Individual Investors Should Treat Obtaining Financial Advice Like Buying a New Car

29 Tuesday Oct 2019

Posted by wmosconi in asset allocation, behavioral finance, Consumer Finance, financial advice, financial advisor fees, financial advisory fees, financial goals, financial markets, financial planning, financial planning books, financial services industry, Income Taxes, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, investments, personal finance, reasonable fees, reasonable fees for financial advisor, reasonable fees for investment advice, reasonable financial advisor fees, risk tolerance, stock market, Stock Market Returns, stock prices

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I had a long conversation with a friend and business associate about how I think individual investors approach obtaining financial advice. We went back and forth for almost 30 minutes. However, I found myself stumbling upon the analogy of purchasing a new vehicle. This analogy encapsulates how individual investors might want to think about building their investment portfolios, setting financial goals and how to obtain them, establishing their risk tolerance, and addressing any special situations that might pertain to their specific situation (e.g. caring for an elderly parent in their house). I should state at the outset that, if you have more than $1 million in investable assets (i.e. an accredited investor), the size of your portfolio demands special attention. If you have not amassed $1 million, please read on to the rest of this article.

First, I would like to lay out the typical new vehicle purchase scenario and then turn to its applicability in the case of financial advice. Most people start off the process by doing a good deal of research on the available options. After considering his/her situation, the individual will go to the vehicle dealership. For the purposes of this particular example, let’s suppose that the vehicle dealership offers a number of different car manufacturers as options and then the various models associated with them. Luckily today, there is a lot less haggling (well at least upfront in the process) and the vehicles’ prices are normally right around the MSRP. However, you as a consumer need to select the car make and also the specific model.

Usually a salesperson will assist you with the process. Even though you can do a lot of homework prior to picking out a new vehicle, it still does not fully capture actually looking at the vehicle. Of course, you also need to sit in it and take a test drive. The salesperson is able to translate what your needs are to try to select the best option. For example, do you need to transport the kids to basketball practice? What if you take turns carpooling and pick up an extra 3-6 kids? How big should your SUV be? What if you drive a lot of highway miles and a lease option may not work for you? Do you like to have a decent amount of horsepower to be able to merge onto highway traffic? What about the manufacturer’s warranty? Does the dealership service the vehicles onsite? What about financing options (i.e. buy or lease)? The list of questions could go on and on.

Given the entire list of questions you might ask, the salesperson is an integral part of the vehicle buying, or leasing, process. After the salesperson has finally answered all of your questions, let’s say you decide on a price, the financing options, and the color/options/model. If you make the purchase, the salesperson will earn a commission. Once you leave the dealership’s parking lot, you are then responsible for the maintenance of the vehicle. Fingers crossed, you should only need to take car of oil changes and normal maintenance (e.g. changing the air filter, flushing the transmission fluid, etc.). What would you do if the salesperson came over to your house and wanted to check if you were still pleased with the vehicle you selected in the second year? Does it fit your needs and perform as expected? Wow, that experience would be one of pretty good customer services. But now, the salesperson’s next utterance is that you own him/her $500. What? Well, he/she responds that he/she helped you out and things are going according to plan. My guess is that you would be dumbfounded and refuse to pay another commission to the salesperson in year two of ownership.

What in the world does this have to do with financial advice? I would argue that the analogy fits quite well with the normal way financial advice is given to individual investors. When you first sit down with a Financial Planner, Financial Advisor, or Registered Investment Advisor, he or she really walks through your entire life situation. Additionally, that person will assess your tolerance for risk which is not always as easy as it sounds. Usually most financial professionals will include questions that relate to your behavior under certain instances of financial market conditions. So, you cannot simply ask only objective yes/no questions. Other big thing that may come up are any insurance, tax planning, or estate planning needs that you have. Another significant area is trying to find out if you might have any special circumstances. The caring of an elderly parent was provided above. But there are myriad other situations that might require special planning considerations unique to your family.

The vast majority of financial professionals no longer charge commissions. Rather, they will charge a fee based upon the total asset in your portfolio of stocks, bonds, other assets, and cash. The financial services industry calls this an AUM (assets under management) fee in the jargon, and a very typical fee that one will see is 1%. What does that mean? Well, to use round numbers, let’s say you have $1 million dollars in your account of financial assets. You would then pay a fee of $10,000 ($1 million * 1%). To be technical though, the fee is normally prorated over four quarters throughout the year and not in one lump sum. Given all the assistance that I listed in the previous paragraph, there is no doubt that the financial professional earns his or his AUM fee. But what happens when year two of your financial relationship begins?

For illustrative purposes, I am going to assume that your life situation does not change at all. In the first year of your relationship with the financial professional, he or she is likely to have prepared an asset allocation for at least the next five years. One would expect a long-term investing plan. Of course, he or she may recommend that based, upon the price movement in the financial markets, you should reallocate your investments to either the same target allocation in year one or slightly different percentages. He or she may even recommend that you sell a particular investment and replace it with what he or she deems to be a better performing investment vehicle for the future. Well, to keep using round numbers, if your investment portfolio stays constant, you would pay another $10,000 (again $1 million * 1%).

The year two situation is akin to car maintenance in year two of your ownership of that vehicle from my car vehicle purchase analogy. Now, if you blew a head gasket in your car’s engine, you would want to take the vehicle back to the dealership or go to a trusted mechanic. The latter represents a major change in your life situation, financial goals, income tax ramifications, and other major events. Otherwise, we have a situation where you are paying the car salesperson another commission in year two. Now my analogy may not be entirely “apples to apples” (as my business associate said during our discussion). However, it is close enough to get to the point that I am trying to make in terms of financial advice. You need to be very cautious with how much money you pay in expenses for financial advice. Why? It really eats into the investment performance returns you will realize. I am all for paying for financial advice when there is a complicated situation, but, if nothing of import changes, it can be hard to justify.

So, what can you do if my analogy resonates with you? Well, there are two options that I will provide. However, there are other avenues to proceed down. I will discuss each in turn.

First, you can select a financial professional that charges a fee-only amount or one that charges by the hour. The fee-only financial professional will charge you a set amount per year for financial advice, and, in almost all cases, it is significantly lower than the $10,000 in our example. The hourly financial professional is just as it sounds. In the second year, you might require 10 hours of financial advice throughout the year, some of which might include just coaching you through the inevitable volatility in financial markets. Depending on the area that you reside in, you can expect to pay anywhere between $250 to $500 per hour. Using the 10-hour amount, you would be paying anywhere from $2,500 ($250 * 10 hours) and $5,000 ($500 * 10 hours). Using either type of financial professional with a different fee structure will lower your overall investment fees. Note that the quality of financial advice usually does not decrease in most cases. And yes, there are certain cases where the quality will increase markedly.

Second, you can use an external investment account at the beginning of your relationship with a financial professional that charges a percentage of assets under management (AUM). What does this mean? The vast majority of asset managers are large and sophisticated enough to handle this arrangement at the outset. For example, you would establish an investment account where your financial professional is located. Next, you would establish an investment account with another brokerage firm and allow your financial professional to have access to the investment portfolio you maintain. Note that the access is only for purposes of preparing reports for you and not to execute actual trades of stocks, bonds, mutual funds, or any other financial asset. For instance, you might keep 50% with the financial professional’s firm and another 50% in the external account. You would just maintain the portfolio allocation that your financial professional would like you to have in the external account. In order to ensure that you do not deviate from his or her investment recommendations, your monthly or quarterly investment performance reports would lump together the assets at the financial professional’s firm and your external account.

In regard to the second option, just because asset managers can easily do this reporting for you, does not mean that they will not push back. Some asset managers and financial professionals get even confrontational. It is understandable since the more assets you maintain at their firm the larger the investment advice fee. But this response can be very informative for you. If your financial professional does not handle your request of this potential option diplomatically, this may be a cue to seek financial advice elsewhere.

So, have I successfully convinced you that buying investment advice is just like buying or leasing a new vehicle? My guess would be that you think the analogy is not a perfect one. I will readily admit that it is not and really is not meant to be. Rather, I wanted to get you thinking about the financial advice you receive and investment fees from another viewpoint. Investment fees have an outsized effect on the returns that you will experience over time.

