Flight to Safety: The Portfolio that Makes for an Uncertain Future

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Harold Evensky CFP® , AIF® Chairman

Certainty Isn’t Safe

Harold Evensky (HE): Kirin, good to see you. Where’s Autumn?

Kirin (K): She’s out shopping. I wanted to see you alone. I’m very upset and concerned about my investments; I don’t want her to know and get worried.

HE: Kirin, what’s worrying you?

K: Well, as you know, most of my money is in a series of large, one-year CDs that I’ve been rolling over every year. A few years ago, I was getting almost 9 percent. It’s been going down every year, and now I’m facing rolling them into CDs that are paying only 1 percent! Harold, we can’t live on 1 percent.

HE: I hear you and, indeed, rates have come down significantly. We might find a bank paying a tad more, but it would be a small increase. Let’s talk about repositioning at least some money into a balanced portfolio.

K: A balanced portfolio? That sounds like it has stocks?

HE: Indeed, the idea is to balance your investments between stocks and bonds—probably somewhere in the range of 50 percent bonds and 50 percent stock.

K: Harold, forget it! The market’s too risky. No way am I buying stock.

HE: Okay, Kirin, let’s talk about designing a laddered bond portfolio.

K: What’s that?

HE: Well, we would buy a series of high-quality bonds maturing each year during a period of time. If you invested $100,000, we might buy ten bonds, one maturing in one year, the next in two years, and so on until the last $10,000 was invested in a ten-year bond. That way, if interest rates go up in a year, you’ll have the money from the maturing bond to invest at the new higher, ten-year rate, and if rates go down, you’ll have most of your money invested in bonds paying a higher return than the current market.

K: Sounds cleaver, but forget it. No way am I tying up my money that long.

HE: Okay, Kirin, I give up. Stop buying your one-year CDs and buy five-year CDs. At least they pay a little bit more.

K: Harold, no way. Long-term to me is a green banana.

HE: [By now, I was more than a little frustrated.] Kirin, go ahead make my day—die. [Normally, I wouldn’t be so blunt, but Kirin was not only a client but also a long-time friend and I thought he needed a significant wake-up call, so I went on.] If you really did die, I would be distraught because you’re a good friend, but what keeps me awake at night and should keep you awake at night is not dying and having no financial assets to support your lifestyle. As my friend Nick Murray would say, your problem is confusing safety and certainty.

CDs are certain in that you can have confidence that you will receive the interest payments promised and your full principal back at maturity. In the real world, the friction of taxes and inflation is likely to result in your certain payments buying less and less. That means your standard of living will gradually be eroded. That is not safe. The moral? Don’t confuse certainty and safety. A safe investment portfolio has a high probability of allowing you to maintain your standard of living. For most of us, that means investing in both bonds and stocks.

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.

Biggest Mistake A Great Stock and a Great Investment May Not Be the Same

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Harold Evensky CFP® , AIF® Chairman

“That’s a great stock; I think I’ll take a big position in my portfolio.” That’s how all too many investors make their investment decisions. Mistake, big mistake.

Randi: Hello, Harold.

Harold Evensky: Hi, Randi. What’s new in the accounting world?

R: Don’t ask. It seems like every time Congress passes a law simplifying the tax code, they add a thousand more pages to it.

HE: So what are you calling about? Do you want me to flex my lobbying muscles?

R: Actually, it has to do with the newsletter I edit for our professional accounting group. It’s our investment issue, and I can’t think of anyone more qualified to help me with it.

HE: I’m flattered. How can I help?

R: The issue coming up is a very important one. I was wondering if you could give me a great topic for the lead article.

HE: Now I’m even more flattered. How about a story on the biggest investment mistake most investors make?

R: What a great idea! You’re so smart!

HE: Well, shucks, I was hoping somebody would notice.

R: With all your investment wisdom, what mistake do you think the article should discuss?

HE: Well, where should I start? Investors had been making the biggest mistake for a long time, but it wasn’t until August 1991 that advisors started to give it serious consideration.

R: What happened in 1991—other than a new tax law?

HE: That month, a prestigious investment journal published an article that would eventually turn the investment profession upside down.

R: I knew you were the right person to call.

