The December Rout

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Harold Evensky CFP® , AIF® Chairman






In case you haven’t been paying attention, it’s been a bit rocky lately in the market, so I thought this might be a good time for a little recent history.




BLOOMBERG, DECEMBER 26, 2018, 10:23 AM


Investors withdrew $56.2 billion from mutual funds during the week that ended Dec. 19, according to data from the Investment Company Institute. The mutual fund market hasn’t experienced a one-week outflow so large since October 2008.



We’re always preaching patience and long-term investing but we’re also well aware that scary headlines such as the ones above make it difficult to remain in the market when “experts” are warning that the world is coming to an end. So, I decided to track the daily headlines post-“Rout” to see how helpful the daily news might be for investors. I believe you’ll find the almost daily flip-flopping enlightening and it will persuade you to ignore the financial pornography and remain a patient long-term investor. Be sure to note the flip-flop between the red and green boxes, particularly the heavy ones.

Obviously I didn’t know where the market was going when I started this, but I haven’t been surprised that the media coverage followed the classic pattern below.

The moral is, next time you think you should make your investments decisions based on financial pornography and “breaking news,” reread the history below since the beginning of the “December Rout” and think twice before you bail out.

Investment success is based on time IN the market, NOT market timing!















Buffett: Stocks are ‘virtually certain’ to rise in years ahead

‘Miraculous’ U.S. economy remains the engine, says Berkshire chief. He’s not worried.

Warren Buffett assured Berkshire Hathaway investors that they’re likely to continue seeing “substantial” investment gains, aided by what he describes as the long-running U.S. economic miracle.

“Our expectation is that investment gains will continue to be substantial—though totally random as to timing—and that these will supply significant funds for business purchases,” Buffett said in his annual letter to Berkshire

Naysayers may make money by pushing “gloomy” forecasts, he said, but “heaven help them if they act on the nonsense they peddle.”

If you made  it this far, I hope you found it useful and this history lesson provides some comfort as we struggle (once again) through volatile markets. Just remember, patience pays and we’re here for you if you’d like to chat further.



Harold Evensky


Evensky & Katz / Foldes Financial Wealth Management



Important Disclosure
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Evensky & Katz / Foldes Financial Wealth Management (“EK-FF”), or any non-investment-related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from EK-FF. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. EK-FF is neither a law firm, nor a certified public accounting firm, and no portion of the newsletter content should be construed as legal or accounting advice. A copy of EK-FF’s current written disclosure Brochure discussing our advisory services and fees is available upon request. Please Note: If you are an EK-FF client, please remember to contact EK-FF, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. EK-FF shall continue to rely on the accuracy of information that you have provided.

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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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.

Market Timing for Fun and Someone Else’s Profit – Don’t Do It

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Harold Evensky CFP® , AIF® Chairman

A broker stands looking out of the window of his sumptuous office down at the marina thirty stories below with his client at his side. “See those yachts down there?” says the broker to his client. “The one on the left is mine, the one in the middle is my partner’s, and the one on the right is our office manager’s.”

“Where are your clients’ yachts?”

David Samuel: Hello, Harold. It’s David Samuel again. I know you have that AAII meeting coming up next week, but this can’t wait. My brother said he just got a call from his broker, who told him to bail out of the market at least for the next few months because the firm’s technicians said they see a major correction coming within weeks. I assume you’ve probably seen the same and agree, but I just wanted to double-check.

Harold Evensky: David, I just want to be sure I have this straight. You’re saying the broker is confident enough in his crystal ball to say that everyone should run to cash?

DS: You got it.

HE: Hum, I know he works for a big wire house; I wonder if that firm has moved all its money to cash? I don’t think so, because a move of that magnitude would have made the papers, and none of the managers we monitor have made significant liquidations recently. It somewhat makes you wonder what your brother’s broker knows that no one else does.

DS: Well, I understand that he’s been in the business for decades and he’s a senior VP at the firm, so he must know something.

HE: I’m sure he knows how to sell, because the impressive title comes with generating big commissions for the firm. There are many quality SVPs who earn their commissions from long-term quality advice.

Unfortunately, there are some who succeed by focusing on generating commissions independent of the client’s needs. That’s the basis for the old joke: “How do you make $1,000,000 in the market? Start with $2,000,000.” In deciding whether market-timing advice is something you want to follow, remember, when market timing, a broker earns a commission for the sale of each and every one of the positions their clients sell and another commission when they repurchase those positions. Here are a few things you might want to consider:

Can you name the top ten musicians of all time? The top ten baseball players? The top ten presidents? Of course, you can. We might argue about the list but most people can make up a list.

Now, tell me the top ten market timers of all time? Can’t even name one, can you? Your brother’s broker may be the first, but do you really want to bet on that?