Their impact is even greater if you take into account the “opportunity cost” of investment fees. However, that is another topic entirely that I will not delve into. If you would like more information on the idea of “opportunity cost” and investment fees, you can refer to a previous article that I wrote. Here is the link:

https://latticeworkwealth.com/2014/02/26/what-is-the-800-pound-gorilla-in-the-room-for-retirees-it-is-12-5/

Bonds Have Risks Other Than Rising Interest Rates. Dividend Stocks are not Substitutes for Bonds.

24 Sunday Jul 2016

Posted by wmosconi in academics, asset allocation, bond basics, bond market, Bond Mathematics, Bond Risks, bonds, Fabozzi, finance, finance theory, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, financial planning, financial services industry, Fixed Income Mathematics, foreign currency, Frank Fabozzi, Individual Investing, individual investors, interest rates, investing, investing advice, investing information, investing tips, investment advice, investments, math, MBS, personal finance, rebalancing, rebalancing investment portfolio, rising interest rate environment, rising interest rates, risk, risks of bonds, Search for Yield, statistics, types of bonds, volatility, yield

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The main reason why Financial Advisors are recommending that individual investors sell bonds is that interest rates are likely to rise over the next 3-5 years or more. Although those sentiments have been a familiar refrain over the last 3-5 years though. Well, I would tend to agree that interest rates are poised to rise at some point toward the end of this decade. However, interest rate risk is only one of the risks of bonds. In fact, the size of the bond market dwarfs the stock market. When Financial Advisors are talking about bonds, they tend to be referring only to US Treasury bonds, corporate bonds, and municipal bonds. Interest rate risk greatly affects these bonds indeed. With that being said, they tend to conflate the interest rate risk of these bonds with the entire bond market. Remember that interest rates have dropped from 16.30% on the 1-month US Treasury bill back in 1981 to roughly 0.25% today. Therefore, bond prices have been rising for over 35 years and most financial professionals outside of the fixed income markets have forgotten (or if they are younger than 50) how bonds normally work, especially in a rising interest rate environment.

But does it even matter really? Yes. Here is an urgent note to all individual investors: “Beware of financial professionals that recommend dividend stocks or other equities as replacements for your fixed income allocation”. What I mean by this is that the volatility of stocks is far greater than bonds historically. Yields may be very low in money market funds, US Treasuries, and in bond mutual funds now. However, your risk tolerance must be taken into account at all times. While it is true that many dividend-paying stocks offer yields of 3% or more with the possibility of capital appreciation, there also is significant downside risk. For example, as most people are aware, the S&P 500 index (which represents most of the biggest companies in America) was down over 35% in 2008. Many of those stocks are included in the push to have individual investors buy dividend payers. With that being said, stock market declines of 10%-20% in a single quarter are not that uncommon. If you handle the volatility of the stock market well, there is no need to be concerned. However, a decline of 10% for a stock paying a 3% dividend will wipe out a little more than 3 years of yield. Individual investors need to realize that swapping traditional bonds or bond mutual funds is not a “riskless” transaction, meaning a one-for-one swap. The volatility and riskiness of your portfolio will go up commensurately with your added exposure to equities. Sometimes financial professionals portray the search for yield by jumping into stocks as the only option given the low interest rate environment.

While your situation might warrant that movement in your portfolio allocation, you need to be able to accept that the value of those stocks is likely to drop by 10% or more in the future just taking into account normal volatility in the stock market historically (every 36 months or so in any given quarter). Are you able to handle that volatility when looking at your risk tolerance, financial goals, and age?The purpose of this blog post is to discuss the risk factors associated with bonds in greater detail. Most bonds, such as Treasury notes and bonds, corporate bonds, and municipal bonds, will go down in value when interest rates go up. Conversely, they will go up in value when interest rates decrease. This characteristic of these types of bonds is called an inverse relationship. For a primer on how most bonds function normally, I have posted supplementary material alongside this post. You can refer to it to brush back up on bonds and how they work, and I also provide a historical look at interest rates over the last 35 years. Here is the link to that prior blog post:https://latticeworkwealth.com/2014/01/02/a-bond-is-a-bond-is-a-bond-right-should-you-sell-bonds-to-buy-stocks-supplementary-information-on-how-bonds-work/

There are many risk factors associated with investments in bonds. A great overview of those risks can be found in Fixed Income Mathematics the Fourth Edition by Dr. Frank Fabozzi who teaches at Yale University’s School of Management. Most fixed income traders, portfolio managers, and risk managers use his Handbook of Fixed Income Securities as their general guidebook for approaching dealing with the trading, investing, and portfolio/risk management of owning fixed income securities. Suffice it to say that he is regarded as one of the experts when it comes to the bond markets. Dr. Fabozzi summarizes the risks inherent in bonds on page 109 of the first text referenced above. The risks are as follows:

Interest-rate risk;
Credit risk;
Liquidity risk;
Call or prepayment risk;
Exchange-rate risk.

Most of fixed income folks and myself would add inflation risk, basis risk, and separate credit risk into two components. Bonds have two types of risk as it relates to payment of principal and interest. The first risk is more commonly thought of and referred to as default risk. Default risk is simply whether or not the company will pay you back in full and with timely interest payments. Credit risk also can be thought of as the financial strength of the company. If a company starts to see a reduction in profits, much higher expenses, and drains of cash, the rating agencies may downgrade their debt. A downgrade just means that the company is less likely to pay back the bondholder.Here is an example to illustrate the difference more fully: a company may have a AA+ rating from Standard & Poor’s at the beginning of the year, but, due to events that transpire during the year, the company may get downgraded to A- with a Negative Outlook. Now the company is still very likely to pay back principal and interest on the bonds, but the probability of default has gone up. As a point of reference, AAA is the highest and BBB- is the lowest Standard & Poor’s ratings to be considered investment grade. You will note that the hypothetical company would need to be downgraded four more times (BBB+, BBB, BBB- to BB+) to be considered non-investment grade or a “junk” bond. Bond market participants though will react to the downgrade though because new potential buyers see more risk of default given the same coupon. So even though the company may not default eventually on the actual bond, the price of the bond goes up to compensate for the interest rate required by the marketplace on similarly rated bonds to attract buyers.Now I will address the full list of risks affecting bonds outlined by Dr. Fabozzi above. Any bond is simply an agreement between two parties in which one party agrees to pay back money to the other party at a later date with interest.

All bonds have what is referred to as credit (default portion) risk. Credit risk in general is simply the risk one runs that the party who owes you the money will not pay you back (i.e. default). What is lesser known or thought about by individual investors is interest-rate risk and inflation risk. These two risks are usually missed because investors tend to think that bonds are “safe”. Interest-rate risk relates to the fact that interest rates may rise, while you hold the bonds (spoken about at length in the beginning of this blog post). When financial pundits make blanket statements about selling bonds, they are referring to this one risk factor normally. Inflation risk means that inflation may increase to a level higher than your interest rate on the bond. Thus, if the interest rate on your bond is less than inflation or closer to inflation from when you bought the bond, your purchasing power goes down. The prices of goods and services go up faster than the interest you earn on the bond. Call risk refers to instances where some companies have the option to redeem your bonds in the future at an agreed upon price. This is normally done only when interest rates fall. Prepayment risk is a more specialized case of call risk and refers to people paying their mortgages (or credit cards, home equity loans, student loans, etc.) back sooner than expected. Most people group these two risks into a category called reinvestment risk. Think about the concept in this manner: many people refinanced their mortgages because interest rates went down. They did so because they could lower their total mortgage payment. Well, companies do the same thing if they have the option. Companies can redeem bonds at higher interests and issue new bonds at lower interest rates. Chances are that, if you are the owner of the redeemed bonds, you will be unable to find as high of an interest payment currently if you want to buy a bond with similar characteristics of the company issuing the bonds you own before.The other three risks I mentioned above are less commonly discussed and not quite as important.

Exchange-rate risk exists because sometimes a company issues bonds in a currency other than its own. For example, you will sometimes hear the terms Yankee bonds or Samurai bonds. Since the company is paying you interest and principal in a foreign currency that money may be worth more or less depending on what happens in foreign exchange markets in the future.

Liquidity risk refers to the phenomenon that there are certain crisis times in the market where very few, if any bond market participants, are willing to buy the bonds you are trying to sell. Therefore, you might have to take a bigger loss in order to entice someone to buy the bonds given the current macro environment.

