one, investment advisors included, knows exactly when the market will go up or down, or when to jump in or out.

So managed properly, your investment portfolio would include more than just U.S. equities.  It would include other asset classes whose returns don't always move in the same direction, nor with the same volatility, as the overall domestic stock market.  These risk-diversifying assets would include things like corporate bonds, international stocks, government bonds, and real estate.

Last year, most of these 'non-correlated' asset classes did not perform as well as the U.S. stock market, and if you had them in your portfolio, they reduced your overall return.  However, those assets also substantially reduced your risk of having a horrible year, from which it could take many years to recover.

If your investment advisor had focused on risk as well as performance, then it was mathematically improbable to generate a 15% return in 2014.  They deserve no thanks.

Good investment advisors, and you, should focus instead on risk-adjusted return.  You may not have huge shorter-term investment gains, but more importantly, you'll likely avoid huge losses.

Insurance = Bad Investment, Redux

I've covered this before:  Generally speaking, insurance is a bad investment.

Last week, I got into a prolonged, disagreeable phone conversation about a mutual client with what I consider to be the lowest form of 'financial advisor' on the planet:  A career life insurance agent.  Here's my open letter to him:

What gives you the right to call yourself a financial advisor?  You have one strategy -- convince everyone that their financial situation can be helped with some type of life insurance product, including (and especially) variable and indexed annuities.  Isn't it interesting that these these products generate big commission payments to you?  Never mind that your client pays well over 2% and probably closer to 3% of their 'invested' money every year in expenses to help pay those commissions, a fact you don't audibly disclose.  Never mind that you have little or no expertise in retirement, investment, or tax planning.  Never mind that you don't live by a fiduciary standard, you live by making your insurance company quotas.  You either don't know, or don't care, that not everybody needs life insurance.  In fact, you want people to believe that it's perfectly normal to buy enough life insurance to cover all the income they might make in the future -- a 'future value' approach that makes absolutely no sense, and profits nobody except you and your company.  You are a self-serving loser, and you suck.

This letter doesn't apply to every career insurance agent, just most of them.  As a certified financial planner, I do everything in my power not to be closely associated with them.  Actually, that's a financial strategy that would help everyone!

Yes Means Yes

When our kids were little, and said 'yes' to something we asked, we usually threw in a reminder that 'yes' meant something.  Specifically, it meant a promise, and a person doesn't break a promise.

Unfortunately, some people don't live up to this verbal contract / moral obligation.  Even more unfortunately for me, when this happens in my line of work, that results in a monetary loss.

I'm a fee-only financial planner.  When I first meet with prospective clients, it's typically a fact-finding mission coupled with a trust-building conversation.  I'm asking them what they need, and they're asking me what I do,

Occasionally, this Q & A evolves into the prospect asking a number of specific questions about their situation, basically poking around for free advice.  I have no problem with that, but before it goes far I ask them for a commitment.  This is where it gets real.

Every so often, I'll get the 'yes' from the prospect, and we'll go on to have lengthy conversations about their situation.  Often, I'll put together a more formal presentation, at no cost to them.  Of course, this does cost me, but at this point, I'm relying on the 'yes' that a will eventually be collecting a fee from them.

In the past month, two of these 'yes' folks have called me after I'd done this work, and told me that they were going to work with someone else.  As you might expect, they suddenly disclosed they have a friend or family member who does this kind of work.

So basically, they lied to me to get something they wanted.  Ironically, they had both previously disclosed to me something that suggested they were faith-based.  When people do that in a voluntary manner, any discomfort I may have is overshadowed by the comfort I have in thinking their word will be their bond.

I'm glad to say, these situations happen infrequently -- I can only think of one other time in the past couple of years.  That's good, because working for free isn't something I want to do.

Those who say 'yes' when they have no actual intent to commit are intellectually dishonest, at the least.  At the most, they are freeloading liars with no moral compass.

Even my children know that.

