Kimmunications

Financial Advisor Red Flags

I've been talking with a number of our prospects the last couple of weeks, and the stories they tell of being ripped off by various financial advisors and investment schemes are amazing. The chutzpah of some of these advisors is incredible - I don't see how they can sleep at night when they sell so many investments that are clearly designed to benefit the advisor more than the client.

I thought it would be useful to jot down some of the things to look out for when dealing with a financial advisor or broker. We'll call these Financial Advisor Red Flags. Here they are, in no particular order:

1. Invoking a dead relative in an effort to keep your account.

I met with someone the other day - I'll call her Ann - who gave this egregious example. Her husband was a rapidly climbing young executive before he died unexpectedly. Fortunately, he had life insurance.

Ann said she didn't know anything about investing, so she contacted the salesman who sold her husband the policy. The insurance guy sold her all sorts of insurance products like variable annuities. He convinced her that all these products were in her best interest. But after a couple of years, Ann looked at her investments and realized that they didn't meet all her objectives, so she called up the insurance guy and told him she wanted to pull money out.

Instead of defending the investments he sold her on their merits, he tried to shame her in to staying put. "Your husband trusted me," he said, "and he would be so disappointed in you."

I wish I could say that surprised me, but I've heard stories like this from lots of people. Some of them inherited their parents' financial advisor when they inherited money, and were guilt-tripped when they tried to move the investments somewhere else. Others said their advisor invoked the "but we're friends!" card: "But we've been in Rotary together for 20 years! I thought you trusted me!"

Any time a financial advisor uses a guilt-trip or an emotional plea to try to keep your account, that should be a big red flag.

2. Recommending variable annuities when they're not appropriate - such as in an IRA.

I've written a lot about the problems with variable annuities. They cost too much, they rely on terrible mutual funds that underperform the market, the list goes on. (You can read up on the problems with variable annuities here.) But my primary objection is that they're appropriate for only a small portion of investors. Most of us would be better off in something else.

I get particularly mad when I hear about an advisor selling someone a variable annuity inside their IRA. An IRA is already a tax-advantaged vehicle. A variable annuity is tax-advantaged, too - it makes absolutely no sense to have one tax-advantaged investment inside of another.

3. Recommending you move money out of your 401(k) or stop contributing.

This is financial malpractice at its worst. Sure, 401(k) and similar plans have their faults, but for most of us they form the cornerstone of our retirement plan.  Until you leave your employer and are eligible to roll over the money into an IRA, you probably should stick with your 401(k) plan. And if your employer matches part of your contributions, that's free money you'd be leaving on the table by shifting your savings elsewhere.

It's also a red flag when an advisor recommends you borrow from your 401(k). Treat your retirement funds as sacred. If you need cash to deal with an emergency, pretend that 401(k) money doesn't exist. If you borrow from your 401(k), you're robbing yourself of the power of compounding and exposing yourself to penalties if you leave your job before the loan is paid off.  Read more about 401(k)s here.

4. Constructing a portfolio for you with an expected annual return of less than 10%.

Many advisors still ascribe to the old way of thinking, that the best way to ensure your money lasts as long as you do is with a typical 60/40 portfolio (60% stocks, 40% bonds). But this construction is too conservative, and its expected annual return is only 8%. That 8% may give you a high probability you won't run out of money, but it almost assures you won't be able to buy anything with the money you have left.  In other words, the 60/40 portfolio doesn't take into account inflation and taxes.

To pay yourself 4% of your portfolio each year in retirement (the generally accepted "safe" withdrawal percentage), keep up with the historical rate of inflation and pay Uncle Sam at a marginal tax rate of 25%, you have to earn a 10% return. The formula is your withdrawal rate plus inflation divided by one minus your marginal tax rate, or (4 + 3.5)/(1-0.25). If you want to withdraw more or if your tax rate is higher, you'll have to earn an even higher return.

So a double-digit annual return is your goal. If your advisor builds a portfolio for you that is designed to return less than that, you should look for another advisor.

5. Recommending only mutual funds, especially those that are only available through his/her company.

I don't like mutual funds as a rule. I really don't like actively managed mutual funds because their high fees virtually guarantee over time that you will underperform the market itself. So mutual funds are bad enough - but conflict-of-interest from your broker or financial advisor makes it even worse.

A groundbreaking study by Daniel Bergstresser and Peter Tufano of the Harvard Business School and John Chalmers of the University of Oregon found that mutual funds sold by financial advisors badly underperformed the funds selected by investors on their own. The study is titled "Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry," and you can read more about it here. You can also listen to my interview with one of the authors here.