HE: It carried the fancy title “Determination of Portfolio Performance.” The authors—three big-time money managers named Gary Brinson, Paul Hood, and Gil Beebower—thought it might be a good idea to study the importance of various decisions made every day in managing huge, billion-dollar pension portfolios.

R: Are you telling me that nobody before that had been thinking about whether they were making good or bad decisions?

HE: They were the first to look at the types of decisions in a systematic way. They started by deciding what decisions were actually being made.

R: Like which stocks to buy?

HE: They divided the types of decisions made into categories, and that was one of them. They decided there were only three kinds of decisions that anyone could make that would affect a portfolio’s performance.

R: And one of them is which stocks to buy?

HE: Yes. They called it security selection, which means picking the best stocks and bonds or the best managers.

R: What were the other two decisions?

HE: I’m sure you’ve heard of the second one. They called it market timing. Basically, that means deciding when to be in or out of the market. If the market is going to go down, you want to be on the sidelines. If it’s going up, you want to be totally invested in it.

R: Doesn’t that require predicting the future?

HE: Believe it or not, some professionals, and many retail investors, think they can predict where the stock market will go up or down. So this was the second of their basic decision categories.

R: And the last one?

HE: That one was the real insight. Even before picking the best stocks and bonds, you have to decide how much to put in stocks and how much to put in bonds. This is sometimes referred to as the asset allocation decision. In the article, it was called the investment policy.

R: And those are the only kinds of decisions you make when you invest?

HE: If you can come up with a significant fourth decision, you may be in line for a Nobel Prize.

R: All right. So how do you decide—how did you put it—the importance of each of these decisions?

HE: The researchers decided to look at the decisions and at the performance data of many sophisticated managers over time. And did they ever! The final study used ten years’ worth of data from ninety-one big-time pension plans ranging in size from $700 million to $3 billion in assets. This represented a significant percentage of professionally managed pension money in the United States, managed by some of the nation’s top money managers.

R: Wait. Let me write that down. Okay, so did they find anything noteworthy?

HE: When they looked at their results the authors observed that the results are striking. Startling might have been an even more accurate adjective.

R: What was so startling?

HE: First, they found that two of the types of decisions were actually, in aggregate over the total sample, subtracting returns.

R: Wait a minute. Say that again.

HE: That’s what was so startling. They were looking at the performance generated by the brains and talent of many of the best and brightest of the nation’s portfolio managers to: first, pick the very best stocks and bonds for the portfolios they were managing, and second, to time their trading to try to be in when the markets were going up and out when the markets were going down. And guess what?

R: What?

HE: Looking at all those decisions and the effects of all those decisions, it turns out that on average they contributed negative performance. With all that brainpower and knowledge and experience, the returns were reduced.

R: But that doesn’t make any sense. What about that third category of decisions? The investment policy thing?

HE: Their most important conclusion was that more than 93 percent of the variation in portfolio returns was attributable to policy—meaning, to the mix of assets that they selected.

R: So if I get the mix of stocks and bonds and foreign stocks and all the other assets right, that’s way more important than trying to pick which stocks are going to outperform other ones?

HE: You’re catching on much faster than people in my profession did. It took years for the people in investment management to buy into this conclusion and realize what it meant. So I think you’ve gotten the core of what you need for the article. I’ll send you a copy of the Brinson-Hood-Beebower study and their follow-up study, which came to almost exactly the same conclusions.

R: Can you talk with me about this just a little longer? I feel as if I’m basking in the sunshine of your wisdom.

HE: Really? Well, you know, I guess I’m not quite as busy as I thought. But what else is there to say?

R: I just need to know how this relates to that biggest mistake thing you were talking about.

HE: Let me give you a hint. Do you know what your investment policy is?

R: Mine? Now that you mention it, no. I don’t think I have one.

HE: No investor can avoid having an investment policy. You have one now, but you have it by default.

R: That doesn’t sound good. So how do I find out what mine is?

HE: It’s not hard to figure out at all. In fact, let’s keep it as simple as possible. Take out a pad and make two columns. Write down how much you have in your money market funds, your bond funds, both in personal accounts, your IRA, and 401(k), and how much money you have in stock funds, again, in your personal account, IRA, and 401(k). For now, just make estimates, okay?

