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Chapter 24: Putting It All Together

By: Investor Solutions

The Bad News

There is broad general agreement that America is about to launch an entire generation into retirement without sufficient financial resources to support them. These retirees can expect to live longer, retire earlier, and endure inflation longer than any of the generations that preceded them.

There is also broad general agreement that America has one of the lowest savings rates in the world. Recently there has been some hopeful speculation that as former yuppies and flower children actually feel the cold breath of retirement, savings rates will improve. So far, however, this is just idle happy talk.

Not only are investors loaded down with debt, discretionary saving is thus far not an ingrained habit. This can be partially attributed to the tax code, which encourages conspicuous consumption and punishes thrift. Government, even if it wanted to, is not likely to be in a position to bail out the spendthrift; the demographics are just too discouraging.

A consensus is developing that Americans need to save more, but little thought has yet been given to the idea that they must also invest more effectively. Survey the popular financial press or electronic media and you will get the distinct impression that everything is just peachy keen – investors are making great long-term decisions for themselves, Wall Street is handing out sage advice, and with just one more list of sure-thing mutual funds from Money Magazine, everything will turn out great!

Of course, the truth is not so comforting. Investors have been carefully trained and continuously conditioned to address the problem in just the wrong way. While it’s not exactly an Oliver Stone type thing, there is a loose conspiracy to keep investors in the dark. While all the players never gather in a smoke-filled room to plot against investors, they don’t need to; apathy, greed, and ignorance all work quite naturally to keep investors locked in their mind-set.

Almost all the players have an agenda in opposition to the best interest of the investors. Wall Street wants them to keep on buying expensive and profitable (for the house) proprietary products. The media is out to sell magazines, newspapers, or airtime; any useful information they might pass on in the process is almost an accidental by-product. Fund companies and managers naturally resist the idea that they are not likely to add value through their vaunted skills in either market timing or individual stock selection.

Individual investors, therefore, are being systematically sucked dry without being made aware of viable alternatives. Like lambs led off to slaughter, they innocently place their faith and future in exactly the wrong hands. As you can imagine, the social, political, and economic cost to America is enormous.

Lost in a sea of misinformation, investors float and drift hither and yon, reaping predictably poor results. Using either no strategy or a fatally flawed strategy, the overwhelming majority place their meager and hard-earned savings in the wrong markets and then fail to even come close to a market return.

The Good News

There has, however, been a revolution on Wall Street, so all is not lost. Investors need no longer submit to the tender mercies of Wall Street’s barons. It’s ironic, but investors already have available to them all the tools needed to turn the situation around only they don’t realize it yet. While most large institutions have embraced the new colors, the benefits have yet to filter down to the masses.

Although we may expect some howling and rear guard skirmishes from the barons, ours has been a bloodless revolution with little cost. Investors must first abandon their preconceived notions, then take and use the gifts which modern finance has given to those willing to seek them out.

The action has proceeded on several fronts:

 

  • New economic and financial theory has totally changed the investor’s paradigm.
  • No-load mutual funds have appeared with just the right building blocks to execute the improved strategies.
  • Deregulation has added new institutions and discount brokerages with dramatically lowered costs.
  • Modern communications has liberated investors from the requirement to physically inhabit Wall Street.
  • New technology has placed sophisticated and powerful management tools on the investor’s desktop.
  • A new breed of fee-only investment advisors can utilize all the above to deliver economical, unbiased, and professional advice to the investor’s doorstep.

Before investors can act effectively, they must banish their misconceptions and vanquish the conventional wisdom. Until they purge their heads of a lifetime of accumulated merde, there isn’t going to be room in there for anything worthwhile.

Academic theory and institutional experience have a lot to tell us. Investing is a multi-dimensional process. For starters, investors must consider risk, return, time horizon, and correlation before they can construct an appropriate investment allocation plan for themselves. The most important points we should remember about each of these topics are elaborated below.

