Archive for the ‘Investing Fundamentals’ Category

We have seen a lot of lists of questions you should ask your advisor over the years. They are useful and you should, in fact, ask many of them. The most important question for understanding who you are hiring is usually not on these lists. The question is-What do you do to manage my risk as an investor?

The answer will quickly tell you who you are working with. The “faith advisor” will answer about how you are in this for the long run, how you don’t make a lot of changes if you truly believe in America and in capitalism, etc. They buy into the full faith and credit of the financial services industry and are supported by many experts from the industry (kind of like lobbyists in their approach). On the other hand, the “business advisor” will be able to answer in terms of a process to manage risk as the future unfurls. We suppose there could be a third group who are not able to answer coherently on either side of this issue. That is an answer worth hearing and probably tells you to move on in searching for the “right person”.

The choice is yours. For us, we have a strong belief that you should manage your investments much like you manage a business. You need a process, you need beliefs, and you need to evaluate and adapt as you move forward. A business which does not do this is unlikely to succeed over the long haul.

A good example might be a successful local coffee shop. The owners would have founded their business on a set of core beliefs and would have developed successful processes to implement their belief system. Now, imagine that they hear that that national coffee chain (yes, that one!) is going to open up in the next block. They could ignore this fact and rely on their faith in their current business model and clientele. A better course of action would be to assess the risks (and opportunities!) that will arise from their new competitor. Which business model would you choose and which business do you believe is more likely to survive?

You can (and we believe must) apply these same principles to your investment portfolio. You need to develop a set of beliefs, and then implement them as processes, but also make an ongoing assessment of risks and opportunities an important process which loops back to your portfolio design. In our opinion, investing with faith only is no way to run a portfolio. Or a business.

As many of you may know, Warren Buffet’s first rule of investing is- Don’t lose money! His second rule of investing is- Don’t forget the first rule! This is terrific advice save for one small detail. The detail is that we have never met anyone smart enough to follow these two simple rules. We have never met Mr. Buffet, but we are quite sure that he has not been able to follow these two rules without a few lapses during the past decade.

The third rule of investing is really the only one you need because- you can actually follow it!  Lose money as infrequently as possible and limit the amount of each loss!!

This gives you a plan for investing that you can execute (unlike the far more well known edicts of Mr. Buffet). The process needed to follow this rule will be challenging but you can do it. To lose money as infrequently as possible is to only enter into investments which have a reasonable expectation of being profitable. Buying a tech stock in late 1999  with a price-to-earning ratio of 400 was just not a reasonable concept. Could you have doubled your money as the P/E ration zoomed to 800? Of course, but this was not a likely or reasonable outcome. This investment was more likely to lose money than to make money and should have been avoided. If you did foolishly make this trade (an infrequent loss we hope!), what was your process to keep your loss small? If you allowed your tech stock to fall 90% in value (as most investors did!), you clearly had no process in place that was designed to limit the scope of your losses.

So, make it a mantra and figure out how you are implementing it-

Lose money as infrequently as possible and limit the amount of each loss!!

Americans are a people of faith and belief- that is one of the things that binds us together. Organized religion is an important part of most of our communities and a major social network for many people. Sports have become a second major source of faith and socializing for many. In baseball, who can forget Tug McGraw’s “Ya gotta believe” rallying cry for the New York Mets? How about the hapless New Orleans Saints uniting the hurricane ravaged city of New Orleans on their drive to become Super Bowl champions?  Or the way we root for “Cinderella” during March Madness? Our faith and emotional attachments do much to enrich our lives and are a precious commodity in our lives.

Unfortunately, emotion and faith have little place in our investments. We invest money with a fairly consistent objective- to fund future economic needs through investing our hard earned capital. Implicit in this process is that we invest in order to make a real return (something beyond inflation). Achieving this goal is not a given and usually requires us to take some risk and to carefully weigh that risk in light of potential returns. We refer to that process as Variable Risk Investing^SM.

The traditional world of investment advice is filled with emotion and faith. Primarily, this comes in the form of “experts” who are always of the opinion that now is the time to buy investments. There is never a year in which you are advised not to invest in equity markets. A lot of advisor “guru’s” declare that you should have “abiding faith” in the greatness of free-market democratic capitalism and should therefore fund all future needs by investing in equities. Our contention would be that your “faith” in America is a wholly different issue from the expected returns you have on your investments moving forward. If stocks are way overpriced and the economy is weakening, you are looking at lower than normal returns and higher than normal risk. Is it prudent to invest all of your capital in such a market? It would not be our recommendation and history shows the results can be disastrous.

The flip side of this phenomena are the marketers who make their money by predicting that disaster is lurking immediately ahead (the fear side of fear and greed is their forte). For them, the great reckoning is always upon us. Oddly, they always offer a solution that includes them profiting from you getting out of the way of the impending doom. Bear market funds, gold sellers, equity index annuity sellers and many others await you in this realm of the world. If they can get hold of your fear, they can do pretty well for themselves regardless of your fate.

