2014-02: February 2014 What Works in Personal Finance Newsletter

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What Works in Personal Finance Newsletter


February 2014 Newsletter



Diversification and the credit crisis


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The best personal investment and financial planning practices are durable and should not change because of market cycles and financial crises. Nothing that has happened in the credit crisis changes the value of broad market diversification. Some uninformed post-crisis commentary has questioned the wisdom of diversification, which only indicates a failure to understand what diversification can and cannot do for you.


Diversification across a portfolio can and does mitigate volatility over time. Diversification is really not an option, if your goal is optimized, risk-adjusted personal investing. Full global investment diversification using the broadest, cheapest, most passive index mutual funds and exchange traded funds (ETFs) is the most optimal strategy for the individual investor. Few in the industry will tell you this, because a lowest cost, global and passive diversification strategy is the least profitable to the financial services industry. If you tell a commissioned financial advisor that you want to pursue such a strategy, expect to be told directly or indirectly why you are an idiot.


Complete investment diversification has become an axiom of personal investing, because the specific risks of businesses and other investment entities can be reduced or eliminated with a fully diversified portfolio without reducing your expected returns. A fully diversified portfolio is an absolute investment necessity. Increased diversification reduces portfolio risk without a corresponding reduction in expected portfolio returns. Your investment portfolio should always be as diverse, as is economically practical.


Distinguishing between true investment skill and luck


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Even if an investor has obtained superior results over an extended period, is this sufficient proof that these investment results were actually due to skill? No, these investment results could still be due to chance. Because long-term success may still be due to random chance, there needs to be more stringent criteria for judging true investment skill.


The future unfolds unpredictably, and just because it turns out one way or another does not make an individual investor a genius or a fool. Only if an investor makes numerous specific predictions over time about WHY the prices of various securities will move in particular directions and those predictions come true far more often than not, can investment skill rather than dumb luck be demonstrated. A higher degree of accuracy on specific predictions would be a way to identify an investor with skill.


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Investment Asset Allocation


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Setting your personal investment asset allocation is a critical decision for every individual investor. Asset allocation can be viewed as an extension of the Global Investment Diversification strategy principle to multiple types of assets, such as equities versus fixed income securities. Asset allocation is also how you blend your personal investment risk preference into your investment asset portfolio.


An individual’s risk preference relative to that of the average investor influences the asset allocation that would tend to be most beneficial from a risk-adjusted portfolio performance point-of-view. Your personal investment risk tolerance should determine your investment asset allocation. Investment always involves risk. If your personal capital is not at risk, you simply are not holding an investment. All investors — small or large – skilled or unskilled — irrational or rational — sophisticated or unsophisticated – must navigate the same uncertain securities market and economic waters to get to their financial goals.


While we can only hope that the credit crunch, financial markets crash, recession, and near depression of 2008 and 2009, is an aberration and not the new normal, it is instructive to look at a few data points to see what happened to the apparent asset allocation percentages at certain points during this crisis. If you were an average investor and held the average asset allocation of 2004 to 2007 and had an investment policy to retain that asset allocation through periodic re-balancing, then you would have been a net buyer of equity assets as securities market values collapsed in 2008 and early 2009.


While perhaps emotionally challenging to anyone, this “buy equities into a crisis” (and “sell them into a growth cycle”) strategy would have positioned you for the recovery that occurred in 2009. Most who flew to cash did so after most of the collapse in equity values had already occurred (buy high and sell low), and they were sitting in cash on the sidelines in surprise as equity market values recovered.


Just Buy Index Funds Directly


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Buying an S&P 500 index fund through an investment counselor can substantially increase your initial purchasing costs and and drive up your annual management expense fees. Unfortunately, the vast majority of individual investors buy mutual funds and ETFs through brokers and investment advisers. Rarely do financial advisors recommend that you buy index funds with low fees. This is because low cost, no load mutual funds do not pay them as well as loaded, high fee mutual funds.


Many financial advisors will claim that more expensive, actively managed funds will give you better results, but such self-interested claims are not supported by a vast body of investment research. Unfortunately for your pocketbook, the added costs far exceed the added performance. You get the short end of the stick, while you support your advisor’s lifestyle. Now, is this not supposed to be the other way around?


Equity index funds promoted by investment advisors are often much more expensive. Brokers and investment advisors typically offer you only A Class, B Class, and C Class shares. A, B, and C Share Classes add front-end loads and/or back-end loads, and these share classes often carry much higher annual management fees. Then, a .25% annual 12b1 marketing fee will be tacked on top of these higher annual management fees. These 12b-1 fees provide an ongoing revenue stream to your advisor, so that he or she will be paid to keep telling you to buy more expensive funds. You pay extra to your advisor year after year, so he or she will keep telling you year after year that paying extra is good for you, when most often it is not.


Does this seem like a strange set-up to you? It is. It is called a conflict-of-interest where your best interests get to take a ride in the back seat, while you pay your advisor’s fare at the same time. Now, sometimes an investment advisor will play the industry’s little game of graciousness and cost sensitivity and “waive” the fee for you. Of course, the financial advisor will only waive the fee, if he or she feels that you have already “produced” enough revenue and commissions for the advisor and the firm. While industry representatives will show you business cards that say “investment advisor” or “investment counselor,” they do not tell you that within the industry they are all called “producers.”


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