In the time travel movie Frequency, this Yahoo stock tip was passed through time to the six-year-old Gordo via a mysterious interplay of a ham radio and the aurora borealis. This small bit of incomprehensible information was not only retained by Gordo, but later, when he grew up and became a stock trader, it resulted in him not only being fat, but quite happy as well.

The power of knowing the future is profound. Just imagine, for a moment, if you were given the privilege of seeing stock market results one year from today. A resourceful individual could easily parlay that knowledge into profound wealth. It is no wonder that economists, stock traders, fund managers, and financial advisers alike are desperately trying to find a way to peak around the corner of time to anticipate what the markets will do.

Forecasting markets is not for the feint of heart. Take, for instance, the recent housing bust and subsequent recession. Top economists and investors alike failed to see it coming. Ben Bernanke, the Federal Reserve chairman, testified at the Financial Crisis Inquiry Commission (FCIC) that, “We knew all those numbers, of course, but a lot of smart people, including people like Paul Volcker and others, . . . got it wrong. It is just another example of how difficult it is to predict.” Furthermore, Alan Greenspan commented, “We all misjudged the risks involved. Everybody missed it—academia, the Federal Reserve, all the regulators.”

It was not only the economists that failed to see the crisis coming, but leading investors as well. Take George Soros as an example. He became one of the world’s richest people by predicting the UK currency collapse and betting accordingly, and yet he took an ill-fated stake in Lehman Brothers just before the bank failed in 2008. Likewise, Warren Buffett, the Oracle of Omaha, lost billions in the downturn and testified before the FCIC that “no one saw the housing bubble.”

But just when you think that such foresight is outside the reach of common man, some prognosticator emerges with a specific contrarian view and then with eerie accuracy hits the nail on the head. It’s as though he found his own flux capacitor-equipped DeLorean and sailed from the future to the present with otherworldly insight.

Take for instance, the small group of esteemed economists and financial managers that called the housing crisis. There is Dean Baker, the co-director of the Center for Economic and Policy Research in Washington, D.C., who in the August 4, 2004 issue of The Nation gave a detailed warning concerning the coming housing crisis in an article called Bush’s House of Cards. His predictions were five years early and largely ignored. Then there is Med Jones, the president of the International Institute of Management (IIM), a U.S.-based research and education organization. Although Jones is less known, he turned out to be the most accurate in predicting many of the downturn’s details.

Nouriel Roubini, an NYU economics professor known as Dr. Doom for his wild and dire predictions, became a media darling because of his accurate foretelling of the crisis. More bearish still is Peter Schiff, who now famously predicted the housing collapse in nationally televised debates. Although ridiculed by experts, he showed great courage, and his detailed analysis proved right in the end.

It is these types of expert forecasts that make investors seek the next accurate prediction. Think of how you might have managed your portfolio differently if you had only listened to these warnings before the housing crash. Furthermore, today, there are forecasters out there who are nailing their predictions right before our eyes. A year from now, many will lament the fact that their laser-sharp predictions were carelessly ignored.

So how does an investor know which forecasts to follow and which to ignore? The first thought that comes to mind is to follow the predictions of those that have gotten it right in the past. This method, however, proves to be ill fated. Take, for instance, the four gurus that called the housing crisis. Since that time, each of these prognosticators has supplied a long list of additional predictions. Sadly, the overwhelming majority of them have been tragically afield. In a famous prediction from 2002, Peter Schiff asserted that the Nasdaq would hit 500 and that the Dow would crash to 4,000. If you had followed his advice, you would have lost your shirt.

Nouriel Roubini has made over 30 economic predictions since 2006, with 22 coming up wrong and seven still awaiting fulfillment. Well, at least he got one right—the housing crisis. Whereas Med Jones seems to have a better batting average, Dean Baker’s predictions are about 50/50.

In the end, stock forecasting seems to be a bit more Abracadabra than most investors would prefer. As much as we would like the aurora borealis or at least something or someone to whisper an accurate stock tip that would leave us fat and happy, we are left with the harsh reality that forecasters often flop.

With no real way of seeing around the corner of time, smart investors are left with the proven methods of global asset allocation, low-cost indexing, and disciplined rebalancing. This proven approach may not provide the wonders of time travel, but it does provide a nice bounty to the principled and disciplined—over the long haul.

“It’s my nature,” says the scorpion. “That’s what I do.”

