The Value of a Financial Planner

John_Salter2012

John R. Salter, CFP®, AIFA®, PhD Wealth Manager, Principal

Financial planning is the process of determining how you can meet your financial goals by managing your financial resources. Probably you have already thought about your own financial planning. Maybe you have thought about working, or already work, with a professional financial planner. Whatever your situation, we wanted to discuss the value of working with a financial planner.

Financial planners provide advice on how to achieve financial goals. The quality of the advice should be measured by whether you attain those goals. The value of financial planning lies in the development of a plan specific to your goals, but just as important is the guidance you get along the way.

Below are just a few ways financial planners provide value to clients.

Creating a Financial Plan

One well-documented fact about our lives is we are likely to spend more time planning a vacation than planning for our retirement. And why not? The vacation seems much more fun! However, the vacation is a one-time event, whereas issues related to your financial life have a lasting impact on your future (and your ability to take vacations, for that matter!) A financial plan maps out the steps you need to take in the areas of spending, saving, investing, managing risks, and handling bequests in order to attain your financial goals.

A financial planner provides the analysis and can outline the steps needed to meet your current and future financial goals.

Being a Sounding Board

Should you pay off your mortgage? Should you buy or lease your car? What about buying a rental property? Were you pitched an annuity at a free dinner? A financial planner can help you answer all these questions and more, either through an analysis and/or by providing the details you need to make an informed decision yourself. You can probably think back to times you have contemplated a decision, seemingly to no avail, when an objective opinion could have saved you time.

A financial planner is there to help.

Optimal Investing

Investing should be boring. We should focus not only on achieving returns, but also evaluate the risk we are willing to accept to reach those returns. This “risk” refers to how much your portfolio might drop in a short-term bear market, but also the risk that you might not be able to meet your future financial goals. Our investments should be diversified; we should not have all our eggs in one basket. The best portfolio should arise out of the overlap between your risk tolerance, your financial capacity to take risk, and the risk and return needed to meet your future goals.

A financial planner helps determine your optimal portfolio.

Staying Disciplined

Long term, we are likely to be our own worst enemy in terms of keeping our financial plan on track, both in terms of performing the financial planning tasks we need to undertake and sticking with the investment plan. One notable example is estate planning, which seems to be the last item on everyone’s to-do list. Sometimes we need simple “nudges” to make sure these tasks are completed. Financial planners also help stay on track with our investments. When the market’s down, you want to adjust and make it more conservative, and then get back in when it is up. This is the easiest way to lose money long term. Ongoing management includes rebalancing or bringing the investment mix back to target. In general, this is selling the winners and buying more of what hasn’t done as well recently, and of course assumes long-term investment values will rise. Does short-term market volatility get you worried? Why not have your financial planner help you stay disciplined through the ups and downs of the market cycle, which are inevitable, simply by reaching out to you during rough markets?

A financial planner helps you stay disciplined through the financial planning process.

Managing Behavior

We are human, and therefore we are hard-wired to make terrible financial decisions. We want to be in the market when things are going well, and out when things look bad. We should do the opposite. We focus too much on the short term; we want to make decisions based on short-term noise rather than long-term analysis. We want to be in the winners and out of the losers, whereas being spread across winners and losers (being diversified) is the best long-term strategy. We want our investments to be exciting and sexy, but they should be dull and boring. We want to chase the investments that did well in the too-recent past, but they are likely those that will falter in the short-term future. We make decisions based on simple rules of thumb because we cannot perform complex math in our head. Our behavior, based on the emotions tied to our money, prevents us from reaching our future financial goals.

A financial planner helps manage your behavior and separate emotion from your money.

Tax and Cost Efficiency

In a world of lower return expectations, and given that we cannot control the markets, the ability to control and take into consideration tax and cost efficiency becomes even more important. Many financial planners have access to the universe of financial products. This means they also have access to the range of costs of products and may be able to implement a plan more cost effectively compared to a retail solution. If a financial planner can access a mutual fund for 0.5% less, that is 0.5% more staying in your portfolio. Tax savings produce similar benefits. A financial planner can not only make long-term tax-efficient recommendations but can also strategically position your individual investments in certain accounts to minimize current taxable income. A solution which decreases the tax you pay also results in more money accumulated or available.

Keep on Track

A financial plan is important to meeting goals, and maintaining and monitoring the plan are the check-ups required for progress. Annual meetings with your financial planner provide the opportunity to review your goals and see progress toward meeting them. Of course, we all know life can change at any moment, so updating and monitoring financial plans takes account of the ebbs and flows of life.

So, what is the quantifiable value of a financial planner? Many studies have addressed this question. These examples include many of the topics above, such as the financial planning process, portfolio construction and investment selection, rebalancing, and tax efficiency. The answer? Studies have concluded the value of a financial planner and the financial planning process can add an upwards of 3% in returns per year.

Below are links to a few of these studies.

https://www.fidelity.com/viewpoints/investing-ideas/financial-advisor-cost

http://www.envestnet.com/sites/default/files/documents/ENV-WP-CS-0516-FullVersion.pdf

https://www.vanguard.com/pdf/ISGQVAA.pdf

https://corporate1.morningstar.com/uploadedFiles/US/AlphaBetaandNowGamma.pdf

No matter how you might value a financial planner, the true value comes from the benefits listed above and from following and keeping on track with the financial planning process. Value goes beyond simple products or investment choices and returns. A financial planner is your partner in meeting your future financial goals.

