Jonathan Clements's Blog, page 424

Not So Dumb

IT’S ONE OF WALL STREET’S more galling rituals: its regular dismissal of everyday investors as stupid. They’re the “dumb money” you should watch so you know what not to buy—the sheep that the “smart money” regularly fleeces.

This narrative was bolstered by early behavioral finance research, which detailed our many mental mistakes: In our overconfidence, we trade too much and make large investment bets. We’re overly influenced by recent returns. We assume our investments perform better than they really do. We hang onto losing investments, because we hate selling at a loss and admitting we made a mistake. We discount the future at too high a rate. We latch onto evidence that confirms our beliefs, while ignoring information that might force us to revise our position.

The archetype of the dumb small investor was always a little suspect—and it’s become ever harder to sustain, as evidence mounts that professional investors also regularly underperform the market averages and also make their own fair share of behavioral mistakes.

Moreover, this focus on smart and dumb money ignores an alternative explanation: Even if investors aren’t rational as judged by classical economics, their behavior can make sense if we consider what they’re aiming to achieve with their money.

That’s the intriguing argument advanced by finance professor Meir Statman in his fascinating new book, Finance for Normal People. His book represents what he calls “second generation” behavioral finance. In the first generation, it was all about identifying behavioral oddities and dismissing them as mistakes. In the second generation, those mistakes are being reappraised—and viewed as more sensible when we consider investors’ wants.

As Statman explains, our purchases—including the investments we purchase—offer three benefits: utilitarian (what it does for me), expressive (what it says about me) and emotional (how it makes me feel). Hedge fund performance has been disappointing—the utilitarian benefits are often far less than promised—and yet folks are still anxious to buy, because owning a hedge fund makes them feel special and gives them bragging rights at the country club. They get mediocre returns, but maybe they’re still getting their money’s worth.

That doesn’t mean we never make errors. Investors—professional and amateur—are subject to a host of cognitive and emotional mistakes. Those mistakes can occur when we make decisions based on intuition alone, when it would have been wiser to hit the pause button and call on the reflective, slower-moving part of our brain.

For instance, rapidly trading stocks is unlikely to deliver market-beating returns, but folks find it thrilling and it gives them the occasional winner that they can boast about. So is this a sensible way to address our wants? Obviously not, if we’re betting our entire portfolio on the foolish assumption that we can predict market movements and outsmart other investors. We’re likely falling victim to a host of cognitive and emotional errors. But if we create a “fun money” account with a sliver of our savings, knowing we’ll have lots of fun but probably not much financial success, then it seems more sensible.

In its early days, classical economics would dismiss behavioral finance as just a collection of “interesting stories.” But today, behavioral finance is much more than that. Statman takes the notion of wants, coupled with potential errors, and offers up theories of how portfolios are constructed, how stocks are priced, why markets can’t be beaten and how folks think about spending and saving over their lifetime. The theories may need fine-tuning—but they seem right, because they take fuller account of the messy way humans behave.

Finance for Normal People is geared toward an academic audience, but it has much to offer everyday investors. Statman has an engaging writing style, mixing theory with real-life examples. My advice: Put the book on your bedside table and occasionally dip into one of the chapters. It’ll help you figure out what wants you have—and help you avoid costly cognitive and emotional errors.

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Shaking the Dice

WHEN THE WORLD SEEMS A LITTLE CRAZY, we strive for greater control over our lives, including our financial lives. But the greater control we feel is often an illusion and the steps we take can badly hurt our finances. Want to learn more? Check out my latest article for Creative Planning.

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Land Grab

WHEN WE MAKE INVESTMENT mistakes, often bad advice is to blame. Someone recommends a stock or annuity or no-risk rental property, and we’re so tantalized by the upside that we completely miss the pitfalls. Sound familiar? As a counterpoint to this common trope, I wanted to share my best investment—one I never would have made if I hadn’t listened to those around me.

Before I officially closed on my house in Philadelphia, my parents drove by, so they could see it. My Dad’s first words were, “You should buy that vacant lot next door.” I quickly assured my Dad that the corner lot, filled with trash, wasn’t for sale. In the coming weeks, he kept asking me about it and I eventually checked the public record to appease him. I learned that the lot was owned by a company, it didn’t appear delinquent and it was zoned for building. This convinced me that buying it wasn’t an option, and I thought that put the matter to rest.

