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The Calculus of Trust

Monday, August 30, 2010

The bestselling book “Freakonomics” chronicles the search for the hidden incentives behind all sorts of behavior.  It characterizes the field of economics as the study of incentives – how people get what they want, or need, especially when other people want or need the same thing.  “Freakonomics” gives entertaining examples of how odd results can be explained by carefully evaluating people’s incentives, like how cheating can be applied to teachers and sumo wrestlers and why most crack cocaine dealers are willing to live in near-poverty conditions.

There is no industry more ridden with conflicts of interest and misaligned incentives than investment management. David Swensen, the Chief Investment Officer of Yale University (one of our MarketRiders experts) writes:  “Relationships with external investment managers provide a fertile breeding ground for conflicts of interests….  (we) seek high risk-adjusted returns, while outside investment advisers pursue substantial, stable flows of fee income.”

To properly evaluate any financial advice you are given, you must understand the incentives of the adviser.  If your broker or insurance agent is your best friend, remember that he feeds his family by selling you “products” that may not be best for you.  The financial adviser you pay by the hour may talk a little too much and be pedantic in delivering his advice to keep the meter running.  Those who are paid a percentage of your assets want more of your money.  We explain these incentives in more detail on our website How Wall Street Keeps You at the Table.

Regulations in the financial services industry put another and more subtle dimension on incentives for advisers.  Did you know that a Broker / Dealer works under different legal standards than a Registered Investment Adviser?  Did you know that a Certified Financial Planner must pass much more rigorous examinations than brokers or advisers?  We’ve brought you articles this week so that you can be more informed about these issues and upcoming regulatory changes that could impact you.

Speaking of incentives, our August 14th newsletter comparing the mutual fund industry to the tobacco industry ended up in the New York Times which prompted the VP of Research at Morningstar to make dismissive comments about our arguments.  Applying the Freakonomics incentives concept, we publicly bet him that a portfolio of 10 ETFs recommended by MarketRiders would beat 10 Morningstar 5-Star rated mutual funds.  He refused to accept our wager.  We weren’t at all surprised.  After all, he’ll make much more money perpetuating the myth that his system works, than losing his own money by actually using it.

Filed in How Wall Street Makes Money, Investment Advisors and Wealth Managers, Malfeasance And Fraud, Stock Brokers | | Comments (0)

5 Easy Ways To Learn About Investing

Monday, August 23, 2010

“An investment in knowledge pays the best interest.” – Benjamin Franklin

During Soviet era communism, citizen behavior was managed through a monopoly on information. It was the duty of the KGB to know all they could about information flow and to tightly control it. When Gorbachev became head of the Soviet Communist party, he recognized that a crisis confronted the rigid system of central planning in a world that was becoming increasingly competitive and in which information technology was changing economic and social realities. He persuaded the party elite that if socialism were to survive, economic restructuring (perestroika) would be necessary along with greater openness (glasnost) so that information could be better utilized. What he failed to realize, however, was that once his policy of glasnost took effect, there would be no turning back – people could see for themselves that the only way toward a normal life and improved living standards was to end communism and let markets deliver what consumers wanted rather than what the state dictated.

The fall of Soviet Communism is not unlike the current revolution that is rocking Wall Street. A glasnost-like spread of information is educating everyday investors on how Wall Street really works. Educated investors are using technology for cheap and effective investing and  lowering their fees, their risk and increasing their returns.  The once expensive stockbroker has been replaced by discount online brokerages that provide excellent trade execution. High cost and ineffective mutual funds are being upended by low-cost and tax efficient ETFs. Even investment advisers operating in expensive wood-paneled offices are now being replaced, along with their annual management fees, with unbiased and effective online services like MarketRiders.

This is all part of an information revolution that is rooted in the education of everyday investors.  Educating yourself on proven principles of money management is the cornerstone of investment success.  Fortunately, the erudite, technical finance textbooks are being translated into layman’s terms by kind authors who wish to bring the investing strategies of elite institutions and the world’s wealthiest families to every American.  In that spirit, we are celebrating the back-to-school season with our own selection of easy-to-read and engaging books on investing:

The Seeking Alpha ETF Investing Guide (Free): David Jackson, who founded Seeking Alpha, wrote a web-based book on ETF Investing that provides an interesting and compelling primer on the MarketRiders approach. It is free and easy to read.

Transparent Investing: What Your Broker Doesn’t Want You To Know (Free): Patrick Geddes is a good friend of the MarketRiders team and a leading expert on index investing. Co-founder and Chief Investment Officer of Aperio Group, and formerly the CFO and Director of Quantitative Research at Morningstar, Patrick offers this free downloadable book for any student who cares to learn how to best manage his retirement on his website “Transparent Investing.”  Click on “I Want the Full Story in More Detail” to download it.