Basis risk is a more obtuse type of risk that institutions deal with. Basis risk essentially refers to anytime when interest rates on your bond are pegged to another interest rate that is different but normally behaves in a certain way (referred to as correlation). Now most of the time, the behavior will follow the historical pattern. However, during times of stress like a liquidity and/or credit crisis, the correlations tend to break down. Meaning you can think you are “hedged” but, if the historical relationship does not hold up, your end return will be nothing like what you had expected. These two risks are not something that individual investors need to focus on for the most part, since these types of bonds are not normally owned by them.I will admit that this list is quite lengthy and, quite possibly, a bit too detailed and/or complicated. However, I wanted to lay them all out for you. Why? When you hear Financial Advisors recommend that you sell a large portion of your bonds, and/or hear the same investment advice from the financial media, they normally are really only referring to interest-rate risk primarily and secondarily inflation risk as well. As you can see from the description above, the bond market is far more complex than that to make a blanket statement.Now, as I usually say, I would never advise individual investors to take a certain course of action in terms of selecting specific bonds or not selling bonds to move into more stocks. However, I am saying that you should feel comfortable enough to ask your Financial Advisor why he/she recommends that you sell a portion of your bonds. If the answer relates only to interest-rate risk, I would probe the recommendation further. You can explain that you know that is the case for Treasury notes/bonds, municipal bonds, and corporate bonds. However, there are a whole host of other fixed income securities with different characteristics and risks. Now I am not referring solely to Mortgage Backed Securities (MBS), although the residential and commercial markets for these are in the trillions of dollars. There are bonds and notes that have floating interest rates which means that as interest rates go up, the interest rate you receive on that security goes up. Not to mention that different countries are experiencing different interest rate cycles than the US (stable or downward even).The complete list is too in-depth to cover in a single blog post. My goal was to provide you with enough information to at least ask the question(s). Your risk tolerance and financial goals might make a move from bonds to stocks the best course of action. With that being said, you also have the option of selling bonds and keeping the money in cash or investing in the different types of bonds offered in the fixed income markets while keeping your total allocation to fixed income nearly the same. Thinking holistically about your portfolio, you may be increasing the riskiness of your portfolio beyond your risk tolerance or more than you are aware unbeknownst to you by moving from bonds into stocks. This is something you definitely want to avoid. It can turn out to be a rude awakening and hard lesson to learn one or two years from now.

Four Important Lessons for Individual Investors from the Brexit Vote

10 Sunday Jul 2016

Posted by wmosconi in Alan Greenspan, Black Swan, bond market, Brexit, Brexit Vote, Emotional Intelligence, EQ, EU, European Union, Fed, Federal Reserve, finance, finance theory, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, Greenspan, Individual Investing, individual investors, Internet Bubble, investing, investing advice, investing information, investing tips, investment advice, investments, Irrational Exuberance, Nassim Taleb, personal finance, portfolio, Post Brexit, PostBrexit, rebalancing, rebalancing investment portfolio, risk, risk tolerance, stock market, Stock Market Returns, Stock Market Valuation, Taleb, Uncategorized, Valuation, volatility, Warren Buffett

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The vote by the United Kingdom (UK) to leave the European Union (EU) caught the majority of individual investors by surprise. In fact, the so-called Brexit was not foreseen by many of the most sophisticated professional investors and money managers all around the world. The election results sent shockwaves through the financial markets on the Friday and Monday following the Brexit vote. The most notable effect was the devaluation of the pound to its lowest level since 1985. Over the course of Tuesday through Friday, the US and European stock markets gained back nearly all their losses from the two days after the Brexit vote. This fast-moving volatility has left individual investors feeling confused, frustrated, bewildered, and a bit scared. However, the Brexit vote results offer individual investors a unique set of key lessons to learn and understand.

The four important lessons for individual investors from the Brexit vote are as follows:

1) There are very few seminal events in financial market history that affect the future path of stocks, bonds, and other assets.

The difficult thing to realize about the financial markets is that there are very few consequential events that make an inflection point or major change in the direction of the financial markets. Even more frustrating than that, these consequential events are only known with the benefit of hindsight. In other words, what seems like a monumental event today may or may not be considered one of those major events. Given the fact that there are so few, there is a high probability that the seemingly major events of today will not fall into the seminal event category of financial market history.

What are some of the seminal events in financial market history? Here is a list of some of the seminal events in chronological order: the stock market crash in October 1987, the bursting of the bond bubble in 1994, the Asian contagion of 1997-1998, the bursting of the Internet bubble in March 2000, and the Great Recession of the financial crisis starting in September 2008. There are many more examples previous to 1987, but these are events from recent financial market history that many individual investors will remember. Keep in mind that in between all of these events are a string of other major events that turned out to be minor blips that caused only fleeting financial market volatility or none at all.

Furthermore, these seminal events are confusing to financial market participants in and of themselves. For example, let’s take a closer look at the stock market crash of October 1987. The US stock market dropped over 20% in one day, and things looked very dire. If an individual investor with a portfolio of $100,000 had sold his/her stock mutual funds (primary investment vehicle used by individuals on the day of the crash, he/she would have a portfolio worth $80,000 approximately. That type of individual investor was likely to be very fearful and stay out the of stock market for the remainder of 1987. If an individual investor with a similar portfolio of $100,000 had keep his/her money in stocks on the day of the crash and for the rest of 1987, he/she would actually have roughly $102,000 at the end of 1987. Why? Well, there are not too many investors these days that remember how 1987 really turned out for the US stock market. The S&P 500 index ended up about 2% for the year, so US stocks recovered all of the losses from the crash and a bit more. Here’s a little fun exercise: Ask your Financial Advisor or Financial Planner what the return of stocks was in 1987. The vast majority will assume it was a horrible down year for performance returns.

Another excellent example is the bursting of the Internet bubble in March 2000. The reason it is so interesting is that individual (and even professional) investors forget the history. Alan Greenspan, the Chairman of the Federal Reserve during that time period, gave a famous speech where he coined the term, “irrational exuberance”. Greenspan warned investors that the Internet and technology stocks were getting to valuations that were way out of line with historical norms for valuation of stocks. What do individual investors forget? Well, that famous speech was actually given in December 1996. Yes, that is correct. Greenspan warned of the Internet bubble, but it took nearly 3 ½ years before financial markets took a nosedive. The main point here is that smart, rationale professional money managers and economists can know that financial market valuations are out of whack in terms of valuation at any given point in time. (Note that this can also be stock market valuations that are too low). However, these conditions can persist for far longer than anyone can imagine. That is why individual investors should not be so quick to sell (or buy) major portions of their portfolio of stocks and bonds when these predictions or observations are make.

For a more in depth look at this concept, you can refer to a blog post I wrote three years ago on this very subject. The link to that blog post is as follows:

https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/

2) Investors focus on valuations (no emotions) while traders and speculators focus on market sentiment (emotions) and valuation (no emotions).

The majority of professionals who talk to individual investors and provide advice will explain how important it is to keep emotions out of the equation when dealing with elevated market volatility. When the financial markets are bouncing up and down by large amounts in the short term, it can be very difficult to keep a cool head and resist the urge to buy or sell stocks, bonds, or other assets. The frenetic pace of market movements makes it seems as though an individual investor needs to do something, anything in response. The standard advice is to keep one’s emotions in check focus on the long term, and stick to the financial plan. What is usually missing from that advice is a more complete explanation why.

There are two general types of financial market participants: investors and traders/speculators. These two groups have vastly different goals and approaches to the financial markets. Investors are focused on investing in stocks, bonds, and other assets in order to obtain returns over time from their investments. The long term might be defined as five years. Thus, day-to-day fluctuations in the financial markets mean very little to them. On the flipside, traders/speculators are focused on making gains in stocks, bonds, and other assets in the short term in order to obtain returns. The short term for this group might be hourly, the medium term might be daily, and the long term might be weekly. With this particular group, they need to determine both the likely direction of the financial markets due to both market sentiment and valuation.

As you might imagine, the traders/speculators have to analyze emotions or the psychology of financial market participants. Gauging market sentiment (general short term positioning of traders/speculators in stocks, bonds, and other assets in terms of their trend to buy or sell) is all about emotions. Additionally, they must be able to combine that with proper valuations for stocks, bonds, and other assets. Essentially they need to be correct twice. On the other hand, investors are focused on the long term which corresponds to valuation. Valuation over the long term is not driven by emotions. There is a very famous saying by Ben Graham who taught one of the most well-known investors of all time, Warren Buffett. Graham said, “In the short term the market is a voting machine, in the long term the market is a weighing machine.” The takeaway from Graham’s quotation is that market sentiment (i.e. emotions) can drive the financial markets wildly over the short term. However, after a period of years, financial markets always seem to follow the path back to what their true valuations are. Since emotions are not part of that equation, individual investors should feel more comfortable ignoring or at least subduing their emotions whenever the financial markets exhibit high levels of volatility.