A Working Model

In the investment business, there are three basic models that firms utilize to deliver investments and/or advice to their clients.  They don't all work well for investors.

Let's start with the commission model.  In this model, the advisor (known as a 'Registered Representative' of a 'broker-dealer' firm), is compensated for the investments that are utilized.  Many securities, including virtually all annuities and life insurance, are sold this way.  Those commissions pay the advisor an up-front, often substantial amount, which the investor ultimately repays directly or indirectly via account deductions.

Another model is called fee-based, and it's essentially the commission model with a twist.  That is, these advisors usually have licenses which also allow them to give advice for a fee, in addition to their Registered Representative licenses. These dual-licensed advisors are called fee-based, because they can provide investment advice for a fee, but they primarily continue to utilize commission-based compensation for making a sale.

The third model is the fee-only model. Practitioners of this model are licensed as Investment Advisor Representatives (IAR) of a Registered Investment Advisor (RIA).  Many of them also have attained the Certified Financial Planner® professional designation.  The term 'fee-only' acknowledges that they are only compensated by the transparent, negotiated fees (not unspecified commissions) their clients pay.

Unfortunately, most advisors aren't fee-only, even though that model makes the most sense for those seeking help.  Consider the possible conflict of interest when a commission-based advisor sells an investment product -- can the investor truly know if the size of the commission impacted the sale?  By not receiving commissions for the investments recommended, a fee-only advisor eliminates this uncertainty.

Also, since commissions are paid up-front, what is that advisor’s incentive to provide ongoing client-service?  Fee-only advisors charge a flat amount, or a percentage based on the assets they manage -- but in either case, it isn't paid until AFTER the work is done.  Since this fee is only a fraction of the commissions that would otherwise be paid, the fee-only advisor must continue to work diligently, as the client can end the relationship at any point.

I am a fee-only advisor.  I remove the conflicts of interest that could otherwise exist between investors and advisors, because our interests are the same.  That shared interest shapes how we interact, to create and maintain the trust needed to successfully work together.

A Fitness Problem

Central Iowa has a fitness problem.  But not like you might think.

In the next few weeks, LifeTime Fitness is going to open a huge franchised health club in suburban Des Moines.  This is the latest of many other large 'full-service' fitness facilities in the metro area, including Prairie Life Fitness, Seven Flags Fitness, Aspen Athletic Club, Fitness World West, plus several newer YMCAs that exist in and around the city.

In the meantime, we have a variety of other not-quite-full service health facilities, such as Planet Fitness or CrossFit Des Moines.  Of course, we also have a bunch of 24-hour self-service options, like Anytime Fitness or Snap Fitness.

We also have all kinds of other wellness entities (some with multiple locations and many locally-owned) that actually exist for various boutique exercise classes, including Farrell's Extreme Bodyshaping or Kosama, to name two of more than 20.

So in a metro area of about 300,000, we are overrun with health clubs.  Unfortunately, we are not overrun with healthy looking people.

This begs the question, how do all of these fitness facilities make enough money to exist?  The only logical conclusion I can come up with is, this is an industry that is given money in return for nothing.  Think about it -- thousands of people pay monthly and/or annual membership fees to partake in the venue and/or classes, and then inevitably many of them never actually show up.

This is clearly a great business model, offering a pre-paid service that is never actually performed, with no guarantee of a better outcome.  As a fee-based financial advisor, the cynical side of me would say this business model is a lot that of a commission-based financial advisor!

In the end, not all of these fitness places are going to make it.  That's good, because later this year I'll be looking to buy some excellent used exercise equipment.

(Un)American Pickers

First, a lesson on stock dispersion in investing.

Low stock dispersion means that stocks are generally moving in the same direction. High stock dispersion means that individual stocks are headed in more unpredictable directions, as has been the case so far in 2014.  While the so-called financial experts are always calling it a ‘stock picker’s market’ (because they make money on trading), they are louder about it during those periods of high dispersion.