R: All right, I’m just writing down some numbers here. Let’s say I have $12,000 in a money market fund, $28,000 in a bond fund in a taxable account, and $15,000 in bond funds in my 401(k). Then there’s $30,000 in stock funds in a taxable account and $15,000 in stock funds in my IRA.

HE: Fine. Now we can translate that into percentages pretty easily, just by calculating the percent of the total. You have a total of 55 percent of your money in cash and bonds and 45 percent in stocks and growth investments. Therefore, the policy is 55 percent cash/bonds and 45 percent stock.

R: And that’s my big mistake?

HE: The biggest mistake is having an investment policy designed by accident. Think about it. Do you really want 90+ percent of your financial future determined by chance?

R: No. But does that breakdown really determine more than 90 percent of my future returns?

HE: Not necessarily; 90 percent might be overstating it, but most professional advisors would agree that not carefully deciding how to allocate your investments among cash, bonds, and stocks is a big mistake. If you can’t explain why your portfolio investment allocation looks like the one you have, it’s time for you to do some serious thinking about your investments and redesign your policy.

R: How do I know when I have an appropriate policy?

HE: You’ll know you’re done and you can explain just why your portfolio is divvied up as it is.

R: Perfect. I’m done.

HE: Done with what?

R: The article you just dictated to me. I have it pretty much written, and I didn’t even have to do any research. I’ll meet my deadline and I won’t even have to stay up late.

HE: Just—you know—for the sake of argument, when was your deadline?

R: Tomorrow morning. Why do you think I called a smart guy like you?

HE: I’ve been had, haven’t I?

R: Good-bye, Harold. I have a lot of work to do, so I don’t have a lot of time to chat. I’ll call you when I start working on our next issue.

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.

Net, Net, Net: Expenses, Taxes and Inflation Can Eat Your Nest Egg – What To Do?

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Harold Evensky CFP® , AIF® Chairman

As dangerous as it is to simply extrapolate past returns into future expectations, an even bigger mistake is planning a financial future based on nominal gross returns, forgetting about how large a bite expenses, taxes, and inflation will take from the bottom line. Ultimately, all you truly have to spend is net-net-net returns—the amount left over after those three bullies have taken their share.

Bob: Hello, Harold.

Harold Evensky: Bob, how are you doing? How was the cruise?

B: It was terrific—pure decadence. We’ve already planned the next one. I had lots of time on the cruise and I’ve been thinking about our last conversation. I’ve decided that what you said seems pretty obviously true.

HE: What is? I’m eager to hear it, because lately it seems like nothing is obvious about investing.

B: That when I make investment decisions, I should be looking to the future, not to what happened yesterday.

HE: That’s right, Bob. You’ve recognized one of the fundamental concepts of good investing. Planning your future through a rearview mirror is just as dangerous as using one to drive down a highway.

B: But now I have a problem. I like the idea of looking into the future, but I don’t have a crystal ball, so I’m wondering if you’ve reached any conclusions regarding what to do in a world with lower returns.

HE: As I mentioned, I was feeling a little queasy myself when I started looking over the horizon and concluded that future returns are likely to be lower than we’ve seen in the past. As promised, while you were being spoiled on your cruise, I spent quite a bit of time thinking hard about what to do. In fact, I treated the question as if it were an engineering project. Engineering was my formal education—long, long ago.

B: So your engineering training came with a crystal ball?

HE: I dearly wish it had. For the last couple of weeks, I’ve been crunching numbers and running simulations. I actually put my thoughts and analysis into a paper that will be published in a professional journal. The title is “Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation.” What do you think?

B: Very catchy. But I don’t want to read an academic paper, especially not one with that title. I want to know what I should do.

HE: You’re right. This isn’t an academic exercise. We’re talking about the quality of your life. But the answer actually isn’t that complicated. We start with the idea that the markets aren’t going to be handing out 12 percent-plus average yearly returns, even though this is what investors have come to expect from the stock market. I believe that future stock returns are likely to closer to 7½ percent and bonds about 3½ percent.

B: I’m with you so far, Harold. But be careful about throwing a lot of mathematics at me.

HE: So the question is: what will happen to your portfolio if you get lower returns in the future, right?

B: Right.

HE: Let’s suppose a hypothetical investor is a little more adventurous than you are. He has 60 percent of his retirement money in stocks and 40 percent in bonds.