Feel free to contact John Salter with any questions by phone 1.806.747.7995 or email: JSalter@EK-FF.com

For more information on financial planning visit our website at www.EK-FF.com.

NewsLetter Vol. 11, No. 3 – June 2018

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

Dear Reader:

 

DEPRESSING IF TRUE

“Medicare to go broke three years earlier than expected, trustees say.

Medicare’s hospital trust fund is expected to run out of money in 2026, three years earlier than previously projected, the program’s trustees said in a new report published this afternoon.

“The more pessimistic outlook is largely due to reduce revenues from payroll and Social Security taxes, and higher payments than expected to hospitals and private Medicare plans last year.

“The solvency report is the first since the repeal of Obamacare’s Independent Payment Advisory Board earlier this year as part of a massive spending agreement in Congress. The panel outside experts was designed to tame excessive Medicare spending growth, but costs never grew fast enough to trigger the controversial board, and no members were ever appointed. Social Security faces depletion in 2034, the program’s trustees also said today. That’s identical to last year’s projection.”

https://www.politico.com/story/2018/06/05/medicare-outlook-2026-625908

 

GOOD NEWS? BAD NEWS?

From my friend and long-term care guru, Bill Dyess.

I don’t know if it’s good news that someone needed LTC this long, but it was certainly good news that their insurance covered them. Here are the largest claims as of 12/31/2017 (and they’re still being paid!)

Male Female
Paid to date $1,592,000 $2,600,000
Years claim has been paid 9 years, 10 months 13 years, 9 months
Initial premium/year $4,474/year $2,600/year
Years paid until claim began 6 years, 6 months 13 years, 9 months

 

PITHY THOUGHT

For market timers….

Think about the few times when there was lots of certainty—2000 or 2009. How did that work out?

 

TEST RESULTS

From my last NewsLetter …

A TEST

John Durand wrote Timing: When to Buy and Sell in Today’s Markets, a classic in active investment management. He also wrote How to Secure Continuous Security Profits in Modern Markets, in which he opined: “As this is written, one of the greatest bull markets in history is in progress. People have been saying for several years that prices and brokers’ loans are too high; yet they go on increasing.… People who deplore the high at which gilt-edged common stocks are now selling apparently fail to grasp the fundamental distinction between investments yielding a fixed income and investments in the equities of growing companies. Nothing short of an industrial depression … can prevent common stock equities in well-managed and favorable circumstanced companies from increasing in value, and hence in market price.” When was his book published?

No winners, but here are ones that came mighty close:

Alan Rosoff ……………… 1928

Richard Lorenz………….  1930

Jewell Davis ………….…  1925

The publication date was September 1929.

The Great Depression started October 29,1929.

TIDBITS FROM AARP

  • Only about 37% of couples share financial decision-making equality. For shame!
  • The average parent thinks allowances should begin at age 10.
  • Approximately 29% of women in dual-income marriages make more money than their spouses; that’s up from 16% in 1981.
  • The “average” family in the top 10% of wealth in the United States receives an inheritance of about $367,000, while families at the median level of wealth report an average of about $16,000.
  • The average payout from the tooth fairy in 2017 was $4.13; in the West, it was $6.
  • About 53% of grandparents contribute to their grandkids’ education, and 23% contribute to health and dental bills.

 

FOREWARNED IS FOREARMED

When markets take a dip, it’s not the end of the world (and if it is, who cares about markets?).

06-2018_Market Downturn

Even better, from our perspective, is that corrections are great buying opportunities.

 

GOOD NEWS, BAD NEWS

While the Federal Reserve’s “Report on the Economic Well-Being of U.S. Households in 2017” stated that “overall economic well-being has improved over the past five years,” that optimistic headline masks a lot of sad news.

“Economic Well-Being. A large majority of individuals report that financially they are doing okay or living comfortably, and overall economic well-being has improved over the past five years.

“Even so, notable differences remain across various subpopulations, including those of race, ethnicity, and educational attainment.”

Furthermore:

“Dealing with Unexpected Expenses. While self-reported financial preparedness has improved substantially over the past five years, a sizeable share of adults nonetheless say that they would struggle with a modest unexpected expense.

“• Four in 10 adults, if faced with an unexpected expense of $400, would either not be able to cover it or would cover it by selling something or borrowing money. This is an improvement from half of adults in 2013 being ill-prepared for such an expense.

“• Over one-fifth of adults are not able to pay all of their current month’s bills in full.

“• Over one-fourth of adults skipped necessary medical care in 2017 due to being unable to afford the cost.”

https://www.federalreserve.gov/publications/files/2017-report-economic-well-being-us-households-201805.pdf

 

PHEW!

Good thing I went to college a zillion years ago. Here are the statistics for Cornell’s Class of 2022:

Applicants     –           51,000+ (a record high)

Admit rate      –           10.3%    (an all-time low)

Admitted        –           5,288

 

SAD BUT TRUE

Cyberattacks are a reality of life today, and we take the risk very seriously.

