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Introduction: Preparing for Tomorrow’s Challenges

By: Investor Solutions

Most Americans have a very poor understanding of how the world’s investment markets work, and how to harness the tremendous power of the markets to meet their needs.

After more than 22 years of counseling investors, I am convinced that Americans must invest more, and smarter.

I have never seen an investor that set out to do something dumb. However, investors have been badly shortchanged in their financial education. Recently colleges and universities have enhanced their courses in finance. That’s only natural because most of the pioneering work was done in academia. But if your MBA is more than 5 years old, you have some serious catching up to do.

In some respects American investors are the victims of a sales system designed to milk them. Bad advice often turns out to be far more profitable than good advice.

In other respects, these same investors are their own worst enemies. They insist on shooting themselves in the foot. Fear and emotion rule too many investment choices.

The solution to both problems lies in better understanding.

These articles will outline how investors can develop – and implement – effective investment strategies for the 21st century.

Plunge

My father witnessed one of the defining moments of American history. As a very young man, he was a runner on Wall Street during the Great Crash of 1929. In the middle of the panic, one ruined investor jumped from his office window.

As the day progressed, a gallows humor developed. My father and his young friends began to joke that it was necessary to keep looking skyward to prevent being squashed by falling financiers.

While only one unfortunate actually took the plunge, he made an indelible impression not only on the sidewalks below, but upon the psyche of the entire American people. Over time, the myth of investors raining down on Wall Street became firmly entrenched.

The Crash was shortly followed by the Great Depression, a devastating and traumatic low point in American history. So great was the suffering during the Depression that it still affects the American conventional wisdom. The lore has been handed down to succeeding generations. Today, almost 65 years later, many of our attitudes about investing are shaped by lessons learned then. Too bad most of the lessons we learned from that disaster are wrong!

Legacy of the Depression

One of the enduring legacies of the Depression is a deep distrust of the stock market. The stock market became perceived as risky, irresponsible, foolish, and dangerous. Everyone knew someone or whole families that had been “wiped out” by the crash.

The Role of Margin Investing in the Crash

The real culprit in the crash, speculation with only a 10% margin requirement, is seldom mentioned.

Margin greatly increases both risk and reward in an investment portfolio. An investor who buys $10 of stock with $1 down will see his equity double with only a 10% increase in stock prices. Conversely, his equity will be wiped out if stock prices fall only 10%.

An investor riding on his margin limit will immediately receive a margin call if his share prices decline. He is then required to deposit additional cash into his account to bring him back up to his margin requirements. If he is unable to promptly inject additional capital, his portfolio will be sold for him in order to pay his debts. If a large number of investors receive margin calls at once, the resulting sales will further decrease equity prices.

Notice that if investors had no margin, they simply experienced a 10% reduction in equity. They have no margin calls. They are not required to deposit additional cash. They are not forced to sell. They can, if they wish, choose to ignore the entire event. While not pleasant, financial panic is also not likely.

Other Factors During the Crash

During the market crash of 1929, the central bank did exactly the wrong thing by restricting credit. With credit restricted, even wealthy investors were unable to meet their margin calls. The system went into a free fall.

Most investors have not considered that in the depression that followed the crash, the economy underwent a significant deflation. Investors that held unleveraged, diversified, balanced portfolios actually saw their real worth increase even though prices of both stocks and bonds fell. Prices of goods and services fell far faster than the value of their financial assets. (Stocks fell in real terms, but bonds increased in value as interest rates fell.)

After the Depression, as the war economy heated up, financial assets continued to outperform inflation. The value of diversified portfolios continued to grow in real terms.

Deposit Insurance

A large number of banks failed during the Depression. To restore confidence in the banking system, the government developed federal deposit insurance. Deposit insurance provided Americans with a “zero-risk” savings vehicle.

Americans, who now blamed financial assets rather than inappropriate leverage for the crash, flocked to the banks. Several generations of Americans now have been carefully trained by their bankers to regard “insured” savings as responsible, conservative, and wise. The truth – as we shall see – is that long-term saving rates have failed to generate real, after-tax, after-inflation rates of return.