B: And he probably skydives on the weekend.

HE: Then we look at all the expenses. We take off a percent for the expense of managing the portfolio and assume an average tax rate of 20 percent, because the money is being managed carefully, since lots of the gain would be long-term capital gains, often deferred for many years.

B: Are those actual costs?

HE: They’re actually lower than what a lot of people pay, but they’re about right for somebody like you and the way we do things.

B: So what does that tell you?

HE: A simple math calculation shows that this brave investor might expect returns, after taxes and expenses, of around 5.9 percent a year. That’s compared to more than twice that return for the prior five years.

B: Harold, those numbers are not as good as what I was hoping for when we talked about upping my stock exposure. You’re basically assuming less than half the returns we’ve been getting. But I guess that’s still better than zero returns or losing money.

HE: I agree. They’re not great, but not catastrophic either. I wish that were the only bad news. But planner that I am, I realized I’d left out one major factor—inflation.

B: Okay. So what difference does inflation make?

HE: My last step was to calculate how much an investor could really count on. For all of us, that’s what’s left after paying expenses, Uncle Sam, and covering inflation—what I call net-net-net.

B: You sound depressed.

HE: The result almost put me in the hospital. It was only 2.9 percent!

B: Hold on a minute. You assume that returns on stocks drop from 14 percent to 7½ percent, but what I get to keep from my portfolio goes down 70 percent? Are you sure you weren’t snoozing during the math classes when you studied engineering?

HE: No, I’m afraid my calculations aren’t the problem. The problem is that in a low-return environment, returns go down, but expenses don’t. So they start to represent a much bigger bite of total returns. An even bigger problem in a low-return environment is inflation. Although taxes are proportionate, inflation takes an even bigger bite, as it subsumes all returns, including the portion devoted to taxes and expenses.

B: So what do you do about that?

HE: You may not be able to control markets, but you can control taxes and expenses. So here’s what I think we have to do: use an institutional portfolio design strategy known as core and satellite.

B: What’s that? Investing in space travel?

HE: It just means you put most of your core stock investments into low-cost, tax-efficient index funds and ETFs that don’t try to beat the market, which gets you market returns but at a very low cost. Our target is 80 percent of your stock investments in core investments.

B: I didn’t know there were investments like that.

HE: There are quite a few. For example the iShare S&P 500 has an annual cost of less than one tenth of 1 percent compared to the average for a core, domestic, actively managed fund of 1½ percent plus. And because turnover is minimal, the fund is very tax efficient. In addition, ETFs, due to their design, may also provide additional tax benefits not available to mutual funds.

B: Are you trimming any other expenses?

HE: Since you’re not trying to beat the market with your core investments, you don’t have to do a lot of trading from one fund to another, which will keep transaction costs down as well as taxes. And if you believe that some active managers are capable of beating the market averages, which I do, you can concentrate all your active bets into the 20 percent of your stock investments allocated to a small number of actively managed funds. That’s the portion of the portfolio I call the satellite.

B: Is there a bottom line to this?

HE: That’s the really exciting part. I figure that by effectively managing taxes and investment expenses, you could save about ½ percent a year.

B: What?

HE: Check your e-mail; I just sent you a simple table showing how this all works out. It’s actually beautiful.

B: So let me get this straight: the goal is to reduce my taxes and expenses by 1/2 percent a year?

HE: Yes. Are you as excited as I am?

B: I don’t know how to tell you this, Harold, but that doesn’t sound like much to me.

HE: If portfolios were churning out 14 percent a year, it wouldn’t be much. But when we’re talking about 2.9 percent a year, net-net-net, saving 1/2 percent by managing taxes and expenses for your portfolio means a 17 percent increase.

B: But what if you’re wrong? What if the past twenty years are the way returns are going to be for the next twenty? [See Chapter 12, “Pascal’s Wager,” for help in answering this question.]

HE: That’s a reasonable question. But it’s important not to get caught up in probabilities, but to consider consequences as well. Based on today’s valuations, I think the probability of lower returns is on my side. But if I’m wrong—and there is always that chance—then my strategy may reduce overall returns by maybe a percent, which is not a catastrophe if returns actually turn out to be high.

