Six Things You Need to Know to Make You a Better Investor

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Harold Evensky CFP® , AIF® Chairman

Click the following links to view Harold R. Evenskys, CFP®, AIF® Six Things You Need to Know to Make You a Better Investor presentation that was held at the Coral Gables Art Cinema on Tuesday, June 12th, 2018.

To view the entire seminar: Click Here

To view in segments click the following:

Part 1: Squaring the Curve

Part 2: Returns (No Control)

Part 3: Volatility Risk & Luck

Part 4: Real People

Part 5: Market Timing

Part 6: Knowing Where the Buck Stops


Feel free to contact Harold Evensky with any questions by phone 1.800.448.5435 or email:

For more information on financial planning visit our website at

Staying the Course No Longer Works!

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Harold Evensky CFP® , AIF® Chairman

Ever since the market debacle triggered by the Great Recession, “Staying the Course No Longer Works” and “Modern Portfolio Theory Is Dead” have been popular headlines with the financial media. It sure sounds good; after all, why would any investor willingly subject their portfolio to the massive losses of 2008 and early 2009? They wouldn’t, of course; so does that mean that long-term strategic investing is out the window? One of the core beliefs at Evensky & Katz / Foldes Financial Wealth Management is that to earn market returns an investor needs to be in the market. Is that yesterday’s story? Needless to say, our investment committee takes these considerations very seriously, and we regularly review our investment philosophy and strategies. What we’ve concluded is that a better headline for the critics of modern investment theory would be “The Pot of Gold at the End of the Rainbow.” Unfortunately no one has yet discovered that pot. Here’s our take on the debate.

The critics claim that modern portfolio theory, asset allocation, and buy and hold are all equivalent concepts and all are passé. What surprises me is that the critics seem to believe they have just discovered the truth, when in reality a new group of “gurus” discovers the same truth after every bear market. These critics typically claim that “allocations are solely and simplistically based on projected historical data and traditional methodology that assumes valuation is irrelevant; they are determined at the beginning of the investment process and are never changed, except when they are rebalanced.”

Although unfortunately it is true that many practitioners do in fact develop allocation models based simply on historical data, that is certainly not the case at Evensky & Katz / Foldes Financial Wealth Management. We heed the advice of Harry Markowitz, Nobel Laureate and the father of modern portfolio theory. In his seminal work, Professor Markowitz wrote, “The first stage starts with observations and experience and ends with beliefs about the future performances of available securities.” He is quite clear in rejecting the approach of using historical projections. “One suggestion as to tentative risk and return is to use observed risk and return for some period of the past…I believe that better methods, which take into account more information, can be found.”

We certainly agree. When developing our recommendations for allocations to bonds and stock, we first develop forward-looking estimates for the returns, risk, and relative movement (i.e., correlations) of the various investments we will consider for our portfolios. While there can be no guarantee that these estimates will turn out to be correct, they certainly take into consideration not only the past but also the current market environment as well as expectations regarding future changes. For example, our projections for future returns are modest relative to past returns, our expectation regarding risk is that the markets will remain more volatile than in the past, and finally we believe that we live in an increasingly global world, so markets will move more in tandem in the future than in the past. The result is that the benefits of diversification will be diminished but not eliminated.

Regarding the criticism that allocations are determined at the beginning of the investment process and never changed, except when they are rebalanced—a strategy I call “buy and forget”—again, unfortunately many practitioners do follow this ostrich-like policy. But this criticism should be leveled at the practitioners setting their policies in stone. There is nothing in the literature or in practice to suggest that a policy allocation should not be revisited and revised when and if forward-looking market expectations change. As a consequence, it is our practice to review our assumptions at least annually, and our “strategic” allocations do in fact vary over time as a result of changes in our worldview. Rather than “buy and forget,” our policy is “buy and manage.”

The bottom line is that some may develop allocation models based solely on projections of historical data, but we do not. Some may also ignore valuations; again, we do not. And some may design allocation models and set them in stone; we do not.

Feel free to contact Harold Evensky with any questions by email:

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Are Bonds the Next Bubble to Burst?

Brett Horowitz

Brett Horowitz, CFP®, AIF® Principal, Wealth Manager

Nary a week has gone by in which we don’t get asked this question in some form or other. Newspapers and CNBC trumpet this headline to grab their readers’ attention, and I make no apology for doing the same—although as you will see as you continue reading, the tone of my article will not be quite as alarming. Newsletters tell their subscribers in UPPERCASE BOLD LETTERS the “secret” that only their subscribers can learn as to how to deal with this risk. Never mind the fact that if they actually had the secret, why would they tell you, and why would they need to sell their newsletter to earn a living? Let’s separate fact from fiction and discuss in a clear-headed manner what investors and our clients should do about this supposed impending disaster.

Back in the early 1980s, you could have purchased a 10-year Treasury bond, backed by the full faith of the U.S. government, with an interest rate of just over 15%. During the past 30-plus years, interest rates have decreased, and earlier this year, rates for 10-year Treasury bonds were at 2.5%. Bond prices move inversely to interest rates. If you own a bond with 5% coupon (or interest rate) and rates go up, such that new bonds pay 6%, your bond becomes less attractive, and the price of your bond goes down. However, if you hold that bond to maturity, barring a default, you will get your full money back at maturity. After interest rates falling for 30 years, we’ve already seen them rise this year, and experts have a consensus view that rates will continue to rise going forward, bringing us back to more normal levels. After all, interest rates can’t get much lower!

