Smaller advisors may be better

 

Selecting a financial advisor is a difficult task.  As I’ve discussed in the past, selecting your advisor can be the most important financial decision you’ll ever make.  They should be someone you trust to give you truly independent financial advice, be qualified to do so and be free of conflicts of interests so that they are incented (both financially and morally) to put your interests first, and finally should have the flexibility to implement their best ideas for you.  The type of firm your advisor is associated with may have a lot to do with whether they can provide superior and independent advice.

Large firms often have large and highly paid research staff to develop views on the markets and lists of securities for their advisors to recommend for buying or selling by their clients.  Some of these firms also offer their own, internally managed, products that they try to get clients to invest in.  For example, an advisor representing Goldman Sachs (or any large broker-dealer for that matter) is likely to recommend a Goldman mutual fund to their clients and a stock that Goldman’s research group is recommending as a buy.  While reasonable to invest in a Goldman Sachs mutual fund, the recommendation by your advisor is rife with conflict of interest.  Goldman earns revenues from their mutual fund so the firm serves to benefit from your investing in their fund over a competitors.  Your advisor therefore may be incented to recommend the internal fund over the possibly better external fund.  There are multiple layers of conflict beyond this; the mutual fund fees and kick backs to the advisor are just the beginning.  The point is that in this situation you’re likely not receiving independent financial advice.

Equally importantly, large firms are applying their views on markets across more clients and more investment dollars. Market prices are determined by the average of all buys and sells and therefore by the average views of all market participants.  The larger the firm, the bigger their impact on the market.  Therefore the harder it becomes to “beat the market” with the research from a large firm … this knowledge is already discounted into market prices.

In comparison, small firms are usually employee owned and only sell investment advice, nothing else.  Well at least, these are the firms you should be looking for.  At such a firm, there is little room for conflict of interest as the only source of revenue is from the investment advisory fees paid by clients.  Therefore, over time, if this small firm does not provide good advice, clients will take their money elsewhere.  Hence, the advisor’s interests are more closely aligned with yours.  Ofcourse you still need to evaluate whether your advisor’s moral values are such that they will put your interests before theirs.  And regarding investment research, assuming owners with the right intelligence and qualifications, small firms can take advantage of unique market insights because they control less money and hence can put their clients money to work without moving markets.

Bigger is not always better.  A boutique firm setup to align their principals interests with those of their clients is likely a better choice for most individuals and institutions seeking financial advice.  And when it comes to investment performance, although it is just as difficult to find qualified small firms as it is large firms, the larger firms often have a performance headwind simply because of their size.  Combine this with potential conflicts of interest and everyone should consider their local financial advisor before simply jumping on board with a Morgan Stanley or Raymond James representative.

 

Stocks and Businesses

I’m currently reading the Warren Buffett biography, The Snowball.  I love books about famous people when they give you some insight into how this person thinks – both their inner genius and inner demons – The Snowball fits the bill.  One of the most interesting things is how Buffett was interested in business from a very early age; selling Wrigley’s gum  door to door (now he owns the company) after buying the gum in bulk, buying a classic car and renting it out with a business partner, and leasing pinball machines to barber shops.  Through these many experiences he learned the most valuable lessons about the characteristics of businesses you want to buy.  One of these characteristics is businesses that earn high returns on investment where the term investment also includes labor and human ingenuity.  Leasing pinball machines was one such business with great economics – buy the pinball machines at auction then collect the profits from other people using them at the end of each week – not much work required beyond that.  It’s no wonder why Coca-Cola is one of Buffett’s favorite stocks.

As I read about Buffett’s adventures and many business successes it reminds to look beyond just the stock market and to investment opportunities in the local business arena.  In the same way that there are a few public companies like Coca Cola and Paychex that offer the wonderful business economics that everyone should look for, there are also such businesses available locally.