B: So, Harold—

HE: However, if I’m correct and we don’t focus on managing taxes and expenses, your net-net-net return almost 20 percent lower. In retirement planning, that can make the difference between steak and cat food.

B: Harold—

HE: Basically, in this new environment, you need to chase tax and expense savings, not hot managers.

B: Harold?

HE: What.

B: Can we talk about my portfolio now?

HE: Of course. In fact, that’s what we are talking about.

B: I’m starting to think that stocks may be riskier than I thought. You don’t think there’s a chance they could go down in value, do you?

HE: You mean, like, ever?

B: Yes.

HE: One of the few guarantees I’m prepared to make is that they will certainly go down in value at some point in the future, and some of those drops are going to be dramatic and scary. If I’m right, we may see more of them in the future than we have in the past.

B: So I should keep my money in CDs, right? Or do you think I should be more conservative than that?

HE: We’ve talked about confusing certainty with safety (see Chapter 18), and your response is a good example of it. I need to rerun your retirement projections in light of these more realistic numbers. When I do, it’s possible I may conclude that with these lower return assumptions, you’ll need more money in stocks, not less.

B: I don’t follow you.

HE: With the returns you earned in the past, even that small allocation to stock was generating enough return to push your net worth up enough each year to keep you on track to meet your goals. But now you may need to take a little more market risk to get that same return.

B: I’m feeling queasy.

HE: Don’t worry. It happens to all of us. But I’ll be here to calm your nerves along the way.

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.

‘What a Great Company! I’ll Buy the Stock!’ How to Decide If You Really Should

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

If you’re managing your own portfolio, there are temptations that can lead you astray and cause you to veer away from the investment strategy you’ve settled on, and cost you a lot of money. For example: sooner or later you’re bound to hear a story about a company that’s headed for success—a great investment. The tip may come from a friend, a neighbor, an article you’ve read, or even a new acquaintance at a bar. And if you have some funds available, it’s awfully tempting to think about investing in your new find.

That’s the moment to step back—and beware. You might be falling into a classic investment trap. One of my clients—let’s call him David Samuel—came close to learning this the hard way.

David Samuel (DS): Hello, Harold. It’s David Samuel. I need your advice.

Harold Evensky (HE): Well, good morning, David. It’s been a while. How was your trip to Key West with the kids?

DS: Absolutely terrific! Actually, that’s the reason for the call. I did some wandering around while we were down there. The boys spent all their time on mopeds so I had to tool around on my own.

HE: Whoa! David, are you telling me you were on a moped?!

DS: What’s the matter, don’t you believe it? Ha! I was just like James Dean, I mean cool! Anyway, I met a fellow named Pin Stripe Tout Morgan at the Casa Marina bar. He’s a real player and he let me in on a great opportunity. I’m sure it’s a winner. I’m ready to buy it, but I want to know what you think.

HE: Is this the David Samuel asking me this? The one who sees an opportunity approximately twelve times a day? Well, so far, you haven’t exactly overwhelmed me with new information. You tell me why you should buy it.

DS: Harold, this stock is just so exciting I was sure you’d agree with me. Tout says Super Tech is a great buy (and remember, this is confidential, very confidential). The company produces a revolutionary computer! Our office just bought ten of their new units and our neighbor just ordered four for his office.

HE: Anything else?

DS: Sure, I’ve been watching the tech stocks and their share price has been going straight up. Besides, the whole world depends on technology.

HE: How much are you going to buy?

DS: Oh, I figure I’ll spend about $50,000 of my IRA funds on it.

HE: David, that’s all of your IRA.

DS: I know, but Harold, it’s Super Tech!

HE: The last time we talked, didn’t you say that you had just purchased a new computer? I remember you were excited about it.

DS: You know it! And I was right to be excited. It’s been a terrific machine, does everything but make coffee—and I figure that’s my fault ’cause I just don’t know how to program it.

HE: Well, that’s great. You were lucky to buy such a good toy.

DS: Lucky? Toy? Luck had nothing to do with it. I researched computers for weeks before I purchased that machine. Why, altogether, it cost almost $4,000! That’s no toy.

HE: Okay, okay, I’m impressed. How did you decide that was the right one?