What do market reality and statistics tell us? There are innumerable problems with market timing, including transaction and tax drag. But there are two major problems. You have to make two correct calls: 1) when to get out and 2) when to get back in. Factoring in transactions and taxes, research indicates you need to be correct about 70 percent of the time.

Markets don’t just drop precipitously, but they recover quickly, so waiting for confirmation of the end of a bear market usually means missing a significant part of the recovery. That makes for a tough hurdle.

For example: In a study covering the period 1987–2007, research found that the annualized return for someone invested for 5,296 days was 11.5 percent. Unfortunately, if you missed the ten best days (less than 2/10 of 1 percent), your return would have dropped to 8 percent,

Why would you be likely to miss those best days? Because those best days occurred within two weeks of a worst day 70 percent of the time. And they occurred within six months of a best day 100 percent of the time!

In an industry study in 2008, researchers found that although the annualized market return for the prior twenty years was 11.6 percent, the average stock fund investor earned a paltry 4.5 percent. It turned out that for most investors, market timing was mighty expensive. And, David, unless you’ve recently obtained a working crystal ball, it’s likely to also prove costly for you.

To make money in the market, you have to be in the market through thick and thin. In fact, if you remember our discussion on rebalancing, you’ll remember that bear markets are great buying opportunities for long-term investors. So, my advice is to stop listening to so-called experts spouting nonsense and go back to making money in your business.

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.

Umbrellas and Bumbershoots: How Risky Investments Can Make for a Safer Portfolio

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Harold Evensky CFP® , AIF® Chairman

Harold Evensky: Good morning, class.

Class: Good morning, Professor Evensky.

Andrew: Professor Evensky, why are you carrying that umbrella? The temperature outside is 110 degrees and it hasn’t rained in the past three months!

HE: Andrew, that’s an excellent question. And this umbrella is what we call a prop. It will help introduce one of the most important issues in wealth management: diversification and asset allocation, and why they’re so important in helping our clients meet their goals.

Elizabeth: Professor Evensky, will this be on the test?

HE: So I’ve prepared a little exercise to help all of us think through how to make investment recommendations in light of client goals. Is everybody ready?

Class: Yes.

HE: In this exercise, our clients live in a simple world where they have a choice of only three investments. Two of them are risky. I’ll write the choices here on the whiteboard:

HE: Everybody got that? As a sophisticated planner, you recognize that the swimsuit and umbrella company stocks are very risky, since an investor will either make a great return or no return, depending on the weather. So you’ve consulted with some of the world’s greatest meteorologists and arrived at the following:


Meteorologists’ Predictions

80 percent probability that it will be rainy 90 percent of the time

60 percent probability that it will be rainy 70 percent of the time

30 percent probability that it will be rainy only 20 percent of the time


How would you recommend my clients allocate their investments? Where do you start?

Andrew: Well, you say we should always start with what we know about our clients.

HE: Great start, Andrew. And what important things do we know about them?

Andrew: To achieve their goals, they need at least a 10 percent return. We also know they are not very tolerant of investment volatility. They don’t like their investments to bounce around a lot.

HE: Good so far. Kiran, where does that take us?

Kiran: Only now should we look at the investments. We should look at the possible investment outcomes—which, in this case, seem to depend on the weather.

Nicholas: Professor Evensky, while everybody else was chattering on about the clients, I made up a little table that shows all the different possible portfolio returns based on the weather data you gave us.

HE: Thank you, Nicholas.

Nicholas: I also created a neat little algorithm that will do these same calculations if we ever run into a problem like this again. I could show you after class.

HE: Nicholas, I’m going to go out on a limb and predict that you have a bright future as an investment analyst.

Nicholas: Whatever. Wait. That doesn’t mean I’ll have to talk to actual people, does it?

Carly: Professor Evensky, I’ll check Nicholas’s math.

HE: Thank you, Carly. So does everybody see where the numbers come from?

Suppose, for example, you have 90 percent allocated to umbrellas and it rains 70 percent of the time. That means you will profit from all of the 70 percent rainy days. That’s a net of 14 percent to 20 percent, maximum, times 70 percent, right, Nicholas?

Nicholas: Obviously.

HE: Okay, now let’s consider how we did with our swimsuit company investment. Since only 10 percent is invested in the swimsuit company, and there are 30 percent sunny days, the swimsuit company can profit from only some of those sunny days. So my return is 20 percent, maximum, times the 10 percent I have invested in swimsuits, which equals 2 percent. Add 2 percent return from swimsuits to 14 percent return from umbrellas, and you get a total of 16 percent. If this turns out to be the real weather pattern, I didn’t get the full 20 percent because I owned too many umbrellas and not enough swimsuits.

Kiran: And that’s where all the other possibilities came from?

HE: Correct. You can use the same process to calculate the other figures in the chart. So now what? Do you have an answer to the proper allocation for these clients who need 10 percent a year and don’t like a lot of volatility?