If you own an individual bond, you may not worry as much about rising interest rates, because if you ignore the interim price fluctuations, you will get back the full value of the bond, absent a default. There is a risk, though, that if you need money before the bond matures, the price may not equal what you paid for the bond, and you may recognize a loss. In addition, as we saw during the Great Recession, there have been times when liquidity for bonds ceased to exist. Investors were having such a hard time selling them that they accepted whatever price was offered. This price anomaly will affect the price of other people’s bonds too, similarly to how a foreclosure in a neighborhood affects the prices of the other homes in that neighborhood. The price is only as good as what someone is willing to offer.

Most people choose to own bond mutual funds, since owning individual bonds can be expensive and mutual funds can be very diversified. If you own a basket of 10 $50,000 bonds and you suffer one default, that’s a 10% hit. If a bond mutual fund holds 2,000 positions, a bond default is not even noticed. Bond mutual funds are a basket of bonds with a fund manager deciding which bonds to buy, which to sell, and which to keep to maturity. Just like individual bonds, the collection of bonds in a mutual fund will lose (gain) value if interest rates rise (decline). The easiest way to quantify the effect of an interest rate change is to view a bond’s duration. Duration is a measure of a bond’s sensitivity to interest rates and the higher the number, the greater the impact. A bond fund with a duration of three years means that for every 1% change in interest rates, the price will move by 3%. A bond fund with a duration of 15 years would have a larger move associated with a change in rates than a bond fund with a duration of fewer years.

If we knew that interest rates would rise tomorrow (there’s the rub!), we would sell bonds completely to avoid this risk. While we expect rates to rise over the coming years, we don’t know how or when they will rise. At the beginning of 2017, 10-year Treasury bonds were yielding 2.45%. Had someone bailed out of bonds and sat on the sidelines all of last year because they expected interest rates to rise, they could have missed out on great returns (the Bloomberg Barclays Municipal Bond Index was up 5.45% for 2017). In addition, rates may move differently for two-year bonds than they would for 30-year bonds. Lastly, who’s to say that the United States won’t slip back into a recession and that bonds will be the best-performing asset class for the next 12 months—or that stocks won’t drop 20% because they have become overvalued, and then suddenly a small bond loss looks like a good deal in comparison? The point is that trying to time this event is tantamount to useless, and anyone who says they can do it is either lucky or is bound to be wrong more than half of the time.

Given all this, should you be worried about bond losses? Yes and no. I’ll first point out that bonds are not guaranteed to make money over any period of time. If you want a guaranteed return, you can buy a CD or stuff your money into a savings account. Both currently earn a pittance and are almost certain to lose money to inflation over time. But when bonds do lose money, the losses are usually modest because the lower volatility protects bond investors. The worst annual return by the Barclays U.S. Aggregate Bond Index going back to 1976 was a 2.92% decline in 1994. Contrast that to the worst annual stock return going back to 1976 (measured by the S&P 500, including dividends)—37% in 2008—and you can see that by dumping bonds in favor of stocks, you avoid the interest rate risk but are simply exchanging this risk for overall market risk, which is far greater. Many of our clients have seen us walk through the long-term modeling in Money Guide Pro and have seen that the results frequently look better the more bonds someone owns. While the average returns each year will be lower (if we assume stocks outperform bonds), the volatility is reduced, and that may cause the probability of a successfully funded retirement to increase. If you had a choice between earning 8% per year with a 50% probability of successfully funded retirement, or earning 7% per year with a 90% probability of success, which would you choose? We think that for a majority of our clients, the probability of retirement success is more important than leaving a larger inheritance.

A number of investors have pointed to dividend-paying stocks, Master Limited Partnerships (MLPs), or Real Estate Investment Trusts (REITs) as appropriate alternatives to bonds. All three investments provide a potentially higher yield than cash and bonds, but without the interest rate risk. Sounds good, right? Unfortunately, investors are again simply avoiding one risk (interest rate) for another risk (market risk), as these investments got hammered in the Great Recession. Here’s a table of their returns from 10/31/2007 through 2/28/2009:

Investment (based on Morningstar Office) Cumulative Return
DJ U.S. Select Dividend TR USD -53.32%
Average of the 20 largest MLPs in the Alerian MLP 50 Index* -31.04%
DJ U.S. Select REIT TR USD -66.14%

* The Alerian MLP Index has only been in existence since 4/2009.

So if we have concluded that market timing does not work, and that many classic bond “alternatives” seemingly have more risk, not less, does that mean we sit back and acquiesce to the bond universe? Not entirely. At our firm, we’ve made a number of changes to our clients’ bond portfolios going back several years. First, we shifted a portion of the fixed-income funds into shorter-duration funds. None of the traditional bond funds in the portfolio currently have a duration longer than five years, and there is currently very little invested in long-term bonds. Should rates rise, this will help mitigate the losses. Second, we have carved out 25% of the bond portfolio into what are called “unconstrained bond funds.” These funds have wide latitude and buy foreign bonds, junk bonds, long bonds, and T-bills, or even short the market and make a bet on higher interest rates. The risk exists that these active funds make wrong bets and underperform the market, but so far, their track record has been very strong. The main reason we are using these managers is to protect on the downside should interest rates rise, as opposed to trying to make a high return with high risk. Lastly, we continue to keep an exposure to inflation-protected bonds. If interest rates rise because investors are concerned about higher inflation, these bonds have the ability to outperform traditional bonds.