When you choose someone to help you with financial advice, it is important to know “what they do.”

In professions where the provider is helping individuals with highly personal and important areas like health, credentials mean that the person has earned the right to be trusted. There are understood standards and norms. Doctors are credentialed for his field of medicine. Chiropractors have a different type of training and certification than an oncologist. We know who we are seeing and what they are supposed to be able to do. Attorneys who have passed the bar went through law school and have the legal right to practice.

Such clear certification is very confusing in financial services. It may look like a professional broker at Merrill Lynch or Morgan Stanley provides the same service as someone who is a registered investment advisor. But nothing could be further from the truth. This distinction is critical to understand no matter how much you trust the individual.

A person who is a broker, is just that. He acts as an agent between a buyer and seller of products, usually for a commission. Legally, an individual who works for a “broker/dealer” must pass a “Series 7″ exam, which teaches one about the stock market and securities to prepare the individual to sell commissioned products. Brokers operate under a “suitability standard” under which the broker is required to make investments he judges to be suitable for his clients. He can’t sell micro-cap volatile stocks to old ladies. Brokers and their firms are regulated by a “self regulated organization” (not a government agency) called FINRA. In the industry, brokers are measured by the amount of commissions and fees that they generate from selling products. Product providers pay more for “distribution” through brokers.

Registered investment advisors (RIAs) help individuals manage their money. They must pass a “Series 65″ exam, which tests how well one knows how to help a client invest and operate under a fiduciary standard. That means an advisor is required to act in his clients’ best interests, and disclose to them all conflicts of interest. These advisors are either registered in the state in which they operate, or with the Securities and Exchange Commission (SEC). RIAs are usually measured by assets under management (AUM) because the more assets they manage, the more their fees. They submit lengthy ADV II forms online showing any conflicts of interest, sanctions from the SEC, and exactly how they are paid.

RIAs can’t use customer testimonials in advertising and must disclose when they pay for client referrals. Brokers can use testimonials and hide fees they are paid for referrals.

Under Dodd-Frank, legislators are now considering implementing a fiduciary standard for brokers. They are fit to be tied. The central issue is that if they are required to put your interests ahead of theirs, they will have to disclose conflicts of interest and fees. FINRA is spending a fortune to fight this because if they disclose all fees they receive from all parties, investors will get wise and they will earn less. FINRA’s CEO earned nearly $3 million last year, and FINRA’s top 10 employees all earn over $1 million. They don’t want their members paying them less, so everyone is pulling out all the stops.

A good analogy for the broker versus investment advisor is the difference between an optician and an ophthalmologist. An optometrist conducts eye exams and makes sure that you have healthy eyes but makes money primarily selling you glasses and contact lenses. When you have a cataract, or something serious, you go to a medical doctor—or an ophthalmologist. He has taken a Hippocratic oath to practice medicine ethically. He sells nothing. He puts your health first and can also examine your eyes.

Do you want to trust your money to someone who is just paid for advice? Or a broker who makes money providing advice in order to sell products?

Just remember: If you’re carrying someone across the river, you may want to check on “what they do.”

Greed glands were on fire last week when LinkedIn went public. Maybe this was your
mental ticker tape: “ How could I have gotten in on that action? Why did I miss Linkedin
and now Yandex? When Zynga, Facebook and Foursquare IPO how can I get shares?
How about all those Silicon Valley geeks getting rich again and I’ m not! Are new social
networking companies going to become another tech bubble and will I profit from it?
Am I going to just sit on my hands? Maybe I’ ll just buy LinkedIn now at $90. It is a
good company. I use it. It will eventually go higher.”

That’ s the greed gland talking. There’ s no doubt that LinkedIn is a fantastic business!
This professional network has over 90 million members will soon have revenues of $400
million and has a model with all of the wonderful characteristics of a web-based business.
But it is likely not worth anywhere near $9 billion today. Fortunes have been lost buying
great businesses at the wrong price. Fortunes have been made buying bad businesses at
great discounts (Warren Buffett called it “cigar-butt” investing).