Eighteen months later, my friend Theo was visiting. We were standing on my back deck, looking at the trash and weeds in the lot. Theo was in his second year of law school and had just learned about Adverse Possession, a rarely used legal procedure sometimes known as “Squatter’s Rights,” whereby an individual can claim ownership of land if he has “continuous, hostile, open and notorious” possession for a set period of time—21 years in Pennsylvania. Usually, this law is invoked when contesting small property boundaries—think of a stone fence separating two homes—or in rural areas with large swaths of untouched property. Theo suggested I might be able to use Adverse Possession law to claim ownership of the lot. This struck me as unlikely.

Theo and my Dad continued pestering me about the lot, leading me to do some initial research into the company on record. I tried calling, but could find no number listed. I sent mail to the address on file with the city and it was returned to me. Eventually, through online research, I learned that the company had once produced envelopes and owned various lots in the neighborhood. They had gone out of business in the 1970s and this plot of land was the only piece that remained in the company’s name.

As I shared my findings with Theo, he grew convinced that I had a case. He connected me with a law professor, who told me the first action I needed to take was to fence the land off, securing my claim to “hostile and open” possession. I installed a cheap chain link fence and contacted a law firm that specialized in real estate.

From there, I worked with a lawyer for over a year, investing about $10,000 in legal fees, as we built a viable but challenging case. I was required to use various means and methods to contact the owner, including running newspapers ads and visiting their address of record. In the end, the outcome hinged on whether or not the company appeared in court. If they appeared and contested my claim, I would likely lose. If no one showed up, I’d win. On the day of the hearing, I waited anxiously to hear back from my lawyer. The outcome: The company did not appear and the court granted a default judgment, where I won free and clear title of the land.

Over the last four years, I’ve used my lot as a parking space, garden and extended patio for my small row home. Now, as I transition out of Philly and my neighborhood continues to gentrify, developers are making offers that are nine to 10 times what I paid in legal fees to obtain the land. How can I show my gratitude to Theo and my Dad? As a first step, I figure I’ll send them the link to this blog.

Zach Blattner’s previous blogs include Five Tips for a Better Trip and Zeroing In. Zach is a former teacher and school leader who now teaches teachers across the Philly/Camden region as a faculty member at Relay GSE. He is a self-taught finance nerd who dispenses advice to his wife, friends, family and anyone else willing to listen.

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Footing the Bill

IN MY HOMETOWN OF BOSTON, there’s an old joke about our dismal winter weather. “February,” they say, “is the longest month of the year.” I don’t disagree and so, each year at Presidents’ Day, my family tries to get away for a warm weather vacation.

On these trips, we often stay at the same hotel and, because of that, we have noticed certain patterns. Among them: Most years, there is the same large corporate gathering. Truth be told, it’s hard to miss. There are five-star dinners under a tent by the beach. There are groups huddled with cigars by the pool. In short, it appears that no expense has been spared. Not surprisingly, it turns out that this group is a high-level delegation from a well-known Wall Street firm.

Knowing the hotel bill for my family’s single room, I can only imagine the total cost for this corporate gathering. The opulence, repeated year after year, is an image I can’t shake. It doesn’t take much analysis to figure out how they afford this luxury. Some of it is underwritten directly by individual investors, when they buy mutual funds or trade stocks. And a lot of it is earned from institutions, such as pension funds, which hold individual retirees’ savings. Ultimately, then, this Wall Street firm’s monstrous bill is paid largely by mom and pop investors.

This strikes me as a problem, for three reasons. First, data has shown that fees have the most predictable impact on investment returns, so unnecessarily high fees directly affect people’s ability to meet their financial goals. Index funds have brought down the cost of investing, but financial advisors’ fees remain stubbornly high.

Second, employees who save through their company’s 401(k) plan have no control over the menu of funds available. If the only funds on offer are the high-fee sort, employees are stuck overpaying.

Third, most investment fees are structured as a percentage of a client’s assets. This is a problem because it means that these fees rise quietly over time, as financial markets climb and investors add to their accounts.

Earlier this year, when I decided to start my own investment firm, I made it my goal to serve individual investors, those who I feel are being treated the worst by Wall Street, and to focus on holding down the cost of both my services and the investments I recommend. This was an easy decision. By whittling away unnecessary expenses, I am able to pass significant savings on to my clients.

