Insightful articles on the world of finance and investing
Cashflow Modelling Explained
Many people struggle to actually ‘see’ what they will need to secure the sort of retirement they hope to enjoy.
In this short video, Cambridge Partner Andrew Nutttall diagrams the six key variables that you need to consider if you want to enjoy a secure retirement.
The Seven Hats of Financial Advisers
This article is in the next edition Canterbury Tales – our local Law Society publication – and is written by one of our Directors, Andrew Nuttall. Although aimed at the legal profession, it does a great job of explaining the many ways we help our clients, which go far beyond investment advice.
When people approach us for investment advice at a personal level, or in their capacity as Trustees, they can be inclined to see us as playing just one role – delivering market beating returns year after year. Unfortunately, we don’t have a crystal ball that allows us to always select the top performing fund or security with-out the benefit of hind-sight. However, helping trustees and other clients make sound decisions about their investments is our core role, and we have found that there are seven hats we aspire to wear without ever having to try and predict the future.
The Expert: Investors need advisors who can provide an objective assessment of the state of their finances and then develop risk aware strategies to help them meet their goals.
The Independent Voice: Our clients value an independent and objective voice in a world that is sadly still dominated by people either promoting their employers’ products or other securities that pay a commission and encouraging clients to buy and sell securities.
The Listener: The emotions triggered by financial uncertainty are real. A good adviser will listen to client’s fears, tease out the issues driving those feelings, and provide practical long-term answers.
The Teacher: Getting beyond the fear and flight phase often is just a matter of teaching investors about; risk and return, diversification, the role of asset allocation, and the virtue of discipline.
The Architect: Once the above lessons are understood, the adviser becomes and architect, building a long-term wealth management strategy that matches each person’s appetites and lifetime goals.
The Coach: Even when the strategy is in place, doubts and fears inevitably rise. At this point, the adviser becomes a coach, reinforcing the first principles and keeping the client on track.
The Guardian: The long-term role of an adviser is that of a light-house keeper who scans the horizon for issues that may affect clients and keeping them informed.
Our industry (I believe that one day it will become a profession) is rapidly moving in a positive direction. The provision of prudent investment advice involves much more than making predictions on tomorrow’s winning asset classes, securities or products. There needs to be greater emphasis and focus on process, governance and investor outcomes.
Ten Years On From The GFC – What Have We Learnt?
The GFC (Global Financial Crisis) is widely considered by economists to have been the worst financial crisis since the Great Depression. Its effects were so wide-spread and profound that even Queen Elizabeth, whose personal fortune had fallen by more than $50 million, demanded economists explain why they hadn’t seen the crisis coming.
Around the world blame was distributed far and wide – lax regulations, too much regulation, excessive debt, irresponsible lending, complex financial products, compromised ratings agencies, an over-reliance on mathematical models, and just plain old greed were all cited as culprits.
But aside from a temporary seizure in short-term money markets, global share and bond markets performed as you would expect at a time of heightened uncertainty. Prices adjusted lower as investors demanded a higher expected return for the risk of investing.
And it wasn’t long before the markets started to see a reversal – By the end of 2009, the New Zealand market rebounded by more than 19% after a near 34% decline in 2008. Australia’s S&P/ASX 300 index performed even better, returning to almost the same levels as before the GFC.
Emotions are hard to keep in check during a crisis and there can be an overwhelming compulsion among investors to “do something”. But, as it turned out, those who listened to their advisors and stayed disciplined within the asset allocation designed for them have done considerably better than many people who capitulated and went to cash in 2008−2009.
An investor who had begun investing in the New Zealand market at the start of 2008 would still have experienced a 7.6% annualised return by the end of 2017. Using a global balanced strategy of 60% equity and 40% fixed interest, the return was 5.4%p.a.These results show we can do ourselves a favour, both materially and emotionally, by accepting that volatility is a normal part of investing and by sticking to a well-thought-out investment plan agreed upon in less stressful times.
This blog has been taken from an article by Jim Parker of Dimensional. Read the full story here
Putting the recent market volatility into a longer term context
In the first three weeks of January 2018 alone the S&P 500 crossed ten new record closing highs in 13 days of trading. Then, in February, the index lost all its gains from 2018 in a few days. Over the next 7 months it built up gains again, and then lost all them over the course of three weeks in October. What’s going on?
Let’s remind ourselves how markets work.
Prices went down because some investors decided to sell. But for every seller there is a willing buyer. The aim of the buyer wasn’t to lose money. The buyer bought because they felt that the discounted prices offered them enough return to justify the risk.
Markets bring optimists and pessimists together by finding a price at which they are both willing to trade.
This is our shorthand way of saying at least half the market participants transacting in the last few days thought it was a good time to buy. Not everyone believes the sky is falling, even if the sensational headlines promote such a view.
But what about our investors?
For our clients with a 50/50 portfolio, we recommend a seven-year time horizon at a minimum, and most have a 20 or 30 year time horizon. In other words, any of our investors that are planning to spend money out of their portfolio this year or next year probably have that money sitting in bonds and cash, not in shares.
So, the portion of the portfolio suffering the most from this recent volatility is the portion that an investor has almost no chance of spending or using any time soon. That’s important, because it means that, whilst it’s not particularly comfortable to see volatility like this, it has little practical implication on their portfolio or current lifestyle. For most of our clients, we hope they’d look on this current situation with a level of disinterest.
For clients that are regularly purchasing assets in their portfolios or via KiwiSaver, this is fact a positive development, because they’ll be able to buy more shares with their same regular savings contribution and that will help grow their long-term wealth.
And let’s remember, when we as investors agreed to purchase shares, we accepted this would generally lead to more volatile returns. However, it’s volatility such as this that gives shares their wonderful return characteristics. Without temporary dips such as this most recent one, shares would have the returns of cash – which would not help us reach our financial goals.
Shares are volatile. The chart below shows the quarterly return of a portfolio 98% invested in shares. It goes up and down a lot; there’s no way around it. The chart below, however, shows the growth of wealth this same portfolio has produced since 1991. While the volatility was uncomfortable, it produced large growth despite the Asian financial crisis, the tech wreck, the Global Financial Crisis and anything else you want to throw into the last 20 years or so.
The critical point to remember in all this is the outcome that long term investors get to experience. It’s that share markets, on average, go up more than they go down, and that consistent exposure to these markets is a key driver of long-term wealth creation.
We know the markets can be volatile in the short term, but this is already factored in to our long-term strategies. The worst decision investors can make is to react to short term volatility in a way that jeopardises the achievement of their long-term plans.
If you are still concerned, we want to talk. Give your adviser a call and we’ll be happy to talk through the recent changes to your portfolio in the context of both your short and longer term goals.
Our thanks to Ben Brinkerhoff from our associate company, Consilium, for this great article.
Cambridge (Partners) goes to Oxford
Cambridge Partners Principal Adviser, Jacob Wolt, is on his way to Oxford University to take a major role in the annual conference of GAIA (The Global Association of Independent Advisors). This is a hugely significant event on the international financial scene and will be attended by major, independently-owned investment advisory firms from around the world.
The global conference will be held this Wednesday and Thursday and, on Friday, Jacob will be chairing the Australasian session, which is traditionally attended by member companies from other parts of the world as well. “It is an enormous honour and privilege to be chairing this event,” Jacob explained on the eve of his departure. “GAIA firms are identified by their independence and their over-riding commitment to fiduciary excellence and to ensuring they always put their clients’ needs first. So these get-togethers are always an opportunity to learn from the world’s best and to reinforce our commitment to unified global thinking.”
Cambridge Partners are the only company in the South Island with GAIA membership, and one of only two New Zealand wide. GAIA membership is limited to those companies who meet stringent standards of total independence and transparency in wealth management practices. GAIA member companies must also be certified by CEFEX – an equally demanding independent global assessment and certification organization which provides an independent recognition of a firm’s adherence to a defined standard representing the best practices in the industry.
Everyone at Cambridge Partners would like to wish Jacob safe travels and all the best for this demanding and prestigious role – we have no doubt he will do us all proud.
“I’m at the top of my game – and I don’t feel old!”
Here’s a very interesting interview from retirement commissioner, Diane Maxwell, which screened on TV3 this morning. Well worth a read or watch in its entirety, but here are some of the key points:
– Most ‘retirees’ don’t feel old – ‘they are fit, healthy and active and want to get up in the morning and do something’.
– Most kiwis want to retire when they are aged between 68 and 72 NOT 65
– 63% of people don’t believe they will have enough to retire on when the time comes
Diane Maxwell was reluctant to put a figure on just how much any one person needs for retirement as needs and expectations vary. But she did suggest that one of the key tools to help was to always have a three month buffer – in other words enough money in the bank to tide you over for three months if you weren’t able to earn money during that time.
This was necessary regardless of age because it helped protect against a downward spiral of additional debt which could happen at any time, and seriously compromise long-term savings plans.
And what was the message she was getting back from those she talked to who had either reached or were close to retirement? “Don’t write me off – I’m at the top of my game, and I don’t feel old!”
You are more likely to recognise the stairwell than the person here! That’s because it’s from the set of The Big Bang Theory – one of the longest-running and most popular sitcoms on our screens today. Its Executive Producer Dave Goetsch reflects here on how much his attitude to investing has changed in the last ten years. One of the biggest differences? Finding a good financial adviser.
I haven’t changed because the stock market rebounded. I changed because I learned that there was a different way to think about investing.
Seeing all the recent headlines about the sudden downturn in the stock market has transported me back to February of 2009, when I was close to despair. It’s striking how different I feel now.
In February 2009, the stock market was down around 50% from its high, and everyone seemed to feel like the sky was falling. I was familiar with this state of panic because my relationship to the financial markets was that I didn’t trust them.
They were always going up and down in ways no one could predict, and I couldn’t trust those folks who said that they could anticipate what was going to happen. So when the market went down, I went down with it—sinking into a depression, knowing there was nothing I could do.
What a difference nine years make. I haven’t changed because the stock market rebounded. I changed because I learned that there was a different way to think about investing. I was right not to trust those people who thought they could predict what was going to happen in the markets, but I was wrong in thinking that there was nothing to do. I’ve learned that I can have a great investment experience if I just accept a few simple truths.
I have to understand the uncertainty of the market. The stock market, as measured by the S&P 500 Index, has returned about 10% per year over the last 90 years,1 but there are very few individual years in which it has ever actually returned that amount. In fact, how many of those 90 years do you think the S&P 500 was up more than 20% or down more than 20% for that year? The answer is 40. Astounding, right? I wish somebody had explained that to me decades ago. Then I would have known to look at stock market returns in terms of decades—not years, months, days, or hours. I would understand that so many of those articles and cable news pieces are just noise, designed to keep an audience obsessed and unsettled.
I haven’t changed because the stock market rebounded. I changed because I learned that there was a different way to think about investing.
In order to be a long-term investor, you have to have a long time horizon. This can be hard to remember when you’re being assaulted by noise, but if you can stay strong, the results are stunning. By results, I don’t mean the investment returns, which hopefully are good. The return I’m talking about is how I feel every day. I worry less—not just about the future, but also about the present. Of course, I know that there are no guarantees when it comes to investing, but I feel like I’m going to be okay. I have a plan.
There’s no way I could’ve done this without a financial advisor. I needed someone who could not just talk me through what my asset allocation should be, but also help me work through how I felt about investing and what exactly I could do to change my perspective.
I was a mess nine years ago. Now, my outlook is totally different. The markets haven’t changed; they still go up and down. The difference is, I don’t anymore.
Thanks to our Associates at Dimensional Fund Advisors for the use of this article.
Welcome to James Howard
We’re delighted to welcome James Howard to Cambridge Partners. A Canterbury local, James received his BCom at University of Canterbury majoring in accounting, finance, management and information systems.
Following his graduation, he joined EY, working in the International Tax and Transfer Pricing department. His involvement with the company spanned almost a decade, and included three years in the Netherlands working in the Operating Model Effectiveness team.
Along with New York, London and Singapore, the Netherlands is one of EY’s key hubs for Operating Model Effectiveness, so this was an excellent opportunity for James to challenge himself and gain valuable professional experience in this area. On a personal level, it provided him and wife Kate with an opportunity to fulfil a dream to see more of the world.
“I had a blast and learnt a lot and, to be honest, if it was a bit closer to home we might have stayed,” he says with a smile. “But ultimately the 26-hour flights home become a bit much for both of us. And, as much as we loved our time overseas, we’re very happy to be back in Christchurch closer to our family and friends.”
After initially returning to EY in Christchurch on his return home, James moved to Otakaro Ltd – the crown-owned entity which is responsible for delivering the anchor projects currently underway as part of the Christchurch rebuild. Here James provided Commercial and Economic Advisory in the Strategy and Planning team. “It was great learning and a good experience but ultimately not what I was looking for” explains James. “I missed developing relationships with clients and working with those clients to create value and achieve their goals.”
James loves skiing, mountain biking “Basically any outdoor activities. I also used to be an avid rower, however it’s been a few years since I’ve sat in a boat…” He is still involved in the sport though, as he sits on the board of Southern Rowing Performance Centre.
Why Women Make Better Investors
When it comes to industries, the investment industry is one of the more male dominated around. Because of this, many people just assume that men are better investors.
They would be wrong.
According to data from US financial services giant Fidelity Investments, women are actually superior investors. At least, that’s what US data appears to show.
In sifting through more than 8 million US investment accounts, Fidelity discovered that women not only save more than men (approximately 0.4% more per annum on average), but their investments also earn an average of 0.4% more per year.
Those differences may seem too small to matter, but, extrapolated over a lifetime of saving and investing, the disparity at retirement age is anything but minor.
For a 22 year old starting out with a salary of $40,000 a year, a female investor that both saved more and achieved a higher investment return would see her eventual retirement savings significantly outstrip her 22 year old male counterpart.
What is it, exactly, that makes women better investors?
According to Fidelity, there are three main factors:
Planning with purpose – women tend to think much more holistically about their investments, and build their financial plans around life goals rather than trying to beat the market.
Taking less risk – in this context, taking less risk means generally managing risks better. For example, women tend to make fewer overtly risky bets, such as putting all of their money in a handful of shares, which would be prone to suffering larger price swings and bigger losses in turbulent markets. Consistent with taking less risk, women are also more likely to pick investments that are appropriate for their age and time horizon.
Patience – women generally place fewer trades and are much more diligent at carrying out a long term, buy and hold strategy. Men are 35% more likely to make trades than women, and that extra trading is costly.
Men can also be prone to becoming overconfident that they understand with great precision the value of a share, and this confidence encourages them to trade more.
Unfortunately, many men regard their share investments as a sport that comes with bragging rights, and that is what ends up getting them into trouble. Sometimes their trades will be right, and other times, they will be wrong, but they’ll always pay the costs of trading, and that impacts performance over time.
The data in New Zealand is less revealing. That’s not because the attributes of female investors in New Zealand are necessarily any different, but, absent a New Zealand version of the Fidelity study, it’s very hard to isolate trends in the limited New Zealand savings data available.
While the average KiwiSaver balances of New Zealand females are lower than males, this may have more to do with gender pay inequality than being the result of different savings and investment habits.
Overall, women – at least in the Fidelity study – tend to be more successful investors than men because they do the simple things better. Women have long term goals, and they are better at sticking to their plan. They focus on saving and investing for retirement or a university fund, and are less likely to adopt high turnover strategies attempting to outsmart the market.
However, while women tend to be better savers, they also tend to be more concerned about the risks inherent in the share market. In general, women lack a degree of confidence about investing, despite a growing body of evidence that they may be naturally better at it.
Another inescapable statistic is that around 90% of women, at some point in their lives, are also likely to be the sole decision maker in financial matters, due to divorce, death or other circumstances. In that event, having naturally good investment habits will be particularly valuable.
We think the biggest takeout from the Fidelity study is that these observed behavioural differences between men and women can, over time, lead to different investment outcomes. And, as the study found, those behavioural differences tended to result in better average investment performance by women over men.
That resonates with us. Not because we necessarily agree that women are superior investors, but because our investment philosophy and our carefully crafted investment strategies are based on some of the same favourable investment attributes referred to above (managing risk well, patient trading, etc).
However, in addition to these, we also incorporate significant academic evidence into our portfolio construction, and we focus on smart diversification and cost minimisation. When delivered within a well managed portfolio, these attributes provide additional benefits to all investors.
The end result, and the really good news for readers of this article, is that anyone (male or female) can adopt our investment strategies to become a significantly more effective investor.
Billionaire David Booth’s Investment Tips for New Zealanders
Investment guru David Booth visited New Zealand to talk about his mission to change people’s lives through investments, reports Richard Meadows.
When a billionaire gives you investment advice, you listen.
When it’s backed by the research of several Nobel-prize winning economists, you really pay attention.
David Booth is co-founder and chairman of Dimensional Fund Advisors, which manages almost US$400 billion (NZ$600b) of assets.
When markets are rocky, some investors tell their advisors they would prefer to wait till things are ‘more settled’ before committing money. The problem with that view is the market never is free of worries. Currently, it’s oil and China. A year ago it was the Euro Zone. So when is the ‘right time’?