The greed grand and its secretion of envy will drive you to buy when you feel you are
being left behind. Those who fall prey to it become speculators. It might be wise to clip
the following words and read them when your greed gland starts convulsing:

When you invest or loan your money to companies that operate in our capitalistic system,
you as an owner will be paid. Over the time period that retirement investors care about,
say 20 or so years, that return has been in the 8% – 10% range. Think of capitalism as a
train. If you get on it, your money will grow just because the system demands a return
on invested capital. Over the journey, the train will slow down, backtrack, or speed
up, but it will keep chugging along. Eighteen years ago in 1993 you could have bought
the S& P 500 in a newly minted product called SPY (the first Exchange Traded Fund)
for $33. Today SPY is worth four times that – $132. You’ d have made no decisions,
clipped some dividends and paid minimal taxes without breaking a sweat. No CNBC, no
commentary, little anxiety. Just by owning your small piece of American capitalism.

If you get off the train, you become a speculator, thinking you can get farther than the
rest of us who are on the train. Speculating is thrilling and it cures the temporary itch of
the greed gland. But there are two problems that few overcome. First, you pay taxes on
the gains so your winnings are automatically cut by one third to one half. You have to
run even harder and faster. And second, all speculators make mistakes. Few investors
like to talk about investment mistakes, but everyone makes them. Every seasoned
professional investor knows that avoiding and limiting the inevitable mistake is the single

most important characteristic of investment success.

If you think you have a talent for buying LinkedIn and other IPO shares and sprint ahead
of the train, you may get a town or two ahead this year. But sooner or later, you will
make a mistake. You’ ll buy too high on an oversized bet and feel pain as your losses pile
up. Like all speculators, the train will pass you or run over you at some point in the next
10 or 20 years. Your friends will be having fun on the train and you’ ll be roadkill. So
please, just stay on the train, buy yourself a drink and enjoy the ride.

To get to the bottom of this question, I caught up with Michael Hogan, CEO ofFOLIOfn Investments Inc.

When stock markets began, brokers physically traded share certificates of a company’s stock and had armed guards moving certificates between brokers and their vaults all day. In the 1960s there was a back-office crisis as trading volume went from 5 million shares daily to 15 million shares. The paperwork burden was overwhelming and brokers and stock exchanges came together to form the Depository Trust and Clearing Corporation (DTC).

Fast forward to our highly automated world—there are virtually no share certificates, but only records of how many shares are owned and by whom. The DTC is the heart of the system, and tracks the shares of all securities that all brokers have. After trading is done each day, the brokers settle between one another through the DTC. Your IBM stock held in your Schwab brokerage account is held in Schwab’s name, or “street name” at the DTC. If you sell 100 shares of IBM to someone at Merrill Lynch, that night, the DTC will transfer shares from Merrill to Schwab and cash from Schwab to Merrill. Schwab keeps track of which clients own how many shares. DTC is like a huge file back-up system for everyone’s stocks, bonds, and cash in brokerage accounts.

Anyone can pass a test and become a broker. But a “clearing broker” is part of the elite group plugged directly into the DTC system. There are hundreds of clearing brokers, and thousands of “introducing” brokers. All introducing brokers need to “clear” through a clearing broker.

Clearing brokers hold money and securities and need a multi-million-dollar IT infrastructure to process orders and keep accounts and the capital to deliver securities or pay for them. “The bar is high,” Hogan says. “Clearing brokers must demonstrate to regulators that they have the capability to be part of this highly regulated system. They must reconcile cash and securities on a nearly daily basis with the DTC and all other firms and are audited every week.”

The Securities Investor Protection Corporation (SIPC) restores cash and securities to investors with assets in the hands of bankrupt and otherwise financially troubled brokerage firms. SIPC provides up to $500,000 of protection for brokerage accounts and estimates that no fewer than 99 percent of persons who are eligible have been made whole in the failed brokerage firm cases that it has handled.

Brokers go broke because of bad management or fraud. Lehman went bankrupt because of bad management. SIPC and the DTC quickly restored investor accounts at another broker. As long as the records of the brokerage firm are accurate, and there was no fraud involved, you get your securities and cash back or moved to another broker within a month or two.

When fraud is involved, it is generally with introducing brokers who are able to cash your checks, and create a set of fake books. It is nearly impossible for clearing brokers to commit fraud. Hogan says, “The main way the system breaks down is when you deal with an introducing broker, and you’re told to deposit money with their firm. They steal it and circumvent the system and create statements with a color printer. You’re disconnected from reality and don’t have a cross-check.”

Hogan offers two pieces of advice if you don’t use a clearing broker. When introducing brokers, only make out your check to its clearing broker, and get access to the clearing broker’s website so you can see your account. While introducing brokers have their own branded websites and statements, you should have online access to the clearing broker. Check your balances frequently. In addition, make sure regulators have never sanctioned your broker.