Return

Only equities offer investors a real rate of return sufficient to meet their reasonable long-term goals. With a little examination, most investors will conclude that fixed income and savings-type asset classes may be nothing more than a “safe” way to lose money since their after-tax, inflation-adjusted return may be negative.

Risk

Risk is the only reason that every investor wouldn’t prefer equities for their long-term investments. One of the most appropriate ways to measure risk is to use the variation around an expected rate of return. Higher variation is generally associated with higher returns in the investment world. Investment professionals often measure volatility using Standard Deviation.

Risk can never be avoided. For long-term investors, failure to assume reasonable risk may guarantee that they will never achieve reasonable financial objectives. In other words, the biggest risk may be being out of the market.

Many investors have an exaggerated fear of risk, often believing that risk equates to a probable total loss of principle. This misunderstanding may prevent them from making rational choices for their accumulation needs. Of course, investment risk is only short-term variation, and fortunately for investors, market risk falls over time. So, risky assets may be very appropriate for even very conservative investors with a long-term time horizon.

Diversification is the primary investor protection. Default or business failure risk is almost a non-issue in a properly diversified portfolio. It is just about the only free lunch available in the investment business. Contrary to popular conception, diversification does not reduce expected return, only the variability of that return. Failure to diversify properly is an unforgivable investment mistake. Viewed from a slightly different perspective, the market never rewards investors for taking risks that could be diversified away.

Correlation

Some types of diversification are better than others for investors. Harry Markowitz demonstrated that by combining risky assets which do not move in lockstep as the market goes through its cycle, risk at the portfolio level can be reduced below the average of its parts. This observation, made in 1952, led to entirely different and more rational approaches to investment management. Markowitz’s work was the key perception upon which Modern Portfolio Theory (MPT) was built, and for this he was rewarded almost forty years later when he was awarded with the Nobel Prize in Economics.

MPT revolutionized the way we think about investing. By examining each investment based on its contribution to the portfolio rather than just on its individual risk and reward, investors can fashion portfolios which fall above the traditional risk-reward line. Within certain limits, and over longer periods, investors can simultaneously increase rates of return and reduce risk.

Time Horizon

Investors cannot design an appropriate plan for themselves without understanding their time horizon. Risky assets are not appropriate with short time horizons. An investor that finds himself forced to sell a variable asset at a loss to cover a known or foreseeable commitment has committed a major blunder. On the other hand, because risk is lowered with longer time horizons, and because risky assets carry an expected rate of return sufficient to realize realistic financial goals, investors should pack in risky assets as their time horizon increases.

Time horizon has little to do with an investor’s age. Rather, it should be measured based on the expected liquidation of the investment. The concept that older investors must necessarily have lower risk tolerance is a diabolical idea that must be dispelled. In particular, retirement time horizon must be measured at least to the life expectancy of the investor. Only a simpleton believes the Wall Street Journal theory that investors can determine the appropriate percentage weighting of stocks in their portfolio by subtracting their age from one hundred. This is a surefire prescription for eating dog food in advanced age.

Efficient Markets

Embedded into MPT is the concept that markets are reasonably efficient. Because investors hate risk, they will demand higher rates of return to compensate them for risky assets. Stock prices for risky assets are driven down until the expected rate of return provides the necessary return to buyers. Investors will demand a rate of return which equals a risk-free rate of return plus a market-risk premium plus a premium for the unique risk associated with the investment. Both buyers and sellers reach their opinion of the proper value of stock by studying all available data on the current condition and future prospects of the investment.

Knowledge and information travel so rapidly that neither buyers nor sellers will have an advantage. Few would argue that information is perfect, but prices end up being set efficiently enough so that there may not be much point in trying to outguess the market. Too many hundreds of thousands of buyers and sellers have access to the same data in real time for any one of them consistently to realize an advantage.