The Elements of Investing: The Elements of Investing by Burt Malkiel and Charles Ellis is a timeless and easy to read guide that has a single-minded goal: to teach the principles of investing in the same manner that Professor William Strunk Jr. once taught composition to students at Harvard – using his classic little book, The Elements of Style.  The great thinking and teaching styles of Ellis and Malkiel make even the most academic concepts accessible and fun to read.

The Bogleheads’ Guide to Investing: The authors wrote this book as a service to all investors and all royalties from book sales are donated to charity.  As one reviewer states, The Bogleheads’ Guide is both a textbook for beginners and a refresher course for old hands. It blends elements of financial-planning primers like The Wealthy Barber with tips on why it pays to be cheap, a la The Millionaire Next Door.  We think you would love it!

All About Asset Allocation: Our good friend Rick Ferri is a serious thinker when it comes to retirement investing. Having learned the shenanigans of the Wall Street scene from the inside, Rick ventured out and built a leading retirement investment company called Portfolio Solutions that offers low-cost portfolio management rooted in modern portfolio theory. His book on asset allocation is a must read for any serious student of the index approach.


Filed in Asset Allocation, ETFs & Index Funds | | Comments (0)

Thursday, August 19, 2010

Check out what Jennifer Schultz of the New York Times wrote today in the Bucks Money Blog referencing MarketRiders’ recent cigarette analogy to mutual fund managers.  Seems to have hit a nerve. Make sure to also read a comment posted by Morningstar as they too weighed in on the matter!

How Mutual Fund Managers Are Like Cigarette Makers

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Did Morningstar ‘Fess Up Or Stumble?

Tuesday, August 17, 2010

We love to talk about how our method of investing is as exciting as watching paint dry.  Sometimes, however, there is a little drama in our corner of the investment industry.

Russel Kinnel is Director of Mutual Fund Research for Morningstar, Inc.  He released a study this week proving that mutual fund expenses are better at predicting a fund’s performance than Morningstar’s own 5-Star rating system.  The story was widely reported because it was either an enormous oversight by Morningstar, or signaled an unexpected level of transparency by the firm.

Morningstar has profited by giving investors a winning “system” for buying mutual funds, similar to a Las Vegas card counting system that purports to beat the odds.   Armed with their 5-Star rating system, investors believe they can buy the mutual funds that will outperform their benchmarks.  For nearly 40 years, unbiased research from every corner of academia and industry has demonstrated that buying a portfolio of actively managed mutual funds is a “loser’s game” and that the Morningstar 5-Star rating system has little predictive value. Sadly, investors using it, have lost billions in retirement savings to unnecessary fees, taxes and under performance.

A portfolio of actively managed mutual funds is absolutely, without question, as bad for your wealth as smoking is for your health.  In 1953, Dr. Ernst Wynder published a ground breaking study that established the health risks of cigarette smoking.  In response, the leading tobacco manufacturers organized a massive counter-attack by forming the “Tobacco Institute Research Committee.” What sounded like an unbiased research organization was really a well-funded public relations ploy to calm down the public.  For over 40 years, these manufacturers engaged in brutal litigation and campaigns to manipulate public opinion.  Finally, industry insiders, Dr. Ian L. Uydess, Dr. William A. Farone and Jerome K. Rivers stepped up and testified against their employer Philip Morris which forever changed the industry.

For years, the mutual fund industry has waged a similar war against the passive index investment methods that we support.  Like big tobacco, the mutual fund industry is large, profitable and immensely powerful.  With large advertising budgets to influence “unbiased” mainstream media, they guide investors into bad investments.  Morningstar has lined its pockets as a willing accomplice.  Mr. Kinnel directs Morningstar’s research and has just announced that their rating system is a little bit better than bogus.  In 50 years, will he be heralded as the first industry insider to finally tell the truth?

Filed in Index Funds Versus Mutual Funds | | Comments (0)

Where Portfolio Returns Really Come From

Wednesday, August 11, 2010

Here is a shocking fact: Asset allocation, the idea of spreading one’s money into different buckets or asset classes, accounts for 90% of a portfolio’s return over time. This leaves a paltry 10% of performance tied to security selection and market timing.