When is the right time to invest in the market? Or is there ever a right time?
Let me know if any of these narratives sound familiar to you:
2013 Analyst: “We are deeply concerned about the sharply rising 10-Year Treasury Yield as a headwind for stocks. The end of quantitative easing and the Federal Reserve’s unprecedented monetary policies may forestall further gains in equities.” Total return of SPDR S&P 500 ETF (SPY): +32.31%
2014 Analyst: “A sharp drop in virtually all commodity prices may be signaling a contraction in the global economy and warrant reducing exposure to risk assets. Furthermore, the strongest performing asset class is the 30-year Treasury bond, which is a virtual assurance of the coming apocalypse.” SPY total return: +13.46%
2015 Analyst: “We are worried that market breadth is deteriorating so rapidly. The “FANG” stocks are the only bright spots in an otherwise bleak investing landscape. In fact, the average publicly traded company is now firmly in bear market territory.” SPY total return: +1.23%
2016 Analyst: “We are troubled that utilities and consumer staples stocks are the market leaders and momentum is waning in growth sectors. This bulking up in defensive assets may lead to….” SPY total return: TBD
Should be interesting to see how that last one ends.
Those aren’t real headlines, but made-up approximations based on very real themes that assaulted investors over the last four years. I could go further back in time to sensationalize the concerns of market participants in the cross hairs of any given moment, but I think the point has been made.
The stock market never looks perfect. There is always something to worry about. That is why they call it climbing the “wall of worry”.
If you are waiting on a specific point of certainty in order to invest, you are going to be the last guy or girl holding the bag before the wheels really come off. There are always going to be wars, elections, corruption, debt cycles, stock upheaval, commodity insecurity, and a whole lot of people who are bigger, faster, and smarter than you are in the market. In addition, there are shifting cross currents that offer little in the way of predictable patterns.
For example, right now the stock market is entirely fixated (read: correlated) with the day to day fluctuation in oil prices. Stocks want a rebound in oil to boost the sickly energy sector, prop up the credit markets, and generally re-initiate a sense of inflation or consumption in the global economy.
Years ago, oil prices were a thorn in the side of stocks. If you saw a 5% jump in overnight crude oil futures, you could pretty much count on a big drop in the stock market. Funny how perceptions change over time and “rules of thumb” seem to disintegrate under differing global circumstances.
This all goes to prove a point. There is no certainty when it comes to investing.There is only process and discipline to guide you through the difficult periods. Much of that discipline may involve tuning out the noise of the media that is constantly focusing on short-term themes or sensationalist headlines. They aren’t intentionally trying to hurt or persuade investors down any particular path. They are just motivated by different forces than we are.
Is the stock market rigged? Maybe. Probably even. But it’s the best system we have and it’s continued to multiply the wealth of methodical investors for many generations.
There are going to be periods of turbulence that test the resolve of even the most ardent buy and holder or battle-hardened trader. However, it’s imperative that you lean even further on your specific philosophy during those tumultuous days to achieve a successful outcome.
For me that means taking a balanced approach that pairs multiple asset classes together to smooth out volatility. This includes a stringent focus on security selection and structural asset class combinations to ensure risks are matched appropriately. In addition, I have the flexibility to shift the portfolio to fresh themes in order to take advantage of new opportunities or pair back on areas showing undo stress.
I know that many investors have been chasing their tails with individual stocks or sectors and trying to divine the next big trend. However, in my opinion this type of environment is more conducive to avoiding those hit-or-miss propositions by committing to broad-based ETFs showing lower volatility or relative strength versus their peers.
Put it this way – your ego wants you to own Facebook and Google so you can brag about it on the golf course or over the water cooler at work. Of course, that probably means you own Twitter and Yahoo as well (we’ll just keep those quiet).
One common fantasy among investors is that if they knew the price of certain assets in the future they could deal with today’s volatility. The trouble is that these investing fantasies are based on the false assumption that uncertainty can be eliminated. Barry Ritholtz has more.
Even if you knew ‘the future’ price of stocks, it wouldn’t eliminate uncertainty:
When the media blandly reports that “sellers were out on force on the market today” it’s worth asking who they were selling to. For every seller, there has to be a buyer. And these latter individuals tend to hold the long-term view that falling prices mean stocks are on sale. Ben Carlson explains.
The best times to put your money to work are often when things seem like they’re never going to get better:
The more time we have available to make a decision, the more we are likely to vacillate between one option and another. This usually happens because we forget about what’s most important to us. To break the jam in these cases, a Stanford University professor came up with a novel technique.
Can’t make a decision? Torn between two options? Try the ‘gun’ test, says engineering professor.
A Stanford professor says the ‘gun test’ can help you make big decisions
You can drive yourself crazy deciding whether to attend grad school, take a job offer, or marry your partner.
What if you make the wrong choice, and as a result, wind up unhappy, unfulfilled, and unsuccessful?
In these situations, it may help to use an unconventional strategy that Stanford engineering professor Bernard Roth calls the “gun test.”
Roth, who is the academic director of Stanford’s Hasso Plattner Institute of Design (the d.school), recently published a book called “The Achievement Habit,” in which he outlines techniques for making big life decisions considerably easier.
Here’s how the gun test works: When a student of his is wrestling with a big life decision, he points his fingers in the form of a gun at the student’s forehead and says, “Okay, you have 15 seconds to decide or I’ll pull the trigger. What’s your decision?”
According to Roth, everyone always knows the answer.
“Even if they do not ultimately take that path, this exercise usually releases the pressure built up around the decision-making process and gets them closer to a resolution,” he writes.
In other words, the point isn’t so much to choose as to realize that youcan choose — and that you’ll feel so much better afterward.
Another strategy Roth relies on is the “life’s journey method.” When a student is vacillating between two possible paths, he asks the student to pick one of the choices and then imagine what life would look like as a result.
In the book, he uses the example of a master’s student deciding whether to enroll in a Ph.D. program. The student realizes that if she enrolls, she’ll graduate and get a job in academia; get married and buy a house; have kids; raise the kids; get older and die.
If she doesn’t enroll, she’ll get a job in the industry or start a company; make a lot of money; get married and buy a house; have and raise kids; get older and die.
“The point of this,” Roth writes, “is to get people to realize that there is no way to know where a decision will lead.”
The best way to move forward, he says, is to demonstrate a “bias toward action” and not to be afraid of failure.
These two concepts are key to a strategy called “design thinking,” which Roth says can help solve any problem — from how to build a better lightbulb to how to lose weight.
No matter what problem you’re trying to solve, you’ll want to minimize the amount of time you spend deliberating so that you start doing something as soon as possible. Even if the path you take doesn’t quite work out — and it very well may not — you can always try again.
Roth writes: “I believe it serves people best in life to accept that decisions are part of the process of moving forward and that there are so many variables that it’s a waste of time to try to see the endgame.”
How should the average investor react as global stocks experience volatility? Charisse Jones with five tips for the every day investor.
If you haven’t figured this out by now, it’s time you did: Stocks are risky. They are risky — as in volatile — over the short and the long term.
But that doesn’t mean you should avoid investing in stocks … except maybe Chinese stocks. Nor does it mean that you should just ride out the jaw-dropping volatility in the market, either. What to do?
First, turn off the TV. Joseph Tomlinson, a certified financial planner with Tomlinson Financial Planning, in Greenville, Maine, suggests “turning off CNBC” and not reacting to these sorts of events by trying to time the market. “Don’t attempt a strategy of bailing out temporarily until things ‘calm down,'” he says.
Second, think big picture. The longer your investment time horizon the more likely it is that you can not only ride out this current crisis, but continue to invest in stocks as they go “on sale,” as some investment experts like to say during times like these. People today can expect to live on average to nearly 80. So someone in their 20s has an investment time horizon of at least 60 years, and for someone in their 40s its four decades. And, while past performance, as the famous investor warning goes, does not guarantee future results, stocks over the long term have gained on average 10% to 12% per year since the late 1920s.
“Millennials shouldn’t be concerned with volatility,” said Dirk Cotton, a financial adviser and author of the Retirement Café blog in Chapel Hill, N.C. “They have decades to recover from losses, and risk enables them to earn higher returns.”
On the other hand, pre-retirees — those in their 50s and early 60s — as well as retirees have shorter investment time horizons, say 20 or 30 years, and can’t afford to put their retirement lifestyle at risk. They just don’t have as many years to recover from bear markets as do Millennials and Gen Yers. So they might revisit how much they invest in stocks.
As a general rule, consider subtracting your age from 100. That should tell you how much to invest in stocks. So, if you’re 50, consider investing 50% in stocks and 50% in bonds. And if you’re 25, consider investing 75% in stocks and 25% in bonds.
Third, review (or create) your investment policy statement. Investors, no matter their life stage, should always have an investment policy statement (IPS) for their portfolio. It’s a blueprint outlining how much to invest in stocks, bonds and cash given their time horizon, risk tolerance and investment goals.
Your IPS — not your emotions — should tell you when to rebalance your portfolio, when to sell and buy. Again, regardless of life stage, the tumult in the Chinese market, might be a chance to buy, not sell, stocks.
Robert Powell is editor of Retirement Weekly, contributes regularly to USA TODAY, The Wall Street Journal and MarketWatch.
How about that 550-point intraday dive last week in the Dow! Did that finally get you to sell?
Or was it one of the many headlines about the trillions of dollars that have been wiped out of the stock market in the worst start for the Dow in history — since 1897! And worst start for the S&P 500 since the Great Depression began in 1929.
Oh, c’mon, that was “so last Wednesday.”
Surely, when all the major indices ripped higher on Friday, and stocks registered their first positive week of the year, and that diving-Dow had two straight days with triple-digit gains, you had plowed right back into the stock market and banked all those big gains.
It seemed like the panic and the paranoia were over — until the Dow dropped by another 200 points on Monday.
And so far in January, investors have yanked near-$7 billion from U.S. stock funds, according to Thomson Reuters Lipper data. Investors have also put more than $3 billion into money market funds — the market’s under-the-mattress cash equivalent. But the more alarming data comes from last month, when investors pulled $48 billion from stock funds. That is eerily similar to 2008, as the financial crash hardened: Investors took $49 billion out of stock funds in Sept. 2008 and $55 billion out of stock funds in October 2008.
Kudos to investors for the great timing. Except for the fact that from 2008 to 2012, the S&P 500 generated a cumulative return of 8.6 percent.
Here’s the problem: If an investor missed the 36 percent drop in the S&P 500 in 2008 — or even worse, bailed on the markets mid-carnage — they probably also missed the 26 percent gain in the S&P 500 in 2009, and the next three positive years for the index that followed.
In 2011, investors pulled another $94 billion from stock funds, and in 2012 another $129 billion, when the S&P 500 was up 16 percent. Hundreds of billions of dollars pulled out of stocks during a period of time when a stay-the-course strategy would have netted an 8.6 percent cumulative gain. Not a shoot-the-lights-out strategy, but nothing to sneeze at either in today’s low-return — not to mention nil savings rate — environment.
“The global financial crisis created such a high level of risk aversion that people didn’t just wait for the start of the rebound. In some cases, they waited for years,” said Kristina Hooper, U.S. investment strategist at Allianz Global Investors. “I can’t tell you how many investors I came across in 2011, 2012 and even 2013 who had missed out on a lot of the comeback in the stock market and were still sitting in cash.”
It’s what Lipper’s head of Americas Research, Jeff Tjornehoj, calls the dilemma of the do-nothing investor: More often than not, the do-nothing investor does better.
“It’s a rocky ride, but the do-nothing investor would have been fine and avoided headaches,” Tjornehoj said, referring to those who stayed invested through the crash. He added, “If you know precisely how to move between stocks and bonds and everything else, you would have done better, but how many investors know how to do that?”
“The big issue is that when you go to cash, you have to be right twice,” said Mitch Goldberg, financial advisor and president of Dix Hills, New York-based ClientFirst Strategy. “First, you have to be right about getting your timing correct when you sell. If you are selling because it is your panic reaction in a down market, I think it’s fair to say you probably got that part of the decision wrong. The second part you have to get right is the timing of your buy orders. And if you are waiting for the perfect time to buy, you’ll never pull the trigger.”
And here’s a key that many investors who plan to be smarter than the “herd” miss, especially in markets like the one investors faced last week, with huge swings in the norm day-to-day. A move to cash works against the investor to a greater degree when there is greater volatility.
“Friday’s rally in global equity markets is a case in point of how investors who just binged on cash are missing out on a big rebound,” Goldberg said. “It’s tough to time, and missing out on the best days of the year has a restraining effect on long-term performance,” Goldberg said.
Allianz Global Investors provided an example of just how much investors can lose out in just a few days. The Allianz economic research and strategy team looked at the period from 1973 to the end of 2014, comparing four different approaches to investing in the U.S. stock market. Investors who missed the three biggest days of each year see their gains go down dramatically.
In the first approach, $100 is invested on the first day of the year and another $100 dollars added at the start of each year thereafter. The total return over the four decades was $52,251.
In the market-timing approach, if an investor invests the same $100 at the start of each year but misses the top three days of the year, the total return was $2,953.
The best return of all came from investing $100 on the day of the lowest index level of the year — the best day of the year to invest — and adding $100 on the lowest-index-level days of subsequent years. That approach netted a total return of $54,355.
“The problem is that we can never predict when the best days will occur, so we have to stay fully invested all the time to experience them,” Hooper said, adding that most days in any given year (both positive and negative) will typically produce a net flat performance.
Those “big day” misses, or gains, compound over the years.
The key problem I see when investors go to cash has a lot to do with procrastination,” Goldberg said. “They think about getting back into the market in a conceptual way, but when it comes right down to it, they often don’t because they didn’t implement a disciplined strategy to get back in. If the stock market bounces and rips higher, they say to themselves, ‘I could’ve gotten in lower, so now I’ll wait for another pullback.’ Then the market pulls back and they say to themselves, ‘I’ll wait to see if it goes lower.’ And so on.”
Tim Maurer, director of personal finance for The BAM Alliance of financial advisory companies, said that the field of behavioral finance has demonstrated how our brains often think (wrongly) when it comes to evaluating the pain of losses versus the pleasure of gains.
Maurer said to consider the decision between staying invested after a market decline or moving to cash as a four-step process:
The pain of staying invested is that I could lose even more.
The pleasure of moving to cash is that my worry is eliminated and I’m guaranteed not to lose any more.
The pain involved in moving to cash is that I’ll miss the upside, thereby eliminating my opportunity to recoup recent losses in the next market up move.
The pleasure in staying invested is that I’m giving myself a better chance to achieve my financial goals in the long term — the reason I invested in the market in the first place.
He said the four-step process has one purpose: to bring the vast majority of investors back to the conclusion that they shouldn’t get out of the market.
“The market has historically paid investors a premium over cash and bonds precisely because it requires investors to endure times of volatility,” Maurer said. “Without volatility, we’d have no reason to expect higher long-term gains.”
A few weeks ago — amid one of the many recent bouts of extreme daily selling — a friend asked me whether they should sell their Facebook shares. I asked, “And replace them with what?” She didn’t have an answer.
Another friend, in his 40s, texted in a panic to ask if it was the time to get out of stocks. I asked him what stocks, in particular, he meant to sell. He said no stocks, just moving his retirement portfolio as a whole out of equities. I replied with several exclamation points — you can imagine the words that preceded the punctuation yourself.
“At the start of December, I addressed a roomful of high-net-worth financial advisors and asked them, ‘How many of you expect the market to fall more than 10 percent in 2016?'” said Allianz’ Hooper. “Nearly every hand in the room went up. And yet now that the market has experienced the sell-off, many are not viewing it as a healthy correction but are panicking and fearing the worst.”
Hooper said the psychology is easy to understand. Sell-offs are by nature disorderly and create a contagion of fear, and investors believe that when stocks go down 10 percent in value, there’s something “the market knows” but a Main Street investor doesn’t.
“In reality it is just a herd, and herding is a dangerous activity for investors,” Hooper said.
There is always a good case to be made for rebalancing from stocks that have run up a lot into stocks that seem undervalued. Maurer said it’s good to be “greedy” like Berkshire Hathaway chairman and CEO Warren Buffett through stock rebalancing. But when Lipper fund-flows data shows net negative flows in equity funds, that’s not what’s going on with the mass of retail investors.
Goldberg isa “big proponent” of raising cash at times, but said the time to do it is when stocks are rising and then wait patiently for new opportunities. “I never feel pressure to be fully invested at all times. But I do not believe in going to cash as an ‘all or nothing’ trade,” he said.
Cash proponents will argue that staying invested is a disaster-in-the-making for retirees. Goldberg said retirees are naturally the most fearful, but it’s the cash mentality rather than staying in equities that is the “never-ending wealth destroyer pattern.”
“You’re now giving up on an asset class that historically has been a hedge against inflation,” Goldberg said. “Sure, inflation is nonexistent according to headline statistics. But if you pay for health insurance, which as a senior could easily be sending a big proportion of your income on health care, you know you are ground zero for inflation pain.”