2.9% of advisors have faced successful attacks on their firm (not us).

44% of firms with more than one employee require mandatory cybersecurity training (we do).

81% of advisors believe addressing cybersecurity is high or very high on their priority list (we believe it’s very high).

 

IF YOU HAVEN’T SEEN THIS

New York Times

“Hoping to thwart a sophisticated malware system linked to Russia that has infected hundreds of thousands of internet routers, the F.B.I. has made an urgent request to anybody with one of the devices: Turn it off, and then turn it back on.

“The malware is capable of blocking web traffic, collecting information that passes through home and office routers, and disabling the devices entirely, the bureau announced on Friday.”

https://www.ic3.gov/media/2018/180525.aspx

 

TULIPS

As I wrote in my last NewsLetter:

Here’s what Crypto pioneer Mike Novogratz said on Monday on CNBC’s “Fast Money” (12/11/17).

“This is going to be the biggest bubble of our lifetimes.” Which, of course, does not stop him from investing hundreds of millions in the space. While conceding that cryptos are the biggest bubble ever … “Bitcoin could be at $40,000 at the end of 2018. It easily could.” Then, of course, it may not.

Turns out, so far, it’s “not.”

06-2018_Bitcoin USD Price

 

GOOD ADVICE

Also from AARP, an excellent article (as always) by Jean Chatzky: “Planning for the Worst.” Why disability insurance may be a must-have for you and this article is must-have reading for my younger readers.

https://www.aarp.org/work/working-at-50-plus/info-2018/disability-insurance-chatzky.html

 

DISMAL

“Dismal Outlook for Millennials” was the headline in a planadviser article. Why?

67% 66% 47%
Feel they will outlive their savings Have no retirement savings Think they will be unable to retire when they would like to

And, to my amazement,

Only 34% Only 21%
Participate in a retirement plan Are worried about their retirement security

 

THE ANSWER IS “BECOME A CEO”

“Income inequality in the United States has increased significantly since the 1970s, after several decades of stability….”

Wikipedia

The New York Times ran an interesting, albeit depressing, story highlighting this issue:

“Want to Make Money Like a CEO? Work 275 years.

“This year, publicly traded corporations in the United States had to begin revealing their pay ratios—comparisons between the pay of their chief executive and the median compensation of other employees at the company. The results were predictably striking.”

Examples included:

CEO Median Employee Years to Earn
Walmart $22.2 million $19,177 More than 1,000
Live Nation $70.6 million $24,406 2,893
Time Warner $49 million $75,217 651

 

https://www.nytimes.com/2018/05/25/business/highest-paid-ceos-2017.html?emc=edit_nn_20180525&auth=login-email

 

 WHY WE NEED A FIDUCIARY STANDARD

From the Wall Street Journal:

https://www.wsj.com/articles/wells-fargos-401-k-practices-probed-by-labor-department-1524757138

“Wells Fargo’s 401(k) Practices Probed by Labor Department
“Department is examining if bank pushed participants in low-cost 401(k) plans into more expensive IRAs

“The Labor Department is examining whether Wells Fargo & Co. has been pushing participants in low-cost corporate 401(k) plans to roll their holdings into more expensive individual retirement accounts at the bank, according to a person familiar with the inquiry.

“Labor Department investigators also are interested in whether Wells Fargo’s retirement-plan services unit pressed account holders to buy in-house funds, generating more revenue to the bank, the person said.”

It’s important to note that at this stage, it’s just a “probe,” but it’s no secret that these actions are common throughout the financial services world. If you’re responsible for a 401(k) plan, be sure your advisor is a 3(38), not a 3(21), fiduciary.

From the National Institute of Pension Administrators: “A 3(21) investment fiduciary is a paid professional who provides investment recommendations to the plan sponsor/trustee. The plan sponsor/trustee retains ultimate decision-making authority for the investments and may accept or reject the recommendations. Both share the fiduciary responsibility. By properly appointing a monitoring an authorized 3(38) investment manager, a plan sponsor/trustee is relieved of all fiduciary responsibility for the investment decisions made by the investment professional.”

 

WE HAVE A LONG WAY TO GO

“The Securities and Exchange Commission’s enforcement strategy to protect retail investors resulted in the return of a record $1.07 billion to harmed investors in 2017, SEC officials said Tuesday.”

Financial Advisor.

 

“JPMORGAN TO REMOVE SOME FIDUCIARY RULE HANDCUFFS, OTHERS MAY FOLLOW”

“JPMorgan Chase & Co. is telling its brokers and private bankers to prepare for changes to its retirement account policies and products in preparation for the likely repeal of the Department of Labor’s fiduciary rule next week.

“The message, sent in emails from bank executives to advisors at J.P. Morgan Securities, Chase Wealth Management and Chase Private Bank on Wednesday, signals that Wall Street firms are poised to move quickly to reverse restrictions that they imposed to comply with the conflict-of-interest rule that took partial effect last June.”