If stocks have low dispersion, presumably an active stock picker should find it more difficult to beat a relative benchmark index.  Conversely, when stocks are acting more independent of one another, there should be more opportunity for skillful (or lucky) investors to outperform.  Of course, there is also a greater opportunity for the less skillful (or unlucky) investor to underperform.

A new study titled Dispersion:  Measuring Market Opportunity, by S&P Dow Jones, suggests there is no evidence to support the notion that stock picking is easier or better done when there is wide dispersion among individual stock returns.  In fact, the data suggest the probability that actively managed mutual funds will outperform the market (already a less than 50% chance after expenses) is no higher during periods of high dispersion than low dispersion.

It all makes sense.  Why should a greater percentage of active fund managers outperform during periods of high dispersion?  Their skill doesn't suddenly increase during these periods.

Money managers who masquerade as financial advisors have lots of marketing ploys they use when promoting their services, and saying it’s a ‘stock picker’s market’ is among the most used.   But the truth is the same as always – there’s no extra benefit to the guesswork of active management.   Use a passive, index-type approach to investing, and you’ll be farther ahead in the long run.

How To Lose Money In The Market

Do most mutual fund managers add value in their attempts to identify 'mispriced' securities? 

Based on a recent analysis of the CRSP (Center for Research in Security Prices) Mutual Fund Database returns data through 2012, we have a pretty good idea of the answer.

This CRSP report documents survivorship and performance in the U.S. mutual fund industry, and illustrates the negative impact of high fees and turnover on returns.  In summary, for the periods examined:

*Outperforming funds were in the minority
*Strong track records failed to persist
*High costs and excessive turnover may have contributed to underperformance

The underperformance among mutual funds points to an important guiding investment principle:  Choosing a long-term winner involves more than seeking out funds with a successful track record, since past performance offers no guarantee future success.  Investors must consider other variables, including a mutual fund’s underlying market philosophy, investment objectives, and perhaps most importantly, cost. 

The competitive landscape makes the search for future winners a formidable challenge. Confronted with so many fund choices – and lacking an investment philosophy to guide their search – some investors resort to picking funds that have strong track records, reasoning that past outperformers will continue to outpace their benchmarks.

According to the CRSP analysis, only about a quarter of the equity funds with past outperformance during the initial three-year period (2007-2009) continued to beat their benchmarks in the subsequent three-year period (2010-2012).  The results for funds with good five- and seven-year track records were similar – only about a quarter beat their benchmarks in the subsequent period.

So, do most mutual fund managers add value in their attempts to identify 'mispriced' securities?  This CRSP analysis of U.S. mutual fund industry performance tells us the answer is a resounding, "No!"  It’s more proof that a broad, low cost investment approach is the best one.

How To Win A Coin Toss

If you were told your odds of investing success were no better than a coin toss, how would you react?

Standard & Poor's recently published an annual year-end scorecard, called the Standard & Poor’s Indices Versus Active (SPIVA) report.  SPIVA compares the performance of active mutual funds versus their respective benchmark indices.  Not surprisingly, the results continue to favor the indices.

For the 5-year period ending December 31, 2012, 79% of actively managed U.S. equity funds failed to beat their benchmark index.  The percentage that failed for international equity and fixed income funds were 66% and 69%, respectively.  Put another way, the odds of picking an active fund that outperformed its benchmark were less than successfully calling a coin toss!

Unfortunately, these results do not fully paint the picture of active management's underperformance.  SPIVA’s return measurements do not take into account significant fees that most active mutual funds charge.  Additional costs include management expenses, commissions, and marketing fees, all of which further reduce returns.

This is another of a multitude of studies that reach the same conclusion:  Investors expose themselves to additional market risk from active managers' attempts to outperform a given benchmark – risk that is not compensated by higher returns.  Further, the higher costs associated with active mutual fund investing make the probability of outperforming the market extremely unlikely.