Just last weekend I was at one of the local laundromats.  It is small with about 20 washers and 20 dryers but is completely unmanned.  This specific laudromat doesn’t offer a wash ‘n fold service or dry cleaning or anything else for that matter – just washing and drying.  Being in there, seeing all the traffic, and just about every washer and dryer full of clothes got me thinking about it as a business idea.  It sure seemed like a cash cow from this perspective.  No labor costs other than collecting the quarters at the end of the week.

Another good example is a friend’s optometry practice.  I’ve been consulting with this friend on her buying into her practice.  The price she is paying for her share of the practice is only 3 times her share of the profits, after paying her own salary.  If you add her salary to the mix, then she’s only paying 2 times her annual income.  This translates into a 50% return on investment!!!  That is, her income pays for the investment after only 2 years!  What a steal.  Even as an outside investor earning only the 33% ROI, that is still better than most companies listed on the New York Stock Exchange will earn.  Only a few like the Coke’s and Paychex have the economics to consistently earn such high returns on capital.

Stocks simply represent shares of real businesses.  Therefore buying stocks should be looked at in the same light as buying a business.  Warren Buffett has always looked at stocks in this way while remaining disciplined about only buying those with the ability to continue to earn high returns on investment.  In hindsight, it’s no surprise he has had the success he’s had.  There’s no reason the rest of us can’t achieve high returns on our investments as long as we stay disciplined about only buying businesses with superior economics.

Spending down in retirement

When accumulating savings for retirement, many people take the view that the road ends at retirement as if magically on that day the world changes.  While saving for retirement you must slowly shift towards the portfolio you will hold while in retirement.  And then during retirement, the challenge shifts to making sure you always have enough money to meet current liquidity needs while also figuring out how to properly spend down your savings to last the rest of your life.  That’s what I’ll talk about this week.

Many articles recommend a spend down rate that starts somewhere between 4-6% and rises as you get older and your portfolio shrinks in size.  But what happens if the market crashes in your first year of retirement like it did in 2008?  Do you continue the same spend down rate on a smaller portfolio and manage on less income, or do you temporarily increase your spend down rate to maintain your target income?

The answer to this question comes back to how you structure your portfolio as you phase into retirement.  Just like an insurance company buys bonds with its premiums to hedge against the liability of paying out future insurance claims, individuals need to also “hedge” their spending liabilities, especially in the short-term.  One way to do this is to think about your portfolio as a group of buckets where one bucket is a short-term one that is meant to be withdrawn as income for the first 1 to 5 years, a second medium term bucket of laddered bonds, and then possibly a third bucket of riskier securities like stocks that do not have to be touched for at least 7 to 10 years.  With this structure, you have essentially guaranteed your income in the short- and medium-term while also giving yourself the flexibility to allow your stocks to recover following the crash if that were to occur early during your retirement.

So how much money do you allocate to each bucket?  That depends on a few factors including how much annual income you desire from your portfolio traded off against how long you hope your portfolio to last.  The size of the first bucket should essentially equal the amount of income you need for the first 3-5 years.  The second bucket, similarly for the next 3-5 years, but discounted by current interest rates.  Finally, the remainder of your portfolio can be invested in the third bucket.  Ideally, over time, as the final bucket grows in value, you can replenish the other buckets with earnings from this one though the more likely scenario is that you will end up slowly selling down assets in the third bucket to make sure you have enough in the other two buckets.  Either way, if constructed properly, this structure should get you through retirement without being buffeted around by big moves in the stock market.

The slide of the US dollar

Over the past couple weeks, the slide of the US dollar has made headlines after having spiked in value during the peak of the credit crisis during the Fall of 2008.  Recent news reports have leaked that some countries are colluding to force the downfall of the US Dollar as the World’s reserve currency.  In addition, reports about the health of the US economy are beginning to come in weaker than expectations leading to a renewed loss of confidence among investors.  All this while the US Fed continues to print money in an attempt to reflate the economy and move past the debt crisis.