In fact, if any retiree has a portfolio constructed with investments that would collectively go to zero in a stock market correction, the only question worth asking is, Who designed your portfolio, and how quickly can you fire them?
There’s a reason that famed investors like Vanguard Group’s Jack Bogle and Buffett sound like a broken record with the“stay the course” mantra.
It’s not just because their millions and billions allow them to do so with comfort — though that helps.
Watching the Olympics a few weeks ago, I got pulled in to the drama of short-track skating. It has to be one of the more entertaining Olympic events. The races are fast, and almost anything can happen. If you had a chance to watch the women’s 500-meter final, you saw a perfect example of the fine line between skill and luck that drives this sport.
Seconds after the race started, Elise Christie of Britain made a passing move in the second turn that caused her and Arianna Fontana of Italy to crash. Park Seung-hi of South Korea then slipped in the next turn. Only one skater, Li Jianrou of China, didn’t fall down. While the other skaters managed to get back up, there was no way for them to catch Ms. Li, and she won the gold medal.
Ms. Li is clearly an exceptional athlete (she was overall world champion in 2012), but it’s impossible not to see the role that simple luck played in the race. Even she described her win as “very lucky.” Skill may have gotten her to the Olympics, but luck played a role in her gold-medal victory.
So if Ms. Li, a world-class athlete, is willing to acknowledge the role of luck in her success, what makes it so hard for the rest of us? Well, we like thinking we’re just that good, particularly if we’re talking about our investment success. As a result, we become the lucky fools that Nassim N. Taleb described in his book “Fooled by Randomness.”
“Lucky fools do not bear the slightest suspicion that they may be lucky fools — by definition, they do not know that they belong to such category. They will act as if they deserved the money. Their strings of successes will inject them with so much serotonin (or some similar substance) that they will even fool themselves about their ability to outperform markets (our hormonal system does not know whether our successes depend on randomness),” Mr. Taleb wrote.
What sets off the lucky fool syndrome? Psychologists call it the self-attribution bias. It means we’re inclined to take all the credit for things going well, but we have no problem blaming outside forces when things go wrong. On top of our bias, we have a very difficult time separating skill from luck.
As a result, we’re susceptible to the lucky fool syndrome and the problems that come with it. In a 2013 study, the researchers Arvid Hoffmann and Thomas Post highlighted how a self-attribution bias can hurt investors and lead to repeated mistakes because they “simply attribute bad returns to factors beyond their control.” The same study also showed that when we ignore the role of luck, we’re also blind to bad investment behavior like overtrading or underdiversification.
Knowing that these issues exist, we have a choice. We can continue to float along on a cloud of serotonin, playing the fool and suffering the consequences, or we can challenge our biases. It’s not easy to make the right choice, but it’s doable. It starts with getting a better handle on the difference between skill and luck.
“There is actually a very interesting test to determine if there is any skill in an activity, and that is to ask if you can lose on purpose. If you can lose on purpose, then there is some sort of skill. Investing is very interesting because it is difficult to build a portfolio that does a lot better than the benchmark. But it is also actually very hard, given the parameters, to build a portfolio that does a lot worse than the benchmark. What that tells you is that investing is pretty far over to the luck side of the continuum.”
So if investing involves a fair bit of luck, then the next step is to measure where our success falls on the luck-skill continuum. Plus, the more we measure, the more likely we are to avoid the bias and act the lucky fool. After all, investing leaves a pretty clear trail of breadcrumbs.
Start by pulling out tax records and year-end brokerage statements that lay out the facts. If we’ve been cruising along and assuming we’ve done something special, it’s time to put on our no shame/no blame hat and look at all the data. For instance, many investors I know designate a small portion of their portfolio as a play account. Because it’s a play account, they feel comfortable betting on riskier investments, and sometimes those riskier investments deliver an excellent return.
But it doesn’t take much for us to project that small success across our entire portfolio. So we need to ask ourselves how our whole portfolio did. Then, we need to calculate our rate of return and compare it with the return of index funds representing the broad market.
My experience shows this test will surprise almost every investor. The numbers will invariably make the case that what we thought was a spectacular success can’t compete when it’s measured as a part of the whole and compared with a benchmark. With this knowledge, it becomes a bit easier to counter our bias and avoid the lucky fool syndrome.
It’s easy to get sucked into believing that investing success is all about skill. I suspect it follows the rule that the smarter you are, the smarter you think you are, and that’s a problem for investors who believe intelligence determines our investment returns. It becomes a self-confirming cycle if they see great investments returns. The great returns verify the original idea that our smarts determine our investing success, and the next investing success starts the cycle all over again.
We can interrupt the pattern, and avoid the mistakes that come from it, by testing the context of our success with a second, simple question: Were the markets already going up? Even though it’s tempting, we shouldn’t confuse being a genius with a rising market. For instance, if we experienced superior returns in 2013, it’s very difficult to attribute our success to skill. However, we’re inclined to be very selective when we look at our success. We highlight the events that confirm our bias and ignore the facts that point to outside forces.
In this case, we’ve got the data to test our theory. How did we do in a non-record-breaking year? Did we see incredible results or were they close to the benchmark? If it’s the latter, it’s hard to argue that our smarts have built a portfolio that does a lot better than the benchmark.
Look, I understand that we really like how the lucky fool syndrome makes us feel. Besides all that lovely serotonin flooding our system, we love the idea that we’re really that good and capable of beating the market. That said, I doubt any of us wants the consequences of being the lucky fool. So it comes back to the choice I raised earlier: Do we float along or do we challenge the bias?
Nobel Prize-winning psychologist Daniel Kahneman lists the “over-confidence effect” as one of the most common ways people fool themselves. In this short video, Professor Kahneman explains that over-confidence often runs in tandem with the contrary tendency of loss aversion.
Human beings can at once be irrationally over-confident and unnecessarily loss averse. How is that?
Don’t Make the Trading Gods Laugh
People who attempt to make money from short-term trading in the financial markets can get hooked on particular views of the future. This view often stems from an illusion of control. The alternative approach, says Barry Ritholtz, is to ignore the noise and stick to a long-term plan.
Your greatest strength in investment is not in showing how smart you are, but in admitting how little you know. Read more here: http://bv.ms/1zQVNhq
Doing Nothing is a Decision
“All of humanity’s problems stem from man’s inability to sit quietly in a room alone.” – Blaise Pascal
Making constant changes to your carefully chosen investment portfolio can give you the illusion of control. The problem is that more activity does not necessarily correlate to better results. This article notes that simply doing nothing can be a positive decision.
Investing is one area of life where staying “busy” is not necessarily equated to better results.
Just because everyone else is investing or spending in a certain way doesn’t necessarily make it safe. The herd often moves according to cycles of fear and greed. In this article, Carl Richards says you should always start from the basis of what is right for you.
When it comes to investing, sticking out from the herd is not always a bad idea:
14 Meaningless Phrases That Will Make You Sound Like a Stock-market Wizard
Media insiders will tell you that market pundits save their blushes when their forecasts prove to be wrong by using “weasel words” — slippery phrases that provide an easy out. In this article, the writer lists 14 meaningless phrases that can make you sound like a market guru with actually saying much.
Being a financial forecasting pundit often comes down to mastering a few meaningless phrases.
The path to financial security is less likely to be paved with perfect investments than with prudential decisions. Indeed, it’s the avoidable risks that often stand people in good stead—whether it is not paying too much in fees or not listening to television finance gurus. Sound investing often comes down more to avoiding mistakes than kicking perfect goals every time. Read Original Article here.
Ben Carlson was spot on this week when he wrote “there are many different ways to make money in the markets. But I think that there are a few universal ways to lose money.” Here are some ways to ensure you are unsuccessful managing your finances:
Spend more than you earn.
Refuse to budget.
Track your investments daily.
Do what the “experts” on CNBC recommend.
Frequently change strategies.
Purchase products with high fees.
Avoid having a plan at all.
So much of being successful, financially and otherwise, simply consists of not making the big mistakes. You don’t have to hit homeruns – just don’t strike out. To paraphrase Shane Parrish, avoiding stupidity is easier than seeking brilliance. Charlie Munger said “It is remarkable how much long-term advantage people like [Warren Buffett and myself] have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” Rather than focusing on perfection, look to minimize the errors.
You often hear that the best investment solutions are simple ones. That may be, but simple does not necessarily mean easy. An idea may be simple at a conceptual level, but difficult at the implementation level. Carl Richards says we can bridge this divide by asking ourselves some tough questions. Just because an investment solution is simple does not mean it is easy. It ultimately comes down to you. See Original Article Here.
“Can it really be that simple?”
Over my career, I’ve heard these words from so many people. Clients, friends and family all just assumed that the process of financial planning needed to be complex. This assumption doesn’t surprise me. The traditional financial industry is built, in large part, on the notion that complexity equals quality. In fact, the more complex the solution, the more someone should pay to access it.
But there’s a problem with this argument: It’s wrong.
Seekers of financial advice overlook simple prescriptions because when they hear simple, they make the leap to easy. But sticking with good money decisions isn’t easy. So how do we bridge this gap? Here are two things to consider.
Stop confusing simple with easy. People often ask me, “What’s one thing I can do that will have a big financial impact?” I almost universally suggest they spend less and save more. You can imagine the looks I get. That’s too simple. It couldn’t possibly work.
But if it’s so simple, why doesn’t everyone do it? Think about all the simple financial advice we’ve heard over the years. Create and stick to a budget. Avoid unnecessary debt. Save money in an emergency fund.
All of these things are simple, but that doesn’t mean they’re easy. So to avoid the hard choices, we pretend that simple won’t get the job done and go looking for complexity, often in our investments, in order to make up for high spending and low savings.
Stop confusing concepts with application. If we all had unlimited resources, life would be easy. But almost every financial decision comes with complicated trade-offs. So when we hear, “Spend less, save more,” we’re likely to ignore it. We have a mortgage. We haven’t had a raise in five years. We have children who always seem to need something. Clearly we need more than, “Spend less, save more.”
Not really. We do, however, need to ask ourselves some difficult questions. Simple solutions put the weight on us to act. Only we know the “why” behind our money decisions. To spend less and save more, we have to dig deeper. That can get messy.
Remember those complicated trade-offs? Suddenly, they’re everywhere. We bought a house that was at the upper end of our budget. We haven’t really done anything at work to merit a raise. We have a hard time saying “no” to our children. So what are we going to do to correct those things or change course?
Whatever the answers, simple solutions bring us face to face with some painful truths about what we are or are not doing, and why. Oddly enough, I’ve found that a lot of people just aren’t comfortable with this process. They’re much more comfortable spending time and money on complicated solutions that don’t require much, if any, self-reflection.
We could keep going down this path or we could try something different. So for one week, I want you to try following a single piece of simple financial advice that until now you’ve always ignored. It will likely be harder than you think, and you may even be tempted to give up by Wednesday. Don’t.
Give yourself one week to ask questions and weigh your decisions without assuming that simple won’t be enough. Along the way, you may discover that simple does more for you than complex could ever dream of.
Investors have a habit of thinking in terms of extremes. Active or passive. All-in the markets or all-out. Stocks are either topping out or about to bottom. Markets are perfectly efficient or wildly inefficient.
It’s much easier to go to the extreme viewpoints because it acts as something of a mental shortcut. The brain is constantly looking for these shortcuts as a way to conserve energy. This line of thinking leads people make binary decisions, which is a difficult place to be because (a) markets are hard and (b) things aren’t always black or white when it comes to financial choices.
Investors have been asking for a number of years now whether or not it’s time to get out of U.S. stocks. Larry Swedroe discussed the idea of higher expected returns in foreign stocks in a piece from this past week:
Clearly, if investors want the higher expected returns, they should consider tilting their portfolios (have a higher allocation) to international developed-market value stocks and emerging markets value stocks. However, earning the highest expected returns isn’t generally an investor’s only objective, or sole consideration.
If earning the highest expected returns possible was, in fact, an investor’s sole consideration, we would likely concentrate portfolios to a greater degree than is prudent.
Yes, you could increase your expected return today by lowering your allocation to U.S. value stocks and more heavily weighting international developed, and especially emerging market, value stocks. However, doing this would also decrease your level of diversification, increasing idiosyncratic risks. Again, we have the same trade-off.
Swedroe brings up a great point on how to think about risk in a way that’s not very apparent to most investors at first glance. Many simply want a buy or sell answer so they can move on. Risk takes many different forms in the markets. No matter what you do, it never completely goes away. Your risks just change based on how you’re positioned. It becomes a game of pick your poison.
This is why I think it’s so important for investors to understand the concept of regret minimization. I discussed this topic in my book:
Investing really comes down to regret minimization. Some investors will regret missing out on huge gains while others will regret participating in huge losses. Which regret will wear worse on your emotions? Missing out on future gains or future losses? Diversification within a well-thought-out asset allocation is your best option to minimize these two regrets. You’ll never go broke practicing diversification, but you must be willing to accept short-term regrets in place of long-term ones. Diversification also helps control your behavior. You never completely miss out on the biggest gains while you never fully participate in the biggest losses.
Of course, diversification can’t completely protect you from poor performance over days, months, or even years. You have to be able to withstand losing money at some point to be able to make money. But diversification does protect investors from experiencing numerous poor cycles or decades, which is where real risk resides. Diversification is about accepting good enough while missing out on extraordinary so you can avoid terrible. Famed value investor Howard Marks once said, “Here is part of the trade-off with diversification. You must be diversified enough to survive bad times or bad luck so that skill and good process can have the chance to pay off over the long term.”
Swedroe and Marks both mentioned the word ‘trade-off.’ In many ways, every investment decision you make requires the acceptance of certain trade-offs. That’s how risk works. You can’t protect your portfolio from every eventuality. There’s no right or wrong answer for every investor. It really comes down to finding the trade-offs you’re comfortable dealing with.
But I think a lot of investors delude themselves into thinking that they can some how position their portfolios in a way that completely eliminates all forms of risk. There’s no way to completely eliminate risk from the markets. It really comes down to figuring out which risks are necessary, which risks you want to avoid and which risks will minimize your regrets over the long run.
A Wealth of Common Sense is a blog that focuses on wealth management, investments, financial markets and investor psychology. Ben Carlson, CFA manages portfolios for institutions and individuals at Ritholtz Wealth Management.
Bradley Nuttall Granted DIMS Licence
New Zealand’s expert independent wealth management provider, Bradley Nuttall Ltd is pleased to announce that its DIMS (Discretionary Investment Management Services) licence from the Financial Markets Authority is effective from 30th October 2015.
A DIMS licence is where buy-sell decisions about a customer’s investment portfolio may be made on behalf of a customer, without the need for their authorisation for each transaction. Licensing of DIMS was introduced as part of the Financial Markets Conduct Act 2013, which is replacing most of New Zealand’s existing financial markets conduct law. The new DIMS licensing arrangements place greater obligations and minimum standards on providers, which regulators hope will deliver better protection to investors.
The DIMS licence enables Bradley Nuttall Ltd to continue to provide the financial market services it has been offering clients for the last 25-years. Please click here for more information concerning the DIMS licensee obligations.
Global stocks fell off a cliff in mid-August and they ‘ve been showing their mean streak since.
Shock and terror are spreading as though the zombie apocalypse has arrived. But why?
Besides the famous certainty of death and taxes, there’s another bit of unpleasantness that everyone can count on: The stock market will go down. The silver lining is that it has always gone back up.
“On average, the stock market, as measured by the Standard & Poor’s 500 index, experiences four declines of at least 5% every year. The average intra-year decline is 14%,” says Andrei Voicu, CFP professional, director of market and portfolio strategy at Coury Investment Advisors in Pittsburgh.
Stock market corrections, downturns or pullbacks should come as no surprise. Even 100-year floods happen every so often. By choosing investments that reflect your needs and risk tolerance, stock market volatility should be reduced to what it really is: mostly noise.
What’s your plan?
Having an investment plan in which you are reasonably confident helps allay free-floating anxiety and address questions about what to do in reaction to events over which you have no control.
“That is the easy first thing: Do you have a plan about your investments and overall financial outlook?” says CFP professional Jonathan Duong, CFA, founder and president of Wealth Engineers in Denver.
An investment policy statement can help map out the direction investments should take. It’s also useful to have handy when anxiety starts to mount about the economy. You are prepared for contingencies and girded for worst-case scenarios.
These are the questions your investment policy statement will answer:
What is your goal?
Pro tip: Quantify your goal if possible. For instance, I need $3 million when I retire in 30 years. Armed with this data, you can calculate the rate of return needed. That will dictate the level of risk in your portfolio — or the extra amount you’ll need to save to hit that goal if the level of risk is not feasible.
“Without expectations for risk, there cannot be expectations for return,” says Duong.
How long will you be investing in the stock market?
Pro tip: “The longer the holding period, the less the probability of losing money. Historically, there were no 20-year holding periods with negative returns,” Voicu says.
What is an appropriate asset allocation plan?
Asset allocation is what financial professionals call spreading money around various types of investments, such as large-cap stocks, small-cap stocks and high-quality corporate bonds. It should be based on your goals, time frame and risk tolerance.
