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

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Harold Evensky CFP® , AIF® Chairman

Harold Evensky: Good morning, class.

Class: Good morning, Professor Evensky.

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

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

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

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

Class: Yes.

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

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


Meteorologists’ Predictions

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

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

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


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

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

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

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

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

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

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

HE: Thank you, Nicholas.

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

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

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

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

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

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

Nicholas: Obviously.

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

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

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

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

HE: Good, Alicia. Why?

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

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

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

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

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

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

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

HE: Right. So?

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

HE: And?

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

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

Kiran: But there’s still risk, right?

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

Class: Yes, Professor Evensky.

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

Elizabeth: What’s that?

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

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

False Security: When Stop Loss May Really Mean Guaranteed Loss

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

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

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

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


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

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

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

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

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

B: Why? High Tech is the future.

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

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

Dr. C.: Exactly! Would you?

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

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

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

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

B: And what about losses?

Dr. C.: Not so much.

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

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

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

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

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

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

[Nine months later]

Dr. C.: Hello, Joe.

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

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

B: I did notice, yes.

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

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

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

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

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

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

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

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

[One week later]

Dr. C.: Hello, Harold.

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

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

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

Dr. C.: Tell me more.

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

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

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

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


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

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

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

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

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

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

Dr. C.: What do you mean?

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

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

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

Dr. C.: I never thought of that.

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

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

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

Getting Your Money: The Difference Between Liquidity and Marketability

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Harold Evensky CFP® , AIF® Chairman

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

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

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

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

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

HE: Sorry, Elizabeth. What’s up?

EB: I need some advice for my mom.

HE: About?

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

HE: Good grief!

EB: Excuse me?

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

EB: What on earth does principal fluctuation mean?

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

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

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

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

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

Mrs. E.: Right.

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

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

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

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

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

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

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

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

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

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

EB: You know this fund?

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

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

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

EB: Touché! So what’s your diagnosis?

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

EB: All that?

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

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

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

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

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

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

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

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

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

EB: So tell me how they’re different.

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

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

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

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

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

EB: And marketable investments are?

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

EB: I think so, but so what?

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

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

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

EB: No.

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

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

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

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

EB: Right.

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

EB: No.

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

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

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

EB: Right.

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

EB: I don’t know. Ten years?

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

EB: Not very, no.

HE: What if I told you it was 100?

EB: That would make me extremely uncomfortable.

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

EB: I’d say you were joking.

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

EB: Never?

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

EB: How can it possibly?

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

EB: What?

HE: It sends an apology letter.

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

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

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

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

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

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

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

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

EB: Yet again, I don’t follow you.

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

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

HE: And that means?

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

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

EB: Not when you put it that way.

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

EB: Okay, I’ll talk to her.

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

EB: What game?

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

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

HE: I’m glad I could help.

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

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.

The Titanic: The Future Ain’t What it Used to Be

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Harold Evensky CFP® , AIF® Chairman

We’ve seen the warning on every investment site, in every prospectus, in every description of every mutual fund ever peddled: “Past performance is not indicative of future returns.” So it amazes me how many investors base their expectations for future investment returns on past market returns. Some base it on long-term historical returns because a long history seems to imply some statistical comfort. Others focus on more recent returns. Both approaches are recipes for disaster.

Bob: Hello, Harold.

Harold Evensky: Hi, Bob. We haven’t talked in . . . gosh, let me check my watch. How have you and Mena been doing these last few days?

B: Harold, this is no time for small talk. I’ve been watching the markets.

HE: Like everybody else, I suppose. I can’t seem to find a channel on television that isn’t talking about the run-up in stocks.

B: Harold, it’s taken me awhile to catch on but this is a great market!

HE: And that’s what you called to tell me?

B: Look, I know I’ve been somewhat conservative about investing in the past.

HE: That may be an understatement. You think CDs are risky investments.

B: You never know when a bank is going to fail at just the moment when the FDIC fund is— Well, anyway, that’s not why I called. I’ve been watching stocks go up and up and up, and I think I’m finally convinced that the stock market is where I need to put my retirement money.