DS: First, I went through all of the back issues of my computer magazines for the last year. I subscribe to three. Then I bought a few computer-rating books. That helped me narrow it down to four possibilities. I checked them out at a few stores. Oh, wait, I remember now. I also called around to see who was using what. I eliminated one because a few of my friends told me the service was lousy. Then I went to the stores. I liked the look and feel of all three, so I took all of the tech material home, created a big spreadsheet, narrowed it down to two, called the dealers back to bargain for the best price, and bought my winner.

HE: I’m impressed. I’ll bet you knew those machines inside out by the time you bought one.

DS: I think I could have built one.

HE: David, who’s the president of Super Tech?

DS: What’s that?

HE: Who’s the president of Super Tech?

DS: How would I know?

HE: How big a piece of the U.S. PC market does Super Tech have and how does that compare to the share it had last year?

DS: What are you talking about? I have no earthly idea.

HE: How about Super Tech’s price-to-book ratio or its price-to-earnings ratio? How do those figures compare to Lenovo’s or Sony’s?

DS: All I did was buy a home computer. What’s that got to do with all these questions?

HE: Nothing.

DS: Nothing? Then what are you rambling on about?

HE: The $50,000 you want to plunk down on Super Tech. You’ve just finished eloquently describing what an amazingly intelligent, diligent process you went through to buy your computer, which is clearly not a toy. You put all that time and energy and work into a purchase that cost you almost $4,000, and now you expect me to take you seriously when you say you want to invest $50,000 in a company when you don’t even know who the president is. Does that make any sense?

DS: Well, not if you put it that way; but I don’t need to know all that stuff. All I need to know is that it’s a good stock and the company’s going places.

HE: Okay, let’s talk about a good stock. Would you agree that a stock is good because it represents ownership in a good company?

DS: That makes sense.

HE: Is Super Tech a good company?

DS: Harold, that’s a silly question. You know it is.

HE: I wouldn’t argue with that. What’s it selling for now?

DS: Right at $37.

HE: So Super Tech’s a good company, you think it’s a company on the move, and you can buy a share for about $37, right?

DS: That’s right. And that’s why I said it’s a great stock and I want to buy it.

HE: David, suppose I told you that this morning’s Wall Street Journal had a big write-up on Super Tech and described it in such glowing terms that today it’s selling up $20 from yesterday, so it’s trading at $57. Still want to buy it?

DS: I don’t think I would. That’s pretty expensive.

HE: Hold on. I didn’t say Super Tech was in trouble. I said that the market experts agree with you and they think Super Tech’s terrific. Why wouldn’t you buy it?

DS: I told you. It would be too expensive at that price.

HE: Isn’t Super Tech still a good company?

DS: Sure.

HE: Do you see the catch yet?

DS: No.

HE: It’s simple. You fell into a classic Investor Trap. You’ve confused a good company with a good stock and a good price. When you raved about Super Tech and told me it was a great stock, you were talking about the company, not the stock. A company can be outstanding, but there is a price at which you just aren’t getting what you pay for. The experts would say the stock is overpriced.

DS: Okay—

HE: The point is that in picking stocks, you’ve got to know two things and know them better than almost anyone else. 1) You have to know all about the company and how well it’s likely to do in the future. 2) And you have to know what amount is a fair price to pay for a piece of that future. If you’re still the expert in medicine that I’ve known you to be, you haven’t had time to know that stock and its price better than anyone.

DS: That’s pretty depressing. If that’s true, how am I going to make money in the market?

HE: It’s not that complicated. You spend your time finding and hiring the people who do have the time and brains to do the research. Why don’t you come to our AAII 1 meeting next week? I’m going to be talking about the three Ps of selecting professional fund managers. My way won’t make you rich, but it won’t make you poor. If you want to get rich, do it by being a great doctor. The real market pros have little sympathy for novices. They just take their money.

DS: Okay, Harold. You’ve convinced me. I’m not buying. I’ll see you next week at the AAII meeting. But you’d better have something good to say, because I’ll still have that $50,000, and I want to put it to work for me.

HE: By the way, if you lost the money in your IRA, you can forget offsetting gains in your taxable accounts with the IRA loss. But if you make a killing with your IRA investment, that capital gain will eventually be taxed at the higher ordinary income rates. So whenever you see a real opportunity like Super Tech, let’s talk about making the investment with your taxable money.

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.