Pro tip: Think about worst-case scenarios, such as the recent financial crisis. The S&P 500 lost more than 55% between Oct. 1, 2007, and March 5, 2009. Some portfolios lost more than that and some lost less. Smart asset allocation and diversification can lower the risk in your portfolio and improve returns.
“If the market trends down 5%, find out how far your portfolio has fallen. If you’re down an equal amount or more than a major index like the Dow or S&P 500, you may find you’re taking more risk than you like,” says Robert Laura, president of Synergos Financial Group in Brighton, Michigan.
What is your process for rebalancing or selling investments?
Pro tip: “Maintain a disciplined investment approach. Stay invested and reallocate your portfolio to its intended target allocations if they get out of range. Rebalancing may reduce risk and is an automatic way of buying low and selling high,” Voicu says.
If an investment really is a stinker, “take the time to find out if it’s a company-specific issue or something across that industry,” Laura says.
“Market pullbacks are common and every industry goes through cycles, so it’s important to develop a process to both select and sell investments based on what’s happening and not just feelings or short-term headlines,” he says.
Planning short-circuits panic
There can be unforeseen and expensive consequences to blindly selling in scary market conditions, including transaction costs and opportunity costs. It typically costs money to buy and sell investments. Depending on your holdings, it could cost money to get out and get back into the market.
Selling low also locks in losses.
“Trying to time markets in the short run is counterproductive, as the odds are against you. You have to guess right twice: when to get out and when to get back in. If you don’t guess right, long-term returns will be compromised and short-term paper losses may turn into permanent ones,” Voicu says.
Employing patience and taking the long view will help you get to the other side of market tumult battered but intact.
“Only the investors who stick with their investment plan harvest the returns from stocks,” Duong says. “Jumping out does not lead to success.”
In times of duress, use market volatility as a gauge for your risk tolerance. When market conditions return to calm, fine-tune your approach to investing to be better prepared next time.
Don’t worry, the market will tank again.
Sheyna Steiner covers investing, retirement, CD rates and other personal finance topics for Bankrate.com. She is a co-author, along with seven other Bankrate reporters and editors, of “Future Millionaires’ Guidebook.” Bankrate.com’s editorial, corrections policy
When the stock market swings wildly, investors naturally ask themselves: What should I do?
It’s Michael Liersch’s job to help them answer that question. He’s the head of behavioral finance at brokerage giant Merrill Lynch, a unit of Bank of America Corp.
Liersch studies how and why investors react to market moves and shares what he’s learned with the 15,000 Merrill Lynch financial advisers who deal with the public. (Some other Wall Street firms have investor-behavior departments as well.)
Investors’ mettle has been tested lately. The Dow Jones industrial average briefly plunged 1,000 points in one session a few weeks ago, setting off days of chaotic swings, and experts predict more volatility before the year is out.
Liersch, 39, was asked to discuss how investors react to such turbulence and the mistakes they often make. Here’s an excerpt:
Q: There’s an old saying that each day the stock market is a battle between investors’ fear and greed. Is it your job to sort that out?
A: It’s really helping investors take a step back from judging themselves that way. When you think of the words “fear” and “greed” there’s an automatic judgment that you’re on one side or the other.
Q: Meaning they’re not always afraid or greedy?
A: What I like investors to focus on is what matters most to them (with their money). Is it their family? Maybe they have kids they want to support, or are saving for retirement. Is it a special-needs family member they want to make sure is going to be OK?
It’s within the context of those goals that they would ask, “Should I be behaving differently based on the market’s movements?”
Q: But when markets are plummeting there’s an urge to do something, right?
A: The major mistakes people make is thinking they either need to take extreme action or to completely ignore the markets when there’s a lot of volatility. The fact is, there’s no one correct way to behave during times of volatility.
You should always be engaged in how your money is working. The question is: Should something change about my investments based on what’s happened in the markets in the context of what I’m trying to accomplish?
Q: Is it true that individual investors are lousy at timing the markets when stocks are so volatile?
A: Yes. Time and again data show that investors tend to enter at market peaks and exit at the valleys. Some research suggests this behavior costs investors multiple percentage points annually in investment returns.
Q: How does one avoid this mistake?
A: Work with someone who can provide checks and balance for your choices. That might be a spouse, a partner, a trusted professional. That person can help you make the right trade-offs.
There’s no getting away from it. Market volatility tends to make investors feel uncomfortable, leading to knee-jerk decisions. Investor educator Brian Portnoy, CFA, Ph.D., recommends asking yourself at these times whether you are trying to resolve a long-term financial problem or a short-term emotional need.
Hello, volatility. It’s been a while.
As stock market investors, we should appreciate that we’ve had it relatively easy for years. It’s hard to understate how smoothly the equity markets have climbed since things settled down after the 2007-09 crisis. Since then, returns have been way above average while volatility has been way below average.
Profiting from a risky asset always involves a cost – a “price of admission.” That price is not only the uncertainty of whether the asset’s expected returns will be reached in the time frame relevant to us, but also the ride along the way. Contrary to the conventional wisdom of legends like Warren Buffett, Howard Marks, and Gene Fama, volatility is indeed a form of risk because lots of volatility often compels us to make bad decisions. (I’ll offer a full rant on that topic in a subsequent blog.)
Volatility’s return is a source of discomfort for all of us as it forces us to pay more attention to near-term market moves, which is mentally tiresome. And it tempts us to make more near-term decisions than we’ve been used to. It’s hard to resist counterpunching. In the moment, a rope-a-dope strategy means you’re getting pummeled.
Some basic tenets of behavioral finance can prove insightful at times like these. The goal is not to change your mental make-up – that’s impossible – but to appreciate that our hardwiring leads to some quirky behavior. Self-awareness can help us hedge bad decisions.
It’s the disposition effect that is top of mind for me now as I speak with financial advisors about how they’ve begun to brace themselves and clients’ expectations for choppier times. This effect states that you are wired to invest differently depending on whether you’re winning or losing.
We tend be to risk averse when we are sitting on gains and risk seeking when we are sitting on losses.
But why? The godfathers of behavioral finance, Amos Tversky and Daniel Kahneman, wrote in a 1979 seminal paper: “Our perceptual apparatus is attuned to the evaluation of changes or differences rather than to the evaluation of absolute magnitudes.”
To interpret the academics: It’s the journey that counts, not the destination. Life (and our portfolios) happens incrementally. So you measure progress based on where you now sit relative to your starting reference point.
Zero, it turns out, is a powerful reference point. When you’re ahead – great. But then we tend to sell winners quickly because we crave the psychic gratification of being right and the financial joy of booking a real gain. This is sometimes the wrong move, especially as stocks with positive momentum tend to keep going up.
On the other side of zero, we tend to feel the pain of losing far more than the joy of winning; this is the powerful notion of “loss aversion.” Thus, we’ll go further out of our way to avoid realizing a loss by holding on to a position in the red. Selling a loser? Boy, can that sting.
Realizing a loss renders us “officially” wrong. For advisors, that can prove to be a painful conversation with clients. Overall, advisor and client alike are often desperate to get back to scratch, even when it doesn’t matter much to the bottom line (“absolute magnitudes” to the academics). Sometimes, we’ll even “double down” – add more to a losing position – in the hopes of recovering from losses even more quickly. We look like a hero when we get off the ropes and land a haymaker.
With a more-heightened alert to choppier markets and the hard-to-shake feeling that we must “do something” during such times, please be cognizant of this disposition effect. It says nothing about the underlying value or risk in any of your investments. From a purely analytic point of view, there can be both good reasons to sell a loser (e.g., you were in fact wrong on the thesis) or to hold a loser (e.g., the value’s still there, perhaps even more so now).
But it does speak volumes when emotions trump analysis. Doubling-down, or any other number of trading strategies, might feel like the right thing to do in the moment. At those times, take a breath and ask whether you are solving for a short-term emotional need or a long-term financial problem.
The answer to that question will likely put you in good stead.
Warren Buffett, widely known as the Wizard of Omaha and acknowledged as the most successful investor of the 20th century, famously said about hedge funds:
“Hedge funds are in the midst of a fad. It’s distinguished by an extraordinary amount of fees. If the world is paying hedge funds 2% and a percentage of the profits, and the losers fade away, then it won’t be good for all investors. Obviously, some will do well, but not in aggregate.”
The term “hedge fund” was coined because hedge fund managers could “hedge” their fund’s positions by going long (betting on positive performance and investing in securities) or short (betting against the performance of the underlying securities and selling them short).
The theory is that hedge funds can maximise returns and eliminate risk.
The reality is often quite different.
In a study published in the Financial Analysts Journal, Burton Malkiel (Professor of Economics at Princeton University) and Atanu Saha concluded that “ hedge funds are far riskier and provide much lower returns than is commonly supposed.”
Hedge funds are typically private, aggressively managed funds that take leveraged, speculative positions in currencies, equities, commodities, financial derivatives, and interest rates in the hope that the speculative position will pay off.
Hedge fund managers typically charge a management fee and a performance fee. Performance fees are marketed as providing an incentive for the fund manager to generate positive performance. However, because of the one-sided nature of performance fees, fund managers only share in profits not losses, they actually incentivise excessive risk taking. Some of the most spectacular financial blow-ups of all time have involved hedge funds.
Hedge funds are often incorporated in jurisdictions with minimal disclosure requirements and relaxed regulatory oversight, provide fund prices only once a month, have wide investment latitude and require lock in periods of investors so that getting out can be a time consuming and expensive process.
Unfortunately, due to the opaque nature of many hedge funds, it is very difficult for investors to understand what the hedge fund is investing in and, consequently, what types and how much risk the hedge fund is taking.
It is precisely for this reason that Bradley Nuttall advises against investing in hedge funds.
Bradley Nuttall Ltd is proud to announce we have achieved a prestigious certification from CEFEX an independent global assessment and certification organisation. This is an exclusive accreditation which establishes global best practice standards for investment selection, monitoring and reporting. CEFEX works closely with investment fiduciaries and industry experts to provide comprehensive assessment programs to improve risk management for institutional and retail investors. CEFEX certification helps determine the trustworthiness of investment fiduciaries.
Bradley Nuttall and New Zealand Wealth, both based in Christchurch, have recently been issued with CEFEX Certification for adherence to the Fiduciary Practices set out in the fi360 handbooks.
NZ Wealth provides support services to a growing number of advisers in NZ, including Bradley Nuttal.
As a certifying organisation, CEFEX provides an independent recognition of a firm’s conformity to a defined Standard of Practice. It implies that a firm can demonstrate adherence to the industry’s best practices, and is positioned to earn the public’s trust. This registration serves investors who require assurance that their investments are being managed according to commonly accepted best practices.
Visit the website for more information on CEFEXcertification.
fi360 Pacific trains and supports investment fiduciaries in New Zealand, Australia and the wider Pacific region. Trustees, Superannuation Funds, professional legal and accounting firms and financial advisers utilise our unique training programs and services to ensure appropriate knowledge and processes are applied for sound investment governance.
Market Timing: A Picture is Worth a Thousand Words
They say a picture is worth a thousand words.
I could easily spill a thousand words on market timing. I could talk about how each trade involves a willing buyer and seller; each with equal interests, each with the same access to information.
I could talk about the fact that, over about 85 years, the S&P 500 has gone up on only 51.02% of the days.[i]
I could talk about the concentrated nature of returns. I could show that being out of the market, and missing the best month each year, drops returns by about 7% per year.[ii]
I could talk about a psychologist from Berkeley, named Philip Tetlock, who studied over 82,000 varied predictions of 300 experts from different fields over a period of 25 years, and concluded that expert predictions barely beat random guesses. Ironically, the more famous the expert, the less accurate his or her prediction tended to be.[iii]
I could talk about Nobel Prize winner Bill Sharpe’s contention that timers need to be right 74% of the time to overcome the frictions and costs of their moves.[iv]
I could talk about magazine covers, like the Death of Equities[v], that featured just before five years of 14.44% average compound returns for the S&P 500.[vi]
I could talk about how studies – ranging from the landmark paper by Brinson, Beebower and Hood[vii], to the most recent study on NZ managed funds – have found that the average contribution of market timing to returns is negative.[viii]
I could talk about a study of 1,557 managed funds and 210 institutional funds, where the author concluded timing ability of managers is, on average, negative.[ix]
I could talk about how the majority of market timing newsletters underperform the market.[x] I could talk about how, on average, market timing newsletters underperform the market by over 4.00%.[xi]
I could talk about how the market timing gurus whose calls are tracked have less than 50% accuracy.[xii]
I could talk about evidence that shows economists can’t time markets either.[xiii]
I could talk about how the predictive power of last year’s return to correctly forecast this year’s return is 0.01%.[xiv]
I could talk about the wise words of Warren Buffett, who said “The only value of (share) forecasters is to make fortune tellers look good.”[xv]
I could talk about the simple logic that all market timing calls offset each other. If you buy, someone must sell. If you sell, someone must buy.
I could talk about a lot of things.
I could show you this picture of monthly returns and simply ask you to find the pattern.
Wishing you the very best of luck…
[i] www.ifa.com, “Positive vs. Negative Returns in Various Time Periods”, 85 Years, 5 Months (1/1/1928 – 5/31/2013); S&P 500
[ii] NZX and Returns 2.0. Calculations performed by NZ Wealth. Returns gross of all fees and taxes
[iii] Burton Malkiel and Charles Ellis, “The Elements of Investing”
[iv] Sharpe, William, “Likely Gains From Market Timing”, Financial Analysts Journal, March – April, 1975
[vii] Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, “Determinants of Portfolio Performance”, Financial Analysts Journal, July-August 1986, pp. 39-44; and Gary P. Brinson, Brian D. Singer and Gilbert L. Beebower, “Revisiting Determinants of Portfolio Performance: An Update”, 1990, Working Paper.
[viii] Rob Bauer, Roger Otten, Alireza Tourani Rad, “New Zealand mutual funds: measuring performance and persistence in performance,” Accounting and Finance 46 (2006) 347–363
[ix] Wei Jiang, “A Nonparametric Test of Market Timing.” Journal of Empirical Finance 10 (2003) 399– 425
By Jay Franklin, Head of Risk at Index Funds Advisers (ifa.com), modified with permission by Ben Brinkerhoff
A hedge fund is a private actively managed investment fund that has the ability to take risks not allowed within normal managed funds, such as those used by Bradley Nuttall. Since they have permission to take these risks they are advertised as (but often fail to deliver on) dampening the risks of normal managed funds. The fees of hedge funds are extrodinary and those managers that beat the market consistently often become billionaires.
However, as a whole, hedge funds have failed to deliver their investors a higher return than US Treasury-Bills, according to a new study.1 But there are still a few that have provided stellar above-market returns. One of them in the United States is Steven Cohen’s SAC Capital, which is now the subject of an ongoing United States FBI/Security Exchange Commission investigation of insider trading that made the cover of Bloomberg Businessweek, in a very well-written article by Sheelah Kolhatkar. While it is too early to determine if Cohen will meet the same fate as another corrupt hedge fund operator – Raj Rajaratnam of the Galleon Group, who is currently serving an 11-year prison sentence – the FBI is working hard to get one Cohen’s underlings to turn on him.
As several have pointed out, consistently beating the market is usually the result of insider information. In trader jargon, it is referred to as a “black edge.” One trader turned witness opined that a hedge fund that refrained from using insider information would not be expected to survive. As Kolhatkar brilliantly put it in her recent Bloomberg article, “Trading on nonpublic material information is similar to doping in professional cycling: once someone like Lance Armstrong starts doing it, everyone else has to as well.”
So the prevailing question for any hedge fund operator is, “How do I get an edge so that I am not left behind?” One way, perhaps the oldest way in the world, is made apparent in a salacious ‘help wanted’ ad on backpage.com. Since I cannot do justice by quoting part of it, here is the whole ad (except for the contact information):
Secret Agents Needed
Do you have an open mind, a sense of adventure and the desire to make some serious cash? We’re a group that specializes in extracting key pieces of information from business leaders by seducing them with beautiful ladies such as yourself. Each assignment pays between $5k and $20k depending on the value of the information and how long it takes to obtain it. We also reimburse for travel expenses, if any. We have immediate needs for beautiful, sophisticated ladies who will do anything it takes to find out what we need to know! Please send photos and tell us something about yourself.
A few who followed the case in which corrupt hedge fund manager Raj Rajaratnam was put in jail will recall Danielle Chiese, the femme fatale who acquired information in the manner described above. She is now serving a 30-month sentence at the same federal prison that hosted Martha Stewart a few years ago, also in connection to trading on insider information. In one of her more colorful recorded conversations, she boasted of “playing” one of her paramours “like a finely tuned piano.” It is not difficult to understand why Forbes magazine designated hedge funds as The Sleaziest Show on Earth.
Bradley Nuttall advises investors that, rather than striving to beat the market, they should view the market as an ally whose returns are there for the taking. And finally, if anyone does come across material non-public information, they should contemplate how they would look in a prison uniform before acting upon it.
1Simon Lack, The Hedge Fund Mirage (New Jersey: John Wiley & Sons, Inc., 2012).