If your investment horizon is short-term, bonds may prove to be a low- (or negative-) returning investment. Never assume that bonds will always provide positive returns: if someone is looking out 30 years, they will see ebbs and flows in all markets. Our advice: stay relatively safe in your bond portfolio, stay connected to the annual review of your Money Guide Pro retirement plan, and stay calm. Unfortunately, the headlines are more entertaining than the reality of the situation.

Feel free to contact Brett Horowitz with any questions by phone (305.448.8882 ext. 216) or by email:

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Should I invest in Bitcoin?

Roxanne Alexander

Roxanne Alexander, CAIA, CFP®, AIF®, ADPA® Senior Financial Advisor

Bitcoin discussions have plastered the financial media over the last couple of weeks, making everyone wonder whether this new digital currency is the next bubble. Although there have been many innovations in digital currency markets and crypto-currency does have some advantages, before taking the plunge, make sure to look at the risks.

The Bitcoin concept was developed to create a new type of currency shielded from devaluation and dilution by government monetary policy. Only small amounts are being released, as coins are “mined.” The mining process gets more complex as computer algorithms are solved, which slows down the creation of additional coins over time, and ultimately controls the supply. Think of having a limited supply as demand increases — similar to the gold standard in which paper dollars were matched to the gold supply. This is no longer the case, as the United States and other governments print money as needed, thus devaluing their currency. Bitcoin was also developed to address a lack of access to money, high transaction costs, and forced reliance on middlemen — the big banks.

In my opinion, the recent run up in the value of Bitcoin is speculative. The more investors who rush to get a piece of the pie further increase the demand for a limited supply. Although there has recently been a huge return on Bitcoin and a few success stories, Bitcoin still has many potential downfalls such as technological risk, financial risk, legal risk, and tax risk.

Most concerning, there is no financial regulation in this space, so many bitcoin providers have gone out of business — leaving investors with no options to recover their assets. Once your bitcoin disappears, there is virtually no legal recourse to retrieve it. Transactions occur peer-to-peer and are operated by a decentralized authority. There is no bank or central government backing the currency.

Volatility and financial risk — Bitcoin experiences significant daily price swings, making it difficult to use as a currency. For example, you can buy an item such as a soda using Bitcoins in the morning only to find that you paid 10 times more for the soda by the afternoon. This unstable pricing makes Bitcoin less conducive to business transactions. Furthermore, many people are speculating rather than using Bitcoin for commerce; thus, few businesses accept it as payment. Bitcoin embodies the traits of a speculative investment rather than a currency; it is essentially a start-up and most start-ups do fail. Mismanagement and underfunding could crash the system. The volatility of Bitcoin trumps that of the stock market and if you get in at the wrong time, it might only be downhill from there. Should investors get spooked and decide to bail, you may find what you paid being sliced in half in a matter of days.

Technology and security risks — Do you trust computers? Currently, there are no individuals or organizations who can be held accountable if something goes wrong. The Bitcoin system is run and developed by volunteer programmers, so a bug or glitch could bring the system down quite easily. You access your Bitcoins via a private key to gain access to your digital wallet — if you lose this key, your bitcoins are gone for good. If you happen to get a computer virus, it can infect your Bitcoin wallet and steal your Bitcoins.

Tax issues — Bitcoins are treated as “property” as opposed to currency for tax purposes; consequently, the accounting can be a nightmare since you must constantly track the value and pay taxes only on capital gains.

Despite the illegal activity that was previously facilitated using Bitcoin, I do see potential uses of crypto-currency, particularly for smaller transactions which can bypass bank and credit card fees. However, without regulation there is still a huge risk for future development. If Bitcoin does evolve and regulations are created, there is a potential use for government spending since Bitcoins can be programmed. By sending currency in this manner, fraud and theft can be prevented since you can specify how the money should be spent. That being said, governments are unlikely to loosen control of monetary policy without a fight, meaning Bitcoin may take years to become a widely acceptable payment option.


Some useful links/books:

Bitcoin and the Future of Money: Jose Pagliery (2014)

Feel free to contact Roxanne Alexander with any questions by phone 305.448.8882 ext. 236 or email:

What You Need to Know About CDs

Kristin Fang

Danqin (Kristin) Fang, CFA, CFP® Financial Advisor

What is a CD and what do CDs provide?

As explained by Investopedia, “A certificate of deposit (CD) is a savings certificate with a fixed maturity date and a specified fixed interest rate, and can be issued in any denomination aside from minimum investment requirements.” CD maturity terms vary from one month to five years or even ten years with different interest rates determined by both the market interest rate and the maturity terms. The longer the term is, the higher the rate is. Additionally, there is usually a $1,000 minimum required for most CDs available on the market, and a CD with a greater than $100,000 minimum is known as a jumbo CD, accompanied by a higher interest rate for the same specified term. All CDs are FDIC insured up to $250,000 per account registration.

What is the difference between a Brokered CD and a Bank CD?

CDs issued directly by depositary banks are called bank CDs, while CDs offered by brokerage institutions are called brokered CDs. The brokered CDs are bulks of CDs bought by the brokerage firms, such as Charles Schwab or Fidelity Investments, and then re-sold to investors after slicing and repacking. The advantage of owning brokered CDs is diversification because you can buy different bank CDs from one brokerage firm and see the values and due dates all listed on one aggregated brokerage statement. This also helps you to track all your CDs easily. However, the disadvantage is the additional risk associated with owning CDs from banks that go under. Also, when buying brokered CDs, it is prudent to net the brokerage fees, although de minims in most cases, off their higher nominal interest rates when comparing them to the interest rates offered by bank CDs.