Think of how radical this fact actually is. When you turn on CNBC or tune into Jim Cramer, you don’t hear cogent discussion on asset allocation. Rather, what you do hear is an expert waxing eloquent about his current prognostications on the market’s direction or which stock to buy or sell – market timing and stock selection advice. As the finance media spins like a whirling dervish over these matters, many investors wring their hands wondering if they should buy or sell, get in or get out. All the while real returns are being determined by the investor’s ability to identify and rebalance to asset allocations.

At MarketRiders, we sometimes describe asset allocation like the peloton in the Tour De France. The peloton is the large group of riders that move together in a pack. In the front, a strong rider “pulls”, a term for breaking the wind for the rest of the group. The lead rider must work up to 25% harder to help the peloton while the other riders enjoy drafting behind this lead rider. Once the lead rider becomes exhausted, he pulls back into the group, letting the next rider move forward to take a pull. Cyclists call this pacelining, and they know that by working together, they will, over the length of the race, achieve a significantly higher speed than riding alone. Even Lance Armstrong in his heyday could not come close to holding an individual pace that could match the speed produced through the shared work of the peloton.

Asset classes behave similarly.  For a season, one asset class will be out front, outperforming. But surely enough, in time, that asset class tires and drops back, in a sense, to regroup. Another asset class moves forward to pull your portfolio closer to your retirement goal. By keeping your target exposure to all your asset classes through disciplined rebalancing, you benefit like a cyclist in the peloton, always enjoying the work of a strong asset class that is leading your portfolio forward. To see how asset classes have performed over the past ten years, take a look at our education page.

Asset allocation worked just like pacelining over the past ten-year period of investing – a period billed “the Lost Decade”.  It was one of the worst in the past 100 years, with US equities losing a shocking 0.2% annually according to Wilshire Associates. As Rick Ferri pointed out in an interesting Forbes article, an investor who embraced a simple asset allocation strategy by diversifying across four classes (US stocks, foreign stocks, bonds, and REITS) and rebalanced to that allocation, realized a return of 4.2% compounded annually. Like a peloton, while US stocks got exhausted, the other classes pulled the group ahead.  Although this may not be the most exciting return, but for a lost decade, it isn’t too shabby. Asset allocation works.

Filed in Asset Allocation, Benefits of Asset Allocation, Portfolio Diversification | | Comments (0)

How Money Doubles — Understanding The Law of Compound Returns

Monday, August 9, 2010

The latest biography on the world’s most famous investor is titled “The Snowball – Warren Buffett and the Business of Life.”  The term “snowball” is a metaphor for a core investment concept:  the Law of Compound Returns.  Understanding it is critical to your success as an investor and should be at the center of all your investment decisions.

Think of the Law of Compound Returns as a force of nature that describes how wealth grows.  A small snowball rolling down a hill will gather weight, which increases its speed, which keeps increasing its size.   Wet snow and a long hill are the conditions that turn a snowball into a very large boulder.  Continuing with the metaphor, snow moisture relates to an investor’s rate of return, and the size of the hill is one’s time horizon.

If you achieve a higher rate of return for many years, your wealth can snowball into a fortune. For example, from 1925 – 2003 a portfolio of bonds smoothly appreciated an average of 5.4% per year (dry snow) snowballing to 61 times its original size, while a portfolio of US stocks appreciated 10.4% (wet snow), snowballing to over 2200 times its original size.    But higher returns require that you stomach large portfolio fluctuations.  During this period US stock investors endured depressions, wars and periods of stagnation, as the bond holders calmly clipped coupons and watched their capital depreciate.

Your job as an investor is to find a level of risk that you can live with and then structure the most efficient portfolio that delivers a rate of return commensurate with the level of risk you are assuming.   Then you must help the Law of Compound Returns work its magic.

At MarketRiders, we can’t give you a longer hill, but we can help keep your snow wet.    Taxes, investment fees, and underperformance interrupt the Law of Compound Returns and lower your returns.  They dry out your snow.

First, using low fee ETFs and investing with our software lowers your fees and increases your returns without assuming any more risk.  Second, deferring taxes lets more money continue to snowball year after year.  Trading in and out of ETFs can increase taxes and takes a bite out of the snowball as it rolls down the hill.  That is why we recommend ETFs that are well-constructed indexes that you’ll never have to sell.  After you’ve held your ETFs for a year, small gains from rebalancing are taxed at the lower long-term capital gains rate.  And finally, since ETFs mimic an index they will have good and bad years.   But, unlike an investment manager, an ETF will never lose your money betting on an investment theme that didn’t pan out.

Take a minute to play with this calculator to see how much your money will snowball given different rates of return and time horizons.

Filed in Law of Compound Returns | | Comments (0)