A related part of the story is the financial media (both TV and print) almost always provide information for traders/speculators. To be perfectly honest, the financial media would not have much to talk about if long-term investing was the topic. Essentially they would recommend analyzing one’s risk tolerance, define one’s financial goals, and then build a portfolio of financial assets to reach those goals over the long term. Yes, true investing is very boring actually. The financial media needs to have something more “exciting” to talk about in order to have viewers (readers) and the corresponding advertising dollars that come from that. Therefore, the stories and article appearing in the financial media are geared toward traders/speculators. Now if you are an investor, you can either ignore this bombardment of information or take it with the proverbial “grain of salt”. Thus, you can keep your emotions in check when all the traders/speculators are wondering how to react to the market volatility right now each and every trading day or week.

For a more in depth discussion of managing one’s emotions as it relates to investors, you can refer to one of my older blog posts. The link to that blog post is as follows:

https://latticeworkwealth.com/2015/06/11/two-steps-to-help-individual-investors-become-more-successful-at-investing/

3) The benefit of diversification can disappear or be reduced greatly whenever there are periods are elevated volatility.

The benefit of diversification is one of the hallmarks of the proper construction of an investment portfolio for individual investors. The basic premise (which has been proven over very long periods of time) is that investing in different asset classes (e.g. stocks, bonds, real estate, precious metals, etc.) reduces the volatility in the value of an investment portfolio. A closer look at diversification is necessary before relating the discussion back to the Brexit vote. The benefit of diversification stems from correlations between asset classes. What is correlation? To keep things simple, a correlation of 1 means that two different assets are perfectly correlated. So a correlation of 1 means that when one asset goes up, the other asset goes up too. A correlation of -1 means that two assets are negatively correlated. So a correlation of -1 means that when one asset goes up, the other asset goes down (exactly the opposite). A correlation of 0 means that the two assets are not correlated at all. So a correlation of 0 means that when one asset goes up, the other asset might go up, go down, or stay the same. Having an investment portfolio that is properly diversified means that the investments in that portfolio have a combination of assets that have an array of correlations which dampens volatility. Essentially the positively correlated assets can be balanced out by the negatively correlated assets over time which reduces the volatility of the balance in one’s brokerage statement or 401(k) plan.

What does all this correlation stuff have to do with the Brexit vote? Surprisingly, it has quite a bit to do with the Brexit vote. Note that this discussion also applies to any situation/event that causes the financial markets to exhibit high levels of volatility. During extreme volatility like investors witnessed after the Brexit vote, the correlations of most asset classes started to increase to 1. Unfortunately for individual investors, that meant that diversification broke down in the short term. Most all domestic and international stock markets went down dramatically over the course of the two trading days following the Brexit vote. Therefore, individuals who had their stock investments allocated to various different domestic and international stocks or value and growth stocks all lost money. When correlations converge upon 1 during extreme market shocks, there is really nowhere to “hide” over the short term. In fact, the only two asset classes that did very well during this period were gold and government bonds.

What is the key takeaway for individual investors? Individual investors need to realize that there is an enormous benefit to having a diversified portfolio. However, diversification is associated with investing over the long term and thereby harnessing its benefit. There are times of market stress, like the Brexit vote and aftermath, where diversification will not be present or helpful. When those times come around, individual investors need to keep emotions out of the picture and stick to their long-term financial plans and investment portfolios.

4) The surprise Brexit vote provides the perfect opportunity for individual investors to evaluate their risk tolerances for exposure to various risky assets.

The two trading days after the surprise vote by the UK to leave the EU (Brexit) were very volatile and very tough to keep emotionally calm. Individual investors were faced with a very unusual situation, and the urge to sell many, if not all of their investments was very real. That reaction is perfectly understandable. Now for the bad news, there will be another time when volatility is as great as or larger than the volatility that the Brexit vote just caused. In fact, there will be many such periods over the coming years and decades for individual investors. In spite of that bad news, the Brexit vote should be looked at as a learning experience and opportunity. Since individual investors know that there will be another period of elevated volatility, they can revisit their personal risk tolerances.

It is extremely difficult to try to determine or capture one’s risk tolerance for downturns in the financial markets in the abstract or through hypothetical situations. You or with the assistance of your financial professional normally asks the question of whether or not you would likely sell all of your stocks if the market went down 10%, 15%, 20%, or more. How does an individual investor answer that question? What is the right answer? There is no right or wrong answer to that type of question. Each individual investor is unique and has his/her own risk tolerance for fluctuations in his/her investment portfolio. A better way to answer the question is to convert those percentages to actual dollar amounts. For example, if an individual investor starts with $100,000, would he/she be okay with the investment portfolio decreasing to $90,000, $85,000, or $80,000 over the short term. Note that the aforementioned dollar amounts sync up with the 10%, 15%, and 20% declines illustrated previously.

The opportunity from the Brexit vote is that individual investors have concrete examples of the volatility experienced in their investment portfolios. It is far easier to analyze and determine one’s risk tolerance by looking at actual periods of market stress. Depending on your stock investments, the total two-day losses might have been anywhere between 5% to 10%. Let’s use a 10% decline for purposes of relating this actual volatility to one’s risk tolerance. If an individual investor was invested 100% in stocks prior to the Brexit vote, he/she would have lost 10% in this scenario. Let’s use hypothetical dollar amounts: if the starting investment portfolio was $100,000, the ending investment portfolio was $90,000. Now the vast majority of individuals do not have all of their money invested in stocks. So let’s modify the example above to an individual investor who has 50% in stocks and 50% in cash. In that particular scenario, the individual investor has $50,000 invested in stocks and $50,000 invested in cash. If stocks go down by 10%, this individual investor will have an ending investment portfolio of $95,000. Why? The individual investor only losses 10% on $50,000 which is $5,000 not the full $10,000 loss experienced by the individual investor with a hypothetical portfolio of 100% in stocks.

The importance of the illustrations above and its relation to the Brexit vote is that one can quickly calculate the actual losses from a market decline with a good degree of accuracy. So let’s say that you had 60% of your money invested in stocks prior to the Brexit vote. If the overall stock market declines by 10%, your stock investments will only decline by 6% (60% * 10%) assuming the other 40% of your investment portfolio remained unchanged. So let’s put this all together now. If you look back at the stock market volatility caused by the Brexit vote, you need to adjust the overall stock market decline by the percentage amount you have invested in stocks. That adjusted percentage loss will be close to the decline in your overall investment portfolio. Now whatever that adjusted percentage amount is, ask yourself if you are comfortable with that percentage loss over the short term. Or is that way too risky? If the adjusted percentage is way too risky for you and makes you uncomfortable, that is perfectly fine. The important piece of knowledge to learn is that you need to work with your financial professional or reexamine your investment portfolio yourself to reduce your exposure to stocks such that the adjusted percentage loss is reasonable for you to withstand. Why? Because there will be another market volatility event on the order of magnitude of the Brexit aftermath or even worse.

Keep in mind that I am not making a financial market prediction over the short term. The important point is that the history of financial markets has shown that periods of elevated market volatility (i.e. lots of fluctuations up and down) keep occurring over time. The Brexit vote provides a real-life example to determine if your risk tolerance is actually lower than you first imagined. The next cause of market volatility may be a known market event similar to how the UK vote to leave the EU was. The harder things to deal with are market volatility stemming from the unknown and unforeseeable. These market volatility events are called “black swans” which is the term coined by Nassim Taleb in his book by the same name several years back. A “black swan” can be a positive event for the market or a negative event for the market. As it relates to individual investors and risk tolerance, the negative “black swan” is applicable. Now the term “black swan” is improperly used today by many investment professionals. A “black swan” is an event that by definition is unknown and cannot be predicted. When it does occur though, there is a period of extreme market volatility afterward. Thus, you can adjust your risk tolerance to be better prepared for future events that will cause market volatility, either known events like the Brexit vote or unforeseen events. The Brexit vote aftermath should be embraced by individual investors as a golden opportunity to ensure that they are properly (or more precisely) measuring their risk tolerances.