In 1929 there were lots of problems in the world’s economy. The crash certainly was not the sole cause of the depression. Still, most Americans link the two together.

Today the average American has serious misperceptions about the nature of stock market risk, in part based on events that occurred long before his birth. As a result he is woefully prepared to meet his financial needs of the future. Solving tomorrow’s problems is not likely to be successful if based on yesterday’s flawed analysis.

Conventional Wisdom

John Kenneth Galbraith was a true giant among men (he stood 6’8″): a Harvard economics professor, John F. Kennedy’s faculty advisor and later confidante, member of the President’s Council of Economic Advisors, a power in the Democratic party, ambassador to India, acclaimed author, and general all-around neat guy.

Galbraith proposed the concept of Conventional Wisdom, which he defined as ideas which are so ingrained in our culture that no one ever questions them. Unfortunately, conventional wisdom is often wrong. Galbraith argued persuasively that public policy built on conventional wisdom was doomed to failure. By challenging and exposing conventional wisdom, Galbraith was able to shape the economic and political policy debate for a generation.

Conventional wisdoms can continue to influence our behavior in spite of overwhelming, abundant, and irrefutable evidence that they are wrong. We often simply cannot let go of them. These ideas from Hell often simply refuse to die, no matter how often struck down.

An investment plan built on conventional wisdom is doomed. A successful investment strategy for the 21st century requires a clear understanding of the environment. You must re-examine all of your preconceived notions, abandon the useless, and be willing to incorporate the many useful new advances into your strategy.

Of course, not all the problems facing the American investor today are the result of grandfather’s stories of the Depression. But most Americans would be well served to take a quick review of finance from the ground up.

Tomorrow’s Challenges

Tomorrow’s problems are distinctly different from those that faced our grandfathers. Our grandfathers could expect to work to at least age 65, and die promptly within a few months or years after retirement. The new Social Security system would pay for most of his reasonable needs, and for each retiree receiving benefits, several hundred were contributing. With a limited life expectancy, inflation wouldn’t have time to seriously erode his income. He anticipated an extended family to care for him, and support him if need be.

Today’s American sits upon a retirement time bomb. As industry downsizes, right sizes and cuts fat, he may be forced into retirement long before he expected or is economically prepared to. “Moderate” inflation is a government policy. Demographic trends are particularly discouraging. With increased longevity, a 60-year-old and his wife must project a 35-year retirement for at least one of them. Social Security will provide only a small fraction of his retirement needs. By the year 2020, for each retiree receiving benefits, only 1.5 will be left in the work force to support him. This eliminates any chance for real benefits increases and sets the groundwork for an intergenerational war. Extended families are a thing of the distant past. Savings rates are at historic lows, and the lowest in the developed economies.

Meanwhile, our politicians, most of whom have never experienced a vision farther out than the next election, are falling all over themselves to proclaim that Social Security is sacred, and will not be subject to any cuts. Hopefully, most Americans are taking that with a grain of salt. We are going to have to take responsibility for our own financial futures by investing more.

The private pension system is under systematic and continuous attack by a government desperate for increased revenue. Limitations on both deductibility of contributions and withdrawal of benefits erode the system each year. Meanwhile, increases in insurance, funding, and regulatory costs have made defined benefit plans less and less attractive for employers. It shouldn’t surprise us that fewer employees will enjoy the traditional pension.

Help Arrives

Wonderful new tools are available to help. Contributions by academia and institutions have changed the face of modern finance. Institutions and multi-billion-dollar funds have used these advances for years to improve their results. By now, they have stood the test of time. Best of all, you can easily, effectively and economically translate the new techniques to your portfolio. You don’t have to be a billionaire to invest like one. You just have to know the “secrets.”