 

ONE MORE TIME

As I continue to beat the fiduciary drum continually, what can I say? It’s REALLY important. So, below is an excerpt from an interview with Phyllis Borzi in my friend Christopher Carosa’s FiduciaryNews.

FN: Now to the present. It looks like the Conflict-of-Interest Rule has not survived its court challenge and that the current administration seeks to, in essence, rewrite it. Still, the impact of the Rule remains. The term “fiduciary” – in part thanks to your efforts, in part thanks to John Oliver – has been elevated in the minds of the investing public. What aspects of the Conflict-of-Interest Rule are now “baked into the cake” of the retirement industry and would be hard to reverse, formal regulation or not?

Borzi: It’s probably too early to tell. But one of the lasting legacies of the DOL conflict-of-interest rules is in the greater public understanding of the need to seek an advisor who is willing to agree in writing to be a fiduciary. Unfortunately, most consumers are not yet at the point where they can tell for sure whether someone who assures them they are acting in their best interest (and thus using that term as a marketing slogan) is genuinely accepting legal liability as a fiduciary. That’s why consumers must get that acknowledgement of fiduciary status in writing and not simply accept the representations of individuals purporting to be acting in their interest.”

That’s why getting the Committee for the Fiduciary Standard’s oath (http://www.thefiduciarystandard.org/wp-content/uploads/2015/02/fiduciaryoath_individual.pdf) signed by your advisor is so important.

You can read the full transcript of the FiduciaryNews interview here:

http://fiduciarynews.com/2018/05/exclusive-interview-phyllis-borzi-says-original-fiduciary-5-part-test-left-plan-sponsors-holding-the-bag/?utm_source=BenefitsPro&utm_medium=IsthePerfectFiduciaryRuleEvenPossible&utm_campaign=051718z&ct=t(EMAIL_CAMPAIGN_5_15_2018)

 

ROBO PLANNING

The hot story in the planning world is Robo-Advisors: i.e., planning based on computer algorithms. I just heard a quote from an MIT AgeLab presentation that captures my thoughts:

“My life is not an algorithm; my life is a story.”

 

PRINCIPLES

Of course, when discussing fiduciary concepts, it’s important to consider principles, so I thought I’d share the story of “A Man of Principles” from my friend Phil.

“In 1952, Armon M. Sweat, Jr., a member of the Texas House of
Representatives, was asked about his position on whiskey. What follows
is his exact answer (taken from the Political Archives of Texas):

“‘If you mean whiskey, the devil’s brew, the poison scourge, the bloody
monster that defiles innocence, dethrones reason, destroys the home,
creates misery and poverty, yea, literally takes the bread from the
mouths of little children; if you mean that evil drink that topples
Christian men and women from the pinnacles of righteous and gracious
living into the bottomless pit of degradation, shame, despair,
helplessness, and hopelessness, then, my friend, I am opposed to it
with every fiber of my being.’

“‘However, if by whiskey you mean the lubricant of conversation, the
philosophic juice, the elixir of life, the liquid that is consumed
when good fellows get together, that puts a song in their hearts and
the warm glow of contentment in their eyes; if you mean Christmas
cheer, the stimulating sip that puts a little spring in the step of an
elderly gentleman on a frosty morning; if you mean that drink that
enables man to magnify his joy, and to forget life’s great tragedies
and heartbreaks and sorrow; if you mean that drink the sale of which
pours into Texas treasuries untold millions of dollars each year, that
provides tender care for our little crippled children, our blind, our
deaf, our dumb, our pitifully aged and infirm, to build the finest
highways, hospitals, universities, and community colleges in this
nation, then my friend, I am absolutely, unequivocally in favor of it.’

“‘This is my position, and as always, I refuse to compromise on matters
of principle.’”

 

DELAY MAY BE GOOD

If you’ve not yet planned your retirement, the two major contributors to increasing the probability of financial success are delaying retirement and social security. If you have questions, check with us. That’s our forte.

06-2018_How Americans Claim.png

Source: Wealthmanagement.com

 

A GOOD START

https://www.bloomberg.com/news/articles/2018-05-24/carney-and-dudley-urge-banks-to-prepare-for-move-away-from-libor  

“10 Universities with the most billionaire alumni”—a useless but interesting tidbit. Here’s the list:

SCHOOL                               # of Billionaire Alumni

University of Michigan                         26

University of Chicago                           29

University of Southern California       29

Yale                                                         31

Cornell                                                    35

MIT                                                           38

Columbia                                                53

University of Pennsylvania                 64

Stanford                                                  74

Harvard                                                188

 

 

OVERCONFIDENCE

“The overconfidence effect is a well-established biased in which a person’s subjective confidence in his or her judgments is reliably greater than the objective accuracy of those judgments, especially when confidence is relatively high.” ~Wikipedia

Overconfidence (e.g., Lake Woebegone, where all the children are above average) is a classic behavioral heuristic and one that often leads to poor investment decisions.

“There’s a Big U.S. Gender Gap in Retirement Investing Confidence Wealth Management

“Sixty percent of college-educated, not-yet-retired men say they’re comfortable managing their investments, compared to 35 percent of women.”

It’s that recognition of reality that makes women generally better investors then men.