Early in my career, an industry veteran summed things up: “This is the most overcompensated profession in the history of the universe.” I couldn’t have said it better. My hope is that in the future, when I am an industry veteran advising young people, I will speak of the industry’s high fees—and the lavish getaways that they paid for—as an historical anomaly that’s long gone.

Adam M. Grossman’s previous blogs were Trust Issues, Contain Yourself and Take It Slow. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers.

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This Week/May 14-20

ELIMINATE DUPLICATION. Many folks have multiple bank and brokerage accounts, multiple funds that invest in the same market sector and even multiple advisors. This can make sense if, say, the goal is to increase FDIC insurance. But often it reflects a naïve notion of diversification—that more accounts somehow mean greater safety. My advice: Simplify—for your sake and the sake of your heirs.

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Odds Against

IF YOU WANT TO BEAT the market, you need to pick stocks that perform well enough to overcome the investment costs you incur. That task is made harder not only by the market’s efficiency, but also by another hurdle: skewness.

What’s that? The most a stock can lose is 100% of its value, but the possible gain is far greater than 100% and potentially infinite (though no stock has got there yet). In any given year, the market’s highest-flying stocks—which might double or triple in value—skew the market averages upward, so most stocks end up lagging behind the averages.

Investors have long been aware of this phenomenon, but a recent academic paper took the notion—and added a huge exclamation mark. Hendrik Bessembinder, a finance professor at Arizona State University, looked at U.S. stock performance over the 90 years through December 2015. Here’s what he found:

Over their lifetime, 58% of stocks underperformed one-month Treasury bills and a majority lost money. For purposes of the study, lifetime was measured from 1926 or whenever a stock was listed through to 2015 or whenever a company was delisted.
The 25,782 stocks that existed during these nine decades managed to create some $32 trillion of value for shareholders, over and above what they could have earned in T-bills. But the top 86 stocks accounted for half that wealth.
The largest wealth creator was ExxonMobil, at $940 billion. Other major contributors were Apple, General Electric, Microsoft, IBM, Altria Group, General Motors, Johnson & Johnson, Wal-Mart Stores and Procter & Gamble. Most of these stocks performed well. But their large contribution to wealth creation also reflected both their size and corporate longevity.
Over the 90 years, the U.S. stock market’s entire gain, over and above T-bills, can be attributed to less than 4% of stocks. The other 96% collectively matched T-bills.
Smaller-company stocks were especially likely to lose money—not a huge surprise. More surprising: Higher returns were clocked by companies with little or no debt. (This latter insight reflects performance since 1962—the period for which data on leverage was available.)
The typical stock was around for only seven of the 90 years. In fact, of the 25,782 stocks, just 36 were in existence for the full nine decades.

Skewness is a powerful argument for broad diversification, especially through total market index funds. That way, you don’t run the risk of badly trailing the market. But instead of appreciating that powerful argument, many investors are drawn to the sizzling sideshow.

What sideshow? While skewness means most stocks and most active managers will end up with market-lagging results, that still leaves a modest number of winners—and their triumph can be spectacular. The danger: Inspired by those big winners, many investors will stray from more diversified strategies, and try their hand at picking hot stocks and star managers. Most, of course, will pay dearly for their greed—thanks to skewness.

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Value for Money?

WHAT’S THE BIGGEST CHALLENGE facing investors? Forget politics, low interest rates or high stock market valuations. I would argue there’s an even bigger challenge: How do you find financial advisors who are worth their fee?

On offer are brokerage firms, insurance companies, banks, mutual funds, accountants and independent advisory firms, all of them employing charming people who would love to help you. Problem is, there isn’t a lot of uniformity in the products and services they offer, and their fee schemes range from reasonable to outrageous.

Depending on who you ask for help, you might face layers of sales commissions, transaction fees and product expenses. Indeed, the same investment product can be offered with different pricing schemes. Often, smaller purchases trigger higher costs, while larger buyers can enjoy substantial discounts.