HE: Let me have a look at your portfolio. Right now you have about 23.8 percent of your total assets in the stock market, and I remember having to twist your arm a few years ago to get you to go that high. So what kind of an increase are we talking about? Thirty percent? Thirty-two percent?

B: All of it.

HE: All of it? You? The fellow who remembers the Tech Bust and Grand Recession as if it were yesterday, wants to go all-in on stocks?

B: What’s the problem? Stocks have been going up for the last five years. I know a trend when I see one.

HE: Bob, before you take this flying leap, could we talk for a minute? I’d like to get your advice on something that’s been bothering me for a while. We can get back to your investment idea in a minute. Okay?

B: Sure.

HE: I’ve just finished reading a couple of economic studies by researchers for whom I have a lot of respect. They discuss the extraordinarily high market valuations based on price-to-earnings and price-to-book ratios in the markets today.

B: I think I know what those are. Price-to-earnings is called the P/E ratio. That’s the stock price divided by the last twelve months’ earnings and it tells you how expensive the stock is compared to what the firm is earning. Price-to-book is the P/B ratio and it’s the company’s stock price divided by the company’s book value. It tells you how much you’re paying per share for every dollar of company book value.

HE: That’s good. A lot of investors would have no idea what those terms mean. Anyway, when you look at all these P/E and P/B ratios across the entire market, it looks as if stocks are very expensive compared to long-term values. —

B: So that means I’ve made a lot of money, and so have your other investors, right?

HE: I guess that’s one way of looking at it. It’s also yesterday’s story. My challenge is that to calculate how much you and everybody else needs to save to have a reasonable probability of being able to afford retirement, I have to come up with an estimate of what kinds of returns you’ll get in the future. We call it “future market return assumptions.”

B: I don’t understand why that’s a problem. Can’t you just base your projection on an average of what the markets have done in the past?

HE: I wish it were that predictable. Of course, I could do that. Unfortunately, there’s no reason to believe that calculation would provide a reasonable “guesstimate” of future returns. I have to come up with a number I can believe in. When my clients are ready to retire some years down the road, having relied on that number, they need it to be right—or they can’t retire.

B: Okay, so how can I help you?

HE: Tell me what you think about this: I look at today’s valuations and the research, and everything tells me that the investment future cannot possibly be as rosy as it has been throughout the last couple of decades. So I’m sitting here at my desk telling myself that it’s time to stop futzing around and acknowledge that, despite what financial headline writers seem to think, I believe they’re being way too optimistic in estimating future market return assumptions. And I need to tell my clients that.

B: They’re not going to like hearing that.

HE: Tell me about it. Why do you think I’ve put it off so long?

B: You do have a problem.

HE: I have to come up with a way to decide what numbers to plug into my fancy Monte Carlo software—and all the other sophisticated software I have on my desktop.

B: You know, Harold, maybe I’ll wait a week or two while you look into this thing that’s bothering you before I commit totally to the stock market. In fact, you know what you should do? Write an article about it. You’re a good writer.

HE: I like that idea. I could call it “Heading for Disaster? The Assumptions Advisors Use for Investment Planning May Threaten Their Clients’ Future.”

B: Perfect title. And when you’re finished with your research, we can revisit my portfolio.

HE: It’s a deal.

[Two weeks later]

B: Hello, Harold.

HE: Hi, Bob. What’s happening?

B: I was wondering if you’ve gotten around to writing that article yet. I noticed the market went up again yesterday, and I was thinking maybe I’m in danger of missing some of the upside of this bull market thing.

HE: Yes, your timing is perfect. I did write the article, and I submitted it yesterday. My research confirmed my gut feeling that the assumptions that I (and most practitioners) have been using for our planning are much too optimistic. I’m more convinced than ever that returns for many decades in the future could easily be significantly less than investors have enjoyed over the past seventy years.

B: So does that solve your problem?