We believe that realism (not faith or emotion) is the only course to steer to financial success. To participate in up markets and to avoid losses as often as possible is the road to success. To either let your emotions drag you down a dark alley or to always look at your portfolio through rose colored glasses is counter productive. Capital protection and growth is a serious business. Always treat investing as an objective task. It helps you “live long and prosper”.

Well, we have all reluctantly survived another political campaign. The government has become the object of everyone’s scorn. They are at fault for everything that might be wrong in your life. Just two years ago everything wrong in America was the fault of banks, corporations, and Wall Street. It is always comforting to know who is responsible for all life’s ills, isn’t it?

In reality, we have transferred our debt problems from individuals and corporations to the government (this process is referred to by the dirty word “Bailout”). Why didn’t we ever blame individuals for any of these problems? That is simple. You don’t get many votes by informing the voters that they have made foolish decisions that are not sustainable. Nope, it is much better to blame “them” (the government or the corporations) for all of our woes. Ultimately, of course, we are the government and the corporations, but……..that is a small detail that can be easily overlooked.

The world of behavioral finance teaches us that a dollar is a dollar. We often ascribe different meaning to it (e.g. “government debt is worse than my personal debt”), but that is unrealistic thinking that leads us astray. We need to bring our books into better alignment. Our future cannot be one in which we continue to consume by spending money that we don’t have.

So, a simple idea. We must all admit it is pretty much an across the board problem that we have. People, corporations, and the government made bad decisions, spent money they didn’t have, believed that doing so was not a problem, and now the “chickens have come home to roost”. If all three conspired to cause this problem, then don’t all three have to be involved in the solution? By having a realistic discussion and a holistic solution, we could successfully address our long term issues. We can and must move forward together, learning to live within our means, deciding what that costs and how we will pay for it, etc. This means that we need to behave like…………….grownups!!!

Finally we have bi-partisanship in the Senate!!! Senator Tom Harkin (Democrat, Iowa) was joined by Committee Republicans in approving an amendment to stop the SEC from being able to regulate equity indexed annuities. These controversial products are often sold by people who don’t understand them adequately to other people who are totally clueless about how these products worth. All for a big fat commission check, of course!

Senator Harkin is someone who has at times impressed us by seeming to stand up for the common man. Yes, at age 69 he now stands firmly against the people and for the insurance companies. He wants to make sure that one of the most abused products on the market is not regulated with rules to protect consumers. Iowa has a lot of insurance company employees and, we assume, contributes handsomely to the coffers of the Senator.

At almost 70 years of age, it is time for anyone to “do the right thing”. In this case, the right thing is simple and apparent to anyone. Yet, for a change, we are close to Senator Harkin and our elected officials acting in a manner that is to our direct detriment. Thanks a bunch!!

We all know the story of the tortoise and the hare. Most of us have seen examples of  this concept in action at times during our lives. Now may be one of the times to see the tortoise beating the hare at investing.

Let take two investors, each of whom has $100,000 to invest. Investor A (the tortoise) gets 20% of market up and 20% of market downs. Investor B (the hare) gets 100% of market ups and 100% of market downs. Now, let’s add some volatile market returns (certainly not beyond the realm of possibility). The market goes up 50% and falls 40% in year 2.

Investor B has a lot more fun at cocktail parties than Investor A. Our hare (B) gets to brag about the huge returns in year one, while the tortoise (A) tries his best not to discuss his portfolio. Arithmetically, our hare ends up with a 5% annual average return (up 50% and down 40%). Our poor tortoise averages only 1% per year (up 10% and down 8%).

The hare, unfortunately, has only $90,000 of his original $100,000 investment left after year 2. Perhaps his excitement was worth $10,000 but we are not that interested in excitement here at Capstone. The tortoise has $101,200 to show for his investment. He averaged less arithmetically, had less excitement, but saw the return of his principal along with a small return on his principal.

When the odds of favorable outcomes are heavily on your side, it may be better to be a hare. When the odds are more neutral or against you, think hard about being a tortoise. The tortoise can make a bit of money in a turbulent environment while the hare loses his.

Today Senator Dodd dropped from his financial reform packet the demand of a fiduciary duty on those who give investment advice. Simply put, this means that you the client will continue to be taken advantage of by the vultures that put themselves first at all times and that this will remain legal!

There are a myriad of financial products that will continue to be sold due to their high commissions and the story selling that surrounds them. Whether they are appropriate for you will continue to be up to you to determine. Of course, whether these are good solutions for you or not will require you to study investments and financial planning for a few years as many of these products are complex and intentionally opaque. An equity indexed annuity is a prime example of the difficulties you will encounter in understanding and evaluating whether something is a good investment. Not only are these complicated (though the sales pitch is simple), but you are unlikely to know about similar or better products available with FDIC insurance that may be preferable. Why won’t you know about them? Because they pay far smaller commissions so they will not be presented by sales people who do not have to put your interests first.

The thought that you would pay someone for investment advice (whether that is by fee or commissions) who is not legally bound to at least try to put your interests first is absurd. That the financial services industry at this late date would campaign to avoid this level of responsibility is deplorable. Given all that we have gone through, you would hope that putting clients first would be acceptable to all moving forward.

