I am not endorsing any political views, but I did note an observation made by Bernie Sanders in the recent Democratic presidential primary debate. He stated that Wall Street’s “business model is greed and fraud.” There’s a lot of data supporting that view.
A history of unethical conduct
The Securities and Exchange Commission (SEC) compiled a list of enforcement actions that led to or arose from the financial crisis. Here’s a small sampling:
Citigroup – The SEC charged Citigroup’s principal U.S. broker-dealer subsidiary with misleading investors about a $1 billion collateralized debt obligation (CDO) tied to the housing market in which Citigroup bet against investors as the housing market showed signs of distress. The court approved a settlement of $285 million, which will be returned to harmed investors.
Deutsche Bank AG – The SEC charged the firm with filing misstated financial reports during the financial crisis. Deutsche Bank agreed to pay a $55 million penalty.
Goldman Sachs – The SEC charged the firm with defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter. Goldman agreed to pay a record penalty in a $550 million settlement and reform its business practices.
J.P. Morgan Securities – The SEC charged the firm with misleading investors in a complex mortgage securities transaction just as the housing market was starting to plummet. J.P. Morgan agreed to pay $153.6 million in a settlement that enables harmed investors to receive all of their money back.
Merrill Lynch – The SEC charged the firm with making faulty disclosures about collateral selection for two CDOs that it structured and marketed to investors, and maintaining inaccurate books and records for a third CDO. Merrill Lynch agreed to pay $131.8 million to settle the charges.
Even though penalties ordered or agreed to as a result of misconduct surrounding the financial crisis exceed $1.9 billion, the fines paid by these firms and others amounted to little more than a slap on the wrist. Many believe it’s back to “business as usual” for them.
Perpetuating a belief in an expertise that doesn’t exist
That “business” means persuading you to give them your money to “manage.” This is no mean feat. The data is overwhelming that the securities industry does not have the expertise to “beat the market” reliably and consistently. A recent Standard & Poor’s Indices Versus Active (SPIVA) scorecard found that over the one-, five- and 10-year periods ended Dec. 31, 2014, more than 80 percent of large-cap actively managed funds failed to deliver incremental returns over the benchmark.
Think about that information. The S&P 500 index consists of the 500 largest and best-known publicly traded companies in the United States. To “beat the benchmark,” all active managers have to do is overweight the winners and underweight the losers. As my colleague, Larry Swedroe, recently noted, 2014 gave them plenty of opportunity to do so. There were vast differences in the returns of the 10 best-performing and the 10 worst-performing stocks in the index that year.
If active managers had skill, surely more than a small minority would have been able to identify the “winners.”
Better alternatives
As I previously discussed, investors familiar with this hustle have a far better alternative. They can simply refuse to entrust their money to those with no demonstrated expertise. Instead, they can choose to become evidence-based investors and capture global returns using low management fee index funds.
This prospect is Wall Street’s worst nightmare. It has marshaled its vast resources and is fighting back with articles extolling the purported benefits of active management.
Meritless advice
Jim Cramer leads Wall Street’s charge. Here’s the “advice” he gave in a September 2015 article to those just starting out on their investment journey. It’s so irresponsible that I want to quote it.
Cramer is credited as saying that he believes a diversified portfolio of five to 10 individual stocks is the best way to maintain a portfolio.
The article then goes on to quote him directly: “Now, before you start picking stocks, you need to forget everything you’ve ever heard about that classic piece of so-called investing wisdom, buy and hold. We don’t buy and hold here on ‘Mad Money’ — it’s a great way to lose your shirt.”
As usual, Cramer referenced no data to support these views. In reality, the latest research indicates that, for investors in U.S. equities, to be confident of reducing 90 percent of diversifiable risk 90 percent of the time, the number of stocks required is, on average, about 55. In times of distress, it can increase to more than 110 stocks.
Investors can easily reduce risk through appropriate diversification by purchasing low management fee index funds.
Cramer’s observation that a “buy and hold” strategy is “a great way to lose your shirt” is also belied by the evidence. For the period from Dec. 31, 1993 through Dec. 31, 2013, the average investor had an annualized return of about 2.2 percent. Investors who “bought and held” an index fund tracking the S&P 500 earned 8.5 percent, less the low management fees charged by the fund.