Why More Information Can Lead to Poor Investment Decisions
How many people make investment decisions based on the last thing they read in the paper or heard on TV?
In their minds, they believe they’ve found the missing information that resolves their uncertainty. But is the uncertainty truly resolved? No; what they’ve done is overemphasise the value of the new information they’ve heard. While we probably know that’s true intuitively, experts can provide insight into this process.
We like to think that more information drives smarter decisions; that the more details we absorb, the better off we’ll be. It’s why some of us subscribe to Google Alerts and cling to our iPhones.
Knowledge, we’re told, is power. But what if our thirst for data is actually holding us back? What if we are biased to weight the value of new information inappropriately and disproportionately, therefore compromising our decision-making process?
That’s the question raised by Princeton and Stanford University psychologists in a fascinating study, titled “On the Pursuit and Misuse of Useless Information” (Journal of Personality and Social Psychology, Vol. 75, No 1).
Their experiment was simple. Participants were divided into two groups.
Group 1 read the following:
Imagine that you are a loan officer at a bank, reviewing the mortgage application of a recent university graduate with a stable, well-paying job and a solid credit history.
The applicant seems qualified, but during the routine credit check you discover that, for the last three months, the applicant has not paid a debt to his charge card account. The existence of two conflicting reports makes it unclear whether the outstanding debt is for $5,000 or $25,000, and you cannot contact the credit agency until tomorrow to find out which is the correct amount.
Do you approve or reject the mortgage application immediately, or wait until tomorrow when more information is available?
Group 2 saw the same paragraph, with one crucial difference – instead of the amount of the debt being unclear, the second group was told upfront that the unpaid debt was exactly $5,000.
Here’s where it gets interesting. Once the participants in Group 1 who decided to wait for more information were told the size of the debt was only $5,000, 21% of that group rejected the mortgage application. Compare this with the 71% of Group 2 participants (remember, that group didn’t need to decide whether to wait for any further information) who chose to reject the applicant immediately.
To say the findings are surprising is an understatement. Why would the rate of rejection be three times higher in Group 2?
The answer underscores a troubling blind spot in the way we make decisions.
The human mind hates uncertainty. Uncertainty implies risk, randomness and danger. When we notice information is missing, our brain raises a metaphorical red flag and says, “Pay attention. This missing information could be important.”
Seeking out information comes with a downside, however, which accounts for the intriguing difference between the two groups in the study described above. When data is missing, we overestimate its value. Our mind assumes that, since we are expending resource locating information, it must be useful.
The majority (75%) of participants in Group 1 couldn’t help but wait for additional information. And because their attention was now focused on whether the debt was $5,000 or $25,000, their thinking about the loan had shifted – it was all about the size of the debt rather than the simple fact that the applicant had not paid anything off this debt in three months.
This instinct to find the missing information, and subsequently assign it too much importance, explains why investors love market forecasts. Investors want to fill in the missing piece of information, which for most is something along the lines of “what is the market going to do next year?” But the forecasts are consistently wrong.
Below are leading Australian economists’ forecasts in the Sydney Morning Herald for 2011, compared to the actual results:
This shows how difficult it is to forecast correctly, even over short periods of time. How wise is it to make investment decisions based on forecasts like the above?
Information is addictive; learning is associated with the release of dopamine! In a world where every click brings the promise of a discovery, we are all at risk of becoming addicts. The challenge lies in deciding which questions are worth exploring and how much importance we give to their answers.
The role of the adviser is to know the questions that really add value, and then make considered decisions based on the sum of all the information. This means avoiding overemphasising the importance of recent information, and understanding what is unknowable, so we can avoid trying to fill the gap with forecasts. By doing this, we can keep clients’ investments on track and afford them peace of mind.
With thanks to Rick Walker and an article published by Ron Friedman, PhD, in Glue, 4 December 2012.
The Too Good to Be True Test
Some myths die hard. One is the notion that there are people who can pick winning investments year after year without ever losing money.
Take boutique investment business Ross Asset Management (RAM), which has gone into receivership owing clients hundreds of millions of dollars.
New Zealand’s Serious Fraud Office has launched an investigation into RAM, whose Wellington offices were raided by regulators in November following complaints from investors that they were unable to get their money out.
RAM was headed by financial advisor David Ross and worked out of a small office with just two support staff.
Some 900 individual investors were attracted by the group’s reported returns, which receivers PricewaterhouseCoopers estimated at 25 per cent a year since the year 2000.
Yet while Ross claimed to be holding investments worth nearly half a billion dollars on behalf of clients, PwC found records of just $10 million. The whereabouts of the rest is unclear. While not making any direct claims of fraud, both PWC and the Financial Markets Authority have said RAM had “characteristics of a Ponzi scheme”.
Under such a scheme, a manager reports false and inflated returns and pays out these false returns to investors from contributions made by new investors. The problem with such schemes is managers have to keep reporting high returns, even if they are false, to attract new money in order to meet withdrawals.
Certainly Ross appeared to have convinced a sufficient number of people to keep money coming in. One client was quoted saying that Ross “seemed to know everything about what was going on in the market” and had a “fantastic” track record.1
This supposed track record was based on a strong bias towards small, high-risk mining shares, very concentrated portfolios, the lack of any audit record and the reliance on a single individual with no back-up expertise.
The investment performance of RAM’s funds was reported without any independent verification or audit. There was no independent custodian. As well, receivers found no record of broker transaction statements, no record of portfolio valuations, no broker contract notes and no registry records.
Just to put RAM’s losses into perspective, assuming investors in the RAM funds lose everything, the total loss in proportion to the size of the New Zealand economy will be about twice that of the Bernie Madoff Ponzi fraud in the US.
While the upshot of all this is a depressing one – hundreds of people look to have lost their life savings – it nevertheless provides a number of key lessons for investors everywhere.
Firstly, one should be sceptical about any scheme that promises consistently positive returns – well above the market – year after year. Not even Warren Buffett has managed to beat the US S&P-500 these past three years.2
Risk and return are related. So it is possible to outperform the market, but not without accepting more risk. Besides, if you were consistently able to generate 25-30% returns, why would you share your insights with anyone else? You wouldn’t need to.
Secondly, any investment based on a few shares or a couple of sectors – like RAM claimed to be doing – means taking on unnecessary risk. That’s a gamble, not an investment. By contrast, diversification allows you to capture broad market forces while reducing the uncompensated risk associated with individual securities or sectors.
Thirdly, you should never under-take an investment without first receiving independent advice from a fiduciary paid by you to do due diligence on the opportunity and to tailor a strategy to your needs, not based on what they have to sell. In the case of RAM, Ross was both providing the advice and investing the money. And he was doing so without an independent custodian. That should have rung alarm bells somewhere.
Finally, it is not a good idea to make an investment based on the supposed ability of an individual to forecast the future. Aside from the fact that there is no evidence that anyone can do so with any consistency, it means the success of your investment is a highly-correlated to an individual’s expertise or integrity.
A better idea is to insist on a clear investment philosophy, a transparent investment process, an approach based on evidence rather than forecasts or intuition and a consistent application with proper safeguards for investors.
No-one can guarantee a positive return every year. But you can be sure that a structured approach based on the principles of modern finance and the efficacy of capital markets will add value with higher reliability and confidence than one based on instinct and prophecy.
There has been a lot in the news recently regarding Ross Asset Management Ltd. Like anyone with any knowledge of the circumstances, we are angered and disappointed by what we’ve read. We understand that this must all be a little unsettling, and perhaps more so because Mr Ross had an Authorised Financial Adviser (AFA) qualification.
It is for this reason that we have written this article on how to ensure your assets are safe.
Fortunately, the process is straightforward:
1. Ensure an independent third party has custody of your assets
An adviser should never personally take control over their clients’ funds. Rather, an independent third party (in our case, Aegis) should hold all assets and conduct buy and sell transactions.
2. Ensure the third party custodian is reputable
Our clients’ accounts are held by Aegis and its custodian, Investment Custodial Services Ltd (ICSL), which is a wholly owned subsidiary of ASB Bank.
3. Ensure that the third party custodian reports to you independent of your adviser
You should be able to determine what your account is worth 24 hours a day, 7 days a week, without needing to contact or notify your adviser.
4. Ensure you know what you own
You should be able to easily and independently look up the investments in your portfolio, find them online and review their statements and prospectuses. This includes both individual shares and managed funds.
5. Ensure what you own is highly diversified
If you look on your statement and find only a few shares all from the same industry, you have a problem. A few years ago, many regretted the fact that they had concentrated their portfolio in a few finance companies. Investment concentration is a horrible idea. You want diversification across industries, countries and investment types including shares, fixed interest and real estate.
If you can check off all of the above you may or may not have a great performing portfolio, but at least you can be more confident that your portfolio is worth what you think it’s worth.
Remember, the AFA letters only tell you that an adviser has the necessary training and expertise required to be a good adviser. While they also carry an implicit guarantee of prudence and client-first advice, it is a sad fact that fraudsters in any profession don’t tend to care too much about best-practice. In the case of Ross Asset Management, there was sadly a big difference between understanding the appropriate ethical and moral standards for adviser behaviour, and actually putting them into practice.
Lastly, and perhaps most importantly, investments that seem too good to be true, often are. Those of us who do this work honestly have had a difficult time over the past 10 years. It’s been a bumpy road involving many honest conversations with our clients. Ross was sailing along with great returns. How did he do that? It appears that he did it by lying. Investments provide return because they bear risk. It’s a simple and true statement. Higher risk leads to higher return, but also more uncomfortable and frequent down periods.
There will always be charlatans that try to convince us otherwise. We just hope you don’t believe them.
How the Best Investor in the World Beats the Market
For good reason, Warren Buffett has long been considered one of the most judicious investors of his generation. In fact, his firm Berkshire Hathaway has the highest risk-adjusted returns of any listed U.S stock or managed fund with a history of more than 30 years.
Which begs the question: What’s the source of Buffett’s above market returns?
The “conventional wisdom” has always conveniently been that his success is explained by his share-picking skills and his discipline. However, a new study1provides some very interesting and unconventional answers.
The following is a summary of the study’s findings:
From November 1976 through December 2011 (a 35 year period), Berkshire realised an average return of 19.0% pa over and above the risk free asset (being U.S Treasury bills). In comparison, the S&P 500 (or the 500 largest listed stocks in the U.S) returned 6.1% above the risk free asset. That is an incredible result over such a long time period.
(It’s important to remember that Standard & Poor’s research comprehensively demonstrates that most investors don’t even get the market return – or in this case the S&P 500 return – over 5 years or longer. This is entirely due to ill-disciplined behaviour in volatile markets).
As risk and return are related, you would expect Berkshire to have been exposed to more risk than the overall market to achieve this result. And indeed it was, with one measure being that Berkshire’s share price was 58% more volatile than the overall market. So only investors who remained disciplined and held onto their Berkshire stock would have enjoyed the long term performance.
Berkshire had to endure periods of substantial losses compared to the overall market and significant drawdowns to achieve its results. For example, over the 20 month period to February 2000 (during the IT boom), Berkshire shares lost 44% of its market value, while the overall stock market gained 32%.
Not many fund managers could survive a 76% underperformance over a two year period! And no doubt there were many media commentators desperate to fill their column space each day who wrote off Berkshire shares during this time.
Buffett is clearly a proponent of our mantra “It’s not timing the market that counts, it’s time in the market that matters.”
Buffett has boosted returns through the use of low cost debt to invest.
Buffett has stuck with his strategy for a very long time period, surviving rough periods where others might have been forced into a fire sale or allowed emotion to interfere with the disciplined process of investing.
Buffett’s approach is to buy large stakes in operating businesses and, in certain cases, provide strategic advice to management. He tends to nurture and support management more than other investors.
The study concluded that it is Buffett’s strategy that generated the alpha or above market returns, not his stock selection or market timing skills.
Our approach of targeting the dimensions of higher expected returns focuses on the factors that drive returns and deliver a premium:
Cash & Fixed Interest
Credit & Term – only take credit risk and term risk where the bond portfolio is widely diversified and investors are adequately rewarded.
Market – over time the sharemarket provides higher expected returns than cash and bonds because risk and return are related.
Small – a well-diversified portfolio of small companies provides a higher expected return than large ‘blue chip’ shares because small companies are riskier assets to own and tend to have a higher cost of capital. A higher cost of capital over the mid to long term results in a higher expected return.
Value – a diverse portfolio of ‘cheap’ shares as measured by book to market ratios provides higher expected returns than large, established ‘growth’ companies because these value companies are riskier assets to own.
It is the ones relating to the sharemarket – plus some additional elements like low cost borrowing – that the report concluded were the foundation of Buffett’s success.
Buffett’s genius thus appears to be in recognizing long ago that “these factors work… and sticking to his principles,” the study finds. It notes that it was Buffett himself who stated in Berkshire’s 1994 annual report: “Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.”
When the study considered all the factors that Buffett targets in his investment approach, it found that only 0.1% pa of Berkshire’s stock price outperformance compared to the market could not be explained. In other words, whilst 0.1% could be attributed to skill or luck, the remaining outperformance could be quantified by academically accepted investment strategies employed by Buffett.
So we know that Buffett has one extrodinary gift that few others share, he is disciplined. He combines that discipline to buy primarily value (out of favour) shares and using low cost debt.
Whilst the average high net worth investor cannot access the type of low cost debt available to Buffett, you can access the other factors that contributed to his market-beating results.
Bradley Nuttall’s Asset Class investment approach already captures the academically accepted factors that drive returns, plus ‘momentum’.
The academics we work with in the U.S have, after extensive research, uncovered a sixth factor that is currently being tested. This may be another evolution in our investment approach that is helping to provide our clients with the greatest probability that their lifestyle and financial goals will be achieved.
So in our own way, we are capturing the nous of Buffett through our evidence based approach to investment. However instead of our clients spending their time like Buffett studying the market for opportunities, we hope our clients are instead enjoying full and meaningful lives that don’t involve the day to day worries of investing.
Adapted from Larry Swedroe, Money Watch, 2 October 2012, and from Rick Walker at Stewart Partners, Sydney Australia
1. ‘Buffett’s Alpha’, by Andrea Frazzini and David Kabiller of AQR Capital Management, and Lasse Pedersen of New York University and the Copenhagen Business School, 29 August 2012
People who make bad money decisions can often rationalise them. Here are 10 common excuses.
Human beings have an astounding facility for self-deception when it comes to their own money.
We tend to rationalise our own fears. So instead of just recognising how we feel and reflecting on the thoughts that creates, we cut out the middle man and construct the façade of a logical-sounding argument over a vague feeling.
These arguments are often elaborate short-term excuses that we use to justify behaviour that runs counter to our own long-term interests.
Here are 10 of them:
“I just want to wait till things become clearer”.
It’s understandable to feel unnerved by volatile markets. But waiting for volatility to “clear” before investing often results in missing the return that goes with the risk.
“I just can’t take the risk anymore.”
By focusing exclusively on the risk of losing money and paying a premium for safety, we can end up with insufficient funds to retire on. Avoiding risk also means missing the upside.
“I want to live today. Tomorrow can look after itself.”
Often used to justify a reckless purchase. It’s not either-or. You can live today AND mind your savings. You just need to keep to your budget.
“I don’t care about capital gain. I just need the income.”
Income is fine. But making income your sole focus can lead you down dangerous roads. Just ask anyone who invested in collateralised debt obligations.
“I want to get some of those losses back.”
It’s human nature to be emotionally attached to past bets, even the losing ones. But as the song says, you have to know when to fold ‘em.
“But this stock/fund/strategy has been good to me.”
We all have a tendency to hold on to winners too long. But without disciplined rebalancing, your portfolio can end up carrying much more risk than you bargained for.
“But the newspaper said….”
Investing by the headlines is like dressing based on yesterday’s weather report. The news might be accurate, but the market usually has already reacted and moved on to worrying about something else.
“The guy at the bar/my uncle/my boss told me…”
The world is full of experts, many of them recycling stuff they’ve heard elsewhere. But even if their tips are right, this kind of advice rarely takes account of your circumstances.
“I just want certainty.”
Wanting confidence in your investments is fine. But certainty? You can spend a lot of money trying to insure yourself against every possible outcome. It’s cheaper to diversify.
“I’m too busy to think about this.”
We often try to control things we can’t change – like market and media noise – and neglect areas where our actions can make a difference – like costs. That’s worth the effort.
Given how easy it is to pull the wool over our own eyes, it pays to seek out independent advice from someone who understands your needs and your circumstances and who keeps you to the promises you made to yourself in your most lucid moments.
A recent article appearing in the Financial Times caught our eye—or perhaps we should say ear. At first glance it was unremarkable—just one among dozens of recent think pieces suggesting that investors were losing interest in stocks as markets around the world continued to stagnate.
But the tone of the article sounded remarkably familiar. We dug out our copy of the “Death of Equities” article appearing in BusinessWeek on August 13, 1979, to have a fresh look. Similar? You be the judge:
“This ‘death of equity’ can no longer be seen as something a stock market rally—however strong—will check. It has persisted for more than ten years through market rallies, business cycles, recession, recoveries, and booms.”