Alicia: Well, I guess we have to toss out the safe investment.

HE: Good, Alicia. Why?

Alicia: At a fixed 8 percent, the CD is a nonstarter. For someone who needs 10 percent, only receiving 8 percent, no matter how guaranteed, would be a failure.

HE: Good thinking. Of course, when you present the alternatives, our client might elect to revise the goals so that 8 percent would suffice. But before we recommend that, let’s look at the risky alternatives. What do you see here?

Kiran: I’d apply Modern Portfolio Theory, and come up with a blend of the risky investments. If you blend investments that respond differently to different investment climates, then the result is a portfolio with less volatility.

HE: Very good. And did y’all get my joke? Investment climate—rain or sun—pretty funny, right?

Kiran: Professor Evensky, maybe you shouldn’t try to be funny in class.

HE: Yes, well, the important thing is that we can blend these risky investments. And in this simplified investment world we’ve created, what do you notice immediately?

Alicia: The risk and return patterns are exactly the opposite. You make money in swimsuits when it’s sunny, and when it rains, your return comes from umbrellas. It either rains or it doesn’t.

HE: Right. So?

Alicia: So in that simplified investment world, if we put half in swimsuits and half in umbrellas, we’d always be making 20 percent on half of our portfolio and 0 percent on the other half.

HE: And?

Andrew: For these clients, if they invest half of their money in swimsuits and half in umbrellas, no matter what happens, even if it never rains again or the deluge never ends, or anything in between, the clients will get a guaranteed 10 percent return—which is exactly what the client needs.

HE: Excellent. Of course, in the real world, you probably have thousands of different drivers of the profits of tens of thousands of different companies. If you were to bet on any one of them, there’s the possibility that whatever you were betting on, just the opposite would happen and you could lose a lot of money. But if you spread your bets around, and the economy grows—which it has done since people were living in caves—then all of those bets across all of those different drivers will smooth out some of the ups and downs. And there’s a high probability, based on history, that your clients will get returns commensurate with their willingness to wade into the world of market risk. Diversification really works.

Kiran: But there’s still risk, right?

HE: Of course. The moral here is not that you can eliminate risk; but in designing your portfolio and evaluating risk, you need to consider the risk of the combined investments, not the risk of each individual investment. And let’s not miss something equally important: you need to consider the risk of not achieving your goals by confusing certainty and safety. Does everybody get it?

Class: Yes, Professor Evensky.

HE: And yes, Elizabeth, this will be on the test.

Elizabeth: What’s that?

HE: But I wanted to get back to something we talked about earlier. Who thought that my investment climate joke was funny? And try to keep in mind that your grade might depend on it.

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.

False Security: When Stop Loss May Really Mean Guaranteed Loss

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I was reading a story in one of my profession’s trade journals about a financial advisor’s solution to helping retired clients develop income strategies in a volatile market. The advisor has been in business since the early 1970s, but the 2008 financial crisis was his wake-up call to move to “tactical investing.”

I have to confess that I’m a skeptic about anyone’s ability to call market turns, so I was already biased when I started reading the article. But I lost it when the story said his major strategy was using stop-loss orders to avoid big declines.

For those not familiar with a stop-loss order, I’ll explain: it’s an instruction to your broker to put in a sell order if your stock price ever drops below a predetermined price.

To find out more about the dangers of this strategy, let’s eavesdrop on this advisor’s conversation with a customer.


Dr. Charles (Dr. C.): Hello, Joe [the broker]. This is Dr. Charles.

Broker: Dr. Charles, how can I protect your investments today?

Dr. C: I have a large investment in High Tech, Inc., after all, you recommended it to me.

B: A terrific investment recommendation, if I may say so myself.

Dr. C.: Well, yes, but the thing is I’m becoming a bit concerned about it.

B: Why? High Tech is the future.

Dr. C.: Maybe so, but the stock is bouncing around like a yo-yo. It’s finally back up over the high it reached eighteen months ago, but I’m afraid, given its history, it’s going to drop back down again on me.

B: Would you like me to protect you from your stock investments going down?

Dr. C.: Exactly! Would you?

B: Certainly. I’ve been practicing this safe investment methodology since, well—there really isn’t any reason to get into how recently I’ve changed my entire investment philosophy. The point is it looks as if you need a stop-loss order.

Dr. C.: A stop-loss order? Is that what it sounds like it is?

B: The point of a stop loss is to stop your losses and let you keep your gains. You like gains, don’t you?

Dr. C.: Yes. Yes, I do.

B: And what about losses?

Dr. C.: Not so much.

B: So let’s look at the old terminal here. I see that High Tech is trading at about $56½, which is a pretty nice run during the past couple of weeks.