What is an Early Withdrawal Penalty?

With CD investments, you are restricted from withdrawing your funds before the maturity date unless you pay a penalty. The penalty usually takes up a few months’ worth of interest, depending on the issuing institution. This allows you to redeem your CDs before their maturity and opens the door to a more sophisticated CD investing strategy to be introduced next. Sometimes paying the penalty has a better outcome.

Advanced CD Investing Strategy

Regardless of the investment time horizon for your cash, you buy a five-year CD. Should the interest rate increase the following year, you’d then weigh your early withdrawal penalty against your interest income earned in the first year. If paying the penalty is the better option, then withdraw your entire CD portfolio and buy into a new five-year CD that offers a higher interest rate either from the same bank or from a different provider. In order to make this strategy work, a careful investigation of the early withdrawal penalty rules is key. Based on my research experience, some banks charge a lower early withdrawal penalty than others, for example, 180 days’ worth of simple interest versus 540 days’ worth of simple interest for a five-year CD. Let’s look at an example here:

You have $100,000 to invest for one year and are comparing a one-year CD offering 1% APR and a five-year CD offering 3% APR from the same bank. The early withdrawal penalty is 180 days’ worth of simple interest on the five-year CD.

Scenario 1: If you choose to invest in the one-year CD, your interest income after one year will be approximately $1,000 (1% multiplied by $100,000, to simplify the math from daily compounding to a simple interest calculation).

Scenario 2: Instead, if you choose to invest in the five-year CD, after one year, your gross interest income before paying the penalty will be approximately $3,000 (3% multiplied by $100,000), but you will need to pay approximately $1,480 ($3,000 gross interest divided by 365 days and then multiplied by 180 days) in early withdrawal penalty, which is equivalent to 180 days’ worth of simple interest, in order to redeem your five-year CD before its maturity date. This will net you approximately $1,520 in interest income ($3,000 gross interest income minus the $1,480 early withdrawal penalty), which is $520 more in interest income compared to Scenario 1. Clearly, with the additional $520 net interest income pocketed in Scenario 2, you are better off to invest in the five-year CD and pay the penalty at withdrawal in one year.

Below is a chart summarizing both scenarios:

CD Blog Picture

Caveat of using this strategy:

Please keep in mind that the outcome of this strategy depends heavily on the interest rates offered and the early withdrawal penalty levied by each bank. A prudent approach is to run the math thoroughly before taking any action, because banks adjust their CD rates periodically. For questions, please feel free to contact us at Evensky & Katz / Foldes Financial Wealth Management.

Feel free to contact Danqin (Kristin) Fang with any questions by phone 305.448.8882 ext. 222 or email:

The Efficient Frontier: How Much Risk Can You Stomach?

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Harold Evensky CFP® , AIF® Chairman

Anchoring on the efficient frontier may sound like something out of Star Trek, but it’s not. It’s better.

Harold Evensky (HE): Mr. and Mrs. Curtis, good morning. I’m Harold Evensky and this is my partner, Matt McGrath. Welcome to Evensky & Katz. I always like to start by asking, “What brings y’all here?”

Mr. Curtis (Mr. C): Well, Harold, Vickie and I are thinking about retiring in just a few years. We’ve saved quite a bit and think we’ll be in good shape, but we had some friends who retired a few years ago, who thought they were in good shape only to discover that things didn’t work out quite as well as they expected and they’ve had to do some major cutting back in their lifestyle. We don’t want that to happen to us. The Hamptons said you helped them do some planning for their retirement so we thought we’d like to work with you to do the same.

HE: Wonderful. Let’s have some fun envisioning your future. And that’s the key—it’s your future. Our job is to empower you to plan that future. Suppose we start off with an introduction: “Modern Portfolio Theory and You.” Matt, may I have a blank sheet of paper from your pad? Thanks.

Here’s a simple picture of the investment world. On one axis, we’ll plot risk and on the other, return.

The Efficient Frontier Chapter Image file - .01.png

As you’d expect, cash would not be very risky, but it would not provide much in the way of return, whereas stock might provide a high return but at some risk. Bonds are somewhere in between.

With just these three choices, we could still design thousands of portfolios. For example, 99 percent bonds and 1 percent stock or 99 percent stock and 1 percent bonds. If I put dots on my graph for the risk and return combinations of all of these combinations, I’d fill up the picture with dots. Then, if I drew a line enclosing all of those dots, I would end up with a curved line that’s called the efficient frontier.

The Efficient Frontier Chapter Image file - .02

That means, at least theoretically, there is no best portfolio but rather an infinite number of best portfolios, depending on the risk one is willing to take. We know that everyone would like to have a portfolio with no risk and lots of return. Unfortunately, the real world of potential portfolios lies on or below the efficient frontier. So what does that mean for you?

Well, it means we have to do some planning, and then you’ll have a decision to make. First, as I said starting off, we need to make a best guess as to what return your portfolio would need to earn over time to provide you the money you need to accomplish all of your retirement goals. Then we need to make a best guess as to your risk tolerance. If we just focused on your return needs, we might conclude it was possible to achieve your financial goals with a portfolio allocated 90 percent to stock. But that might not work out very well if we faced a major bear market in a few years. After you saw your nest egg lose 40 percent, you’d call us and say, “Harold, we can’t stand it. Please sell our stock and put our money in cash!”

That’s why we define risk tolerance as the point of pain and misery you can survive—with us holding onto your belt and suspenders—just before you make that call to tell us to sell out.