 

OLD MEN

Given my current age, I kind of liked this:

One evening the old farmer decided to go down to the pond, as he hadn’t been there for a while.
He grabbed a twenty-liter bucket to bring back some fruit while he was there.

As he neared the pond, he heard voices shouting and laughing with glee. As he came closer, he saw it was a bunch of young women skinny-dipping in his pond. He made the women aware of his presence and they all went to the deep end. One of the women shouted to him, ‘We’re not coming out until you leave!’

The old man frowned, ‘I didn’t come down here to watch you ladies swim naked or make you get out of the pond naked.’

Holding the bucket up he said, ‘I’m here to feed the crocodile….’

Some old men can still think fast.

 

Hope you enjoyed this issue, and I look forward to “seeing you” again in a few months.

 

_HRE SIGNATURE

Harold Evensky

Chairman

Evensky & Katz / Foldes Financial Wealth Management

 

Check out the link below for Harold’s previous NewsLetter:

NewsLetter Vol. 11, No. 2 – April 2018

 

 

Buyer Beware: What Do You Get From Your Advisor?

Brett Horowitz

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

Although I have never been to Thailand, I have read that you cannot go more than a few feet in a typical town market without someone yelling “same same.” It is the vendor’s way of telling you that what they offer is the same as everyone else, thus encouraging you to end yourcomparison shopping and buy from them.

Recently I spoke with a gentleman considering whether to become a client of our wealth management firm, and he asked matter-of-factly how we are different than all the other hundreds of investment firms in the area. It seems that most of the public thinks of all financial firms as “same same,” yet they differ widely. Here are a few of the things that may distinguish one financial advisory firm from the next.

You Don’t Know What You Don’t Know

I cannot tell you the number of prospective clients who sit down to meet with us and have no idea how to answer the following three major questions.

  1. What return do you need in order to meet your personal goals?

If your portfolio is making 20% per year but it is loaded with risky assets that are keeping you up at night and you only need to earn 5% per year to live your current lifestyle, what is the point of taking the extra risk? Is your plan to make as much money as possible or to have the ideal lifestyle with the least amount of risk? If your goals change, shouldn’t the asset allocation (and desired return) be altered as well?

  1. Is your portfolio performing suitably to help you meet your goals?

If you are not receiving performance reports every so often, how do you know if the current advisor is doing a good job in helping you meet your goals? What does this performance tell you about the likelihood that you will meet your goals? Do you have a plan in place for tracking your goals?

  1. How does your current advisor get paid, and what is the total cost of your relationship?

If you cannot determine how much your advisor is being paid, isn’t it vital that you ask, to make sure the fees are reasonable? The US Department of Labor 401(k) fee website (http://www.dol.gov/ebsa/publications/401k_employee.html) compared two investors who started at age 35 with a 401(k) balance of $25,000 and never contributed again. Both investors earned 7% per year before fees, but one paid a 0.5% annual fee and one paid a 1.5% annual fee for the investments. The ending value after 35 years would have been $227,000 for the investor who paid a 0.5% annual fee versus $163,000 for the investor who paid a 1.50% annual fee. The 1 percentage point difference in fees reduced the account balance at retirement by 28%! An advisor cannot control the market, but they do have some control over taxes and expenses.

Out of Sight, Out of Mind

We recognize that you have a lot going on and you do not always get around to completing your tasks. Perhaps you bought a life insurance policy years ago and have never revisited that decision to determine whether it still makes sense. Perhaps you never made a change to your estate documents or IRA beneficiaries after a marriage or divorce. Or perhaps you have not revisited your 401(k) allocation since the first time you made the initial selection.

Is this something that your advisor addresses? Does your advisor even know or want to know about your social security benefits, life insurance, or estate documents? Or have you simply been reduced, in your advisor’s eyes, to “a number?”

There are also certain age milestones that should prompt you to confer with your financial expert to ensure that decisions are made responsibly, such as:

  1. A few months before age 62, we suggest you sit down and go through a social security analysis to determine the optimal age for beginning to collect benefits.
  2. A few months before age 65, we recommend you research and apply for Medicare (as delaying will likely lead to penalties, based on the current Medicare rules).
  3. At age 70½ (or earlier for inherited IRAs) and each year thereafter, you need to decide the best approach in taking Required Minimum Distributions from your IRA.

Tax Brackets

Knowing your tax bracket and working with your accountant can help you achieve the highest after-tax return on your bonds.

Tax Sheltering

Placing certain assets to take advantage of IRAs, where you do not pay taxes on income and gains, can help boost your overall return.

Capital Gain Distributions and Tax Losses

If you are not watching out for mutual fund capital gain distributions at the end of the year, you are likely to get hit with a large tax bill. In addition, one of the ways to lower your tax bill is to take advantage of losses in your account once they take place.

Rebalancing

It is important to keep your asset allocation consistent with your goals by rebalancing between stocks and bonds. This may also lead to higher risk-adjusted portfolio returns over time.

The Devil Is in the Details

At the end of the day, it will benefit you to find a firm that puts a lot of time, effort, and thought into these details. The plan that is put in place on Day 1 should not be “buy and hold” (often described as “set it and forget it”), but rather “buy and manage,” with changes based on research, long-term projections, and unique circumstances. I can assure you that all financial firms are not “same same.” It is incumbent upon you as the buyer to ask the right questions before choosing the firm that’s best for you.