Dr. C.: Right. But before that run, it was priced below what I paid for it.

B: It looks like the last trade was at $56. It’s been trading in a pretty narrow range, between $50 and $60, for the last few days.

Dr. C.: So what can I do to protect myself from the next drop?

B: Tell you what. I’ll put a stop loss in for you at $52. Your basis is $48 so, if worse comes to worst, you’ll lock in a profit of $4/share.

Dr. C.: Thank you, Joe. You’re the best. Now I can sleep at night.

[Nine months later]

Dr. C.: Hello, Joe.

B: Hello, Dr. Charles. How can I protect your investments today?

Dr. C.: Well, you may have noticed the screaming headlines in the newspapers or heard the cable television folks talking about the fact that the bottom dropped out of the tech market.

B: I did notice, yes.

Dr. C.: High Tech was clobbered worse than most. I just wanted to be sure my stop loss got executed.

B: Yes, sir, I see your position now. It did get traded.

Dr. C.: Thank goodness, I just saw it trading at $32! Sure am glad I got out at $48. With my 10,000 shares, I still made a nice profit of $40,000. Thanks, Joe. That’s all I wanted to find out.

B: Uh, hold on a minute. You’re correct that it’s now trading at $32.25. But when the initial sell-off hit, the stock actually dropped all the way down to $27.

Dr. C.: Now, I feel even better that I was able to sell out.

B: Well, that’s the thing. When your stock dropped below $48, that triggered your stop-loss order, all right. Then your shares were sold at market. Unfortunately, the price you sold at was $29.50 not $48.

Dr. C.: What?! How could you have sold me out at $29.5?! I said I wanted $48 minimum.

B: Well, I’m afraid that’s not how a stop-loss order works. I just assumed you knew that when we set it up. All a stop loss does is trigger an open-sell order when and if the stock price drops below the stop-loss price. What happened with High Tech is that with the huge volume of sell orders pouring in, a few trades were done at $48, resulting in your open order to sell “at market.” Unfortunately, there was already a ton of sell orders on the books ahead of you. So by the time your order was executed, the price was $29.50.

[One week later]

Dr. C.: Hello, Harold.

Harold Evensky (HE): Pardon me. Who is this?

Dr. C.: My name is Dr. Charles. I saw you were quoted in the Journal, and you had some skeptical things to say about stop-loss orders. I’m looking for a new financial advisor, and I was hoping you could tell me more about what you think of stop-loss strategies.

HE: On the surface, they look great. They cost nothing, and they preserve all the possibility of further gains, and if you don’t know how they work, you might think that they eliminate the potential of loss beyond the stop-loss order price. Unfortunately, that’s an illusion.

Dr. C.: Tell me more.

HE: The major problem with stop-loss orders is they’re executed mindlessly. There is no guarantee what price you’ll sell at once the stop-loss order is triggered. If the market’s falling rapidly, you may end up selling at a price well below your stop-loss price.

Dr. C.: Actually, I found that out the hard way.

HE: I’m sorry to hear that. But you’re not alone. Here’s a quote from John Gabriel, a Morningstar strategist:

One type of trade that we vehemently avoid more than any other is known as a “stop-loss” order. Consider yourself warned: if you perform an online search for this term, you’re likely to find some misleading definitions. For instance, you may come across an explanation like, “setting a stop-loss order for 10 percent below the price you paid for the security will limit your loss to 10 percent.” Our main problems with this statement are that it is blatantly false, imparts a false sense of security, and can lead to truly disastrous results.


Dr. C.: I wish I’d seen that a month ago.

HE: Gabriel went on to say, “We often quip that a more appropriate name for a stop-loss order would be a guaranteed-loss order”—strong stuff and I couldn’t agree more.

Dr. C.: Do you know of any strategy that does work to limit losses?

HE: You can somewhat mitigate the risk of selling way below your targeted stop-loss price by using what’s called a stop-loss limit order. It’s a little more complicated, but it tells your broker to enter a sell order if the price drops below the stop-loss, but also tells him not to sell if it falls below an even lower limit order. The catch is, if that happens, it means you still own the stock after the price has dropped.

Dr. C.: So, in other words, safety is an illusion.

HE: My bottom line is: If you decide to be a market maven and pick your own stock, then you should decide when to sell, depending on the market environment at the time. Don’t fall for the false security of a mindless automatic trigger. In fact, you may not want to sell at all.

Dr. C.: What do you mean?

HE: When you go to the grocery store and something goes on sale and the price is really cheap, does that mean you go home, rummage around your refrigerator, and offer to sell stuff back to the store at a price that is lower than you bought it?

Dr. C.: Of course, not. I’d probably take advantage of the low price and buy extra.

HE: Then why do people do just the opposite with stocks? When stocks go on sale, the first thing people think about is selling. To my way of thinking, a big drop in price may be a terrific opportunity to buy more, not a reason to sell.