With those two anchors, we can now revisit our graph. Suppose the results look like this.

The Efficient Frontier Chapter Image file - .03.png

We have two portfolios for you. Portfolio A is one that provides the return you need to achieve your goals, and B is one in keeping with your risk tolerance. Which one is right? In fact, both are, but our recommendation is to plan on Portfolio A. Why? Even though we believe you can live with more risk and would end up with more money, determining risk tolerance well in advance of a terrible market is more art than science. The consequence if we’re wrong and you bail out of the market that would be catastrophic. So why take that extra risk if you don’t need it to achieve your goals?

How about if we found a different outcome? Suppose we concluded that you needed Portfolio A to provide your needed return but had a risk tolerance associated with Portfolio B in this picture.

The Efficient Frontier Chapter Image file - .04.png

That’s not very good, because now you have to decide between eating less or sleeping less. In this case, our recommendation would be to readjust your goals to meet the return expectations of Portfolio B. Why? Again, when markets seem okay, it’s all too easy to say, “I’ll take a bit more risk.” But later, when it seems the world is coming to an end, you’re not likely to remember your willingness to hang in there.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Managing Risk: Smart Ways to Avoid the Bad and Manage the Good

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Harold Evensky CFP® , AIF® Chairman

Come and join me again in my Wealth Management class.

Good morning, everyone. I hope you all had a great spring break. Anyone do something especially fun?”

“Professor E, I went home to Istanbul to visit family. It was all too short a trip but it was wonderful seeing everyone, as I’d not been home in a long time.” [That was my ace teaching assistant, Cagla.]

“Henry, how about you?”

“Well, I’ve been working on my dissertation, so I hunkered down to move it along. I still have a lot to do but it feels good having such a good start.”

“Excellent. Is everyone ready to get back to the best class in the program? [Needless to say, the class offers a resounding confirmation.]

Okay, this afternoon we’re going to begin with a discussion about two Nobel laureates, Harry Markowitz and William Sharpe. I know you all have thoroughly read the assigned material including some of their seminal works, so my question is this: how would you describe the significance of their work to a client? Katie, why don’t you start with Professor Markowitz?

Katie: Professor Markowitz recognized that in investing we need to consider risk as well as return. That may seem pretty obvious today, but at the time, the sole focus of investors was on which investment would provide the highest return. To the extent risk that was considered at all, investments were simply categorized as conservative or speculative. In fact, for decades, there were lists of legally approved, “safe” investments for fiduciaries such as banks and trusts. For our clients, the significant insight Markowitz introduced was the concept that a well-designed portfolio of individually risky investments could actually result in a safer portfolio. Professor Evensky, may I use the blackboard to demonstrate?

HE: Of course.

Katie: Okay, picture two very volatile investments. Although we expect that over the long-term their returns will be positive, on an annual basis their returns may vary significantly. Basically, this is our expectation of traditional investments such as stocks.

Here’s a simple example:

Managing Risk Chapter Image file - .01.png

Although stocks A and B are both very volatile, they both trend up. As my graph demonstrates, if we were to invest half of our portfolio in A and half in B, we’d end up with an overall portfolio with almost no volatility. Unfortunately, in the real world, we can’t find investments that complement each other so perfectly, but we can find investments that don’t move in exactly the same pattern, or as a mathematician would say, investments that are poorly correlated. That’s the wisdom that Professor Markowitz introduced. So today we don’t think in terms of risky investments but rather in terms of complementary investments; that’s why professional advisors and wise investors are so focused on portfolio diversification.

HE: Well done, Katie. David, how would you explain Professor Sharpe’s contribution to your clients?

David: Well, I’d start with this picture:

Managing Risk Chapter Image file - .02.png

Professor Sharpe demonstrated that there are two fundamental types of risk—unsystematic and systematic. Unsystematic risks are those uniquely associated with individual investments. This kind of risk is considered unrewarded because it’s risk that provides no expectation of extra return.

There are many reasons an individual investment might fail. A company may be badly managed and go belly up, or it might be well managed but fall prey to unfortunate market conditions, such as an energy company facing a collapse in oil prices. From the investor’s standpoint, it doesn’t matter whether the business failure is due to poor management or market forces. If the business fails, the investor is the loser.

At least theoretically, an investor may eliminate this unsystematic risk by diversifying. For example, a real estate investor owning and renting out a single-family home that ends up unoccupied would face a total loss of income, but if he or she owned ten homes, a single vacancy would mean only a 10 percent loss. Here’s what unsystematic risk looks like in the stock market:

April 20, 2010 – BP Deepwater Horizon Oil Spill

Stock Price April 20, 2010 ……..……………….. $50.20

Stock Price Three months later ……………….. $28.74

I can buy a portfolio of five hundred of the bluest blue chips—all the stocks in the S&P 500—but if the market drops 20 percent, that means my diversified blue chip portfolio took a major beating. In my pie graph, that risk is the first wedge of systematic risk—market risk. Many investors say, “I know that and that’s why I buy only high-quality municipal bonds.” Well, as we know, bonds are subject to something called interest rate risk. That means if I buy a bond and a few years later interest rates go up, the value of my bond goes down.

Some astute investors respond by saying, “I know that. That’s why I buy only one-year CDs and roll them over. That way, when rates go up, I get the new, higher return.” That also sounds as if it makes sense, but rates can go down and the investor’s income can drop precipitously. That risk is called reinvestment risk. (See Chapter 18, “Flight to Safety.”) So, although many investors think of bonds as a simple, safe alternative to stocks, the reality is that they come with their own unique kinds of risks.