 

Feel free to contact Brett Horowitz with any questions by phone 305.448.8882 ext. 216 or email: BHorowitz@EK-FF.com

For more information on financial planning visit our website at www.EK-FF.com.

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

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

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

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

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

Built-In Bias

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

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

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

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

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

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

HHTHTTHTTH

TTTTTTTTTTT

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

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

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

Muddled Math

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

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

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

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

Framing

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

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

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

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

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

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

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

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

Life Timing: What Did Lynn Hopewell Teach Us?

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

You’re not average, so don’t plan the quality of the rest of your life based on averages.

I was sitting front row center in a big conference room at our national planning symposium; I’d been looking forward to this talk for a while. The speaker, financial planner Lynn Hopewell, was a good friend and one of the most thoughtful practitioners I knew. My partner, Deena, and I had been responsible for planning this program and we invited Hopewell to speak because he told us he had a few major concepts he wanted to share with his peers. Here’s what he shared that day:

And End Not So Near

Welcome, everyone. I have few stories to tell that I hope will be a wake-up call for the financial planning profession. The first is about my planning for an engineering client, Ms. Jane. She is sixty-three, a very successful and accomplished civil engineer, and president of a major structural engineering firm. She hired me to work with her in developing a comprehensive retirement plan. Well, since I too am an old engineer, I know how they think—detail, detail! So I worked very hard to provide Ms. Jane a plan that would resonate with her. Finally, I was sitting down with her, ready to blow her socks off, and after going through my complete analysis, I thought I had.

“Mr. Hopewell,” she said, “I’m very impressed with the thoroughness and depth of your plan. I have only one small question.”

Well, needless to say, I was beaming at the compliment and looked forward to answering her “one small question.”

She went on, “I understand that selecting a mortality age—the age the plan assumes I die and will no longer need income—is a critical element in the planning process.

“Obviously,” I said, “if we arbitrarily use a very old age, such as one hundred, we’re likely to have to tell you to reduce your spending so that your nest egg will last to that age. Of course, if you die before one hundred, you’ll be leaving a lot of money on the table that you could have enjoyed spending while you were alive. If we assume a much younger age and you’re long-lived, the consequences could be even worse because you’d run out of money before you ran out of time. As a consequence, we work hard to select a reasonable planning age.”

“That makes sense to me,” she said, “and I understand that the age you selected for the plan is based on the projected age of my death from a national mortality table.”

“Correct! And not just any mortality table. We spent quite a bit of time consulting with actuaries to determine which table reflected the most current actuarial data.”

“I understood that. What I’m still a little confused about is the meaning of that age. As I understand it, if the table says my mortality age is eighty-eight, that means half the people will have died by eighty-eight and half will still be alive.”

“Correct.”

“Well, doesn’t that mean if I plan to age eighty-eight, I’ll have a 50 percent chance of outliving my plan?”

That question hit me like a Mack truck. Ms. Jane was correct. Even worse, in thinking about it, I realized that anyone with the resources to need the advice of a financial planner was likely to have had better health care and nutrition than the average of the universe of individuals making up the mortality table. That means Ms. Jane had better than a 50 percent chance of outliving my plan. This was a major wake-up call for me and should be for any practitioner relying on a traditional mortality table. Lynn said, “After acknowledging Ms. Jane’s point and scheduling a follow-up visit to give me time to consider the ramifications of her simple question, I hunkered down in my office to consider how I might resolve this problem.”

So, I went back to my own office and did the same. After additional conversations with my actuary friends, I concluded that a reasonable solution would be to use more customized actuarial tables—those that allowed me to factor in whether the client is a smoker, nonsmoker, her current health, and whether the lifespan of her immediate family is long, average, or short. Then, using the appropriate customized table, we would select an age that represented only a 30 percent chance of her outliving the age indicated in the table.

Here’s an example that shows how big a range the mortality age can be depending on these factors:

Life Timing Chapter Image file - mortality age range

Obviously, there is no guarantee that the age selected will coincide with the client’s mortality; however, following this process is likely to provide a much more realistic estimate.

Well, Lynn was right. That was a major wake-up call, because I’d been using a standard actuarial table and mortality age for my planning assumption. That was about to change.

Even if Lynn had stopped there, this information would have justified all of the time and cost of attending the three-day symposium, but there was more. Lynn’s next story was about the ah-ha moment he had one day when developing a college funding recommendation.

College Calculations

Not long ago I was preparing a simple college funding recommendation for a client. You know how that goes. It’s a simple time-value calculation that requires input on how many years until college, how many years of college the client wants to pay for, the annual cost, and the college tuition inflation rate. My input looks something like this:

Life Timing Chapter Image file - college calculations

A financial calculation would result in a recommendation that the client set aside about $145,000 to fund this expense. When I presented this to the client, he asked how confident I was about my number. When I thought about his question, I realized the answer was not very. My estimate was what we refer to as a “point estimate.” This means that unless every assumption I made was exactly right, my recommendation would either over- or underfund the college tuition bill.