Dr. C.: I never thought of that.

HE: If you want to come in and talk with me, I can set up an appointment. But I’m going to warn you in advance: I don’t have any magic formula for protecting you against the ups and downs of the stock market.

Dr. C.: Believe it or not, at the moment, that’s music to my ears.

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.

Getting Your Money: The Difference Between Liquidity and Marketability

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Harold Evensky CFP® , AIF® Chairman

Having the option to sell an investment whenever you want and getting all of your money back is not the same thing.

Dr. Elizabeth Boone is a surgeon, a long-time friend and client. I’d been looking forward to chatting with Elizabeth about how my alma mater just trounced hers in basketball.

Receptionist: Hello, Harold; it’s Dr. Boone on 88.

HE: Hello, Elizabeth. Did you see the game?

EB: Forget it, Harold. Our best rebounder was out with a broken collarbone, the referees had to use braille to read the scoreboard, and our coach had the flu. Besides, I’ve got a problem.

HE: Sorry, Elizabeth. What’s up?

EB: I need some advice for my mom.

HE: About?

EB: She just received an inheritance from my aunt’s estate and she’s asking me how to invest it. I told her CDs are safe, but right now the rates are so low that she’d get more return if she buried her money in the backyard. She doesn’t have to pay much in the way of taxes and since she mostly needs income, her broker suggested one of those government bond funds and preferred stock that pay high dividends. I wanted to check with you to make sure that was all right.

HE: Good grief!

EB: Excuse me?

HE: Elizabeth, I’ve heard this same story about six zillion times. Let me ask you a few questions: first, how worried would your mom be about principal fluctuation?

EB: What on earth does principal fluctuation mean?

HE: Will your mom be worried if the value of her fund goes up and down, as long as her income is fairly steady?

EB: I don’t even need to ask her. She and Dad had big tax-free bond portfolio years ago. When interest rates went up, they’d watch their bond prices go down with each statement! I thought they’d die from bleeding ulcers. Harold, I also had lots of those long-term bonds and I still have the ulcers. Never again! You know how I feel about that. You’re the one who restructured my portfolio.

HE: Okay, Elizabeth, okay. Just checking. Second question: how carefully have you or your mom checked into the suggestion of government funds and preferreds?

EB: Pretty well, Harold. You know my mom—she’s sharp. She asked a lot of good questions of the broker and jotted down the answers. Let me read you the gist of how the conversation went:

Broker: Mrs. E., based on what you’ve said, you want income and safety, right?

Mrs. E.: Right.

Broker: Well, I think we should split your investment between our government fund and a portfolio of well-selected preferred utility stocks.

Mrs. E.: Mr. Broker, this is almost all of my money and you’re right, I’m really concerned about safety and income. How safe are these investments?

Broker: Mrs. E., the preferred stocks we’ll buy are all from highly rated companies—real blue chips—and the government fund invests in bonds guaranteed by the United States government. We’re talking safety!

Mrs. E.: What happens if I need my money?

Broker: Why, Mrs. E., don’t you worry, there are safe investments.

HE: That’s it? That was their conversation?

EB: Mom also said he was really comforting. He even got up from his desk and walked over and patted her shoulder and said, “These investments are exceptionally safe and you can sell whenever you want. Just call me and I’ll put in an order and you’ll have your money in a week.” Then he said, “Now, if you’ll just sign here—”

HE: But she didn’t sign, right? Tell me she didn’t sign and I’ll be a lot happier.

EB: Mom told the broker she wanted to talk to me first. She asked him to mail some information and I have it now.

HE: Let me guess. The prospectus on the government fund says “guaranteed by the federal government.” And the brochure has American flags all over it.

EB: You know this fund?

HE: No, but I do recognize the marketing strategy. And the rating sheets for the preferred stocks he wants her to buy say that the company balance sheets are so strong they could win an Olympic weight-lifting championship.

EB: Something like that. So we should go ahead? I started to tell her to go ahead, but remembering those great tickets I got you to the big game, I figured you owed me a bit of free advice.

HE: Elizabeth, I’ll give you the free advice, and I won’t even mention the current price of the other four hot tips I talked you out of.

EB: Touché! So what’s your diagnosis?

HE: I don’t think you want me to give you a lecture on good financial planning. Suffice it to say your mom shouldn’t do anything but put the money into a money market account until she reviews her entire financial situation, including her needs for cash flow and emergency reserves, tax planning, insurance, and her estate planning as well as her Social Security and pension income. All of those will make a difference in deciding what she should buy.

EB: All that?

HE: When you do a diagnosis, do you just give advice off the cuff based on what the patient says she wants, or do you probe a little bit?

EB: I probe a lot. What kind of a doctor do you think I am?