What should you do? I think there are two questions that should be foremost in your mind when dealing with anyone in financial services (insurance, stock brokers, financial planners, etc.). First, ask them if they are acting as a fiduciary? If they do not respond in the affirmative, make sure you ask them how they are compensated for a transaction and how much they are compensated for the transaction. If they are not forthright in disclosing these answers (e.g. they say their compensation is built into the product and you don’t pay anything additional), then you need to run for the exits. If you get a reasonable answer, then you may choose to proceed with the transaction. Just remember-caveat emptor.

We have finished one of the most disappointing decades for investors imaginable. In real terms (i.e. taking into account the decade’s inflation), the returns on stocks were negative for the decade. Those investors who sprinkled in bonds did a bit better, but may or may not have kept up with inflation. Those investors who veered from the traditional and had the vision to add commodities, real estate, etc. probably were able to actually experience growth for the decade. However, they still a rather muted return.

The “sales forces” of financial services are out there now beating the drums for this new decade. Surely after a poor decade we should return to the norm by having excellent returns on our investments, shouldn’t we? Unfortunately, this decade is not really setting up to be any easier for investors than the previous one.

Stocks are certainly not beginning the decade by being cheap by historic measures, so we should expect an average to below average return. Thus, the range bound or secular bear market is likely to continue for some time in equity markets. Unfortunately, commodities and bonds are no longer cheap like they were at the beginning of the past decade. So, returns will be still tough to come by moving forward.

We think the key moving forward will be to be tactical with your risk budget. By that, you or your advisor needs to keep an eye on what are the risks and what are the potential returns of investments. So, if the stock of a great company has fallen to a very low price, buying the stock may increase your risk but be justified by potentially large gains. On the other side, if a stock is very expensive by historic measures it may have rather limited potential appreciation and considerable potential loss. To sell that position and reduce your risk may be the prudent decision. 

So, while investors traditionally have to decide on how much risk to take and stuck with that decision, we believe the prudent course is to adjust your risk budget by the opportunity available to garner good returns. You might still average the same amount of portfolio risk through a market cycle, but get to that average in a way that benefits your bottom line.

Sounds like the credo of the ultimate workaholic! But we don’t think so.

We have long held that for us personally retirement was not a goal. Restylement, with its ability to give you more time to pursue the things that are most important to you, is what appeals to us. There is something that we don’t like about retirement- there is a connotation of withdrawing in the word that does not appeal to us. We know retirement will still be the goal for many, but others will increasingly choose restylement as their goal. The ability to do the things you are passionate about and spend less time doing the things that you don’t enjoy.

This past week we were on “vacation”, but it did not work out that well. We found there were pressing work issues that needed to be dealt with during our time away. So, it occurred to us to re-think vacation a bit also. It seems to us that “vacation” is a corollary to “retirement”. The root word “vacate” has to do with leaving, emptying, etc. Our goal when we go away is really not vacating, but recreation. We want to re-create, not merely empty. Our goal in getting away is to refresh, step back, enhance, get new ideas flowing, etc. So, we did not really have our “vacation” spoiled by having to do a bit of work while away. We were still able to enjoy all the benefits of the time away and have it serve us well in “re-charging” for the road ahead. So- no retirement and no vacation, but bring on restylement and recreation. They both sound good to us.

This past week not one but two clients asked if they shouldn’t be selling all their bonds now. Odd question and the second one sent off our radar. We smelled something rotten in Denmark, or maybe somewhere a bit closer to home. Which of the two sources was responsible? Jim or Suzie? We correctly guessed Jim. Yes, the client admitted, they had been watching Jim Cramer who suggested they dump all their bond holdings. We are going to say this to all who will listen-JIM CRAMER AND SUZIE ORMAN ARE NOT YOUR FRIENDS!!!!!

Their approaches are extremely different (Jim is certainly the more offensive of the two to us), but ultimately they both share only one goal-self promotion. They are the anti-fiduciaries. They do not put your best interests first. They are all about promoting themselves. If you perish as fodder in their self promotion scheme, they will not miss a meal nor feel a moment’s sorrow.  I am pretty sure if Warren Buffet listened in daily to Mr. Cramer and followed all his advice he could have had his home foreclosed upon by now. Cramer uses the shotgun approach, trying to hit a home run by taking 100 swings in every direction. So, he usually has a home run or two to remind you about. The other ideas strike out and are replaced by another hundred swings for the fences.

Suzie’s approach is far more demure but just as lacking in ultimate usefulness. She likes to make sweeping generalizations (“X is a bad thing to do as an investor”). The problem is she has not taken the time or effort to understand your unique situation and needs, so her “advice” might be right for over 50% of listeners but dead wrong for you. You become the fodder in her fame.

A fiduciary, plain and simple, is charged with putting your interests first. The person may be inept and may not give you good counsel. However, they at least must attempt to give you good counsel. That would seem like a good first step in evaluating who you should listen to.

We know it is a little late for New Year’s Resolutions, but………..How about it! Why not tune out Jim and Suzie and devote that time to something that will add to the quality of your life?