What do you get in return for those costs? A 2017 study by Russell Investments pegged the value of a top-notch advisor at some four percentage points a year. The study looked at five areas where advisors can add value. The potential value added is shown in parentheses:

Selecting investments (0.33%)
Financial planning (0.75%)
Tax planning (0.8%)
Portfolio rebalancing (0.2%)
Helping clients avoid behavioral mistakes (2%)

As the above numbers suggest, many clients and advisors wrongly focus on good investment choices as the sole measure of value, and yet softer skills are more important. Identifying special needs or making smart tax choices can help the bottom line far more than choosing a good mutual fund—and that good mutual fund isn’t much help if the next market dip scares you out of the stock market.

Four percent is a substantial annual reward for hiring quality help. But will you get that much value from your advisor? The Russell study focuses on advisors who are held to a fiduciary standard—with good reason. Fiduciary rules discourage advisors from accepting sales commissions and require they provide ongoing attention to clients.

Among providers, you’re most likely to find a fiduciary advisor in a bank’s trust department or at a so-called RIA, or registered investment advisor. Fiduciary advisors typically charge fees for specific services or an annual percentage of a portfolio’s assets, often around 1%.

Non-fiduciary advisors can also add value in the five areas identified by Russell. But will they? Portfolio rebalancing and monitoring client behavior depend on ongoing contact. But a commission-charging broker or insurance agent may not monitor a client’s portfolio or stay in touch during turbulent times.

Similarly, custom financial and tax planning advice requires deep client knowledge, expertise and considerable time. But the necessary time may not be productive for a commissioned advisor. Spending hours studying tax returns and trade confirmations doesn’t put food on their table.

An additional issue with non-fiduciary advisors: Some offer “proprietary” investments or mutual funds—products “manufactured” by the financial firm that employs them. Sometimes, those products impose high costs. If the costs are too high, they may more than offset the value of the advice you receive. On top of that, with any proprietary product, you have to ask, “Is this really the best product for me to buy—or is it the best product for the advisor to sell?”

Dan Danford is a Certified Financial Planner with the Family Investment Center in Kansas City, Mo. He learned early on about money from his late father, Thad Danford, who charged rent on the family lawn mower when Dan cut neighborhood lawns. Dan is the author of Stuck in the Middle: The Mistakes That Jeopardize Your Financial Success and How to Fix Them. His previous blog was Fake News.

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Truly Taxing

IN 1934, WHEN I WAS ONE year old, a federal income tax return was one page, and came with two pages of instructions. It was hand carried to the house by a live postman. The IRS regulations were 200 pages—though some say it was 400—all of which were memorized by the tax author J. K. Lasser.

When I was a young man in the workforce, we still got the several-page income tax form by mail, accompanied by a booklet of instructions that ran about 20 pages, as I recall. If you had a rental property or something more complex, you could buy J. K. Lasser’s tax guide, which was about 3/8 inch thick.

Almost everything that was added to modern tax forms and instructions since then was for social engineering. Now there are a stack of forms, many of which you have to download from the internet. If you want the 106 pages of instructions for the basic 1040 return, you can get them on the internet—or a copy will be mailed to you, but you’ll likely have to wait 10 days for delivery.

The federal tax code now totals 74,608 pages. The Constitution fits on three pages with single spaced typing or only four sheets of the original handwritten 28 3/4 inches by 23 5/8 sheets. The 27 amendments amount to only three additional typed pages.

Congress was less wordy in 1787, used more noble language and lawyers weren’t paid by the hours they booked. Their objective wasn’t to parse who got government money because people had to be self-sufficient. And there was no IRS. Must have been refreshing by comparison.

Henry “Bud” Hebeler is the retired president of Boeing Aerospace Company and the author of Getting Started in a Financially Secure Retirement. His previous blog was Unhealthy Increases. To read more from Bud, visit his website at AnalyzeNow.com.

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This Week/May 7-13

SNATCH THE MATCH. Are you on track to contribute enough to your 401(k) to get this year’s full matching employer contribution? If not, crank up your contribution now, so you can spread the required sum over this year’s remaining paychecks. In 2017, the maximum 401(k) contribution is $18,000, or $24,000 if you’re age 50 or older.

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May’s Newsletter

INDEX FUNDS were initially designed to match the performance of the broad stock market. But today, they’re just as likely to be built to capture a subset of stocks, especially those that reflect a particularly investment style or factor. Welcome to the world of smart beta. But is smart beta truly smarter and better? That’s the topic I tackle in May’s newsletter.

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