HE: A good one. So you can see my point. But if you want me to diagnose your mom from afar, then let me at least introduce you to two important ideas that will help you evaluate the investments Mr. Broker suggested: liquidity and marketability—the big L and M.

EB: I need to write this down so I can tell Mom.

HE: Don’t get hung up on the fancy words—focus on the concepts. Both liquidity and marketability refer to attributes of investments. You’ve heard me say that investments don’t have morals; they’re not good or bad. They have attributes, and those might be right or wrong for you or your mom, just as an antibiotic might be good for a patient with an infection but not so good for helping a patient who’s in a lot of pain.

EB: Maybe you should leave the medical analogies to me.

HE: Liquidity measures how easily your investment can be converted into cash whenever you want to, no matter what’s happening in the economy or to the stock or bond market, without losing any of your original investment. Marketability measures how easy it is to sell an investment when you want to. With me so far?

EB: I’m not sure. Those sound the same.

HE: You’re right; they do. Both relate to converting your investment to cash. Both measure how fast and how easy it is to do that. And neither is good nor bad. The problem is that they’re not the same.

EB: So tell me how they’re different.

HE: There’s one big difference. Liquidity refers to getting the full amount of your original investment back at any time. Marketability is about getting fair market value when you sell. And there’s the catch! You know yourself from your ulcer experiences with the bond funds that full amount and fair market value are often very different.

EB: So if the market goes down, and Mom tells the broker she wants her money back—

HE: The amount she gets could be less than she invested originally. And she’s back on ulcer medicine—or worse. She could be in danger of running out of money.

EB: So she wants something liquid, right? What kinds of investments are liquid?

HE: The most common liquid investments are checking and savings accounts, money market funds, Treasury bills, and that wad of cash she was going to bury in the backyard.

EB: And marketable investments are?

HE: There are lots of marketable investments. The list includes stocks and bonds, mutual funds, and government bond funds. Got it now?

EB: I think so, but so what?

HE: So knowing what you know now, take another look at that government fund with the flags on the brochure and the preferreds with their balance sheets on steroids. Suppose your mom wanted to sell her government fund or preferred in a few years. How much would she get back?

EB: I guess I really don’t know. How could I?

HE: You can’t unless you have a working crystal ball. You don’t have one, do you?

EB: No.

HE: I always ask, because I hope that one day I’ll find someone who has one and I can ask to borrow it for a while.

So we know the government fund is secure from a credit standpoint, and for now let’s assume the preferred stock issuers remain in good financial shape. But with both investments, you still have interest rate risk. That’s what the broker should have talked about, and probably would have, if he or she wasn’t so focused on making the sale.

EB: You mean the risk that interest rates will go up?

HE: Exactly. The broker is selling your mom two investments paying a fixed interest rate. Right?

EB: Right.

HE: When interest rates go up, people can go out on the market and buy investments with fixed rates higher than what you mom is getting. So do you think anybody would want to buy her investment, with a lower yield, at the price she paid for it?

EB: No.

HE: You’re right. To take an extreme example, let’s say she buys a bond with a twenty-year maturity today and gets a fixed 4 percent, and ten years from now, interest rates have gone up to the point where a bond with the same credit rating, and ten years to maturity, by the same issuer, is paying 8 percent. If she wanted to sell her bonds, she would be offered about $7,000 for her $10,000 investment. She’d lose money and get an ulcer.

EB: Okay, but she still has the preferred stocks, right?

HE: Let’s talk about those. From the talk about interest rate risk, you can see that the longer the maturity of the investment, the more interest rate risk you’re taking. Rates probably aren’t going to double in one year, but they just might in ten. And during twenty years, you have no idea what’s going to happen, right?

EB: Right.

HE: So tell me: what is the maturity date on the preferred stocks the broker was recommending?

EB: I don’t know. Ten years?

HE: What if I told you it was thirty? Would you be comfortable then?

EB: Not very, no.

HE: What if I told you it was 100?

EB: That would make me extremely uncomfortable.

HE: And if I said that those investments would mature in a thousand years, what would you say to me?

EB: I’d say you were joking.

HE: Actually, I was underestimating. The answer is that those preferred stock investments never mature.

EB: Never?

HE: Not even when the Earth crashes into the sun. So your mom is subject to a seriously whopping interest rate risk. And it gets worse.

EB: How can it possibly?

HE: If you own a bond issued by the company selling the preferred stock and the company fails to pay on its bond obligation, it files bankruptcy. Guess what that same company does if it can’t pay on your preferred stock?

EB: What?

HE: It sends an apology letter.

EB: So maybe the broker’s advice wasn’t as great as I thought it was. Mom says he was really nice.

HE: I’m sure he’s a very nice person who pets his dog. But the bottom line for your mom is that those government bond funds and preferreds may have a good story, and they pay what today seems like an attractive rate, but they come with a boatload of risks and they are, irrevocably, not liquid. They certainly may play a role in many portfolios but not 100 percent of your moms.

