Notes, Views, & Occasional Provocations Regarding Investments & Personal Finance

In the wake of Bernard Madoff and other financial-advisor scandals coming to light these days, people are understandably asking, Who can they trust for financial advice?  Unfortunately, there’s no professional certification, credential, or academic pedigree that can really help consumers answer this question to full satisfaction.

So what else can you rely on?  ”Intuition” or “gut instinct,” say some.  But there are perils here, too, as some recent research suggests about what kind of advice sells.  In “Humans Prefer Cockiness to Expertise,” the New Scientist reports:

The research, by Don Moore of Carnegie Mellon University in Pittsburgh, Pennsylvania, shows that we prefer advice from a confident source, even to the point that we are willing to forgive a poor track record. Moore argues that in competitive situations, this can drive those offering advice to increasingly exaggerate how sure they are. And it spells bad news for scientists who try to be honest about gaps in their knowledge.

It spells bad news, too, for our efforts to rely on instinct or intuition when attempting to assess the quality of financial advice.  What we perceive as a “good feeling about someone” may merely be our “bias for confidence” masquerading as a weightier insight.

Hat tip to Abnormal Returns for the New Scientist article.

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As of Friday, the S&P 500 Index has risen 31% above its March 9th low.  (Actually, it rose higher than that at one point, but gave back 5% last week.)  It’s been a magical rally — the kind we often see immediately following a bear market — but has it been built on magical thinking?

Charts like the one below suggest this might be the case.  It shows 12-month reported earnings for the S&P 500 Index since 1936, and two things stand out:  (1) the past 20 months have seen by far the steepest earnings drop since the data has been recorded; (2) earnings have fallen back to levels not seen since the Great Depression.

Yes, the stock market is typically a leading indicator, anticipating economic growth by six to nine months. But with reported earnings for the companies in the S&P 500 Index about to turn negative for Q3 2009 (thus playing havoc with P/E ratios because of the negative denominator), it’s hard not to think the market may have gotten ahead of itself in recent weeks.

None of this should matter for long-term investors with decades not just years ahead of them. But if you’ve been kicking yourself for not rebalancing or investing new cash back in March, you can stop now.  The pendulum could easily have swung further the other way; and it might be headed back in your direction as we speak.

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The calamitous market events of recent months have understandably caused a lot of investors, both institutional and individual, to question the soundness of their investment strategies.  In fact, I think it’s fair to say that the only investors who are not asking questions and trying to learn from last year’s extraordinary (though precedented) events are either dead or grossly incompetent.

But if you’ve built your portfolio upon time-tested principles of diversification and your portfolio at least survived last year to thrive another day, your strategy is probably entitled to a strong presumption in favor of staying the course.  Switching course itself could introduce a whole new level of risk that might produce its own dire consequences.

An excerpt from a 2007 New York Times profile of hedge-fund manager John Seo illustrates this point:

As a boy, John Seo learned everything he could about the Titanic. “It was considered unsinkable because it had a hull of 16 chambers,” he says. The chambers were stacked back to front. If the ship hit something head on, the object might puncture the front chamber, but it would likely have to puncture at least three more to sink the ship. “They probably said, What are the odds of four chambers going?” he says. “There might have been a one-in-a-hundred chance of puncturing a single chamber, but the odds of puncturing four chambers, they probably thought of as one in a million. That’s because they thought of them as independent chambers. And the chambers might have been independent if the first officer hadn’t gambled at the last minute and swerved. By swerving, the iceberg went down the side of the ship. If the officer had taken it head on, he might have killed a passenger or two, but the ship might not have sunk. The mistake was to turn. Often people associate action with lowering risk or controlling risk, but experience shows more often than not that by taking action you only make the risk worse.”

Hat tip to Keir Oxley at Double Bay Management & Planning for the article.

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Did you ever see a basketball game where a defender swiped the ball from the point guard, ran the length of the court, and then missed the layup?  It’s painful to watch.

That’s how I felt reading an article from Slate.com that’s circulating around the net called The End of Personal Finance.  The article raises an important point about how betrayed many people feel by the current financial paradigm in which they attempt to accumulate wealth during one half of their adult lives in order to support themselves during the other half without additional wage earnings.  Unfortunately, the author doesn’t do much with this point other than to run around the court in several directions, apparently unconcerned with where the basket might even be located.

What makes the article a little dangerous, though, is that it wraps important truths within several misleading arguments.  For example, the writer notes correctly that many people underestimated the risks of stocks, in part because of encouragement by the financial-services industry to buy them.  True enough.  But her proposed alternative is not a diversified portfolio of financial assets, or even to avoid risky assets altogether. Rather, for her the answer is gold.  Why?  Because it’s had a great run the last several years.  

Talk about replacing one idol with another . . . .