I have always advocated a different approach to investing, one that acknowledges what SPIVA confirms.  Specifically, allocating and owning a portfolio of passively managed, tax efficient, and low cost funds allow investors to capture the most that capital markets provide year after year.

Investors’ assets should not be left to chance.  By using a passive investing strategy, you can markedly and consistently improve the odds of investing success beyond the toss of a coin.

Post #200

Since July of 2009, I've been writing random thoughts out in this blog.  This is post #200, so just as I did with post #100, let's review some of what was covered in the last 100 posts, or basically the past two years.....

I spent a little time writing about the importance of certain singers and song lyrics.

I spent some time writing about finance and investing, which is the work I do for a living.

I spent a good deal of time writing about politics, particularly in 2012 as related to the presidential election.

I spent a bunch of time writing about people who are dishonest, how to identify them, and calling them out.

I spent too much time, but will probably spend more, writing about the moral hazards of religion.

I spent a lot of time, and will definitely spend more, writing about how taxpayers are being shafted by people in government who make selfish decisions.

(Un)conventional Thinking

One of the simplest and most common questions asked of investment advisors is, "What stock should I buy?"  Another frequent request is, "Where do you think the market is going?"

Although these questions ask different things, they share something in common – they are asking someone to make a forecast.  The conventional thinking is, in order to have a successful investment experience, advisors and investment managers should be able to predict the future.  Just pick the investments that will do well, and avoid all the others, right!?

Unfortunately, man versus market isn't a fair fight.  More often than not, the market is going to win.

Identifying investments that have outperformed in the past is easy, but there is no way of determining what will outperform in the future.  While some fund managers are going to ‘beat the market’ from time-to-time, a mountain of academic research tells us it’s no more than you would expect by chance.  In other words, the market always has investments that will do well, but there’s no logical way for man to determine which ones they will be.

So instead of trying to predict the future, I think about this instead:  In the aggregate, investors earn market returns before fees. Since the market reflects the collective holdings of all investors, the value-weighted average investment experience must be the market return after fees.  This is not just a theory; it is a universal truth based on simple arithmetic.

This arithmetic gives me something reliable – rather than a prediction – from which to base investment decisions.  Specifically, if I broadly diversify investments based on client risk tolerance, and keep investment costs to a minimum, I have significantly increased the likelihood of an above-average investment outcome.

Making investment decisions based on this logic certainly isn’t glamorous.  It would be much more exciting to declare which individual stocks I ‘like’ based on a hunch, and then regularly update that list.  Still, I vastly prefer our more reasoned approach.

Investors may never lose the urge to form an opinion about the future, or to ask their advisor for one.  But if those investors ask me, they should expect to hear some unconventional thinking.

The Liars Club

As we enter the heart of election season in presidential election year, so do we enter a time when the rhetoric is at an all-time high.  If only it was just rhetoric.

These days, we don't have rhetoric, which would be fairly defined as persuasive but insincere speech.  Instead, we have intellectual dishonesty, which I would define as a failure to apply a rational standards that one is fully aware of.

(Yes, I got those definitions with the help of the internet, defined as a place from which you can get information to help prove your point.  Also, don't confuse these terms with another one of my favorites, 'truthiness', coined by Stephen Colbert as something people claim to know intuitively because it feels right, in the gut, without regard to the facts.)

Intellectual dishonesty is what political campaigners (and most people) engage in these days.  It's when a person knows but ignores the facts, and says or does something contrary to those facts in an attempt to convince people otherwise.  Let me use it in a sentence: "Every word that comes out of Michele Bachmann's mouth has the smell of intellectually dishonesty."

While this kind of thing obviously happens in politics, but just think about the day-to-day applications.  What workplace doesn't have one or more employees who aren't as sharp as their co-workers, but tries to cover up their shortcomings by skewing the truth, and parsing the blame onto others?  And don't get me started on the so-called 'financial advisors' who spend their days selling products to people who don't need them, in order to get a big commission.

Intellectual dishonesty is the same as lying, and it is currently pervasive in our society.