Finally, there is the last wedge—purchasing power erosion. We all know that throughout time the costs of things we buy and the services we need go up due to inflation. That’s the other real risk of depending on bond income as the sole source of cash flow. Many investors get in trouble by confusing certainty with safety. Bond returns may be certain, but when you factor in inflation as a primary source of income, they’re certainly not safe.

HE: David, well done. I believe your future clients will be well served by your educating them about the wisdom of the laureates.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Dangerous Measures: The Fine Art of Calculating Returns

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Harold Evensky CFP® , AIF® Chairman

The person responsible for translating the math chapter of my book, Wealth Management, into Japanese told me, “You give me much headache.” Welcome to the math chapter.

Okay, class, today we’re going to be discussing one of the most common activities for financial planners, namely, the calculation of investment returns. Accounting in some measurable way for changes in investment values is fundamental to the work of financial planners. It may come as a surprise to you that such a simple concept is fraught with danger. The danger lies in the potential misuse of valid measurements.

There wouldn’t be much room for confusion if there were only one valid measure of investment return. Unfortunately, the mathematics of finance offers many choices. Among the most common are:

  • Current return
  • Total return (holding period return)
  • Real return
  • Compounded return
  • Time-weighted return
  • Dollar-weighted return (internal rate of return (IRR) and modified IRR)
  • Arithmetic return
  • Risk-adjusted return
  • Sharp ratio

Let’s consider each and I’ll simplify the discussion by assuming that we’re referring to the income received for a full year.

Current Return

This is perhaps the most popular measure with investors and some mutual fund marketing mavens. It is frequently referred to as the yield or payout. It’s an attractive measure because it provides a simple measure of the annual payout on an investment.

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Although simple, this measure has a major problem. Consider the number we use for total income. That single number doesn’t distinguish the nature of the income. Is it interest income or principal payments, or capital gains, or some combination of those? There’s no way of knowing how consistent an income stream will be in the future. I’ll promise to pay you a current return of 20 percent per year as long as you don’t ask me for any money after five years.

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Okay, let’s focus on the interest income. Will that resolve the problem? Not necessarily. The bond fund we’ve invested in may hold many premium bonds. Those are bonds that were issued when interest rates were much higher, so although we receive significant current annual income, some of that is actually a return of principal. When bonds mature they will be paid off at par not at the bonds’ current market premium value.

Now we can talk about some measures that may be more useful.

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This simple measure eliminates potential misleading factors that affect current return, but it fails to answer a number of important questions. Measuring total return is only a starting point in evaluating investment returns.

Real rate of return = Total return minus Inflation rate

Another simple but very important calculation determines what investment advisors call “real return”—how much did an investor actually make after inflation. Earning 10 percent if inflation is 3 percent would be nice, but if a few years later inflation is 8 percent and they’re still earning 10 percent total return, that wouldn’t be so nice. All our clients live in the real world, so all of your planning should be based on an “after inflation” real return.

Compounded Return

Now we’re getting to the number most investors are looking for: “What did I earn last year?” The most common measure is called the Internal Rate of Return (IRR). It’s also known as the dollar-weighted return. This calculation considers the timing of additional investments your clients made and/or withdrawals they took during the year and the return of the investments in the portfolio.

Time versus Dollar-Weighted Return

We’re not done yet, one more to go. The power of IRR to include interim additions and withdrawals from the portfolio is also its Achilles’ heel. If you’re evaluating the performance of a portfolio when you have control of the external cash flows, the IRR provides a valid measure. If you have no control of the external cash flows—when your client adds or withdraws money—you need to consider using two measures. The IRR will provide a valid measure of your client’s portfolio performance; however, it will not answer the question of how successful your recommendations were.

To answer that question, you need an alternative investment-return calculation known as the Time-Weighted Return (TWR). Basically, this measure calculates how the investment would have performed if no new additions or withdrawals had been made during the year. After all, if you and your selected money managers have no control of the timing of external cash flows, your performance should not be penalized (or rewarded) for your client’s unfortunate (or fortunate) investment timing.

For example, consider the results of two investors, each of whom invested in the same mutual fund. Investor A invested $90 at the beginning of year one and an additional $10 at the beginning of year four. Investor B placed $10 in the portfolio at the beginning of year one and $90 at the beginning of year four. Here are the results of their investments:

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So there you have it, two investors, investing in the same portfolio, resulting in six different performance numbers. What do those numbers tell us? The average annual return? Not much. The dollar-weighted return? Investor B was lucky and invested the bulk of his money at opportune times and the advice was credited with a 9 percent annualized return.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Market Timing: A Fool’s Game

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Harold Evensky CFP® , AIF® Chairman

Markets don’t care about what you need.

The Trujillos visited me a few months after the technology market crashed in 2002. They were a lovely couple—both in their mid-seventies—Mr. Trujillo was dapper in his tailored blue blazer, and Mrs. Trujillo was beautifully coiffed and dressed in a lovely St. John suit (my wife’s favorite high-end store). They had scheduled the meeting after sustaining significant losses during the tech market crash. After the traditional introductory “how are you” courtesies, Mr. Trujillo came right to the point.

Mr. Trujillo (T): Mr. Evensky, our investments were decimated in the market crash and we’re desperate to recover those losses. We’ve cut our expenses to the bone. The only basic needs remaining are our club and golf dues and our annual cruise. We’re hoping that you, as a professional, can help us.