Summary of Important Lessons for Individual Investor from the Brexit Vote:

There are very few monumental financial market events that should cause individual investors to feel inclined to immediately change their investment portfolios. Plus, they can only truly be identified by hindsight;
Investors should focus on valuation of financial assets (no emotions here), traders/speculators worry about market sentiment (emotions) and valuation (no emotions here);
The benefit of diversification can disappear or be greatly reduced during periods of extreme market volatility and financial market stress over the short term;
The surprise Brexit vote offers individual investors a valuable opportunity to see if their risk tolerances are aligned with the possibilities of short-term market declines. This real-life event can be used to redefine one’s risk tolerance to better withstand similar periods of market volatility that will inevitably occur in the future.

Free Book – A New Paradigm for Investing on 50 year-old Investment Advice Available on Amazon.com

13 Wednesday May 2015

Posted by wmosconi in academia, academics, alpha, asset allocation, beta, books, college finance, finance, finance books, finance theory, financial planning, Free Book Promotion, Individual Investing, investing, investing books, investment advice, investments, Modern Portfolio Theory, MPT, personal finance, risk, stock market, stocks, volatility

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I have decided to make my recently published book FREE for several days, May 13, 2015 through May 17, 2015 (it normally retails for $4.99). The book is another installment in my A New Paradigm for Investing series. In this particular book, I focus on the use of Modern Portfolio Theory (MPT) as the primary tool by Financial Advisors to recommend portfolio allocations. The theory is over 50 years old, and most of its assumptions have been shown to be less and less useful. I explore the reasons why in my text. I have tried to write in such a manner that you do not need a degree in mathematics or statistics to understand its contents. Moreover, you do not need to know about the intricacies of MPT in order to follow my logic. You would find the same information in a college textbook but in a condensed format here. It actually is quite surprising how little Financial Advisors know about MPT in general and how the ideas apply to individual investors.

Note that this book is available for download onto a Kindle. Additionally, there is a Kindle app for iPhones and Android devices which is free to download. Amazon.com Prime Members can borrow the book for FREE as well. I have provided a link below to make it easier. My email address is latticeworkwealth@gmail.com should you have any questions/comments/feedback.

The book is:

A New Paradigm for Investing: Is Your Financial Advisor Creating Your Portfolio with a 50 Year-Old Theory?:

http://www.amazon.com/New-Paradigm-Investing-Financial-ebook/dp/B00FQQ0CKG/ref=sr_1_1?s=books&ie=UTF8&qid=1381520643&sr=1-1&keywords=a+New+paradigm+for+investing+by+William+Nelson

I would like to thank my international viewers as well of my blog that can be found at https://latticeworkwealth.com/. I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would strongly recommend following for their content and insight):

Followers on @NelsonThought:

The Wall Street Journal Wealth Report @WSJwealthreport – #wsjexperts
The Wall Street Journal Central Banks @WSJCentralBanks – Coverage of the Federal Reserve and other international central banks by @WSJ reporters
The Royce Funds @RoyceFunds – Small Cap value investing asset manager
Research Magazine @Research_Mag – Latest industry information for wirehouses and ETFs
Barron’s Online @BarronsOnline – Weekly financial news magazine of Dow Jones
Cleveland Fed Research @ClevFedResearch
Pedro da Costa @pdacosta – Central banking and economics reporter at The Wall Street Journal
Muriel Siebert & Co. @SiebertCo
Roger Wohlner, CFP® @rwohlner – Fee-only Financial Planner for individuals
Ed Moldaver @emoldaver – #1 ranked Financial Advisor in New Jersey by Barron’s 2012
Muni Credit @MuniCredit – Noted municipal credit arbiter
Berni Xiong (shUNG) @BerniXiong – Author, writing coach, and national speaker

Followers on @LatticeworkWlth:

Tracy Alloway @tracyalloway – US Financial Correspondent at Financial Times
Vanguard FA @Vanguard_FA – Vanguard’s ETF research and education
EU External Action @eu_eeas – Latest news from the European External Action Service (EEAS)
Charlie Wells @charliewwells – Reporter and Editor at The Wall Street Journal
Sri Jegarajah @CNBCSri – CNBC anchor and correspondent for CNBC World
Jesse Colombo @TheBubbleBubble – Columnist at Forbes
Alastair Winter @AlastairWinter – Chief Economist at Daniel Stewart & Company
Investment Advisor @InvestAdvMag – Financial magazine for Financial Advisors
Gary Oneil @GaryONeil2 – Noted expert in creating brands for start-ups
MJ Gottlieb @MJGottlieb – Co-Founder of hustlebranding.com
Bob Burg @BobBurg – Bestselling author of business books
Phil Gerbyshak @PhilGerbyshak – Expert in the use of social media for sales

A New Paradigm for Investing on 50 year-old Investment Advice Available on Amazon.com

01 Saturday Mar 2014

Posted by wmosconi in asset allocation, beta, business, Consumer Finance, Education, Fama, finance, financial planning, Free Book Promotion, Individual Investing, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investment advisory fees, investments, Markowitz, math, Modern Portfolio Theory, MPT, passive investing, personal finance, portfolio, risk, Sharpe, sigma, statistics, stock prices, stocks, volatility

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I have decided to make my recently published book FREE for today only, March 1, 2014(it normally retails for $4.99). The book is another installment in my A New Paradigm for Investing series. In this particular book, I focus on the use of Modern Portfolio Theory (MPT) as the primary tool by Financial Advisors to recommend portfolio allocations. The theory is over 50 years old, and most of its assumptions have been shown to be less and less useful. I explore the reasons why in my text. I have tried to write in such a manner that you do not need a degree in mathematics or statistics to understand its contents. Moreover, you do not need to know about the intricacies of MPT in order to follow my logic. You would find the same information in a college textbook but in a condensed format here. It actually is quite surprising how little Financial Advisors know about MPT in general and how the ideas apply to individual investors.

The book is:

1) A New Paradigm for Investing: Is Your Financial Advisor Creating Your Portfolio with a 50 Year-Old Theory?:

http://www.amazon.com/New-Paradigm-Investing-Financial-ebook/dp/B00FQQ0CKG/ref=sr_1_1?s=books&ie=UTF8&qid=1381520643&sr=1-1&keywords=a+New+paradigm+for+investing+by+William+Nelson

Followers on @NelsonThought:

– The Wall Street Journal Wealth Report @WSJwealthreport – #wsjexperts

– Institutional Investor @iimag

– The Royce Funds @RoyceFunds – Small Cap value investing asset manager

– Research Magazine @Research_Mag – Latest industry information for wirehouses and ETFs

– Barron’s Online @BarronsOnline – Weekly financial news magazine of Dow Jones

– Cleveland Fed Research @ClevFedResearch

– Euromoney.com @Euromoney

– Pedro da Costa @pdacosta – Central banking and economics reporter at The Wall Street Journal

– Muriel Siebert & Co. @SiebertCo

– Roger Wohlner, CFP® @rwohlner

– Ed Moldaver @emoldaver

– Sylvia Maxfield @sylviamaxfield – Dean of the Providence College of Business

– The Shut Up Show @theshutupshow

– Berni Xiong (shUNG) @BerniXiong

Followers on @LatticeworkWlth:

– Tracy Alloway @tracyalloway – US Financial Correspondent at Financial Times

– Vanguard FA @Vanguard_FA – Vanguard’s ETF research and education

– EU External Action @eu_eeas – Latest news from the European External Action Service (EEAS)

– Direxion Alts @DirexionAlts

– Charlie Wells @charliewwells – Editor at The Wall Street Journal

– Jesse Colombo @TheBubbleBubble – Columnist at Forbes

– Alastair Winter @AlastairWinter – Chief Economist at Daniel Stewart & Company

– AbsoluteVerification @GIPStips

– Investment Advisor @InvestAdvMag

– Gary Oneil @GaryONeil2

– MJ Gottlieb @MJGottlieb

– Bob Burg @BobBurg

– TheMichaelBrown @TheMichaelBrown

– Phil Gerbyshak @PhilGerbyshak

– MuniCredit @MuniCredit

A New Paradigm for Investing: Can Your Financial Advisor Answer These Questions?