What does this mean for investors?  A falling dollar means foreigners find US goods and financial assets cheaper.  This is good for manufacturers and companies with significant foreign operations and therefore could be good for the stock market.  If this were the only part of the story, this would be good for most US investors (as long as most of your spending is in US Dollars it shouldn’t matter what happens to the currency relative to other countries).

Many are worried about the risk of inflation if the Dollar falls too much.  For someone who must import much of what they consume, a falling Dollar means increasing costs because the price of imports will rise.  But while this happens, domestic producers become more competitive limiting some of the cost increases hence costs increase less than proportional to the fall in the Dollar.  Therefore inflation from a falling currency is only a risk if much of our consumption remains from imports.  Since commodities like oil are largely imported, if we continue to remain dependent on oil, this may lead to some inflation.  But we all know that as a nation we are less than half as dependent on oil as we were in the 1970’s when oil shocks did lead to inflation.

Deflation (or stagflation) are also very possible outcomes from a falling Dollar.  What does it mean when the Dollar falls?  It means that there are less people buying US Dollar goods (imports) and assets (bonds and stocks) than there are selling these same assets.  As foreigners sell US assets like bonds, interest rates rise (as we know, China and Japan are the largest holders of US bonds).  As interest rates rise, the cost for consumers and businesses to borrow rises.  Therefore the cost to expand your business or to buy a new car or house rises.  When the buying of houses, cars, and stocks falls so too does their price.  Therefore a fall in the Dollar can actually lead to fall in prices (i.e. deflation).

I am more worried about the deflationary scenario than I am about the inflationary one.  Both are bad but the deflationary one is worse for investors.  The Fed will not continue buying US debt in order to keep rates low.  They have set a limit as to how far they will expand their balance sheet.  Once US government debt levels exceed what the Fed is comfortable with, it’s game over for the US economy.  Deflation will force the debt restructuring (through the more destructive process of bank bankruptcies and high unemployment like the 1930’s) that the government is trying to facilitate right now.  With such an uncertain future, this is a time to emphasize conservative investing more than any other time in recent history.  Only high quality bonds and cash will hold their value in a deflationary environment.

Do you know what you don’t know?

It’s easy to fall into the trap of only planning for the expected.  But we all know that the expected rarely happens and it’s the unexpected that determines the final outcome.  Just this past week, a co-worker of mine was hospitalized and almost had to have his kidney removed (luckily the surgeon was able to fix the problem).  He is only 26 years old and was healthy and active.  Now, who knows how this past week might change his life.

Similarly, it would be nice to only have to worry about retirement when building your portfolio but you have to “know what you don’t know” and plan for the unexpected.  And I’m not talking about planning for various economic scenarios, such as hyperinflation or a default of the US government.  I’m talking about do you have a plan if you lose your job in 5 years?  Do you have enough savings to cushion against this setback?  What if you want to open a business down the road?  Do you have enough savings set aside in a vehicle where you won’t incur penalties for early withdrawal?  The unexpected should make you invest a little more conservatively than you would otherwise.  The possibility of forced early withdrawals tend to shorten what is hopefully the “long-term”.

This is why I like to structure a core portfolio of low risk instruments (nominal and inflation-linked bonds) and build a risky portfolio around it as excess savings permit.  If the savings that you absolutely need to meet your retirement spending needs are invested conservatively then you don’t have to worry about them whether you actually sit on this portion of your savings for 30yrs or draw on it slowly while you are sitting unexpectedly unemployed and looking for a new job (it’s also most likely that you’re unemployed during a recession when risky assets like stocks have fallen in value).

Only risk what you can afford to lose.  The part of your portfolio that represents extra savings can be invested in stocks and real estate and whatever else your heart desires and gut can tolerate.  And ofcourse, even with these riskier investments, following the principles of capital preservation and doing your research will help minimize the risk of loss.

What if you’re wrong?

The question I’ve been pondering over the past few days is what if I’m wrong about what I expect the economy to do, then what?  How should I invest so that I still do ok even if I’m wrong?