Harold Evensky (HE): Mr. Trujillo, I’m sorry to hear about your losses. Perhaps you can give me some idea of how you believe I may be of help?

Mr. T: Well, we thought that by judicious market timing and sophisticated stock picking we can earn returns well beyond what we could by just tracking the market.

HE: I understand. Tell me how you were investing prior to the market crash.

Mr. T: Given the extraordinary returns in technology and all of the news about the new era of the nineties, we were heavily concentrated in technology funds. We recognized the risk of putting all of our eggs in one basket, so we diversified among several well-respected technology funds. For a year, we were doing extremely well; our returns were more than 80 percent. Unfortunately, no one warned us prior to the market crash, and in less than a year our portfolio was down 70 percent! I still don’t understand why we lost so much. It seems that if we made 80 percent and lost 70 percent, we should still be 10 percent ahead.

HE: I understand. Let me do some analyses to see how you’re positioned so I can determine what recommendations may be appropriate. Can we get together next week?

Mr. T: That would be fine.

After the Trujillos left, I gathered the information they had provided regarding their current investments and all of their financial goals. Factoring in assumptions for taxes, future market returns, and inflation, I entered all of the information into our planning software, MoneyGuide Pro, and ran several scenarios with varying allocations between bonds and stocks.

It was bad news: no matter how I jiggled the allocations, my conclusion was the Trujillos could reasonably spend only about one-half of what they considered a bare-bones lifestyle. That’s not the sort of news a planner looks forward to sharing with a client. Unfortunately, although Mr. Trujillo said they needed a return that would enable them to maintain their lifestyle, the reality is that the markets don’t give a damn.

How about Mr. Trujillo’s solution of market timing? As I explained to David Samuel in Chapter 14, “Market Timing for Fun and Someone Else’s Profit,” trying to find the pot of gold at the end of the rainbow is not a viable investment strategy. Unfortunately, their experience with the boom and bust of their portfolio didn’t convince them of the market-timing fallacy. Rather than the impossibility of consistently making the right call on market turns, Mr. Trujillo complained that no one warned them prior to the market crash. He ignored the fact that no one warned him because no one knew in advance. If you think about it, had the impending crash been obvious to professional investors, they would have moved to cash prior to the crash. Of course, they didn’t, and across the board, professionals, including the managers of the Trujillos’ diversified funds, were blindsided, as both investors and professionals have been with every market correction and crash.

You may be thinking about people you know who managed to avoid much of the loss during a bear market, and I’m sure that’s true. In fact, one of the major arguments for active management is that it may not work all of the time, but it comes to the forefront during bear markets because an active manager can reduce his or her equity exposure, whereas an index fund must stay fully invested. Although that statement is true, the conclusion is not.

In 2013, my graduate assistant (who’s now a professor), Shaun Pfeiffer, and I researched this argument. We found two fatal flaws: 1) The majority of active managers did not avoid bear market losses. 2) Even more importantly, those who managed to avoid losses in one bad market generally fail to do so in subsequent bad markets.

As for Mr. Trujillo’s confusion about his loss versus his expected 10 percent gain, it’s a classic—and dangerous—mental math trap. Big losses have far greater ramifications than most investors understand. Suppose the portfolio was valued at $1,000,000 before the big 80 percent gain. It would have grown to $1,800,000. If it then lost 70 percent, the 70 percent was a loss on the $1,800,000 portfolio, leaving a balance of only $540,000! Even worse, to get back to the $1,000,000, the Trujillos would need an 85 percent return. Not likely.

What did I tell the Trujillos? As tactfully as I could, I walked them through the numbers and tried to explain the reality of their financial position. Unfortunately, I was unsuccessful and they continued to insist that having cut expenses to the bone, they would have to simply find someone who could help. I wished them the best but feared they would simply be digging themselves into a deeper hole with progressively less opportunity to at least mitigate the pain.

The moral? Markets don’t have feelings or morals. They do not care what an investor needs and there is no investment or strategy that has consistently provided returns well in excess of those earned in the broad markets. Consequently, if you care about your financial future, don’t base the quality of your life on hopes, dreams, and the expectation of being the first person to find that pot of gold or win the lottery. Do your planning based on the reality of the markets.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Irrational Investing: You’re Not the only One Who’s Nuts

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

Good news! You’re not irrational, you’re human.

I just came from one of the most exciting lectures I’ve ever attended. That shouldn’t be a big surprise, because Danny Kahneman, the speaker, is a Nobel Laureate. Professor Kahneman received the Nobel Prize in economics for what has become known as Behavioral Economics. Basically, his studies brought to light the difference between the rational investor—someone who always rationally makes investment decisions in his or her best financial interest—and real people like you and me. We live in a complex world and that’s certainly true of investing.

To manage the complexities of life, we often use something called heuristics to help us efficiently make decisions in spite of complexities. Think of heuristics as mental shortcuts. Most of the time, these shortcuts work out well; unfortunately, they sometimes result in our making decisions that, when looked at objectively, seem irrational. Each of us also comes complete with a bunch of cognitive biases that lead us to create our own reality, which may not be consistent with the real world. Let me share some examples from Professor Kahneman’s lecture.

Built-In Bias

Just after being introduced, Kahneman asked everyone to look at the audience in the room (there were about one hundred financial planners in attendance). After a few seconds of our rubbernecking, he asked us to raise our hands if we believed that the quality of our planning advice is above the average represented by the other planners in the room. Well, surprise, surprise, we were all above average—just like Garrison Keeler’s Lake Woebegone, where all of the kids are above average.