01 Wednesday Jan 2014

Posted by wmosconi in asset allocation, bonds, business, Consumer Finance, Education, Fed Taper, Fed Tapering, Federal Reserve, finance, financial advisor fees, financial planning, Individual Investing, investing, investment advisory fees, investments, math, Modern Portfolio Theory, MPT, Nobel Prize in Economics, personal finance, portfolio, rising interest rate environment, rising interest rates, risk, statistics, stock prices, stocks, Suitability, volatility

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Greetings to all my loyal readers of this blog. How would you like to start off the New Year of 2014 by reevaluating your investment portfolio and how you get investment advice? This book on Amazon.com is available for download onto a Kindle. Additionally, there is a Kindle app for iPhones and Android devices which is free to download. Please feel free to check out the titles below. I have provided links to make it easier. My email address is latticeworkwealth@gmail.com.

The link to the book is as follows:

A New Paradigm for Investing: Can Your Financial Advisor Answer These Questions?

http://www.amazon.com/New-Paradigm-Investing-Financial-Questions-ebook/dp/B00F3BDTHW/ref=sr_1_3?s=books&ie=UTF8&qid=1388595896&sr=1-3&keywords=a+new+paradigm+for+investing+by+william+nelson

The book listed is normally $9.99 but available but I am offering it for a lower price over the course of the next week. For most of the day today, the book is $3.99 which is 60% off. The price of the book will be gradually increasing during the course of that period.

I would like to thank my international viewers as well. I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would recommend following for the content and insight):

Followers on @NelsonThought:

The Wall Street Journal Wealth Report @WSJwealthreport – #wsjexperts

The Royce Funds @RoyceFunds

Research Magazine @Research_Mag

Barron’s Online @BarronsOnline

Vanguard FA @Vanguard_FA

Cleveland Fed Research @ClevFedResearch

Chloe Cho – @chloecnbc – CNBC Asia Anchor for Capital Connection show

Pedro da Costa @pdacosta – Central banking and economics reporter at The Wall Street Journal

Muriel Siebert & Co. @SiebertCo

Roger Wohlner, CFP® @rwohlner

Ed Moldaver @emoldaver

Sylvia Maxfield @sylviamaxfield – Dean of the Providence College of Business

The Shut Up Show @theshutupshow

Berni Xiong (shUNG) @BerniXiong

Followers on @LatticeworkWlth:

Euro-banks @EuroBanks

Direxion Alts @DirexionAlts

Charlie Wells @charliewwells – Editor at The Wall Street Journal

AbsoluteVerification @GIPStips

Investment Advisor @InvestAdvMag

Gary Oneil @GaryONeil2

MJ Gottlieb @MJGottlieb

Bob Burg @BobBurg

Melody Campbell @SmBizGuru

TheMichaelBrown @TheMichaelBrown

Phil Gerbyshak @PhilGerbyshak

MuniCredit @MuniCredit

D.J. Rob-Ski @DJRobSki

A New Paradigm for Investing Available on Amazon.com – FREE for Thanksgiving Holiday

27 Wednesday Nov 2013

Posted by wmosconi in asset allocation, Bernanke, bonds, business, Charlie Munger, Consumer Finance, Education, Fed, Fed Taper, Fed Tapering, Federal Reserve, finance, financial advisor fees, financial planning, GIPS, GIPS2013, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investment advisory fees, investments, math, Modern Portfolio Theory, MPT, personal finance, portfolio, risk, statistics, stock prices, stocks, Suitability, volatility, Warren Buffett, Yellen

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bonds, Charlie Munger, consumer finance, economics, education, Fed, Fed taper, finance, financial advisor fees, Financial Advisors, financial planning, financial services, free books, interest rates, investing, investment advisory fees, investments, retirement, stocks, volatility, Warren Buffett

Greetings to all my loyal readers of this blog. In keeping with the Thanksgiving spirit, I have decided to make my first two books absolutely FREE for the rest of the week. These two books on Amazon.com are available for download onto a Kindle. Additionally, there is a Kindle app for iPhones and Android devices which is free to download. Please feel free to check out the titles below. I have provided links to make it easier. My email address is latticeworkwealth@gmail.com.

The books are as follows:

1) A New Paradigm for Investing: Can Your Financial Advisor Answer These Questions?:

http://www.amazon.com/New-Paradigm-Investing-Financial-ebook/dp/B00F3BDTHW/ref=sr_1_1?s=books&ie=UTF8&qid=1381107823&sr=1-1&keywords=A+New+Paradigm+for+Investing+by+William+Nelson

2) Spend 20 Hours Learning About Investing to Prepare for 20+ Years in Retirement

http://www.amazon.com/Learning-Investments-Prepare-Retirement-ebook/dp/B00F3KW9T2/ref=sr_1_1?s=books&ie=UTF8&qid=1379183661&sr=1-1&keywords=William+Nelson+Spend+20+Hours

The first book listed is normally $9.99 but available for FREE until November 30th. The other book is normally $2.99, but it is also FREE for the same time period.

Followers on @NelsonThought:

The Wealth Report @wsjexperts – #wsjexperts

The Royce Funds @RoyceFunds

Research Magazine @Research_Mag

Barron’s Online @BarronsOnline

Vanguard FA @Vanguard_FA

Cleveland Fed Research @ClevFedResearch

Pedro da Costa @pdacosta

Muriel Siebert & Co. @SiebertCo

Roger Wohlner, CFP® @rwohlner

Ed Moldaver @emoldaver

Sylvia Maxfield @sylviamaxfield

The Shut Up Show @theshutupshow

Berni Xiong (shUNG) @BerniXiong

Followers on @LatticeworkWlth:

Euro-banks @EuroBanks

Direxion Alts @DirexionAlts

Charlie Wells @charliewwells

AbsoluteVerification @GIPStips

Investment Advisor @InvestAdvMag

Gary Oneil @GaryONeil2

MJ Gottlieb @MJGottlieb

Bob Burg @BobBurg

Melody Campbell @SmBizGuru

TheMichaelBrown @TheMichaelBrown

Phil Gerbyshak @PhilGerbyshak

MuniCredit @MuniCredit

D.J. Rob-Ski @DJRobSki

Does it even matter if your Financial Advisor adheres to suitability requirement or acts as a fiduciary? Resounding YES!

18 Monday Nov 2013

Posted by wmosconi in asset allocation, bonds, business, Consumer Finance, Education, Fiduciary, finance, financial planning, Individual Investing, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, personal finance, portfolio, stock prices, stocks, Suitability

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bonds, business, compensation, education, fiduciary, finance, Financial Advisors, financial services industry, investing, investment expenses, investment fees, investments, personal finance, stocks, suitability

A great debate is raging on in the financial services industry regarding the concept of suitability and fiduciaries. In fact, many firms in the financial services industry are lobbying hard with millions of dollars to keep suitability as the “law of the land”. What is the difference even? Does it make a difference in the investments and asset allocation strategy recommended to you? Well, the financial services industry does not want to change the status quo away from suitability; I can assure you of that. In order to answer that question better, I will provide an analogy below to try to explain the concept more clearly.

Imagine that you have a son or daughter who is finishing up his or her senior year in high school. He or she has done remarkably well academically and has participated in many extracurricular activities. Your child is interesting in pursuing a degree in engineering and is not quite sure what school to go to and if mechanical or biological engineering might be the right path. A sensible and perfectly natural approach would be to consult the high school guidance counselor to get some insight. The guidance counselor may recommend the local university in town. The guidance counselor knows that they offer a degree in engineering. Let’s say your son or daughter report back with excitement at the prospect of going off to college and starting on the path to a career in engineering.

After you have that conversation, you run into a friend who you “brag” to about the news. However, that friend is an engineer and mentions that there is a well-respected engineering program only 75 miles away. That university is known as one of the best in, not only in the state, but in the region. You are still very proud of your son or daughter but cannot understand why the guidance counselor did not mention that option. You decide to go to the guidance counselor and ask what his process was when he talked to your son or daughter. The guidance counselor simply states that your child mentioned that he/she wanted to go into an engineering program. The local university offers an engineering program, and it is accredited as well. When you ask why the other university was not mentioned, the guidance counselor replies that his job was only to find a school that had the degree your son or daughter needed. It was not his job to find the best option. Needless to say, you would be extremely perturbed or worse.