Financial Times, 2012:
“Stocks have not been so far out of favor for half a century. Many declare the ‘cult of the equity’ dead.”
“Individuals who are not gobbling up hard assets are flocking to money market funds to nail down high rates, or into municipal bonds to escape heavy taxes on inflated incomes.”
Financial Times, 2012:
“The pressure to cut equity exposure is being felt across the savings industry. … In the US, inflows to bond funds have exceeded equity inflows every year since 2007, with outright net redemptions from equity funds in each of the past five years.”
“Few corporations can find buyers for their stocks, forcing them to add debt to a point where balance sheets seem permanently out of whack.”
Financial Times, 2012:
“With equity financing expensive, many companies are opting to raise debt instead, or to retire equity.”
“We have entered a new financial age. The old rules no longer apply.” —Quotation attributed to Alan B. Coleman, dean of business school, Southern Methodist University
Financial Times, 2012:
“The rules of the game have changed.” —Quotation attributed to Andreas Utermann, Allianz Insurance
“Today, the old attitude of buying solid stocks as a cornerstone for one’s life savings and retirement has simply disappeared.”
Financial Times, 2012:
“Few people doubt, however, that the old cult of the equity—which steered long-term savers into loading their portfolios with shares—has died.”
When the first “Death of Equities” article appeared, the S&P 500 had underperformed one-month Treasury bills on a total return basis for the fourteen-year period ending July 31, 1979 (107.0% vs. 119.6%, respectively). Was buying stocks in August 1979 a smart contrarian strategy? Yes, but only if one had the patience to stick it out for years. Imagine the frustration of an investor who had been counseled to “stay the course” in response to the “Death of Equities” article appearing in August 1979. Stocks did well for a while, jumping over 27% from August 13, 1979, to March 25, 1981, when the S&P 500 hit an all-time high of 137.11. But by July 31, 1982, stocks had given back all their gains, and the S&P 500 was almost exactly where it had been nearly three years earlier. As of July 31, the S&P 500 had extended its underperformance relative to one-month Treasury bills to seventeen years (total return of 150.5% vs. 213.6%).
Imagine this same investor arriving at her financial advisor’s office on Friday, August 13, 1982, with a three-year-old copy of BusinessWeek under her arm. Stocks had drifted lower in the preceding weeks, and the S&P 500 had closed the previous day at 102.42. “You told me three years ago to stay the course, and I did,” she might have remarked to her advisor. “It hasn’t worked. Obviously, the world has changed, and it’s time I changed too. Enough is enough.”
We suspect even the most capable advisor would have faced a big challenge in seeking to persuade this investor to maintain a significant equity allocation. For many investors, seventeen years is not the long term, it’s an eternity.
Superstitions aside, stocks rose that day, with the S&P 500 advancing 1.4%. It wasn’t obvious at the time, but August 13, 1982, marked the first day of what would turn out to be one of the longest and strongest bull markets in US history. The S&P 500 was 16% higher by the end of the month and went on to quadruple over the subsequent decade. The table below shows data for the S&P 500 on a price-only basis. With dividends reinvested, the return would be materially enhanced.
“Death of Equities” Anniversary
1st Anniversary August 12, 1983 – 58.3%
5th Anniversary August 12, 1987 – 224.5%
10th Anniversary August 12, 1992 – 307.9%
20th Anniversary August 12, 2002 – 782.4%
(Almost) 30th Anniversary June 19, 2012 – 1,225.9%
One of the authors of the FT article, John Authers, is familiar with the BusinessWeek article and wary of making pronouncements that might look equally foolish ten or twenty years hence. In a follow-up article appearing several days after the first, he appealed for divine assistance in his forecasting effort: “O Lord, save me from becoming a contrarian indicator.” Nevertheless, after revisiting his arguments he remained persuaded that the climate for equities was too hostile to be appealing.
We should not use this discussion to make an argument that stocks are sure to provide investors with appealing returns if they just wait long enough. If stocks are genuinely risky (which certainly seems to be the case) there is no time period—even measured in decades—over which we can be assured of receiving a positive result. Nor should we seize on every pundit’s forecast as a reliable contrarian indicator. With dozens of self-appointed experts making predictions, some of them are going to be right. Perhaps even John Authers.
The notion that risk and return are related is so simple and so widely acknowledged that it hardly seems worth arguing about. But these articles (and others of their ilk) offer compelling evidence that applying this principle year-in and year-out is a challenge that few investors can meet, and explains why so many fail to achieve all the returns that markets have to offer.
“The Death of Equities,” BusinessWeek, August 13, 1979.
John Authers and Kate Burgess, “Out of Stock,” Financial Times, May 24, 2012.
John Authers, “The Cult of Equities Is Dead. Long Live Equities,” Financial Times, May 27, 2012.
S&P data are provided by Standard & Poor’s Index Services Group.
Stocks, Bonds, Bills, and Inflation Yearbook. Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield).
Harvard Study: Are Financial Advisers Giving “Good Advice”?
Harvard and MIT Professors sponsor the largest ever mystery shop on financial advisers. What did they find?
I’m sorry to say but there is a large, compelling and growing body of research that shows that most households make very poor investment decisions. The reasons why are fairly well documented: we are overconfident, follow the crowd and are ruled by emotions like fear and greed. Every single independent study that I’m aware of shows that buy and hold investors do better than the average investor fleeing in and out of markets and following hot tips. Collectively, academic researchers call the bad investing instincts we all share “biases”.
In the academic world, all that is old hat. But a recent study by the National Bureau of Economic Research (Massachusetts) conducted by professors from Harvard, MIT and the University of Hamburg (and commented on recently in the NZ Herald) added an interesting twist to the discussion.
“We ask whether or not the market for financial advice serves to de‐bias individual investors and thus correct potential mistakes they might make.”
In other words, do advisers prevent their clients from making financial mistakes based on their emotional biases? Good question!
To find their answer, researchers distinguish between “good advice” and “bad advice”.
What is good advice? From the study:
“We define ‘good advice’ as advice that moves the investor toward a low cost, diversified, index-fund approach, which many textbook analyses on mutual fund investments suggest, see for example Carhart (1997).”
Bad advice does just the opposite: it exploits investors’ built-in biases to encourage the high cost and poorly diversified investments that are in the adviser’s best interests to promote.
Armed with these definitions, the study sent out mystery shoppers to perform 284 audit visits to financial advisers.
So what were the results? Not good.
Again, we quote from the study:
“These results suggest that the market for financial advice does not serve to de‐bias clients but in fact exaggerates biases that are in the adviser’s financial interest while leaning against those that do not generate fees. In our index fund scenario, the advisers are even advocating a change in strategy (away from low fee index funds and towards high fee actively managed funds) that would make the client worse off than the allocation with which he or she started off.”
As much as this report looks bad for the financial advice industry, here at Bradley Nuttall we want to stand up and applaud. Finally, researchers understand that advisers are part of the problem. By and large, advisers do more to encourage poor investing behaviour than correct it. Why? Because most advisers (but not Bradley Nuttall) are paid, at least partially, by the “high fee actively managed” investments they recommend. It’s a flawed model.
But there are other reasons bad advice is so pervasive.
Good advice is hard to give. It often means that you tell a prospect or client what they emotionally do not want to hear. This decreases the chance they want to work with you, because your advice doesn’t “feel right”.
Combine this emotional hurdle with the fact that advisers can get paid handsomely to give bad advice – and that bad advice often has the air of exclusivity or inside knowledge that investors love – and you can see why we have a problem.
It’s good advice to suggest that investors will be compensated for the risks they take. The higher the risk, the higher the long term returns will be.
Bad (but emotionally satisfying) advice gives clients the expectation that, due to the adviser’s inside knowledge, there are high-return/low-risk investments out there just waiting to be picked off. This almost always leads to disappointment, as the figure below portrays. Good advice steers clear of get-rich-quick, can’t-lose and glamorous investments.
We strongly advocate the findings of this academic study. Bradley Nuttall has been giving good advice, defined in the study as “low-cost diversified efficient portfolios”, for over a decade now. And to ensure we are never compromised we do not take any revenue from investments we recommend, which is one reason the costs of the investments we use are about four times lower than the industry average.
However, our experience is that investors are confused. They hear so much noise; so many calls to buy or sell; so many worrying and conflicting reports, that distinguishing between good and bad advice is almost impossible.
Who do they trust?
How are they to know?
Here’s hoping that this report, and more like it, will start to have an influence on the hard working investors who simply want financial security and peace of mind.
Those investors, like all others, have biases. But we know that good advice delivered with honesty and integrity can make a big positive difference.
That’s the difference we try to make every day.
Taking the Plunge: Is Now the Time to Start Investing?
Anxiety about the equity market is understandable, but if we wait for the “perfect” time to invest, the risk is we never will.
The child was inconsolable. A day at the pool had ended without her joining her friends in the water. Time after time, she had dipped her toe in, only to shrink back in fear of the unknown. Now she was going home full of regret.
Investing can be a bit like that.
In a period of uncertainty, as we have been seeing, it is quite understandable that investors should seek to time the market. Like the little girl standing at the poolside torn between fear and anticipation, it can be easy to rationalise against taking the plunge.
But the problem is that fear and uncertainty can never be eliminated. Those feelings are the emotional manifestation of risk that is the price we pay for the returns we are seeking. In the case of the girl at the pool, she wants to join her friends in the water, but her fear of the unknown is preventing her from doing so.
The way to deal with these feelings is firstly to recognise them as legitimate and in so doing bring them back down to size. Fear tends to loom larger when we don’t confront it. It’s OK to feel anxious, but not to the point where it stops us ever doing anything.
Secondly, we should think back on the best experiences in our lives and reflect on how often they involved taking a risk – whether it was enrolling in a degree course or changing careers or moving towns or having children. If we waited for everything to be perfect, we might not ever have got around to doing those things.
Thirdly, we might like to reflect that while there is a potential cost in taking that plunge, extreme risk aversion also comes at a cost. For the little girl at the pool, the cost of avoiding that brief moment of fear was a miserable car ride home feeling excluded as all the other kids talked about the fun they had had.
In global financial markets recently, the premium on perceived safety has been particularly high. For instance, investors in the sovereign bonds of Germany, the US and the UK have been prepared to accept negative real yields for the privilege of governments looking after their capital – a risk without a return in other words.
Now those decisions might be completely defensible given the risk appetites of those particular investors. But it’s important also that we realise safety comes at a cost.
Finally, it is worth considering how quickly conditions can change while we are waiting for our anxiety to subside. Financial Author, Westin Wellington recently pointed out that amid all the recent turmoil, 22 prominent US firms have hit at least 52-week highs. These included household names like Johnson & Johnson, Hershey and Wal-Mart.
But this isn’t just a US phenomenon. In Australia, for all the talk about an underperforming equity market, a large number of leading companies have hit 52-week highs – including Commonwealth Bank, CSL, Tatts Group and News Corp.
In New Zealand, many companies recently hit 52-week highs – including Abano Healthcare Group, Infratil, Ryman Healthcare, Summerset Group Holdings, and Telstra.
We don’t know which shares will be the next ones to push to new highs. But we do know that those people sitting on the side-lines in cash – like the little girl shivering on the side of the pool – risk going home without sharing in the returns enjoyed by others.
The takeaway message is that there never is a perfect time to invest. How can there be, everyday half the shares are bought and half are sold. There’s always going to be two equal and opposite opinions. And since 1928 markets behave by going up 51.01% of the days.
We deal with that uncertainty by understanding the risks we are taking, diversifying broadly, making decisions for the long term not based on day by day fluctuations and being mindful of the factors within our own control – like our own behaviour.
So sometimes, you just have to close your eyes and take the plunge.
Investors are now so risk averse they are willing to pay the German government to look after their money; not a risk-free return, but a return-free risk.
Yields on two-year German notes sank to an all-time low of -0.005% on June 1. Looked at another way, anxious investors were prepared to accept a negative return for the comfort afforded them by parking their cash with the German government. And this was even before taking inflation into account.
This isn’t the first time this has happened. Back at the height of the financial crisis in late 2008, negative yields were observed in US Treasuries – a consequence of investors at that time being willing to pay to park money in a safe asset.
The extreme state of risk aversion in global markets is reflected not only in German bunds. In the US, Treasury bond yields have hit record lows, as have their equivalents in Australia, the UK, France, Austria, Finland and the Netherlands.
Government Bonds 10-Year Yield (%)
The causes of this mass shying away from risk are well documented – worries that the euro-zone will break up, concern that the US economic recovery is stalling, signs of a slowdown in China and a loss of momentum in emerging markets. Anyone who takes note of media and market commentary will know that there are a wide range of opinions about the likely outcomes of these issues. The important point for the ordinary investor is that all those opinions and uncertainties are already reflected in current prices.
Here’s how this process works: Security prices are an expression of the market’s aggregate view of future expected cash flows divided by a discount rate (or risk premium) that investors demand for putting their money into risky assets.
When the price of a security falls, it can be due to lower expected cash flows, a higher discount rate or a combination of the two. While we don’t know the exact mix of these influences, we do know that if lower prices are wholly due to lower expected cash flows, expected returns will be unaffected. On the other hand, if it is due to the application of a higher discount rate due to higher risk aversion, we can say expected returns for the risky assets are higher.
Investors’ willingness to pay to park their money in German bonds is an indication of higher risk aversion. Higher risk aversion should be linked to higher discount rates so the probability is that expected return premiums on risky assets have gone up.
Think back to what we saw coming out of the first stage of the financial crisis in March, 2009. Risks were high and prices of risky assets went down. Many investors, overcome by the uncertainty at that time, sought refuge in government bonds. Due to this generalised increase in risk aversion, investors demanded a higher premium before putting their money into equities and corporate bonds. But as risk appetites revived that year, those risky assets paid a very substantial return. Share prices rebounded and the spread of corporate over government bonds narrowed sharply.
The takeaway from all this is that sheltering in what are perceived as the safest government bonds may provide certainty for a time, but also comes at the cost of forgoing the significant increase in risk premiums that may be available.
This is not to argue, by the way, that increasing one’s allocation to risk-free assets is never a legitimate decision. Such a course may well be appropriate for the individual investor, based on his or her own tastes, circumstances, liquidity needs and investment objectives. If possible, however, it is best to develop appropriate asset allocations for individuals based on their risk tolerances outside these periods of distress. That’s because selling risky assets at such times can be expensive.
In summary, it is worth reflecting on the fact that record low yields on government bonds, and in particular negative yields on the safest assets, may be an indication of extreme risk aversion and high discount rates on risky assets. This higher discount rate would have been partly responsible for their recent price decline and will probably be reflected in higher expected returns.
When risk appetites return – and we don’t know when or if that will happen – those risky assets may stage an equally dramatic recovery. Seeking to time those changes can be a very, very expensive exercise. So at times like these, it’s worth reminding ourselves that safety comes at a cost.
The worrying events of recent weeks and months are incorporated into prices. But remember that future events, unknown to us today, can always affect prices in positive or negative ways beyond the expectations built into the market today.
Warren Buffett, legendary US investor, has made billions of dollars investing based on a fundamental behavioural premise (coupled with ingenious business acumen): be “greedy when others are fearful”.
It sounds good. It seems pretty clear, when share prices look like the chart below, that the logical time to invest is at the bottom of the curve.
With the situation in the world so uncertain these days, many investors are reluctant to invest. We understand that reaction, in the current global environment. Many conclude that, since the world has slow economic growth (measured by GDP), it must mean the outlook for shares is also poor.
After all, it is widely believed share market returns are based on economic growth. If growth looks to be sluggish, doesn’t that mean that the share markets will also be sluggish?
How sound is that conclusion?
Fortunately we are here to shed some light and optimism. There is simple and compelling academic evidence that the intuitive link between economic growth and share market returns is probably flawed, or at least over-stated.
Research conducted by an American professor, Jay Ritter of the University of Floridaii, on the relationship between economic growth and real share market returns from 1900 to 2002 (that’s 102 years) showed that economic growth did not at allexplain share market return over the 102 year period. Look at the chart below. You’ll see that the height of the blue bar (economic growth) and the height of the green bar (share market performance) are unrelated across several different countries.
For example, Australia averaged 1.6% per annum real per capita economic growth. That’s the second worst of the six countries listed above, yet it had the best share market performance. Japan had the best per capita growth at 2.90% per annum, but only the fourth best share market performance. UK has the worst growth but the third best share market performance, better than the Japanese. How can this be?
The point is simple – economic growth does not tell us much about how share markets will perform.
It’s important that this result was found for a 102 year period. That period includes a global financial crisis (the Great Depression) and a series of World Wars, oil shocks, currency crises, a tech bubble and a terrorist attack, so it’s very robust data.
So the question remains: why? Why doesn’t economic growth link directly with share market performance? It seems like it should.
The paper offers multiple suggestions:
When the economy grows often it’s the workers who receive the benefit, not just the owners of shares
New businesses owned by private investors, not owned in public share markets, are better at catching the wave of growth
Economies with poor growth have low share prices because market participants are a bit scared, so new investors can get better deals leading to higher potential returns
Buffett captures the last point best in his Berkshire Hathaway 2004 Chairman’s letter:
‘Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful’.