Currently, my view is that the developed world economy is going through a deleveraging and we are undergoing a massive transfer of wealth to developing nations such as India and China.  Public and government debts are too high therefore these debts have to be restructured before credit markets can fuel growth again.  This will take time.  If this is true, then we should expect an extended period of higher unemployment and low returns for stock index investors.

That being said, there are many scenarios that could play out.  It is possible that we are at the beginning of a normal recovery and stocks will continue to rise.  Though with the release of today’s employment status and recent manufacturing reports, this is unlikely.  It is also possible that the economy is sufficiently on the mend and that growth will resume but that an even bigger crisis is just around the corner (e.g. a US dollar collapse).  Then we may see risky assets like stocks continue their rally until they collapse far below today’s lows during this next crisis.  What happens if we enter into a hyperinflationary period?

In any of these scenarios (and there are many more), how should one structure their portfolio to minimize the risk of loss and to have some chance at earning a decent return?  Let’s go back to the principals 1) capital preservation 2) don’t take too much risk (pass the sleep test).  And now let’s translate these into investments.

First, we need a portfolio that can withstand deflation from a collapsing debt bubble and/or a collapsing currency.  Hedging against these risks implies holding gold and possibly an allocation to government bonds.  Next, as the Fed prints money and reflates the economy, there is a risk that the velocity of money spikes and along with it so does inflation.  Both gold (and other physical assets such as oil and real estate) and inflation protected bonds work in this scenario.  Finally, all the fears about how bad the economy is could always be overblown and we could go on our merry way, in which case stocks are likely your best bet.  What this basically comes down to is holding a diversified portfolio that is not biased and rather should perform reasonably well under any scenario.  And don’t forget when selecting individual securities to only invest when there is sufficient margin of safety (i.e. the odds are in your favor).

Portfolio Rebalancing

The conventional wisdom says to rebalance your portfolio to its target allocation between stocks and bonds on a periodic basis.  I do generally believe this is a wise thing to do to maintain the risk profile of your portfolio while also forcing you to take a look at your asset allocation and re-assess whether it is the best one for you.  What the literature does not help with is how to rebalance assuming that is obvious.

Most advisors implement portfolio rebalancing through buying in one asset class and selling from another.  This is fine except that it incurs transaction costs (which can be high for the retail investor) and taxes (which can be high if gains are short-term in nature).  Both of these costs need to be incorporated into any rebalancing methodology and for that matter into every trading decision.

One of the simplest ways to rebalance is to use cash flows into and out of your portfolio to force a rebalance.  Most investors either make additions to or withdrawals from their portfolio every year.  Whether the addition is a planned, periodic addition or a withdrawal is to meet an emergency situation, cash flows in and out occur often enough.  Regular rebalancing incurs a transaction cost and possible tax consequence from both the selling of one investment and the buying of another.  A more cost effective way is to use your next cash inflow to only invest in the underweight asset class or to sell only the overweight class when a withdrawal is necessary.  This action brings your portfolio closer to the target asset allocation while only incurring half the costs.

Ofcourse there will be times where a more mechanical rebalancing will be necessary (your asset allocation is out of whack with no anticipated cash flows in the near future) but using primarily cash flows (including dividends from stocks and coupons from bonds) should reduce costs and taxable events significantly over the long-term.

What to do when the market runs away from you?

Last week I had an old friend in town so I did not write my usual post.  This weekend I am resting for a triathlon and have plenty of time to think and write about my favorite topic.

As stock markets around the world continued their upward trajectory since March lows this week, the question I’m thinking most about is how do you deal with markets running away from you.  Like with everything else in investing, the best way to approach this question is to go back to the fundamentals.

The first fundamental is valuation.  When you make investment decisions, they should be grounded in assuring you are paying a fair price.  Whether buying a stock or bond, you or your advisor should only buy when you are reasonably certain that you will be compensated for the risk being assumed.  Therefore, even when the market has run up, there will be investments out there that can still be purchased at a fair price.  These are always the only ones worth investing in regardless of whether the market has been rising or falling.  If you buy overpriced investments, no matter the market environment, you will earn a sub-standard return and risk not achieving your long-term investing goals.