That little story can serve as the backdrop for the issue of suitability and fiduciaries. There are some financial professionals that offer advice based upon suitability. Other financial professionals are considered to be fiduciaries. Suitability is more akin to the way in which the guidance counselor handled the meeting with your son or daughter. The job was only to find a school that fit the needs. Finding a better option was not really thought of or necessary. The friend actually put you on the path to how a fiduciary approaches things. A fiduciary would find the best option given all the information about your son and daughter and his/her future plans.

Now the definition of suitability and how a fiduciary must act are really complex from a legal standpoint and the corresponding requirements needed to follow either. A fiduciary has additional legal responsibilities to you as a client. In order to be a fiduciary, there are strict rules on compensation, products that meet your financial goals, investment expenses, and conflicts of interest. What might a conflict of interest be? Well, a good example is that many financial services firms have proprietary asset management arms and investment products. If that firm manages your recommended portfolio components, additional revenue goes to that firm. Another example might be that many mutual fund offerings provide the financial professional with lucrative 12b-1 fees that are referred to in the industry as trails. A trail simply means that the financial professional receives an annual amount based upon a specified percentage applied to the client accounts that he/she has with the mutual fund company. Another favorite offering is variable annuities. These types of products offer extremely high payouts which are applied to the face value of the insurance policy. It can be very tempting to offer the variable annuity with the highest payout as long as the underlying investments are acceptable (i.e. they invest in large cap stocks that were one portion of your proposed portfolio allocation).

Now I am not saying that anyone who only has to adhere to suitability requirements will automatically place you into investments that have higher fees for you or are better for his/her year-end bonus. My point is that a fiduciary must adhere to higher standards of conduct and act truly independent. A fiduciary runs the risk of additional liability if they breach their duty to you as a client. A financial professional that only has to recommend suitable products has a much lower hurdle to get over. As long as he or she recommends a mix of stocks, bonds, and alternative investments that meets your financial goals, that is all they have to do. Of course, that financial professional may suggest the exact same products that a fiduciary would. However, they are not required to recommend offerings that are the best in terms of investment fees and the best financial product available given your circumstances.

The important thing to remember is to always ask your financial professional whether or not he/she is a fiduciary. If not, you want to ask them how they come up with solutions that are suitable for you. You can even ask them if there are other options available. If you see recommendations that are heavy on the mutual funds of the firm you are dealing with or life insurance products with large amounts of legalize and complicated forms, you should delve deeper into that financial professional’s logic. You definitely should ask what form of compensation and amount he/she will receive and if any revenue goes to the firm from that financial product. Additionally, I would ask them why a more low cost, passive approach might achieve the same objective but be less expensive for you. Some of the responses might surprise you. If the answers seem to sound more like the guidance counselor, I would urge you to seek a second opinion before you choose that financial professional and start an account with that investment portfolio.

Are Your Financial Advisor’s Fees Reasonable? Are You Actually Adding More Risk to Your Ability to Reach Your Long-Term Financial Goals? Here is a Unique Way to Look at What Clients Pay For

26 Saturday Oct 2013

Posted by wmosconi in asset allocation, bonds, business, Consumer Finance, finance, financial advisor fees, financial planning, Individual Investing, interest rates, investing, investments, math, Modern Portfolio Theory, personal finance, portfolio, reasonable financial advisor fees, statistics, stock prices, stocks, volatility

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More and more financial professionals are charging clients based upon assets under management (AUM). A common fee is 1%. The fee for a $1 million portfolio would be $10,000 ($1,000,000 * 1%). Now you have heard me talk about the importance of keeping fees as low as possible. Essentially you are trying to maximize your investment returns each year. If you have quite a few needs, a Financial Advisor usually can provide a number of different services and advice. For example, you also may need assistance with legal and tax advice. Additionally, you may have more complex financial planning needs. Financial professionals will assist you with portfolio allocation always. Now I am going to look at AUM fees in a way that you may not be familiar with. I can tell you already that the financial services industry will not be happy or agree with this presentation. However, my goal is to help you and provide you with an argument that may finally give you the impetus to manage your own investments or think seriously about working with a financial planner that charges fees on an hourly basis.

I also encourage you to read the Wall Street Journal’s Weekend edition for October 26, 2013. On the bottom of the Business & Finance section, Jason Zweig discusses the many conflicts of interest that Financial Advisors have. FINRA (a Self-Regulatory Organization comprised of all brokerage firms) issued a 22,000-word report about fees, conflicts, and compensation of Financial Advisors. Oddly enough, the words “advice” and “investing” showed up less than 10 times. The financial services industry is concerned about this matter, so you should definitely take note and learn much more about what you are actually paying for.

Example for Retirees:

I will start out with an example for retirees because they tend to be working with financial professionals already. If you are retired and not independently wealthy, you are in the wealth distribution phase of your life. There are some retirees that are permanently in the wealth preservation phase. Wealth preservation simply means that an investor has enough money to live comfortably, but he/she does not need to deplete his/her investment portfolio. Furthermore, this investor does not really try to increase the value of his or her investment portfolio. A retiree in the wealth distribution phase of life is the most common example. This investor is gradual depleting his/her investment portfolio to pay for living expenses on an annual basis. Due to the fact that this person is not working anymore and, thus has no income from work, and longevity keeps getting longer, he/she needs have an investment portfolio that is somewhat conservative in nature. Therefore, it is not reasonable to expect to earn 8% per year. A more common target return might be 5.5-6.0%. If you are working with a financial professional who charges you 1.0%, you need to earn 6.5-7.0% on a gross basis in order to get to that target net return. Now the long-term historical average of stocks is about 8.0%, so the higher your AUM fees are, the more weighting you will need to have in stocks and away from bonds and cash. Well, we have already gone over that, and most individuals that present information will stop there. I want to take this even further though.

Let’s say you are a current retiree with $1 million that you are living off of in additional to Social Security income. You have a target return of 5.5% to fund your desired retirement lifestyle, and your Financial Advisor charges you a 1.0% AUM fee. Thus, you will need to earn a 6.5% return gross to reach your bogey. Now I would like to put in the twist, and I want to do a thought experiment with you. Your Financial Advisor will sit down with you and assess your risk tolerance and ensure that the investment recommendations made are not too aggressive for you. If you cannot take too much volatility (fluctuation in asset prices up and down over the short term), your financial professional will reduce your exposure to equities. Well, I like to present information using economic principles as well. If you just retired and are 65, you have one option right away. You can simply invest all your retirement money in 10-year Treasury notes issued by the Department of the Treasury. Treasury notes are free to buy. All you need to do is to participate in one of the Treasury auctions and put an indirect bid in. What is an indirect bid? An indirect bid is simply saying that you would like to buy a set dollar amount of notes, and you are willing to accept whatever the market interest rate set by the auction is. What is the yield on the 10-year Treasury right now? The 10-year Treasury closed at 2.51% on October 25, 2013. When you go to a financial professional, he/she is selecting investments in lieu of you simply purchasing the 10-year Treasury. Keep in mind that US Treasuries are among the safest investments in the world. They are backed by the full faith and credit of the US government. Stocks, bonds, real estate, gold, and other investment options all have an added degree of risk. With the additional risk, there is a possibility for higher returns though. How does this relate to your 1.0% AUM fee?

Think about it this way: why are you paying your Financial Advisor? You are paying him/her to select investments that can earn you more than simply buying a US Treasury bill, note, or bond. As an investor, you do not want to just settle for that return in most cases. With that being said though, you can just start out there and forget it. You do not need to engage a Financial Advisor to simply buy a 10-year US Treasury note. This means that you are paying the Financial Advisor to get you incremental returns. In our example above for a retiree, your target investment return is 5.5%. If you are able to earn 5.5% during the year, the incremental return is 2.99% (5.50%-2.51%). Remember that you are paying the Financial Advisor 1.0% in an AUM fee. Therefore, you are paying the Financial Advisor 1.0% of your assets in order to get you an extra 2.99% in investment returns. Well, 1.0% is 33.4% of 2.99%. Thus, you are essentially paying a fee of 33.4% in reality. Now your financial professional would flip if the information was presented in this way. He/she would say that it is flawed. The mathematics cannot be argued with; however, I will admit that many folks in the financial services industry would disagree with this type of presentation.

Remember that you started out with $1 million. You could have gone to the bank and gotten cash and hid it in a safe within your residence. AUM fees are always presented by using your investment portfolio as the denominator. In our example, your investment fee is 1.0% ($10,000 / $1,000,000). I urge you to think about this though. Does that really matter? Of course, the fee you pay to your Financial Advisor will be calculated in this manner. But what are you paying for in terms of incremental returns? If you want to calculate what you are paying for (the value that your Financial Advisor provides), the reference to the starting balance in your brokerage account is really moot. It is yours to begin with. Therefore, it should be removed from the equation when trying to quantify the value your Financial Advisor provides in terms of investment returns on your portfolio.