Fear is a natural human reaction to the current catalogue of negative stories from the media, but fearful investors make the mistake of imagining they can sell their shares before these bad news stories affect prices. This information is alreadyembedded in the price, so the only thing a fearful investor consistently achieves is to sell at the bottom of the curve. Warren Buffet responds differently – he acts like it’s Boxing Day and everything is on sale. The trouble for the rest of us is that living true to Buffett’s wisdom is very hard.
Bradley Nuttall’s approach is first to diversify so that we’re not over-exposed to any one set of market expectations for either country or company. We invest in over 40 countries and about 8,000 underlying securities. We resist the urges of fear and use discipline to hold on to our portfolios, knowing (as in 2009 and 2003) that patience will be rewarded. Down-markets are an unfortunate and inevitable reality of global business. But markets have always come back and, with discipline, or even with a bit of greed, smart investors will reap the benefit.
Money in the Bank – Term Deposits vs Fixed Interest
Key Points Overview
For many people, there’s no better bet than money in the bank. And with New Zealand interest rates among the highest in the developed world, why should you risk your capital in fixed income funds when term deposits are so tempting? In answering that question, it’s useful to reflect on what fixed interest is, the risks involved and the various roles this asset class can play in a diversified portfolio.
Term deposits have the attraction of safety. But bear in mind it is harder, and often expensive, to get quick access to your money when it is locked up in the bank. In addition, the recent premium offered by deposit rates is historically unusual and there is the prospect of interest rates going down during your chosen term, leaving you with risk you won’t be able to reinvest your money at attractive rates.
At the height of the global financial crisis in 2008, the New Zealand Treasury made explicit an implied guarantee on retail bank deposits. The initial scheme was extended in 2010 at lower levels of protection, but was removed altogether at the end of 2011.
Concerned at the advertising around term deposits, regulators in Australia (a country whose major banks dominate the NZ market) have warned that if investors are not vigilant and exercise a choice before maturity, banks can roll-over their term deposits at much less lower interest rates than what they originally signed up for.
Term deposits are very safe, but so is a well-constructed portfolio of diversified fixed interest spread between banks, governments and very large corporations.
Finally, when you look at tempting term deposit rates on offer with managed fund returns, the more appropriate comparison is between actual managed fund returns and what you would have been offered on deposit one, three or five years ago. With your funds managed conservatively in a unit trust, you can generate an expected return over cash without compromising liquidity or sacrificing the need to preserve your capital. For an investor looking to grow the purchasing power of their assets, this is a more attractive option.
So, let’s now go back to first principles and examine the definitions and use of fixed interest in a diversified investment strategy…
Fixed Interest 101
What is fixed interest? It’s a broad term that describes bonds or loans that can be purchased and sold on the open market. The borrower, who can be a bank, a corporation or the Government, receives a loan for an agreement to pay it back with interest.
How much interest does the borrower pay?
The rate of interest is typically determined according to two key factors:
The first is the certainty the borrower will pay back the loan. This is called ‘credit’ risk. The more certain the borrower is to pay back the loan, the lower the interest they have to pay, and vice versa
The second factor is how long they’d like to borrow money for. This is called ‘term’ risk. The longer the term of the loan, the more interest the borrower typically has to pay
So investors can seek exposure to these two risk factors, in exchange for interest. The extent and mix of each will depend on both the individual’s risk appetite, and why they are investing in fixed interest in the first place.
There are many reasons why you would want a portfolio of fixed interest:
Fixed interest is typically much less volatile than, for example, shares, so is a good place to put your “just in case” money
Because bonds, and especially bond funds, can be sold quickly, you can get access to your money, in cash, within one day
Fixed interest generates higher returns than an at-call bank account. More on this later…
Fixed interest is a good diversifier to shares. Fixed interest can increase in price exactly when shares are falling, helping smooth out the ride for an investor holding both assets
Speaking to number 4 above, we have a chart showing New Zealand bonds (ANZ Composite Investment Grade Index) compared to New Zealand shares (NZSX All Index) from January 2002 through December 2011.
But there is an alternative to fixed interest: term deposits. Let’s look at term deposits next.
The Attraction of Term Deposits
If your number one goal as a depositor is having next to no chance of any drop in price, then a term-deposit in a large bank looks like a good investment.
A term deposit provides you with two types of certainty:
Certainty that your original investment is highly protected
Certainty that you’ll receive an agreed amount of interest at the end of the negotiated term
Both those certainties are in marked contrast to the experience of many NZ investors, stung in recent years by the collapse of a succession of finance companies. Today, the focus is more on managing risk and sacrificing some return.
Next, a term deposit is typically better than just leaving your money in on-call bank accounts. According to the Reserve Bank of New Zealand[i], the ‘spread’, or premium, offered by retail term deposit rates over wholesale rates has increased since the GFC. This is because banks’ alternative source of funding – in the wholesale money markets – has become more expensive. Hence, they are increasingly reliant on deposits from retail investors and the resulting competition has driven up retail term rates relative to wholesale.
While term deposits are very safe, you can sacrifice other benefits by opting for them:
1. You can’t always access your money as quickly as you might like when it is locked away for one, two, three or five years. You can always break the deal, of course, but fees and charges can be onerous
2. Secondly, keep in mind that the government’s deposits guarantee has now been removed. This is not to suggest the banks are at risk of default. But the proposed removal of an explicit, if not an implicit, safety net does diminish one perceived attraction of term deposits
3. Third, unless you explicitly intervene, term deposits can automatically roll over, when they mature, to much less favourable rates. You can then find yourself locked in for an extended period, at rates lower than are available elsewhere.
To this point, the Australian Securities and Investments Commission (ASIC) in 2010 released a major review of term deposits[ii] that raised serious questions about the marketing and disclosure of these accounts.
ASIC found that authorised deposit-taking institutions – including the big four banks operating in New Zealand – actively advertised higher interest rates on one or two term deposit periods, while maintaining lower interest rates for all other deposit periods. On average, these lower rates were 42 percent below the advertised offers.
Citing poor disclosure by the banks, ASIC also found a weighted average of 47 percent of the $16.63 billion in term deposit funds that rolled over for the first time, automatically defaulted to lower rates. In addition, the regulator noted that, while investors can break their term deposits before maturity, a penalty is still likely to apply. So it is not quite true to say there is no risk in term deposits
4. Fourth, term deposit rates are at historically high levels relative to the existing rates on offer in the money market. While this is a great thing for depositors, it is unusual and may not be maintained.
5. Next, and perhaps most importantly, after taxes and inflation term deposits don’t leave you much, if any, growth in the value of your assets. For example, assume a 3% rate of inflation and a depositor in the 33% tax bracket. If such an investor got a one-year term deposit at 5%, their actual after inflation return would be 5%*(1-33%) – 3% = 0.33%. If that depositor has any aspirations for his/her money to grow to provide future purchasing power, a term deposit is simply not going to achieve that purpose.
Rates Can Go Up…and Down
There is also interest rate risk. While official cash rates started to go up again in mid-2010, they returned to record lows of 2.5% in March 2011, after the Christchurch earthquake. This means investors can come out of a term deposit and have to roll over at less favourable terms, with all the uncertainty that generates.
What’s more, even without changes in the official cash rate, term deposit offers can fluctuate widely – depending on the funding needs of institutions.
How Safe is Fixed Interest?
Fixed interest is very liquid; you can get your money the next day, typically with only a small transaction charge and no penalty. Whatever interest you’ve earned while owning the investment is yours and no one can take that away, such as happens when you break a bank term deposit agreement.
But how safe is fixed interest? This is another way of asking about the risk of default. Investors feel very certain the bank will pay them back. What about a portfolio of diversified fixed interest.
Looking at one of Bradley Nuttall’s New Zealand Fixed Interest portfolios[i] as of 31 March 2012 we see that the top 10 holdings are:
Auckland Intl Airport
This is interesting, because the top holdings are the banks themselves. Banks raise money multiple ways. One is borrowing money in term deposits. Another is going onto the bond market and borrowing from investors. They typically pay investors a higher return; however, the likelihood of getting paid back is virtually identical. Banks are just as likely to pay back investors as they are to pay back term depositors. And if they get in trouble they will turn to the Government, which is the sixth largest borrower in this portfolio.
In other words, the portfolio, made up of the above borrowers, is unlikely to default. However, just like with the bank, it is not impossible.
International Fixed Interest
Bradley Nuttall’s choice for international fixed interest, Dimensional, has managed to be very competitive with term deposits over the long term, by adding only a small amount of term risk and credit risk. While this makes its fund more volatile than cash, it has not compromised the other goal of capital preservation. Plus Dimensional’s fund, like all funds used by Bradley Nuttall, can be converted into cash within one day and does not have the rollover risk that term deposits face.
Like our choice for domestic fixed interest, the international fund is also more diversified than a simple term deposit with a single bank. It invests in a broad range of high quality fixed interest securities, including the bonds of governments, major banks, international organisations like the World Bank and top-rated corporate borrowers.
Perhaps more significantly, the international fixed interest fund is not dependent on what happens to NZ interest rates. Instead, it is diversified across a range of advanced economies including Australia, Canada, the Euro zone, Denmark, Sweden, Switzerland, the UK and the US. Currencies are hedged back to the NZ dollar.
Both the domestic and international fixed interest funds are not locked in to one term. They vary maturities to take advantage of the best interest rates on offer. This reduces the risk of having only poor interest rate options available when the loan principle is repaid.
How Bradley Nuttall Domestic and International Fixed Interest Strategies Compare – January 2005 to March 2012
Finally, when comparing term deposit offers with fixed interest funds, it is important to compare apples with apples. That means comparing what has been delivered by the funds over a certain period with what the banks were offering at the beginning of that period. Below we present a table that compares the BNL strategies with one month bank bills, the overnight cash rate (the interest banks charge one another to borrow money, which is similar to the on-call rate for bank depositors) and six month term deposits.
* Source: BNL NZ Fixed Interest Jan 2005 to April 2009 is ANZ Corporate A Bond Index (Source: Morningstar). From May 2009 Dec 2010 it 100% Harbour Corporate Bond Fund. From January 2011 to Dec 2011 it 67% Harbour Corporate Bond Fund and 33% AMP NZ Fixed Interest Fund.
** Source: BNL International Fixed Interest Jan 2005 to Dec 2011 is Dimensional 5 Year Diversified Fixed Interest Fund.
*** Source: Reserve Bank of New Zealand, interest rates on lending and deposits; wholesale interest rates.
[i] Reserve Bank of New Zealand, Quarterly Statement on Monetary Policy, February 2012
[ii] Review of Term Deposits, Report 185, Australian Securities and Investments Commission, February 2010
What Does the Bank Do With Your Money? Alternatives Beyond Term Deposits
When debating whether to invest in a diversified New Zealand fixed interest portfolio or put your money in the bank, one question worth asking is, “What does the bank do with your term deposits?”
The bank can’t simply hold on to the term deposit and continue to pay interest.
What do they do with the money?
Simple, the bank invests in a diversified portfolio of fixed interest. They issue loans backed by property to mortgagees. They lend to large corporations and small businesses and receive interest in return. To control their risk the bank pays close attention to the credit worthiness of the borrowers and the length of the loans. Importantly, the bank issues many loans and is careful not to put all its money in one basket.
Alternatively, investors could consider investing in a diversified portfolio of fixed interest similar to the bank’s own portfolio. To provide a diversified portfolio of fixed interest there will be an advice fee plus a management fee, say 1.20% combined. However, I’d contend that fee is much smaller than the bank’s implied fee of what they earn on investors deposits versus what they give depositors in terms of guaranteed returns.
I acknowledge that the diversified portfolio of fixed interest bears more risk than the banks guaranteed deposit. However, if such a portfolio fails over the long term to provide positive returns, you can be sure the bank is also going to be in trouble. Why? Because the bank and the diversified fixed interest portfolio are investing in the same thing.
Now a diversified portfolio of fixed interest is liquid. The client can convert it to cash money in one week. But how safe is it?
Looking at New Zealand Fixed Interest over the past 21 years, the worst:
1 year return was 2.35% per annum (best was 16.34%)
3 year return was 4.89% per annum (best was 9.37%)
5 year return was 4.94% per annum (best was 8.11%
10 year return was 5.71% per annum (best was 7.51%)
In other words it’s very unlikely to lose money over periods more than a year.
In some ways a diversified fixed interest portfolio is more secure than the bank. How so? Well, for one, many of the securities in the diversified fixed interest portfolio are bonds issued by banks. If the bank is borrowing from investors it must be lending to less credit-worthy borrowers at a premium. Note that most often a bank will borrow from investors at premium compared to what they pay depositors. Beyond banks, the diversified fixed interest portfolio consists of large corporates like Fonterra and Auckland International Airport as well as the New Zealand Government.
What about the bank’s portfolio? Well in order to make larger returns the bank will often invest in small businesses. Almost every small business has a banking relationship. Small businesses pay big premiums to borrow money. The bank loves it. Remember they are still paying depositors 5% while they can charge small businesses, say, 15%. However, these businesses are much more likely to default than Fonterra or the NZ Government.
Now it doesn’t matter to a depositor if a single small business fails to return the money they borrow from the bank because the bank guarantees the deposit. And the bank protects itself by being widely diversified. But I’d argue that the bank’s fixed interest portfolio is riskier than the one we have on offer.
In other words, the diversified fixed interest portfolio has outperformed short term bank deposits. This is exactly what we expect to occur (especially over 3 or 5 year periods) into the future. Month by month, or even year by year, who knows, but over the long-term this advantage is almost required to occur. If it doesn’t, how can a bank offer those fat deposit rates? If the bank can’t get a high return on its fixed interest portfolio, how are they going to pay big deposit rates to investors? Thus the diversified fixed interest portfolio over the long term is almost destined to outperform deposits. Over the long-term it’s just about inevitable.
By the way, it’s the same principle for foreign diversified fixed interest, but the story is even better because you get much better diversification overseas than you get in New Zealand.
The Trade-off: Preserving Your Standard of Living or Preserving Your Capital
If we had it our way, all investments would be able to deliver two things simultaneously:
Have very little chance of losing money, even over short time horizons
Increase considerably in value.
But in reality, successful investing and financial planning require us to balance “the trade-off”.
What’s the trade-off? On the one hand, we want a good night’s sleep. This is our desire to have only a low chance of making a loss, even over short time horizons. On the other hand, we want a nice place to sleep. This is our desire for our investments to increase considerably in value.
So which is better?
As advisers we’ve learned that neither is really better; there is no optimal solution for all. There is only an informed decision in which both objectives are balanced against each other. Ultimately, the correct mix depends on the particular needs and attitudes of the client.
Having a good night’s sleep
If having a good night’s sleep means being exposed to very little risk of loss, then such an investor’s primary objective is to “preserve capital”. This implies an investment approach that focuses on short term Government Bonds, or even shorter term Government fixed interest and bank deposits. They’re about the safest securities available these days and there is little to no chance of losing money on them.
However, these securities often don’t keep pace with inflation, after taxes.
Consider for a moment that 1-year New Zealand Government Bonds are currently yielding about 2.6% gross. After you pay the necessary tax on that amount, let’s say at a marginal rate of 30%, this leaves you with about 1.8% to take home. According the Reserve Bank’s Inflation Calculator, inflation last year (as measured by the CPI) was 1.8%.
So, while investors heavy in 1-year Government Bonds are more than likely to sleep very well, it is equally clear that they are only standing still in terms of providing for their future.
Having a nice place to sleep
There are other issues to be concerned with apart from a short term chance of loss. What about a long term chance of a diminished standard of living? Investors concerned about protecting their standard of living (purchasing power) in the future tend to prefer investments with higher expected returns and higher volatility. Unfortunately, these kinds of investments can, and do, experience periods of loss.
Imagine a family doctor, 15 years from retirement, who contributes to his KiwiSaver fund. The doctor doesn’t need to use his retirement savings right now and he doesn’t even notice it coming out of his pay each month. Now let’s say that this year, 15 years before he plans to retire, his KiwiSaver account suffers from a bad market and loses 10%.
Does that really have any bearing on the doctor’s life now? Has his standard of living diminished today? Not at all.
His KiwiSaver account has 15 more years to grow and it is very likely to make back that loss, and grow besides. Short term volatility is clearly not the most important issue to this investor.
Investors like the doctor in our example understand that inflation is a slow and silent killer of financial security. Such investors seek out more volatile investments in order to preserve the purchasing power of their capital into the future.
How low volatility investments really do lose money
Most investors will find that an appropriate portfolio comprises some assets designed to preserve capital and others designed to preserve purchasing power. The most suitable mix of the two will depend upon their specific needs and attitude towards short term losses.
Lately, those looking to invest, and a few existing clients, have questioned us about the merits of holding risky assets such as shares and property. Some have queried why they should have risky assets in their portfolios at all. Our response is consistent: we are trying to protect our clients’ purchasing power. If we were to react with fear to recent poor returns and turn to a portfolio heavy in low yield investments, we would almost certainly harm our clients’ ability to reach their financial goals.