The problem, of course, is that’s not rational. Half of the audience must have been below average. Professor Kahneman explained that as humans we have an innate overconfidence bias that leads us to have confidence in our judgment—a confidence greater than objective accuracy would suggest. How, he asked, might that get us into trouble when investing? Lots of ways.

We are often overconfident in our ability to pick investments or in the abilities of the money manager we love or the ability of financial media mavens to guide us to the best investments.

Kahneman told the audience about the research of Terry Odean and Brad Barber, University of California professors, who studied the trading results of almost seventy thousand households during a six-year period, accounting for about two million buys and sales. They found that investors who traded the most—those with the most confidence and the best ideas—earned an annual return 11.4 percent. The problem was that the market return was 17.9 percent. The professors’ conclusion? Overconfidence in your good idea may be hazardous to your wealth.

The best protection we have against overconfidence is to step back and apply a strong dose of humility and skepticism before we act.

Next, Kahneman put up a slide that looked something like this:



He explained that it represented the results of tossing two coins ten times. He and asked which one we thought was the fair coin and which one was bogus. As sophisticated practitioners we knew instantly that the second coin was bogus: Ten tails in a row? Give me a break. In hindsight, I’m embarrassed to say we fell for the heuristic called representativeness. You know the one: if it walks like a duck and quacks like a duck, it must be a duck.

The problem is that the randomness heuristic led us astray. Had we stopped to think it through, we would have realized that getting ten tails in a row is just as random as the first toss series; the problem was it didn’t look random. Our brains, knowing a coin toss is random, took a shortcut and concluded that toss one looked random so it was authentic; toss two was obviously not random, so it must be bogus.

How can that get us in investment trouble? Ever consider investing in a fund with a Morningstar rating of less than four or five stars? Probably not; bad mistake. Use the star information as one element in your selection process, but the Morningstar ratings are not guarantees of future superior performance. You need to do a lot more research than simply defaulting to the stars as the sole selection criterion. Doing so puts you at serious risk of picking a loser and rejecting a superior investment.

Muddled Math

Professor Kahneman also introduced us to the work of Professor Dick Thaler on mental accounting. It seems that in addition to occasionally being misled by our heuristics and biases, we also stumble over what would seem to be simple math. I know this from personal experience with my clients. I remember having a visit after the tech bust from a retired surgeon, who came into my office almost in tears.

“Harold, I don’t understand. Last year I made 80 percent on my investments and this year I lost only 60 percent, yet my statement says I’m way under water!”

My client’s mental accounting told him that a gain of 80 percent less a loss of 60 percent should leave him 20 percent ahead. The reality was that his original $1,000,000 investment grew 80 percent to $1,800,000, so his 60 percent loss was on $1,800,000, for a loss of $1,080,000. The end result? A balance of $1,800,000 less $1,080,000 left him with only $720,000. It was a painful way to learn that big losses take much bigger gains to recover.

Consider, for example, a volatile investment of $100,000 that loses 50 percent the first year, leaving you with $50,000. Suppose the next year you make 50 percent, so your average return for the two years is 0 percent. Did you break even? Nope. Your $50,000 grew 50 percent to $75,000, leaving you $25,000 under water. Remember that the next time you want to risk funds in a high flyer.


Kahneman presented much more on the problems investors face because we’re human and not necessarily rational. Then he provided us with the hope that we might help our clients (and ourselves) be better investors through the power of framing.

Framing has to do with the idea that the way people behave depends on how questions are framed. Suppose I offered you two brands of chocolate bars. One was 90 percent fat free and the other contained 10 percent fat. I’ll bet I know which one you’d chose. Have you looked for prunes lately? You may have trouble finding them unless you look for dried plums. The Sunkist marketing department understands framing.

How can you use this technique to be a better investor? Here are a few ideas:

The next time your neighbor gives you a hot tip, instead of focusing on all the good things that might happen, reframe your focus and ask yourself what might go wrong. My partner, Deena, once helped a client make an important decision by pointing out that if she made the significant investment she was considering and it succeeded, she could increase her standard of living by 10 percent. However, if it didn’t pan out, she would have to work four years beyond her planned retirement date to make up for the loss. She passed on the opportunity. She may not have made a killing and missed out on taking a world cruise, but she was able to retire just when she wanted to.

Reframe your performance-evaluation horizon. Investing for retirement is investing for the rest of your life, so when evaluating your investment’s performance, keep your eye on the long-term, not the daily market gyrations. That means skip the comparisons to last month, last quarter, or year-to-date performance and look at performance over years and market cycles. Also, reframe your benchmark. You might compare your large-cap core manager’s performance to the S&P 500 but not to your portfolio. Instead, consider using a real-return benchmark—compare your portfolio return to inflation. After all, that’s what your plan should be based on.

Are you holding a position in a stock at a big paper loss, but you’re reluctant to sell because then it would be a real loss? If I asked you whether you’d buy that stock today, you’d tell me I’m nuts. You wouldn’t touch that dog with a ten-foot pole! Let’s reframe your decision. Since the cost of trading today is negligible, you could sell your investment tomorrow and have the cash proceeds in your hand almost immediately. That means by holding onto your stock, you’ve made the decision to buy it again!

The moral? We’re human, not rational, and recognizing reality and learning about some of the problems our biases and heuristics get us into and using framing to help manage these risks will make us far better investors.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.