Support for the efficient market theory comes from a variety of sources. In a groundbreaking study, Brinson, Hood, and Beebower found that in ninety-one of the largest pension plans in the country, the overwhelming determinant of performance was the investment policy decision. In the study, the trio defined investment policy as the percentage holdings in cash, bonds, and stocks.

That simple decision accounted for ninety-four percent of the plans’ performance, leaving less than six percent for both market timing and individual stock selection. Attempts to either market time or select individual stocks on average cost the plans. The obvious lesson is that investors should focus their attention on the factors that have the highest impact on return while avoiding non-productive and costly diversions with market timing and individual stock selection.

A study of mutual-fund performance illustrates the futility of trying to beat the markets. On average, funds underperform the market in which they operate by about their expense ratios. Four of five will fail to meet or beat an appropriate index. Beating an index for a particular time period tells us almost nothing about the prospects of a fund to outperform during a subsequent time period.

While many institutions with vast resources have studied mutual-fund performance, none have been able to reliably distinguish between luck and skill or find a formula which will predict future above-average performance. Picking honor roll funds, funds with lots of stars, or funds heavily loaded with up arrows in down periods has proven to be a costly and self-defeating exercise.

As with almost anything, there is an easy way and a hard way to do something. Traditional attempts to add value through management are almost impossible. Today, the weight of the evidence indicates that managers are unable to add value through either market timing or individual stock selection. In fact, attempts to actively manage equity portfolios have reliably increased both cost and risk (variability of returns) while lowering average returns!

Harness the Power!

There is, however, an easier, lower-cost, lower-risk way to attack the problem. Asset-class investing offers long-term investors superior returns and a much higher probability of achieving their goals. Simply put, investors can buy the whole market, or attractive portions of markets, through indexes. Rather than indulge in the fruitless exercise of attempting to beat the market, investors can harness or capture the incredible power of the world’s markets. By combining these markets according to their risk, return, and correlation to each other (MPT), investors can form superior portfolios.

Asset-class investing relies on neither market timing nor individual stock selection. It makes no predictions nor requires any supernatural insight. For long-term success to be assured, disciplined investors need only assume that the value of the world’s economy will continue to grow. This seems a reasonable bet for a capitalist to take, since 4,000 years of recorded history support this.

Asset-class investing has been embraced enthusiastically by institutions. In just a few years, about thirty-seven percent of the institutional marketplace has adopted this approach. Less than two percent of individuals, however, utilize this no-nonsense, highly effective, low-cost, low-risk technique.

Investors who wish to increase their chance of success will find that no-load mutual funds offer almost the perfect building block for asset-allocation investing. At their best, mutual funds offer instant, wide diversification within a target market at a very attractive low cost. However, with over 7,000 non money-market mutual funds available in the United States alone, selection is a problem.

As a rule of thumb, avoid any fund with either a front or back-end load. Shoot for funds with very low expense ratios. Also, eliminate any funds that will not stay fully invested and which do not restrict themselves to a market or well-defined segment of a market (i.e. avoid style drift).

Deregulation – The Beginning of Revolution

After May Day, Wall Street was never the same. The implications for investors were not only enormous, they were quite positive. Previously, Wall Street was the only game in town and it made cost competition illegal. Wall Street did what any good monopolist would do – it screwed the public with high prices and poor service.

Initially, deregulation resulted in higher costs for individual investors, but the arrival of new entrants tilted the balance of power in the individual’s favor. Discount brokerages and no-load mutual funds slashed prices and improved service for investors of very modest means. And when small investors combined forces in Schwab’s mutual-fund marketplace, they suddenly had all the tools to craft portfolios of remarkable sophistication without the “help” of Wall Street’s robber barons.

The runaway success of Schwab’s program attracted more competition and will keep the pressure on for even further improvements. For the investor, this is just another example of the positive effects of competition combined with capitalism.

Wall Street’s Rear Guard Action

Wall Street’s barons can be expected to put on a spirited rear-guard defense of their valuable turf. While no one is expecting their imminent demise, they are faced with pressure to clean up their act and provide better service at lower costs while being burdened with an enormous disadvantage in both structure and cost. How much they can fiddle with a flawed compensation system remains to be seen.