History shows that low yield investments can lose money for long periods of time when we correctly account for the corrosive work of inflation. Let’s review the data.
Table 1 contains 111 years of financial data. We couldn’t get more data if we tried. It shows that short term New Zealand Government fixed interest (abbreviated to ‘short term fixed interest’ from here on) beat inflation before tax. Note, though, that after tax this advantage was virtually nil 1. Over 100 years equities have delivered returns exceeding both short term fixed interest and inflation by a wide margin, even when accounting for taxes 2.
However, investors in equities (another word for shares) must accept the risk of substantial declines – table 2 shows that in the worst period of the entire 111 year sample. Now hold your hat – New Zealand equity investors lost 64% of their investment between 1987 and 1990, whereas the worst return for short term fixed interest was 1.51% in 1942 (not too bad).
But this is all before inflation. What happens when we accurately account for inflation?
You see, it’s not good enough to applaud investments that merely make a positive return. Investment returns need to outpace inflation in order to provide long-term security.
So let’s consider two more important pieces of information:
The after inflation total return for equities and short term fixed interest during their respective worst periods
The after inflation time required to break even from a 100% investment in either short term fixed interest or equities
What about short term fixed interest? After inflation, an investor in short term fixed interest lost 45% from 1937 – 1982 and, in total, it took an investor 55 years to break even! This is by no means a phenomenon that is unique to New Zealand. Investors in Australia, Canada and the US would have found nearly identical results when investing 100% in bills.
So how could an investment like short term fixed interest, that has never had a negative return (remember the worst period return was 1.51%), lose 45% of its purchasing power?
The answer is simple.
The same year that New Zealand short term fixed interest earned 1.51%, domestic inflation was at 4.0% according to the Reserve Bank of New Zealand’s Inflation Calculator. So even though the nominal return on short term fixed interest was positive, an investor was really going backwards in terms of purchasing power. This is not even to mention that the 1.51% yield is taxable.
Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets… their risk is huge.
Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation…
Current (interest) rates… do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label3.
In short, preservation of capital and the preservation of purchasing power are strategies which both have a place in a diversified investment portfolio.
History is clear that an over-allocation to cash, for fear of short-term drops in asset prices, can be an extremely risky strategy and can lead to the destruction of an investor’s purchasing power. It is the goal of any good adviser to find an appropriate trade-off that will enable you to reach your long-term goals, while not being exposed to unnecessary market ups and downs. Perhaps it’s with that combination, that some peace of mind can be achieved.
Why are We So Passionate About Putting Clients First? Just Look at Goldman Sachs…
Over the past year, Bradley Nuttall has blogged, posted or presented on conflicts of interest probably half a dozen times. Suffice to say we are passionate about the subject. But why?
Why is this issue so darn important?
Enter Greg Smith…
Greg Smith, from all appearances, had it all. He was a Rhodes Scholar national finalist, a graduate of Stanford University and an accomplished athlete. From thousands of applicants he was one of the lucky few to be given a job at prestigious New York investment bank, Goldman Sachs. In his 12 years there he rose to a position of Executive Director in the London office, advising clients with a combined asset base of over $1 Trillion.
March 14th was Greg Smith’s last day at Goldman Sachs (Goldman) and what a day it was. He chose it as the day to write an opinion-editorial piece in the New York Times giving the rest of us an inside view at the real Goldman (click here to read).
It’s an ugly view.
First of all it’s important to understand what Goldman is. They are a bank, an investment bank and asset manager and a broker, all rolled up into one. They are probably the most successful conglomeration of these businesses in the world. As a result of this structure, Goldman often sells products they have built and designed, or sell their clients investments from their own account. That’s important for this simple reason: they are almost always conflicted when dealing with their clients.
How does selling your own product create a conflict? Simple – the adviser is biased towards recommending in-house products even if they’re expensive, poorly performing or just not in their clients’ best interest.
How does selling from your own account create a conflict? If Goldman decides it no longer wants to hold an investment because it’s not profitable enough, why is it okay to dump it on their clients?
If it’s not already clear enough what a problem conflicts of interest can create, read some excerpts from Greg Smith’s article below:
…What are three quick ways to become a leader (at Goldman)? a) Execute on the firm’s “axes,” which is Goldman-speak for persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit. b) “Hunt Elephants.” In English: get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman. Call me old-fashioned, but I don’t like selling my clients a product that is wrong for them. c) Find yourself sitting in a seat where your job is to trade any illiquid, opaque product with a three-letter acronym.
…I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients. It’s purely about how we can make the most possible money off of them.
…It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets,” sometimes over internal e-mail.
…I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact.
…These days, the most common question I get from junior analysts about derivatives is, “How much money did we make off the client?”
The simple fact is Goldman Sachs is NOT a fiduciary for their clients. A fiduciary by law must act in the best interest of their clients. They must put their clients’ interest ahead of their own or their company’s interest. That doesn’t mean fiduciaries work for free, but it does mean the fees are clearly communicated and simple to understand. Accountants are often fiduciaries. Lawyers are often fiduciaries. Doctors can be thought of as fiduciaries.
How comfortable would you be with your doctor getting paid by the drug companies or your accountant getting paid by the IRD or your lawyer getting paid by your legal opponent?
Sadly, as a society, we still seem to be totally okay with an investment adviser recommending a money manager that paid orhired him/her to recommend their product.
The greater the money manager’s fee, the lower the client’s return. When will clients learn that hiring an adviser that takes a kickback from a money manager is like hiring an accountant that takes a kickback from the Inland Revenue Department?
It’s time for New Zealand investors to see that this is not only a New York issue. There are brokerage firms and conflicts of interest in New Zealand too. There is no reason to put blind trust in big company names, especially when the structure of the relationship is fraught with difficulty.
This isn’t just an important issue; it may be the key issue in any adviser-client relationship. Bradley Nuttall was among the first advisory practices in New Zealand to adopt the fiduciary framework. We rebate all commissions and we don’t accept payment from any investment funds, companies or managers we hire. This way we, like your lawyer and your accountant, avoid conflicts of interest and focus on representing your best interests.
This is a simple but important duty of care and one that may go unnoticed as we advance the work of client financial planning and advice. However, we believe it is the foundation for long-term client success and a culture of treating clients with the respect and honesty they deserve.
Over the course of a lengthy and illustrious business career, Warren Buffett has offered thoughtful opinions on a wide variety of investment-related issues—executive compensation, accounting standards, high-yield bonds, derivatives, stock options, and so on.
In regard to gold and its investment merits, however, Buffett has had little to say—at least in the pages of his annual shareholder letter. We searched through 34 years’ worth of Berkshire Hathaway annual reports and were hard-pressed to find any mention of the subject whatsoever. The closest we came was a rueful acknowledgement from Buffett in early 1980 that Berkshire’s book value, when expressed in gold bullion terms, had shown no increase from year-end 1964 to year-end 1979.
Buffett appeared vexed that his diligent efforts to grow Berkshire’s business value over a fifteen-year period had been matched stride for stride by a lump of shiny metal requiring no business acumen at all. He promised his shareholders he would continue to do his best but warned, “You should understand that external conditions affecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway.”
As it turned out, the ink was barely dry on this gloomy assessment when gold began a lengthy period of decline that tested the conviction of even its most fervent devotees. Fifteen years later, gold prices were 25% lower, and even after twenty-one years (1980–2010), had failed to keep pace with rising consumer prices. By year-end 2011, gold’s appreciation over twenty-two years finally exceeded the rate of inflation (205% vs. 195%) but still trailed well behind the total return on one-month Treasury bills (398%).
Perhaps to compensate for his past reticence on the subject, Buffett has devoted a considerable portion of his forthcoming shareholder letter (usually released in mid-March) to the merits of gold.
With his customary gift for explaining complex issues in the simplest manner, Buffett deftly presents a two-pronged argument. Like a sympathetic talk show host, he quickly acknowledges the darkest fears among gold enthusiasts—the prospect of currency manipulation and persistent inflation. He points out that the US dollar has lost 86% of its value since he took control of Berkshire Hathaway in 1965 and states unequivocally, “I do not like currency-based investments.”
But where gold advocates see a safe harbor, Buffett sees just a different set of rocks to crash into. Since gold generates no return, the only source of appreciation for today’s anxious purchaser is the buyer of tomorrow who is even more fearful.
Buffett completes the argument by asking the reader to compare the long-run potential of two portfolios. The first holds all the gold in the world (worth roughly $9.6 trillion) while the second owns all the cropland in America plus the equivalent of sixteen ExxonMobils plus $1 trillion for “walking around money.” Brushing aside the squabbles over monetary theory, Buffett calmly points out that the first portfolio will produce absolutely nothing over the next century while the second will generate a river of corn, cotton, and petroleum products. People will exchange their labor for these goods regardless of whether the currency is “gold, seashells, or shark’s teeth.” (Nobel laureate Milton Friedman has pointed out that Yap Islanders got along very well with a currency consisting of enormous stone wheels that were rarely moved.)
When Buffett assumed control of Berkshire Hathaway in 1965, the book value was $19 per share, or roughly half an ounce of gold. Using the cash flow from existing businesses and reinvesting in new ones, Berkshire has grown into a substantial enterprise with a book value at year-end 2010 of $95,453 per share. The half-ounce of gold is still a half-ounce and has never generated a dime that could have been invested in more gold.
Few of us can hope to duplicate Buffett’s record of business success, but the underlying principles of reinvestment and compound interest require no special knowledge. Every financial professional can point to individuals who have accumulated substantial real wealth from investment in farms, businesses, or real estate, and sometimes the success stories turn up in unlikely places. (See “The Millionaire Next Door.”)
Where are the fortunes created from gold?
by Weston Wellington, Vice President at Dimensional Fund Advisors Thursday, February 23, 2012
Warren Buffett, “Warren Buffett: Why Stocks Beat Gold and Bonds,” Fortune, February 27, 2012. Available at: http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/.
Milton Friedman, Money Mischief (Boston: Houghton Mifflin Harcourt, February 1992).
Stocks, Bonds, Bills and Inflation, March 2011.
Berkshire Hathaway Inc. Available at: www.berkshirehathawy.com (accessed February 21, 2012).
Dimensional Fund Advisors LP (“Dimensional”) is an investment adviser registered with the Securities and Exchange Commission.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.
What Happened to 1 of the World’s Greatest Market Timers…
John Paulson is the multi-billionaire hedge fund manager and president of Paulson & Co.
He made one of the greatest calls of all time by short-selling subprime mortgages in 2007, earning him $3.5 billion.
As a result, he has developed guru, or cult-like, status.
With this fame has come new money, flowing in fast and furious into his funds and earning him a record $5 billion salary in 2010. Investors are only too willing to pour in their savings, expecting that his maverick predictions can earn them generous returns.
How could he get it wrong…he called the subprime meltdown?
Apparently nothing is more attractive to investors than the idea that you can pay someone to accurately predict the future and make a lot of money as a result.
Well, the guru John Paulson just submitted his latest regulatory findings. Paulson was expecting shares in Bank of America stock to reach $30 by the end of 2011. Instead, the shares dropped over the course of the year to around $5, at which point he sold (full disclosure: the shares bottomed out at $4.92.) Paulson’s big stake in the bank was one of several bad investment picks that helped lead one of his most high-profile funds to a negative 52.5% return last year, as reported by DealBook.
So far this year, Bank of America is up approximately 38%.
So, Paulson basically bought high and sold low. The www.BehaviorGap.com (and almost everyone else) calls that “Dumb!”
We’re sure that there are some hedge fund managers that made great calls last year and others that did worse than Paulson. Overall, according to Hedge Fund Research, the whole hedge fund industry lost money last year (down 4.8%), in a year when US Indexes were up. What’s crystal clear is that being last year’s guru is no guarantee of future success.
Yet the seduction of the successful speculator remains strong.
Why the heck is market timing so hard that even when people are paid billions to do it right…they can’t do it right?
Because you need to do the following:
Predict the future (nerds call this forecasting)
Predict that the future will be different from the consensus opinion
Be right way more often than you’re wrong (people don’t pay for average here)
Why do you have to predict the future “differently”? There’s no money to be made in having the consensus opinion. Prices already reflect that opinion. To make money you’ve got to bet on the price being wrong – preferably way wrong – and then make money when it ‘corrects’ according to your predictions.
We’re sure many of John Paulson’s investors, like others, are frustrated. What are they to do?
It may sound shocking but we first suggest giving up the idea that people can tell the future. Sure, we can all look at events happening today and say, “Hey, I think what’s happening today will lead to ‘this’ tomorrow.” But when you’re talking about investments, everyone is guessing tomorrow’s news based on today’s facts. Those collective expectations are factored into the price. To make money you have to know that the prevailing expectation is wrong. So really, it’s harder than just telling the future, it’s telling the future differently than everyone else and being right about it.
Who is “everyone else”? Everyone else is typically some pretty smart people who spend all day, every day, doing this or writing software to do it for them. John Paulson isn’t alone in trying to do this.
And here’s the frustrating thing: the prevailing view of the future is almost certainly inaccurate (it is the future, right?) but it seems to be randomly inaccurate.
What do I mean by “randomly inaccurate”? Basically the consensus opinion is such that there are about 50:50 odds its wrong or right. It has to be that way, or else a buyer and a seller would never agree on the price to exchange a share. Each have equal and opposite incentives, both are looking at the same publically available information, and both are free to transact however they wish. It’s only new information, not available at the time of the transaction, that will ultimately show who got the better end of the deal.
It looks like this time it was Paulson that got the worse end of the deal. We’re sure Paulson is not an idiot. He just couldn’t tell the future, and new information came out about Bank of America after he purchased that showed its prospects were worse than foreseen. You can’t blame Paulson for not knowing the future. But I believe you can blame him for acting as if he did… with a lot of other people’s money….people that paid him a literal fortune… people who probably aren’t very happy right now.
So if you give up prediction addiction, what are you left with? I suggest that you are left with investing for a long-term rather than short-term. You understand that in the long-run, bearing risk brings investment return as compensation. What if you don’t have a long-run time horizon? Then you take appropriate amounts of risk off the table by using a balance of more stable investments. Lastly, you focus on your goals, your savings and other things under your control. In doing so, you are bound to make many better decisions and be a whole lot less disillusioned.
The End of Wall Street as We Know It – and We Feel Fine
When I (Ben) had the privileged of working for Index Funds Advisers (IFA.com) in California, one individual I worked most closely with was Jay Franklin, a very bright and passionate advocate of investors.
As IFA and BNL are now associated (BNL is a Network Member of IFA) we are able to publish some of Jay’s articles on our website. Although this one seems a bit focused on the USA I think it’s message is clear and fully endorse it. Link
Lately there has been a great deal of news coverage of the ever-shrinking pool of bonuses awarded to the traders and investment bankers of the too-big-to-fail Wall Street firms. At UBS, for example, certain highly compensated employees will have to face the indignity of having part of their previous bonuses clawed back in the wake of a $2.3 billion loss resulting from the actions of a rogue trader. New York magazine recently ran a detailed piece on this subject appropriately captioned, “The Emasculation of Wall Street.” One of the article’s most poignant statements was voiced by an unnamed hedge fund manager.
“If you’re a smart Ph.D. from MIT, you’d never go to Wall Street now–you’d go to Silicon Valley. There’s at least a prospect for a huge gain. You’d have the potential to be the next Mark Zuckerberg.”
To this, we at Index Funds Advisors, Inc. say “Bravo!” and we wish it would have happened many years sooner. Society derives far greater benefit from the application of brainpower to real world innovations as opposed to financial innovations. The simple fact of the matter is that the primary financial instruments that are used to connect providers of capital with users of capital have existed since the nineteenth century. Much of the innovation that has come from the geniuses of Wall Street has been useless at best and incredibly destructive at worst. Nevertheless, we have seen a few advances that have truly helped investors such as index funds, but none of these required the talents of PhD. Physicists from MIT.
As noted by Matt Taibbi of Rolling Stone in his blog post of 2/8/2012, “The financial services industry went from having a 19% share of America’s corporate profits decades ago to having a 41% share in recent years. That doesn’t mean bankers ever represented anywhere near 41% of America’s labor value. It just means they’ve managed to make themselves horrifically overpaid relative to their counterparts in the rest of the economy.” All we really need from Wall Street are prudent people who will be reliable stewards of their client’s money for which they can expect to be well compensated as opposed to outrageously overpaid. What we don’t need are Fabulous Fabs aided by rocket scientists who help them conjure up new ways to “blow up the client” or “rip the client’s face off.” The world is a better place when the rocket scientists are actually designing rockets (i.e., actual products or potentially beneficial scientific research) and Wall Street bankers are playing their proper role as handmaidens to capitalism.
Regarding the big-time traders, as more and more individual investors as well as trustees of foundations, endowments, and pension plans become wiser and go passive, the traders will have only each other to play against in their zero sum game. We wish them the best.
Finally, the increasing adoption of passive over active will automatically reduce the bloated 41% share to a more reasonable level. This is far preferable to wielding the heavy hand of government regulations which all too often have unintended consequences.