That’s right. There are secrets. But they may not be the ones you think. I’m not going to share any hot tips, or predict when the next big rally or crash is coming. So if that’s what you are looking for, you will be disappointed. But if you would like to get consistent, above-average, long-term results without taking a lot of risk, read on.

Financial economics and management have made huge advances in the last few years. To benefit we will need to unlearn a lot of what we think we know. Today we know that the appropriate approach to managing investments is at the portfolio level through asset allocation, and that risk can best be moderated through the tenets of Modern Portfolio Theory. Yesterday’s preoccupation with individual stocks, market timing, and manager selection turns out to be somewhere between useless and dangerous to your financial health.

Most major institutions and pension plans have quietly adopted this approach. But it is almost unknown in the retail market. Very little about the revolution on Wall Street filters down to the public. The major brokerage houses prefer to focus on the far more profitable (for them), but less effective traditional stock, bond and mutual fund business. Make no mistake about it, Wall Street’s only real commitment is to their own bottom line. Investor returns are clearly secondary. The prevailing motto can be summed up in just two words: Sell More!

Many stockbrokers haven’t taken the time to learn investment management fundamentals. Stockbrokers are salespeople, not competent financial advisors. Their compensation is directly linked to the profit to the brokerage house. Most never receive outside professional education. They are only too happy to take their direction from the house, and the brokerage spoon feeds them exactly what is in the house’s best interest. Until the investing public wises up, it’s easy and profitable for them to keep on “smiling and dialing for dollars.”

For the most part, the media seem blissfully ignorant, content to schmooze and kibitz as they did 20 years ago. Their mission is to sell magazines, newspapers, or air time. The media is full of entertaining and interesting but useless and dangerous ideas about investing. They repeat these ideas endlessly and mindlessly with only minor variations. It’s much more fun to interview last year’s hero, or forecast next year’s calamity, than to discuss asset allocation or Modern Portfolio Theory. Perhaps they think we are all too dumb to understand it.

I must admit, the real story isn’t very sexy. Properly implemented, investing has all the excitement of watching grass grow or paint dry. A good investment manager’s job is to make the process as boring as possible. Ideally we achieve the client’s objective with the lowest possible level of risk. The media has a hard time making that story glamorous. It doesn’t generate exciting visuals or sound bites, and it doesn’t sell.

The Dual System of Financial Services

A dual system has emerged to service investors. Sophisticated institutions routinely utilize modern techniques, and receive economical execution. Retail investors are offered business as usual, advice worth far less than zero, discredited policies, and grossly inflated prices.

There is no need to put up with this abuse any longer. Modern technology and no-load mutual funds have empowered individuals of far more modest means. You can bring these powerful investment tools to bear in an effective, economical, and sensible program tailored to your individual needs. You can harness the power of the world’s most attractive markets to meet your goals. These leading-edge financial management techniques were unavailable to anyone with less than $50 million just a few short years ago.

There’s a fine line between being on the leading edge and being in the lunatic fringe. Keeping that distinction in mind will go a long way toward keeping us all out of trouble. Whenever you are considering an investment course, make sure that it has stood the test of time, and that the expected results fall within the reasonable range. In other words, a healthy skepticism is your best defense. If it sounds too good to be true, it almost always is.

In fairness, many of the issues I will cover may never be settled to everyone’s satisfaction. After all, there still is a Flat Earth Society. The field will continue to evolve. Lots of areas need to be further researched. We have a very imperfect understanding of economics. Many non-economic, random events also affect the world’s markets. Worse yet, investor behavior is often lemming-like and irrational. But the tools for rational investment decisions keep getting better. You will profit from keeping up with the research and debate. (The Internet lets you monitor developments, research, and papers from finance departments in major universities all over the world. Take advantage of it.)

Investment management today is still an art rather than a science. But it has come a long way from the alchemy of just a few years ago. I’ll outline some of the most important advances and the limitations. Even given the limitations of the theory, the techniques I will outline offer the highest probability of achieving your long-term goals. Over the next few months, I’ll post articles designed to help you develop effective investment strategies for your 21st century.