Now remember that I said your target investment return was 5.5%. The long-term historical average of stocks is approximately 8.0%. If you choose to simply allocate only enough of your investment portfolio in stocks and the rest in cash to reach that 5.5% target, you will select an allocation of 68.8% stocks and 31.2% cash (5.5% = 68.8% * 8.0% + 31.2% * 0.0%). Note that I am assuming that cash earns no interest at all and that you can select an ETF or index mutual fund to capture the long-term historical average for stocks. Now your financial professional is working with you to select an investment portfolio that achieves the 5.5% target return, and their investment recommendations will be different than this hypothetical allocation. With that being said, the hypothetical allocation achieves your target return with a simple choice of two assets (an ETF or index mutual fund and hard currency). Keep in mind that you will normally have a portion of your portfolio allocated to fixed income. The 10-Year US Treasury note is trading around 2.50% as of October 25, 2013. If you allocate your portfolio to 60% stocks, 30% 10-Year, and 10% cash, your expected return would be 5.6% (60% * 8.0% + 30% * 2.5% + 10% * 0.0%).

Whatever your Financial Advisor is charging you in terms of fees, you need to make that percentage more in your total return on a gross basis such that your net return equals your target return. In our example above, the assumed AUM fee was 1.0%. That investment fee means that you have to earn 6.5% on a gross basis because you need to pay your Financial Advisor 1.0% for his/her services. After the fee is paid, the return on your portfolio would be 5.5% on a net basis. If we keep the allocation at 30% 10-Year and 10% cash, how much weighting do stocks need to be in your portfolio to ensure that your overall returns is 5.5% after paying your AUM fee? The answer is 72.7%. Why? The expected return of your portfolio is 6.5% (72.7% * 8.0% + 27.3% * 2.5% + 0.0% * 0.0%) before fees. Given the average retiree’s risk tolerance at age 65 or older, most people do not desire to have a portfolio with 65% or larger allocated to stocks. Plus, the historical, long-term average of stocks is just that. It is an average and rarely is 8.0% in any given year. For example the S&P 500 Index has not had a single down year since 2008. The returns for 2009, 2010, 2011, and 2012 were 26.5%, 15.1%, 2.1%, and 16.0%, respectively. The average return over that span was 14.9%. As of September 30, 2013, the S&P 500 Index was up 19.8%. Now I am by no means making a prediction for the remainder of 2013 or 2014 for that matter. However, I wanted to drive home the fact that, if your Financial Advisor sets up your financial plan with the assumption that your stock allocation will earn 8.0% on average, any actual return lower than that estimate will cause you to not reach your target return. What is the effect? You will not be able to maintain the lifestyle you had planned on, even more so if there are negative returns experienced in stocks over the coming years.

Essential/Important Lesson:

Let’s look at the next five years starting in 2014. A five-year period covers 2014-2018. If you start out with $1,000,000 invested in stocks and plan on earning 8.0% per year, you are expecting to have $1,469,328 at the end of five years. Let’s say that the return of stocks is actually only 4.0% per year over the next five years. You will only have $1,216,653 as of December 31, 2018. The difference is $252,675 less than you were expecting. The analysis gets worse at this point though. How can it get any worse? Well, if you were planning on 8.0% returns from stocks per year, the next five-year period 2019-2023 needs an excess return to catch up. Thus, if your starting point on January 1, 2014 is $1,000,000, your financial plan is set up to have $2,158,925 as of December 31, 2023. If you are starting behind your estimate in 2019, the only way you can make up the difference is to have stocks earn 12.2% over that five-year period which is 4+% higher than the historical average. As you can see underperformance can really hurt financial planning. The extremely important point here is that a 1% AUM fee will cause you to be even further behind your goals. Remember that the illustration above is gross returns. You only care about net returns and what your terminal value is. Terminal value is simply a fancy way to say how much money is actually in your brokerage account.

Example for Those Saving for Retirement:

For those of you that are saving for retirement, you should use a different bogey than the 10-year US Treasury. If you are 35 years old, you can simply invest in the 30-year Treasury bond (the jargon on Wall Street is “the long bond”). The closing yield on the 30-year Treasury on October 26, 2013 was 3.60%. Thus, I would suggest that you use this benchmark to calculate your incremental return. If your financial professional tells you that this analysis does not apply to you because you are 45 years old and your timeframe to retirement is 20 years, I would agree. With that being said though, you can find the current yield on a US Treasury bond with 20 years to maturity. Most people are familiar with the Treasury yields quoted in the financial media and on financial websites. Those yields are calculated based upon on-the-run Treasuries. On-the-run simply refers to the most recently Treasuries sold at auction. Once the Department of the Treasury sells new bills, notes, or bonds, those last financial instruments are referred to as off-the-run. Keep in mind that the off-the-run Treasuries still trade on the bond market. You always can get a current yield for them. It is harder to find, but it is available on the Internet. You can find out more information directly on the Department of the Treasury’s website: http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/yieldmethod.aspx if you wanted to learn about this concept in more detail. I would never recommend using a bogey less than the 10-year Treasury note though even if you have fewer than 10 years to retirement. The aforementioned analysis for the calculation of incremental returns and the value-added from your financial professional will apply as in the example for retirees.

I will admit that this is a novel way to look at fees on investment portfolios. However, there are a number of financial professionals that are using this approach now. Keep in mind that one of the hardest questions to answer is in regard to the measurement of how much value your Financial Advisor provides. How do you know if he/she is doing a good job for you? The more common approach is to look solely at investment returns and compare it to a standard index return(s). This analysis is meant to supplement the discussion. I am hoping that this presentation will give you added incentive to seriously consider managing your own investments. Or at the very least maybe try to find a financial planner that charges an hourly fee or flat fee. You can pay a financial planner an hourly fee to sit with you and decide if your life situation and the current state of the financial markets warrant a change to your portfolio allocation among asset classes. That financial planner also can work with you on your emotional intelligence and the urge to sell all your stocks and/or bonds because of current negative news and events.

Of course, I will not dissuade you from seeing a Financial Advisor. On the other hand, I encourage you to have them walk through the value that they provide for you. What can he/she do for you that you cannot do for yourself by buying an index mutual fund and US Treasury notes absolutely free? You can use this analysis as a template for your discussion. Most financial services firms essentially bundle financial advice. Even if you do not need legal, tax, and complicated financial planning advice, you are still paying for it. Now it is nice to have it available to you at any given time, but, if you do not use it or never use it, do you really want to pay for it? It is very difficult to find financial services firms that can separate out those higher level services and provide advice on portfolio allocation and distribution of income to supplement retirement income only. The vast majority of investors do not need complex advice though. For example, the current exemption for estate taxes is $5.25 million. Thus, if you do not have a net worth more than this, estate planning will not be a major concern. Furthermore, if you are not planning on setting up a charitable trust for giving, legal advice is not necessary either. In terms of tax advice, most investors simply have to record capital gains and dividends. There are some techniques to “harvest” capital losses to reduce capital gains, but that is pretty simple to do on your own. In terms of sophisticated financial planning, most investors do not have life situations that necessitate the advice (e.g. providing for the long-term needs of a special needs child, concentrated wealth in a family-owned business, significant stock options, etc.). If your financial services firm offers that advice and you do not use it, you cannot just tell your financial services firm that you do not want to pay for it. There really is not an ala carte option. You will pay your 1.0% (or whatever it may be) AUM fee. The ironic thing is that, if you have a large enough investment portfolio where this advice comes into play, your AUM fee will almost certainly be significantly less than 1.0%. Doesn’t this make you want to learn more about investments and if you can take more of an active role? I sure hope so.

I welcome comments/feedback and constructive criticism. If there are Financial Advisors that totally disagree with my logic and presentation, I would love to hear from you. I can be contacted at latticeworkwealth@gmail.com. As I mentioned in a previous post, I wanted to hear from you. I appreciate the topics selected. In my next few posts, I will devote some time to discussing the issues that were suggested by you. I will get back to my normal selections in a week or so.

Latticework Wealth Management, LLC

~ Information for Individual Investors

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