Ironically, the best way to “lose your shirt” might be to follow Cramer’s stock picking advice. In a well-reported debacle, on April 6, 2015, Cramer gave his hapless viewers a list of 49 stocks to “buy right now.” Six months later, only 28 percent of them closed higher than their April trading price. In just six months, investors who followed Cramer’s advice lost 7.09 percent of their money.
Once you recognize that Cramer and many others in the financial media are just shills for an industry that wants you to chase returns, buy and sell stocks and bounce in and out of the market, you will have made a giant step toward investing in an intelligent, responsible — and evidence-based — manner.
This commentary originally appeared December 8 on HuffingtonPost.com
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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2015, The BAM ALLIANCE
“Recency” can be described as the tendency to overweight recent events or trends and ignore the long-term evidence. It’s one of the more common and costly behavioral mistakes that individual investors can make, often leading them to buy high and sell low. Clearly, this represents a major problem, as such behavior is exactly opposite of the formula for investing success. My colleague, Kevin Grogan, director of investment analysis at The BAM Alliance, provided me some of his thoughts on how to look at this issue.
A Perilous Pitfall
To start, according to Grogan, many investors place too much emphasis on recent, short-term performance when making investment decisions. The financial media tends to exacerbate the problem, rather than helping investors stick to a disciplined strategy. When evaluating your asset allocation and deciding which fund to use, recent performance should not be a significant factor in your choice. Good strategies will have bad years (or maybe even many bad years in a row).
A current example of this focus on short-term performance involves investors questioning whether or not it still makes sense to own a globally diversified equity portfolio. The argument goes along these lines: The U.S. has outperformed international markets by a wide margin for the last five years, and even if you go back as long as 10 years, U.S. markets are still way ahead of international markets.
The chart here displays the trailing performance of the S&P 500 and the MSCI All Country World ex USA Index (an index that combines both developed non-U.S. markets and emerging markets) through Sept. 30, 2015.
The trouble is that stock returns are extremely noisy from a statistical perspective, so even a period as long as 10 years isn’t extensive enough to make a definitive statement that U.S. equities will outperform international equities going forward. To illustrate this, we’ll take a look at some additional data points.
The chart here reports the trailing performance of the same two indexes we considered before, except that the returns are through Dec. 31, 2009. An investor standing in January 2010 and using past performance to make decisions likely would’ve abandoned their U.S. allocation and shifted into international stocks, right before the U.S. wound up outperforming.
Beware High Valuations
In addition, many investors fail to consider that recent outperformance often leads to higher valuations. Higher valuations lead to lower expected returns in the future, and vice versa. The S&P 500 currently has a Shiller CAPE 10 yield of 4.4% and a dividend yield of 2.1%. The MSCI EAFE currently has a Shiller CAPE 10 yield of 6.5% and a dividend yield of 3.2%.
To calculate the expected return using the dividend yield, we can add 2 percentage points to the dividend yield (as an estimate of real growth). This gives a 4.1% real expected return on the S&P 500 and a 5.2% expected return on the MSCI EAFE.
To calculate the expected return using the Shiller CAPE 10 yield, we need to make an adjustment to the raw number to reflect the annual growth in earnings (roughly 1.5% per year). To do this, we multiply the raw number by 1.075 (1.5 x 5 years, the average time lag). This gives us a real expected return on the S&P 500 of 4.7% and 7.0% on the MSCI EAFE.
Either method for calculating expected returns indicates that international markets have lower valuations than U.S. markets. The data is even more compelling for emerging markets, where valuations are even lower. It is particularly difficult to avoid the temptation of chasing the past performance of emerging markets, given how volatile they are.
In short, chasing past performance can cause investors to buy asset classes after periods of strong recent performance, when valuations are relatively higher and expected returns are lower. It can also cause investors to sell asset classes after periods of weak recent performance, when valuations are relatively lower and expected returns are higher.