EB: So what do I do? What would you recommend?

HE: First, let me ask: why didn’t your mom buy CDs?

EB: I told you. Those one- and two-year CDs just don’t pay enough.

HE: Did you look at the five-year CDs?

EB: Actually, we did. They were a little more attractive, but mom’s afraid to buy anything locked up for more than a few days.

HE: Elizabeth, that’s exactly the point! She was confusing liquidity with marketability.

EB: Yet again, I don’t follow you.

HE: It’s not that complicated. Tell me: if your mom purchased a five-year CD today and in three years she needed her money, what would happen?

EB: Actually, we asked about that. They said if we liquidated early, they would charge a six-month interest penalty.

HE: And that means?

EB: Mom would get her investment back and a little less interest than she had expected.

HE: Right; she would get her entire initial investment back and maybe even a little interest. Sounds like a liquid investment. Not very locked up, is it?

EB: Not when you put it that way.

HE: Your mom needs to be sure not to be misled by marketing that confuses liquidity with marketability. “Getting your money back” isn’t the same as getting all of your money back.

EB: Okay, I’ll talk to her.

HE: Maybe she can come to the game with us.

EB: What game?

HE: The game you’re going to get me tickets to, the one where your leading rebounder is going to be out, and our coaching staff has checked with the local institute for the blind to bring in some qualified referees.

EB: I’ll see what I can scare up. Thanks, Harold.

HE: I’m glad I could help.

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.

The Trouble with Sandboxes: How to Tell if a Fund is All it Claims to Be

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Harold Evensky CFP® , AIF® Chairman

One of the hats I wear is as a Professor of Practice in the Personal Financial Planning Department at Texas Tech University where I teach the graduate Wealth Management class. Join me in class as I lecture mutual fund.

There are thousands of mutual funds that offer to select stocks and bonds for your portfolio. But which ones are right for you?

Wealth Management Class: Good morning Professor Evensky,”

HE: Good morning, class. Are you ready to talk about the exciting topic of mutual fund selection?

[Enthusiastic cheers from the students sitting in the front row. The students sitting in the back look up from their smart phones.]

Can anybody tell me what the assignment was?

Michael: The assignment was to evaluate a particular mutual fund that’s being promoted as the only stock fund you need for your portfolio.

Elizabeth: Professor Evensky, is this going to be on the test?

Clay: The ad read “It’s the only domestic stock fund actively managed by professionals with performance that ranked it in the top 10 percent for the past one, three, five, ten, and fifteen years and below average risk.”

HE: Thank you, Michael and Clay. So let’s review some of the terms we’re using here. Elizabeth, what is an actively managed fund?

Elizabeth: Hmm, sorry. I think I was out the day we covered that.

HE: Lisa?

Lisa: “Actively managed” refers to a fund where the manager actively trades the investments with the goal of outperforming an index return benchmark.

HE: And how is an actively managed fund different from an index fund?

Clay: Unlike the actively managed fund, an index manager makes no decisions about what stocks or bonds to buy. He simply wants to own all of the investments listed in the index. If the index drops a stock and adds a new one in its place, the index manager will sell the stock that was dropped and but the one that had been added to the index.

HE: So where did you start your evaluation? Anybody?

Cagla: I started with the three Ps: Philosophy, Process, and People, and I was impressed. Management seems to have a credible philosophy, a thoughtful process, and experienced people, although I noted that current management has only been in place about two and a half years. [See Chapter 13, “The Three Ps of Investing,” for more information.]

HE: You’re on a roll. Who’s next?

Kristin: Well, having passed the three Ps, we then need to evaluate performance. Our clients can’t get yesterday’s returns, but if past performance is good and the fund passes the three Ps, our clients stand a chance of enjoying good performance in the future.

HE: Okay, how would you go about evaluating performance? And performance compared to what?

Lisa: I would begin by determining what sandbox the manager is playing in and select appropriate investable indexes to compare the fund to.

Elizabeth: Excuse me, um, “investable indexes”?

HE: Who can explain what an investable index is?

Lisa: It’s a mutual fund or Exchange Traded Fund (they’re called ETFs), available to public investors that have the goal of earning the return of a market index at low cost. For example: the iShares Core S&P 500 ETF seeks to track the results of the S&P 500 that measures the performance of large-capitalization stocks in the United States stock market. The annual fund cost is only 0.07 percent.

HE: Very good. Now, what’s a “sandbox”? How are you going to determine which sandbox it is? And why investable indexes?

Lisa: By sandbox we mean the nature of the underlying investments. In this case, the fund is a domestic stock fund, so we need to determine the size of the companies the fund invests in and the manager’s valuation orientation, so we can know the universe of managers to compare its performance to.