The author also blames the “personal-finance” industry for having encouraged a false belief in self-reliance.  It’s an interesting point and one I wish she would have explored.  But ever since Americans began settling the West under the doctrine of Manifest Destiny, and even well before as writers such as Henry David Thoreau articulated, the notion of self-reliance has been central to American identity.  The personal-finance industry had nothing to do with creating this belief.  All it did was recognize the truth that any marketer knows:  people love a good story that confirms what they’d like to hear.

Don’t get me wrong.  I can talk about the problems with the personal-finance industry for hours. But this article’s great start down the court ended in a giant air ball.

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Most people I’ve talked to about the recent flu pandemic feel that the media has blown the news – “as usual” — way out of proportion.  Perhaps.  But judging from the print articles I’ve read (haven’t seen much televised news), I’m not seeing that.  So even if this flu pandemic runs its course without many more deaths, I’m left wondering:  could too many media cries of wolf over the years on various topics — Y2K, SARS, etc — have made us too complacent about a virus this time around?

Yale Professor Robert Shiller wonders the same thing this week about people’s reaction to the recent economic shock.  In Depression Scares Are Hardly New, he notes:

The popular mood has a huge impact on the economy, so it’s worth noting what many people seem to forget: Depression scares come and go. And by one authoritative measure, the current outbreak of concern has been surprisingly mild.

According to a well-respected survey by the University of Michigan, people are a lot less concerned with the current economic shock than they were with the Arab oil embargo in 1973-74 or the deep recession several years later.  Why?  Professor Shiller acknowledges he can only speculate, but even his speculations seem a bit lost as he suggests possible explanations for the lack of concern.

I think the lack of concern might simply be a fundamental disconnect between what people are reading and seeing on t.v. and what many of them are experiencing in their own lives.  As a client put it, “I watch CNN and get completely depressed.  But then I walk around town and talk to people and everyone seems fine.”

Or perhaps we really have entered a new age, bred in part by our neverending access to countless data streams:  the Age of Complacency, led by the So-What? Generation.

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Last year, in our November/December newsletter, we took a look at how quickly globally diversified portfolios can recover even after severe bear markets.  The chart below summarizes the results, and you can see the portfolio compositions in footnote 1 of the newsletter itself.

Market Recovery Times for Three Portfolios

This weekend NYT columnist Mark Hulbert took a similar look at the recovery of U.S. equities after the 1929 Crash, in 25 Years to Bounce Back? Try 4½.  He notes:

Historical stock charts seem to show that it took more than 25 years for the market to recover from the 1929 crash — a dismal statistic that has been brought to investors’ attention many times in the current downturn.

But a careful analysis of the record shows that the picture is more complex and, ultimately, far less daunting: An investor who invested a lump sum in the average stock at the market’s 1929 high would have been back to a break-even by late 1936 — less than four and a half years after the mid-1932 market low.

As students of the markets know:

• The stock charts exaggerate the nominal price declines of the 1930’s by failing to account for deflation.
• Stock dividends provided returns not captured in the price numbers alone.  As Hubert notes, in 1932, the dividend yield on the overall U.S. was a whopping 14%.
• The U.S. equities market is much broader the the Dow Jones Industrial Average, which is the typical barometer used to gauge the market recovery after the 1929 Crash, and the broad U.S. market recovered much more quickly than the Dow. 

In fact, the Dow itself would have recovered more quickly if only it hadn’t excluded IBM from its list:

Perhaps the most celebrated illustration of the Dow’s failure to represent the overall market traces back to a 1939 decision to delete International Business Machines from the Dow 30 list. I.B.M. wasn’t restored to the index until 1979. Norman Fosback, editor of Fosback’s Fund Forecaster newsletter, has estimated that the Dow would have been more than twice as high in 1979 had I.B.M. stayed in the index continuously.

Despite even the most recent market rally, it’s certainly not time to say we’re absolutely sure we can see the light at the end of the tunnel for stocks.  But the evidence does suggest the typical recovery tunnel is much shorter than most investors might believe, especially when in the middle of it.

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My dad worked with people from all walks of life — executives, professionals, entertainers, blue-collar workers — many of whom defined themselves by their occupations.  This gave him added credibility when he observed, as he often did, that “people are people first.”

As WSJ columnist Jason Zweig observes this week, in How Group Decisions End Up Wrong-Footed, this axiom applies to investment committees for institutional investors such as pension funds.  He notes:

Idiots, liars and thieves have torched billions of dollars in this financial crisis. But it is a safe bet that at least as many billions were lost by smart people trying to do good, honest work on behalf of others — usually as part of a committee.

This might come as a surprise to someone who is used to thinking of institutional money as the “smart money.”  But in fact, it is well documented that most corporate pension funds have had trouble simply trying to outperform a naive portfolio of the S&P 500 Index and the Barclays (formerly Lehman Brothers) Aggregate Bond Index over any length of time.  