As a former engineer, I remembered that when trying to estimate the probability of uncertain events, we used a technique known as a “Monte Carlo simulation.” Developed at Los Alamos National Laboratory during the Second World War for the design of nuclear weapons, Monte Carlo is really a simple concept. Rather than making a single guess regarding a possible outcome, we make guesses about the likely ranges of the outcomes. We then simulate thousands of possible futures with different combinations of those possible outcomes.

Let’s expand the table I showed a minute ago to more realistically reflect the uncertainty in our estimates.

What we know with some certainty:

  • Years to college 4
  • What we’re making an educated guess about
  • Tuition somewhere between
  • Annual cost $30,000 to $50,000
  • College costs inflation 5 to 7 percent
  • Investment return 6 to 10 percent

With these ranges, there are many thousands of possible outcomes, for example:

Life Timing Chapter Image file - college calculations no. 2

The Monte Carlo simulation calculates for each of these examples how much money that investors would need to set aside today if they want to fully fund four years of education. If the analysis ran a thousand examples, the results, listed in order of decreasing savings, might look something like this:

Life Timing Chapter Image file - college calculations no. 3

In this case, the question was how much should you put away now if you want an 80 percent probability of meeting your goal? The answer would be $167,000, because 80 percent (800/1,000) of the simulations would have succeeded with that amount of savings or less.

Well, this was another major wake-up call for me. In hindsight, it seemed obvious that a point estimate was inappropriate and that a Monte Carlo simulation could provide a more meaningful answer. In wrapping up his discussion, Lynn reminded us that expanding the input matrix meant making more guesses. Despite the mathematical rigor of a Monte Carlo simulation, adding more guesses does not justify adding two more decimal places to the answer. His point was that we should use Monte Carlo as an educational tool and not suggest it is a mathematically accurate answer.

The Takeaways

When planning retirement, don’t assume average mortality—you’re not average.

When attempting to quantify an uncertain future, don’t default to a single estimate. Use a Monte Carlo simulation to develop an understanding of the likelihood of possible outcomes, but don’t take the results as gospel.

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

HRE PR Pic 2013

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.

The Three Ps of Investing: Philosophy, Process and People

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

In Real Estate, it’s location, location, location. In investing, it’s philosophy, process, and people. Most investors look at past performance when evaluating a manager. That’s a rearview mirror approach. If you’re driving forward, keeping your eyes on the rearview mirror is dangerous. Looking backward is equally dangerous for investors. You can’t buy past performance, so don’t invest based just on looking backward. To avoid that mistake, here’s a simple process that works for any investment manager you might hire—mutual funds, separate accounts, or alternatives.

Philosophy

When you are evaluating money managers, find out what their  investment philosophy is. What is their unique view of the investment world? How is it different from those of their competitors? Is it credible that a manager can overcome the drag of expenses and taxes and provide risk-adjusted returns better than other alternatives? Basically, you’re looking for a good and credible story. How might you find it? Read the manager’s letters, prospectus and marketing material; look for something more than “we buy low and sell high.”

Process

A good story is nice, but how does the manager make it work in the real world? Answers to this question may be harder to pin down, but remember, it’s your hard-earned money at risk.

People

Philosophy and process are essential, but ultimately it’s people who make the difference. People will be making investment decisions about your money.

Don Phillips is a managing director and board member of Morningstar. He is a good friend of mine and one of the most-respected professionals in finance. He has some simple advice regarding people: “You want people with passion for the job of money manager.”

Did the managers you are considering invent the firm’s philosophy and process or have they at least been around long enough to have developed a passion for it? If not, even if the investment passes the test of the first two Ps, move on to your next investment alternative.

Testing the Ps

In this conversation with a gentleman I will call Happy Promoter, I put the three Ps to the test.

Happy Promoter (HP): Good morning, Mr. Evensky. My name is Happy Promoter. I’m familiar with your firm and I appreciate your taking the time to see me this morning.

Harold Evensky (HE): Mr. Promoter, it’s my pleasure. I understand you represent Sophisticated Hedge Fund Strategies and you have a new offering available. My friend Mr. Jones suggested I meet with you; I’m always interested in learning about new potential investments for our clients. Please tell me about your program.

HP: It’s a very sophisticated long-short strategy based on an evaluation of a myriad of market dynamics that guide our trading algorithms to ensure that we provide consistent alpha in all markets. Because we can profit in both rising and falling markets, we can mitigate downside risk, and by the judicious use of margin, we can provide returns that significantly exceed the S&P 500. We’ve backtested our strategy for the last ten years and the results substantiate the success of our strategy.

Well, at this point, I’m thinking I need to know a lot more before I take Mr. Promoter’s pitch seriously. Backtesting is a common but questionable way of evaluating a new investment strategy. It mathematically simulates how the strategy would have fared if it had existed in the past. One obvious problem is that unless the strategy is 100 percent automatic—no active decisions or modifications are made by the manager along the way—there is no way of knowing if the simulation is a fair representation of how the strategy will be implemented in the future. An even bigger problem is that there’s no reason to believe that future markets will mirror the historical environment used for the backtesting. Bottom line: because it theoretically would have worked in the past is no reason to believe it will succeed in the future. The financial world is full of failed investment strategies that had wonderful backtest results.