Effectively, investors who chase recent performance are systematically buying high and selling low. A better approach is to follow a disciplined rebalancing strategy that systematically sells what has performed relatively well recently and buys what has performed relatively poor recently.
This commentary originally appeared December 16 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2015, The BAM ALLIANCE
Years ago, my colleagues and I conducted a fairly large-scale research project. We interviewed a bunch of high-income professionals who provided professional services. This group included doctors, dentists and lawyers, and like most of us, they earned money only when they were working. In essence, they traded their time for dollars.
Our finding was this: Homes and retirements accounts aside, the most valuable asset they owned was the person staring back at them in the mirror each morning. Chances are, the most valuable investment you own is the investment called you.
A more technical way to think about it is that the most valuable asset you own is the present value of your future earnings. But here’s the problem: Despite what your spouse may tell you, the investment called you is getting less valuable with every year that passes.
It’s nothing personal. I’m sure you’re great. But this is simple math. Every year that goes by means you have one fewer year to earn money. If I were to sketch this for you, it would look like this.
Traditional financial planning spends almost no time on this issue. Instead, the traditional financial services industry focuses on getting you to take as much money as you can and put it into other investments, like mutual funds, stocks and hedge funds. That’s all fine and, to be clear, a very important part of your overall plan. But far more needs to be said about the investment called you.
One person doing some fascinating work on this topic is Joshua Sheats at his site, Radical Personal Finance. If you’re interested in this subject (hint: you should be), you might want to check out his more technical treatment.
But for this column, I want to focus three ways you can think about this.
The Beginning
Make your starting salary as high as possible. Remember that friend from high school who had a great summer job? At the time, he made what seemed like a lot of money. Everyone was jealous. Then when you headed to college in the fall, your friend’s summer job turned into a full-time job. Why would he quit making money to go to college? But you put in the time and graduated a few years later.
Now your friend is a supervisor, but you’re a doctor. By investing in education and training, you increased your starting point and initial value. Obviously, not all us of really want to become doctors, but you get the idea. In the beginning, don’t let short-term rewards get in the way of increasing your long-term value.
The Middle
Make more money each year. Yes, I know this advice is obvious. But rather than being satisfied with just the annual cost-of-living adjustment, look for ways to increase your value where you work. Pick up new skills. Take extra classes and projects that no one wants. Don’t settle for doing just enough. To borrow a phrase from the author Cal Newport, make yourself so valuable they can’t ignore you.
Outside of your 9-to-5 job, find a side gig if you can make time. What could you do to earn an extra $1,000 each month? What happens if you start earning enough to cover your mortgage? What happens if you build a business that earns more than your regular job? This phase reminds me of Aesop’s fable about the ant and the grasshopper. Do a little more today and avoid being the grasshopper.
The End
Make your working window longer. Look, I know most of us really like the idea of retiring, but it’s a myth. Most people don’t simply work their guts out until 60, then suddenly pull that plug and put on the golf shoes. People are living longer, and you might be facing a very boring 20 or 25 years without work.
You can only golf so much.
Instead, most people find they still want to be doing something. Contributing value to the world. Working. So plan on it (and invest in your health too, so you’ll still be physically capable of working).
But think of this side hustle as an opportunity to do something you love to do. Maybe it looks a bit more like this: You work at your day job until 55 and then slow down a bit. You do more of the work you love. Maybe you’ve always wanted to be a teacher, or perhaps you’d really love to become a guide at your local botanical garden. Whatever the work, it lengthens your overall line.
You may love the job you’re doing now, but your employer might have a set retirement age. Could your value be so great that they might consider working with you as a consultant for a few more years? Adding a little time at the end will give your line another upward bump.
These are just a few of the ways we can invest in ourselves. And by now, you’ve probably thought of a dozen things you can do that are unique to your own life. If you’re willing to share, I’d love to hear your ideas. You can find me on Twitter @behaviorgap or send me an email, carl@behaviorgap.com. Just don’t ever forget that more we invest in ourselves today, the more valuable we become over time and the less we need to worry about that line on the chart.
This commentary originally appeared December 14 on NYTimes.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2015, The BAM ALLIANCE