One reason is that institutional investors are as guilty as individual investors of buying high and selling low. We saw this back in the 2000-2002 bear market, where afterwards the data showed that pension funds were ratcheting up their equity exposure beginning in the late 1990’s all the way through the bursting bubble in 2000, then selling stocks over the next two years, right before equities took off again in 2003.  

Committee-driven institutional investors are also slaves to fashion, as illustrated by the recent rush of many institutions to replicate the “Yale strategy” emphasizing alternative investments over conservative bonds and public equities.  Many institutions are now discovering their hedge fund managers and private-equity wizards were rather scantily clad, after all.  

Now, there are weekly reports that one pension fund and endowment after another is ditching their existing managers, with many committees opting for passive investments instead.  Most likely, however, this, too, is just a passing fad, since there does seem to be inherent disadvantages in the committee approach to investment strategies:

All too often, however, committees don’t work well at all — resulting in a relentlessly short-term outlook, an inability to stick to strategic plans, a slap-dash pursuit of the latest fad and a tendency to blame mistakes on somebody else. In short, for all their power and prestige, investment committees and boards of trustees are only human.

The big question I have is whether this renewed institutional interest in public equities bodes well for the markets going forward or itself is some kind of contrarian indicator that “equities are dead”?

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According to the Wall Street Journal’s Stock Pros Who Survived The Depression, there are, indeed, investors among us who managed money during the Great Depression of the 1930’s and lived to tell the tale.  One key to success — avoid the noise:

Despite innumerable bull and bear markets, 17 presidents, and countless economic policies, they’ve remained remarkably true to their investing philosophy. They’ve also remained remarkably true to their methods: Forget BlackBerrys; most of them hardly touch their desktop computers. And you won’t find CNBC blaring in their offices throughout the day; that’s more noise than news to these gentlemen. Instead, you’ll find stacks of reading material (these guys actually read a firm’s annual report before investing) and a lot of old-fashioned…what do you call it? Oh, right. Math.

Another lesson:  if you’ve lived through enough business cycles, you’re less inclined to call the current bear market a “paradigm shift” or complain that “diversification didn’t work.”  Rather, you call it “just part of the natural cycle of the market.”  As one of the three profiled investors put it:

Despite the constant comparisons with the Depression, Kahn says it’s “absurd” to think the U.S. is headed for a repeat of the 1930s when people “felt so helpless.” Back then, the Feds refused to aid banks and were powerless to adjust interest rates or insure accounts. In fact, Kahn points out, up through 1971, the Federal Reserve couldn’t even lend money if it wasn’t backed by gold. Today our government is creating billions of dollars — literally — to help get the economy back on track, we have programs to insure individuals don’t lose their bank deposits, and there’s a general sense that Washington will do what it takes to help both Wall Street and Main Street. That’s not to downplay the troubles ahead, and Kahn is the first to suggest ultrasafe government bonds for part of a portfolio. But as an investor who has seen dozens of economic downturns, Kahn plainly says this is just part of the natural cycle of the market. “Investors have no reason to feel bearish,” he says. “True value investors are glad the markets are down.”

Sure, things can always get worse.  But even if they do, it’s probably still a good idea to turn off your t.v.

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Today’s Wall Street Journal has a somewhat helpful due-diligence article, Seven Questions to Ask When Picking a Financial Adviser.  But I’m sorry to say the article was disappointing in several respects:

1.  It suggests that it’s okay for an adviser to receive a referral fee from a money manager that the adviser recommends as long as the fee is disclosed.

I disagree.  Referral fees create powerful incentives to short-circuit due diligence on money managers. Disclosing the existence of a poor incentive does little to remove the incentive itself, which is why a financial adviser should be paid only by a client, not by anyone else.

2.  The article buries the “fiduciary question” of whether an adviser will agree, in writing, to place clients’ interests before their own.  

True, the article does state:

Finally, find out whether the advisers are going to take on fiduciary responsibility, in which they are legally bound to act in your best interest. If advisers don’t take this oath, they’re only required to sell you products that are deemed suitable for you — and those may not always be the best fit for your financial situation or objectives.

But when considering whether to retain an adviser for a decades-long relationship, this ought to be the first, not one of the last questions asked.

3.  The article suggests getting a second opinion on your adviser’s recommended investment strategy, but then suggests that an accountant or lawyer might be qualified to provide that opinion.

I have the privilege of working with some of the smartest attorneys and accountants in the land. But to their credit, most would admit that their investment knowledge is pretty thin.  In theory, a second opinion is an excellent idea.  But you probably wouldn’t ask your dentist to review your x-rays, even though the dentist is as much a medical specialist as a radiologist.

Getting the right second opinion is crucial — as crucial as getting the right first opinion — and may require just as much due diligence.

Yes, locating the right financial adviser is hard work.  Which probably makes a soft mattress look pretty appealing to most investors these days.

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