Elizabeth: “Valuation orientation”?

HE: Can someone explain valuation orientation? And tell us how we go about determining the universe for comparison.

Kristen: Generally stocks are categorized as “growth,” “value,” or “core.” Growth companies are ones investors believe will have significantly improving profits. The stock price tends to be relatively high compared to the company’s current earnings, as investors are paying up for those rapidly improving profits.

Value stocks tend to be relatively cheap based on current earnings, as investors do not have great expectations for the firm’s future profits.

Core stocks are those that have mid-range expectations for future profits.

Professionals use a variety of metrics to determine what category a stock falls in. One of the most common is the stock’s price-to-book ratio. That’s simply a number that tells you how much you have to pay for a share of stock to buy $1 of the company’s book value. For example, the stocks that make up the S&P 500 index have a price/book ratio of about 2.6 while the growth stock portion of that index is 3.8 and the value portion 1.9. When we look at a fund that’s investing in S&P 500 kinds of stock, we’ll look to see how the fund’s P/B ratio compares. If it’s in the 1.9 range then we consider it value, in the 2.8 range growth and core in between.

HE: Elizabeth, are you with us on this?

Elizabeth: Not really, sir.

HE: John, define average capitalization for us.

Kristin: Capitalization refers to the financial size of a company. It’s calculated by multiplying the current price of a stock, times the number of shares of the company. So, for example, if a company has 100,000,000 shares outstanding and the stock is trading at $30 it would have a $3 billion capitalization. To give you an idea, the average of stocks in the S&P 500 is more than $60 billion. Although there is no hard and fast rule, generally we would consider stocks with capitalization of less than $2,000,000 small cap; between $2 and $5 billion mid-cap and more than $5 billion large cap.

HE: Okay. And why are we comparing the fund to investable indexes and not to an index?

Elizabeth: Professor Evensky, is that going to be on the test?

Clay: You taught us last week that an index is generally a more rigorous standard than a peer benchmark. But if our clients can’t invest in an index, using one for comparison may be interesting but not very practical.

Sean: The good news is that today, with the large universe of exchange-traded fund index investments, we can invest in almost any index.

Elizabeth: I don’t seem to have any notes on exchange-traded funds.

HE: Very good. Sean, where might we look for the information we need to evaluate funds?

Sean: Certainly we’d want to look at the fund family website, and to get an independent evaluation, we’d look to Morningstar data. It is available in programs for professionals and on the Web for retail investors. You told us Morningstar is the Rolls Royce of the profession.

HE: Okay. What’s next in our evaluation? And what did you find?

Sean: I found the price-to-book and capitalization to be in line with the mid-cap growth universe. For comparison, I selected two exchange-traded funds (ETFs): iShare S&P mid-cap growth and iShare Russell mid-cap growth. Besides the capitalization and price-to-book metrics being similar to the active fund, the correlations with both indexes were high at 0.94.

HE: Thank you, Sean. And?

Kristin: Regarding performance, I found that during its ten-year-plus history, the fund’s return compared to the indexes was most impressive; it was almost 20 percent better than the index returns.

HE: So it does stand apart, so to speak? What do you think, Linda?

Linda: Not so fast is what I think. When I looked more closely, I found that all of that 20 percent outperformance was attributable to returns more than five years ago. When I looked at the most recent last three years, when current management was in place, I found that all the outperformance disappeared.

HE: Terrific. Kiran, what did you find?

Kiran: I looked at tax efficiency.

HE: And?

Kiran: Throughout the last three years, there was almost a 1 percent extra tax drag on the active fund as compared to the much more tax-efficient index funds.

HE: Conclusions?

Kiran: My conclusion would be that, while the fund seems to be of decent quality, if I were making a recommendation to my client, I would recommend the exchange-traded fund.

HE: And why is that?

Kiran: Recent performance of all three funds was quite close on a pretax basis; however, on an after-tax basis the index alternatives would deliver more after tax returns to my taxable clients. Also, with an index investment, I’m basically sure of par performance; that is, after expenses an index will consistently be in the top half of the performance universe, whereas an active manager may do well for one period but poorly the next. So, unless I find an active manager I believe can consistently outperform an index alternative, I’ll stick with the index. It’s like going out on the golf course and being guaranteed to shoot par.

HE: And the moral?

Kristin: Next time I read a glowing article about a hot shot manager, I won’t add that manager to my clients’ portfolios until I determine what sandbox the manager’s playing in, put him through the screen of the three Ps, and select an investable benchmark to compare his risk and returns to. And if it’s for a taxable account, I won’t forget to consider taxes.

Elizabeth: Professor Evensky, is this going to be on the test?

HE: Think of this as a very tough life test, Elizabeth, one that every investor has to pass more than once on the road to retirement.

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.