As long as you have your securities and cash with a clearing broker that has been around for at least 10 years, is run by competent management with a strong financial statement and an unblemished regulatory record, your money is safe.

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.

With such a huge gap between those feeling comfortable investing in stocks themselves and those that feel stocks are an important component of their portfolio, comes the opportunity for one to turn to stock index funds and exchange traded funds.  With index funds you are still a player in the stock market, but the risks are less as you own a basket of stocks, not one individual company, and purchasing them through your discount broker is cost effective and quite easy.  Stock picking and market timing, though claimed to be figured out by many on Wall Street, is hardly ever done time and time again with great success.  The fundamentals of investing 101 might help you make a solid educated guess on what companies to invest in but let’s face it, investing in individual stocks, for beginners and experienced investors alike can still be a risky venture.  So, for those currently not comfortable investing in stocks on their own, check out index funds.  While you are at it, check out some of the on-line portfolio management tools out on the market to help you manage your overall portfolio.

In 2008 it turns out that asset allocation decisions have everything to do with a portfolio performance.

On MarketRiders, we use our own ETF portfolio builder to track some “Celebrity Portfolios” including the “Lazy Portfolios” (published by Paul B. Farrell at Marketwatch). These portfolios mimic allocations based upon Yale University’s David Swensen, Dr. William Bernstein, Ted Aronson, and Bill Schulthesis who wrote “The Coffeehouse Investor.” Community members also have posted many interesting portfolios with unique asset allocations that have held up well in the last few months.

These portfolios use ETFs without active management and we track weighted average portfolio fees. The component ETF fees range from .08% to .50% and the weighted average portfolio fees are between .12% and .21%.

Comparing and contrasting portfolios with similar asset allocations, shows a lot about how to build solid “all weather” allocations that have held up even in 2008. While some of the variance is surely explained by the allocation in non-equities (Bonds, Treasury Inflation Protected Bonds and Cash), a lot of it is explained by the level of diversification amongst the other asset classes.

There’s quite a variance between some of the portfolios – even when their equity exposures are similar. Two portfolios each with 60% equity exposure have dramatically different results.

For example, Bill Schulthesis, a ex-Salomon Smith Barney broker who wrote The Coffeehouse Investor, designed a portfolio with 40% in an intermediate bond index (BND) and 10% in each of 6 stock funds (Vanguad REIT ETF (VNQ), SPDR S&P 500 ETF (SPY), Vanguard Small-Cap ETF (VB), Vanguard Small-Cap Value ETF (VBR), Vanguard Value ETF (VTV), Vanguard FTSE All World ex-US ETF (VEU)). Dr. William Bernstein wrote the “Intelligent Asset Allocator” and “The Four Pillars of Investing” and proposed the same basic allocation. But high exposure to small cap value US stocks and REITs allowed Coffeehouse’s returns to trump Bernstein by over 2 times.

Here are the results as of last night’s close.  These portfolios and the ETFs in them are posted on MarketRiders.

The Best and the Worst Returns

To better understand where the variances lie, we drill down into each asset class to see where returns (or lack thereof) are coming from. Aronson’s portfolio, is the worst so far, down (16.65%) with 80% equity exposure. Unfortunately, Aronson had no REIT exposure and heavy exposure to Emerging Market (VWO) and Foreign Markets (European (VGK) and Pacific (VPL)) which have both been crushed this year. Aronson’s portfolio has performed very well for 5 years on the backs of these asset classes, but 2008 has been his come-uppance.

The MarketRiders “Low Risk” portfolio is doing the best so far this year – down only (1.83%) – but with 25% exposure to equity and Real Estate (RWR). A strong US allocation (iShares S&P SmallCap 600 Index  (IJR) and SPY) over Foreign Developed and Emerging Markets (VEU) helped dampen the losses.

It’s Time to Rebalance!

Today, we’re rebalancing a few of these portfolios where actual allocations now vary greater than 20% off our targets. The most out of balance portfolio is the one built by John Spense and Rick Ferri on MarketWatch. Emerging Markets, Foreign Markets, TIPs and Small Cap US stocks are all out of whack so this portfolio and others will be brought back to their targets.

Stay tuned.  At the end of the year, we’ll report back and show you how these portfolios did.