HE: Not quite. Now I have to decide two things: What is the significance of lower returns for investors? And what should I do about it?

B: What have you concluded so far?

HE: That I still have more work to do, so I’m back to the drawing board. I’ve done some preliminary research and have an idea, but I need to give it some more thought. I’ve rearranged my schedule for the week so I’ll have time to concentrate on this issue.

B: Sounds good. Mena and I will be taking a cruise soon so I’ll touch base with you when we return.

HE: Have a great cruise and give me a call when you’re back and catch your breath. We can then do some planning looking to the future and not the past.

Bob returns from his cruise in the next chapter and the story continues.

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

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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.

Are Target Date Funds Really on Target?

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Michael Walsh CFP® Senior Financial Analyst

Currently there are millions of different investments that people can choose when it comes time for them to create their own unique portfolio. Since financial markets were created, we have seen a multitude of new investments come and go. The important thing to remember is that investments will always be evolving. With the introduction of mutual funds early in the twentieth century, investors now had a way to diversify their holdings and as the old saying goes, “not have all their eggs in one basket.” Looking back, we know those early funds were still subject to market risk and there is no investment that is entirely risk free. In the early 1990s fund companies started introducing the concept of a target date fund that they hoped would revolutionize the way people invest.

Target date funds, also known as glide path funds, shift their allocation over time from higher equity exposure toward larger fixed-income holdings as the fund reaches its maturity. For example, if I were to own a 2035 target date fund in my portfolio, I might have 60% equity and 40% fixed income as my fund allocation. Each year we march toward 2035, the portfolio management team will take equity off the table and invest more in fixed income. So, in 2025 my target date allocation might be 70% fixed income and 30% equities. Today many qualified plans offer target date funds as part of their overall investment menu to participants. Many of these funds are quite good and their investment philosophies and processes are sound. The issue that I have is that many people by default set their target date to the year in which they intend to retire.

As we have seen, with medical advancements and lifestyle changes people have been living increasingly longer. As Harold Evensky points out in his book The New Wealth Management, “65-year old males and females have at least a 50 percent chance of living to 85 or 88 years, respectively, or 8 to 10 years longer than their life expectancy at birth.” Harold goes on to say, “A married couple has a 50% chance that at least one of them will survive until age 91. There is a 25 percent chance that one of them will survive until 96.” These statistics show that individuals or married couples will live a substantial life beyond retirement which they must fund. Using a target date fund that will have an extremely high fixed income position when they turn 65 might not be the best option for a large part of their portfolio. People at that age tend not to want rapid growth in their investments but rather a smoother ride producing returns to sustain their lifestyle. The issue people often forget about is the predator that will attack their cash and fixed-income holdings. This predator is called inflation.

Inflation, also known as purchasing power risk, will increase the price of all goods that we buy on a daily, weekly, monthly, and yearly basis. If your portfolio is not keeping up with inflation each year, you are losing your ability to pay for those consumer goods and maintain your lifestyle. Retirees who depend upon Social Security and their portfolio to sustain their lifestyle need to have some equity allocation in their investments in order to generate returns that will outpace inflation. According to research published by the World Bank Group, a non-profit located in Washington, DC, the United States has on average experienced inflation at 3.85% since 1960. If you have fixed-income positions that are returning 2% when you turn 65 and inflation is over 3%, you might have to restrict your lifestyle in order to stay financially independent.

Having any diversified allocation that is not made up entirely of cash or cash equivalents is always the first line of defense against inflation. While there are many benefits to owning target date funds that offer a glide path for investors, there are also several pitfalls of which people should be aware. To learn more about target date funds or planning for your retirement visit us at and set up an appointment today to speak with an expert.

Feel free to contact Michael Walsh with any questions by phone 305.448.8882 ext. 213 or email:

Evensky, H., Morgan, S., & Robinson, T. (2011). The New Wealth Management. Wiley.

The World Bank. (2016, June 1). Data: Inflation, consumer prices (annual %).  Retrieved from