Although valuation is the most important principle, it is important to remember the reality of markets – they can stay irrational longer than you can stay disciplined.  As we saw from the mid-1980’s through 1999, stock markets ran away for over a decade and anyone who stayed out would have missed the longest bull market in history.  Therefore, it is important to also dollar cost average into your investments periodically.  The best way to do this is set a pre-defined period over which you will make a minimum investment into markets even if valuations are not attractive.  That is, if you are phasing in a large investment and have not found any opportune times to invest over the previous 3-6mths, then you should make a small investment now.  The amount doesn’t have to (and probably should not) be as large as when you find an attractive opportunity.  You will never be able to consistently time market tops and bottoms so maintaining discipline is important and dollar cost averaging is simply one technique to do so.

Some might say that I am a hypocrit because of my recommendation to both dollar cost average and invest based on valuation.  If your portfolio is sufficiently diversified across asset classes, then there will only be rare occasions when all of your investments are above fair price.  During the tech boom in the late 90’s, while stocks were very expensive as a whole, buying gold would have been a great investment.  And within stocks, there were many attractive businesses that didn’t get caught up in the Dot.com fad.  Therefore in your diversified portfolio, as stocks continued to run up, you will generally always have attractive opportunities to invest and therefore mandatory dollar cost averaging shouldn’t be necessary.

In the end, it all comes back to understanding the fundamentals … whether investing or with anything else in life for that matter.

Prudent Investing for the Long-term

This should be a quick post as it’s more just some of top of mind thoughts I’ve had this week.

I’ve been reading the quarterly letters from some respected money managers (incl’ Bridgewater and Elliot Management). I can’t help but notice the number of managers that are traders and not long-term investors. Some have produced good performance and others terrible performance. In the short-run, the performance of markets is so random that I can’t fathom how one can expect a trader’s performance to be consistently good over any reasonable length of time. But since everyone’s out to make a quick buck, they are compelled by greed to invest with traders.

To me, the parallel is private equity shops that leverage companies up with junk bonds thinking this makes a company more efficient, compared to shops like Forstmann Little who take companies private without much debt and make long-term decisions to “trim the fat”. As long as capitalism works and creativity is allowed to flourish, then making investments in businesses that are market leaders and have competitive advantages is the only way I see to reliably come out ahead in the long term.

How did the world forget how to invest?

Or should be the question be, why did we never learn how to invest? Investing is about first understanding why you’re investing (your goals for saving money) and second about prudently placing your money with people who will care for it like it was their own and who are experts in their field and will help it grow. Today’s world sees investing as a complex engineering problem of trying to match benchmarks and indices and trying to find patterns in random market movements to trade against. This is not investing. This is trading! As they say, trading is hazardous to your wealth.

Over the past few decades, Wall Street has hired more and more scientists and engineers to build quantitative models for how markets should behave. As we witnessed last fall, much of this work hasn’t done us any good as it is in part an over-reliance on mathematical models of how the world should work that brought us to the verge of a complete meltdown in our financial markets in the Fall of 2009. Markets and economies are governed by human nature. Some things simply can’t completely be codified into a computer and the randomness of human behavior and emotion is likely one of them.

Some people, like engineers and scientists, love solving very difficult problems. We need these people in society. We need them to be working on problems like how to cure cancer and how to stop global warming rather than how to better track the Barclays Capital Global Aggregate bond index. All are complicated problems, some have more value to society than others.

Investing does not have to be as intellectually challenging as curing cancer. It does require more discipline and emotional control though than almost any other profession out there though. Investing is about finding places to park your money where the risk of loss is small and the probability of receiving more money back sometime in the future is high. This is not an engineering problem. Understand the principles of investing and maintain discipline at all costs … this is the key to investing success.