Conflicts of interest inherent in the commission-based sales system corrupt the entire process. The sales force is poorly trained to implement advanced strategies and the profit margins on those strategies are not sufficient to cover the tremendous built-in overhead of a giant brokerage firm. Thus far, no serious attempt has been made to pass on the cost savings generated by modern technology. Rather, the savings have been sopped up by Wall Street’s bloated establishment. When the public wakes up, the Street is a natural candidate for vigorous downsizing.

Wall Street’s big advantage in the retail market is marketing prowess. Generations of advertising have established a formidable brand name and identity. This position is constantly reinforced by enviable advertising and public relations budgets which ensure that Wall Street’s barons are high in your consciousness when you consider investing.

On the other hand, Wall Street’s abuses have been so well-publicized, widely known, and shocking that few investors really like or trust the Street’s used stock peddlers. As investors become more aware of their alternatives, mass numbers can be expected to defect. Only market share loss is liable to get the Street’s attention. Doing what is in your own best interest – voting with your feet – will force reform and ensure the successful conclusion of the revolution.

A New Breed of Financial Advisor

Deregulation, along with advances in technology, spawned an entirely new breed of professional advisor. Fee-only advisors can now operate from any place with a plug-in phone line, bringing low-cost, independent, objective, and professional advice of the highest quality and sophistication right to the investor’s neighborhood. The clear separation of the sales or brokerage function from the advice function eliminates conflicts of interest and puts the advisor on the same side of the table as the client.

Wall Street’s abuses have been so frequent, and the advantages of fee-only compensation so obvious, that the demand for the new advisors has fueled explosive growth. While fee-only is a far better way to deliver service and advice, it doesn’t guarantee competence or even honesty. Investors must still do their due diligence when selecting an advisor.

All that remains is for the individual investor to take advantage of the gifts he or she has been given. Everywhere the investor looks, things are getting better, but looking is the key since neither the brokerage industry, the fund companies, nor the media have a deep commitment to providing fundamental education. Bad advice is far more profitable than good advice for nearly all the players.

Wall Street’s profits are simply not linked in any way to investor profits. As long as turnover is high, the Street wins either way. With more than 7,000 mutual funds clamoring for shelf space and public attention, hype is the order of the day in fund advertising. As long as Americans will buy dangerous drivel posing as serious financial commentary, the media will happily provide it.

America is a land of shocking financial illiteracy. Ironically, while few investors have any kind of long-term plan and fail to recognize the dimensions of the problems facing them, most are still supremely confident of their abilities. Their lack of discipline and indulgence in self-destructive financial behavior, not surprisingly, yields dismal results. Projecting these results forward generates visions of almost unimaginable financial hardship as the boomers march off to retirement without the financial assets to sustain them.

Just Do It!

Most boomers still have time to avoid a financial disaster. To do this, however, they must begin to budget for some serious investments along with their BMWs, hit the books and do their financial homework, formulate meaningful investment plans, learn investment discipline, and reform their own behavior. But, start you must since time is running out. If you end up missing the benefits of the financial revolution you will have nobody to blame but yourself.

Investors without the time, inclination, or resources to administer their investment program should consider delegating the duty to a qualified financial advisor. The vast majority of investors simply cannot afford the free advice they have been giving themselves. Investing is a serious business and it is not likely that investors will stumble upon reasonably efficient portfolios by themselves.

Marx Had It Wrong

Marx just couldn’t imagine that the workers could end up owning the system. Capitalism is the revolution of the twenty-first century and beyond. The market itself is the greatest wealth-generating mechanism the world has ever seen. A properly diversified portfolio of the world’s equities will harness the tremendous power of the growth in the global economy for you. Riding that wave rather than fighting it is the ultimate Investment Strategy for the Twenty-first Century.