So, I decide I need to take Mr. Promoter through the process I call the “three Ps.”

HE: Mr. Promoter, what you’ve said sounds good, but I need more meat to the story. Can you tell me what your basic investment philosophy is? What do you see in the financial markets that the thousands of other professional investment managers don’t? After all, the market is a zero-sum game. For everyone who makes a buck, there has to be someone else losing one.

HP: Harold—may I call you Harold?

HE: Certainly.

HP: We believe that our sophisticated algorithms will provide the edge.

HE: I understand that, but can you be more specific?

HP: No, I’m afraid that our process is quite confidential and proprietary.

HE: Well then, can you at least give me some details about the procedures you use to implement your sophisticated process?

HP: Good lord, no! Our system is a black box and all the details are carefully guarded secrets. It’s the “secret sauce” that enables us to provide the low-volatility, high returns your clients are seeking.

HE: I see. Then I guess I’d have to look to the experience and quality of the intellectual capital behind your strategy. Will you tell me who developed your sophisticated strategy and what experience they have in implementing it?

HP: Harold, I’m the lead creator of the strategy and I’m supported by a two-man team of MBAs. My educational background is a master’s in History; however, I’ve been fascinated by the market for decades and I spent the last few years studying market movements. I finished developing my strategy just last month. I know that as a sophisticated practitioner you’re aware that alternative managers with well-established track records work only with large institutional clients and have no interest in dealing in the retail market, so a new manager such as I can provide your clients with the best alternative.

Mr. Promoter seemed like a nice guy, but he miserably failed the three Ps, so I thanked him for his time. My only thought after this brief meeting was, “What a waste of time; wait until I get hold of Jones!”

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.

Pascal’s Wager: The 0.1 Percent Risk

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

Playing Russian roulette with a thousand-chamber gun might not seem so risky, until you consider the consequence of that 0.1 percent risk.

I’ve been working with Linda, my client, for the last hour entering data into MoneyGuide, our planning program. We’re now discussing the plan’s time horizon—how long her nest egg needs to last so she can keep groceries on the table.

“Linda,” I asked her, “one of the major guesses we need to make is how long you will need money.” (That’s my tactful way of asking what age she thinks she’ll die.)

Years ago, we used a standard actuarial table to estimate how long someone might live. Unfortunately, as a thoughtful friend pointed out, that means you’d have a 50 percent chance of outliving your nest egg, so today we use an age that, based on your current health, your family’s health history, and if you are or are not a smoker, represents a 30 percent chance of your reaching that age. (Chapter 15, Life Timing. What Lynn Hopewell Teach Us?”)

“Linda,” I continued, “based on your current health and your family health history, we should consider using age ninety-three for planning.”

“Harold, you must be kidding. I’ll never make it to ninety-three! Let’s use eighty-five.”

“Sounds like a nice number. How did you decide on eighty-five?”

“Well, actually no particular calculation. It just seems like a reasonable age to use and I want to be reasonable in my planning.”

“Tell me, Linda, are you familiar with Pascal’s wager?”

“Pascal’s what?”

“Pascal’s wager is a philosophical construct devised by the seventeenth-century mathematician, Blaise Pascal. Here’s my version: If you knew for certain there was only a 10 percent chance that God exists, you would have two ways to live your life: You could conclude the probability of God’s existence was so low you’d elect to ignore morals and ethics and live a totally outrageous life. If, when you died, it turned out that there really is no God, hence no consequences for your immoral life, you lucked out. Of course, if, when you died, you discovered God was not a myth and you found yourself chest high in fire and brimstone, where you’d be roasting for eternity, you might not be very pleased with your choice.

“On the other hand, suppose you decided that, even with the low odds, you would live a moral and ethical life. If, when you died, you discovered there is no God, you would still have lived a comfortable life. If there is a God and you’re rewarded in heaven for your exemplary life, you will have won the eternal lottery.”

“So, what’s this got to do with retirement planning?”

The answer is everything! All too often in planning, we get caught up with the power of probability. Live until ninety-three? Possible, but not likely, so I want to make plans based on living until age eighty-five. Based on probabilities, that’s not an unreasonable response. However, as Pascal taught us, that conclusion is missing an important half of the equation, namely, the consequences. Often the terrible negative consequence of coming out on the short side of the probability overwhelms the low probability.

Let’s suppose Linda does live only until age eighty-five. That means she can spend more between now and then because her money doesn’t have to last for another seven years. Good outcome.

Suppose she lives well beyond eighty-five. If we use eighty-five, as a planning age, that means by eighty-six, if her plan works out as expected, her nest egg will be approaching $0! The consequences of living another seven years supported solely by her Social Security income? That means reducing her standard of living by about two-thirds, which may not be on a par with fire and brimstone forever but it’s high on the quality-of-life disaster scale. The moral? Don’t just consider probabilities when planning—consider the consequences.

“Still want to plan only to eighty-five, Linda?”

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

HRE PR Pic 2013

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

HRE PR Pic 2013

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.