A lot of financial advisors will try to steer you toward proprietary funds that are only available through their company. For example, an Ameriprise advisor may try to steer you toward RiverSource mutual funds, which are only available through Ameriprise. It's not because these funds are the best performing. It's because the financial advisor's employer pays him or her to sell the firm's product. It's another example of conflict-of-interest and is a reason to avoid commission-based advisors. For that matter, let's make accepting commissions its own flag:

6. Accepting a commission from products they sell

Any advisor who takes a commission off the products they sell you has a conflict of interest. You can't tell whether the product he recommends is really in your best interest or if he is recommending the product because it pays him well.

If you do use a financial advisor, your best bet is to go with a "fee-only" advisor, one who doesn't get paid commission on the products they recommend. That's the only way you can be sure to avoid the conflict-of-interest.

This post is getting pretty long, so let's stop there for now. I have lots of other red flags to watch out for, and I'll post those later on. If you have a suggestion for a red flag, send me an email. I will compile your suggestions for a future post.

Investing Like Yale

In times when the market is going every which way, it can be comforting -- and rewarding -- to follow a rigid system. This video from Investment News shows how large university endowment funds follow a system to get better results. It also features an interview with a big-name fund manager who also follows a system.

Key quote: "We've found over the years that the numbers are more reliable than opinions, and that includes my own opinion." - Steve Leuthold, The Leuthold Group

Also, for those of you in the Snider Method® who are nervous about the international stocks Lattco® gives you, pay close attention to the discussion of overseas markets.

Go here to watch the video: http://link.brightcove.com/services/link/bcpid1125967528/bclid1125949998/bctid1498976295

Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.

Market Timers Creep Out of the Woodwork

Have you ever been driving around, listening to the radio, when you hear something so offensive, so wrong, that you can't help but scream? That happened to me last Saturday afternoon. 

I was driving home from our after-show "Lunch Bunch" when I heard a financial advisor - on the same station my show comes on - tell his listeners that we should trust him because he said to get out of the market back in November. He said if everyone had done as he advised, we'd all be happier right now amid this market volatility.

Several other so-called advisors are on the airwaves warning of an impending recession. "Get your money out of the stock market now," they say.

These advisors are suggesting that they can properly time the market. And they want you to pay them a hefty premium to do it.

Why the myth persists

Why do so many think you can successfully time the market? Because we hear about the successful calls all the time. Elaine Garzarelli correctly predicted the stock market crash of 1987. Ralph Acampora became famous for predicting the dot-com bubble. We don't hear about all the market calls they made that didn't come true. But because they got it right once or twice, the media treat them as geniuses.

You're probably familiar with the phrase, "Even a stopped watch is right twice a day." It's the same for many market timers. Abby Joseph Cohen is always bullish, and when she turns out to be right, she's labeled brilliant. Roger Babson is credited with predicting the stock market crash of 1929. But he was giving doom-and-gloom speeches throughout the 1920s, even as the market reached historic highs year after year. When the crash happened, suddenly he was right.

I've even heard stories from friends in the financial services industry that the big firms keep analysts who make opposite calls, just so they can point to the one who gets it right.

The evidence

So our radio financial advisor friend correctly predicted when to get out of the market. Congratulations. But to be a successful market-timer, you can't just know when to get out. You also have to know when to get back in. And that's no easy task. There's about a one-in-ten chance of guessing it correctly, according to Vanguard's John Bogle. He tells William A. Sherden in The Fortune Sellers:

To make money, you have to make two market calls: one to get near a low point and one to get out near a high one, which means that your chance of success is about one hundred to one (one-tenth times one-tenth). And, doing it twice has a one-in-ten-thousand chance of succeeding.

…

In the 30 years in this business, I do not know anybody who has done it successfully and consistently, nor anybody who knows anybody who has done it successfully and consistently. Indeed, my impression is that trying to do market timing is likely not only not to add value to your investment program, but to be counterproductive.

Bogle's impressions are supported by several studies, one of which is from Dalbar. Their Quantitative Analysis of Investor Behavior has, for many years, shown how investors shoot themselves in the foot trying to chase returns. In other words, impulsive investors. But market timers do even worse, according to their 2004 study:

Although the S&P 500 on average grew by 13 percent over that 20-year sample, Market timers actually lost money.

And these financial advisors are suggesting that timing the market is a good thing?

By getting out of the market, as these advisors suggest, you may avoid losing some capital in the short term. But you're almost assured of missing out on the gains when the market starts going back up. According to a study from SEI Investments, the majority of a bull market's gains come in its first few days and weeks. If you wait until you see the market turn, you've already missed a golden opportunity.

From The Wall Street Journal:

SEI looked at the dozen bear markets since World War II. If you held stocks at the market bottom, you made an average 32.5% over the next 12 months. But what if you bought one week after the bottom? Your gain was trimmed to an average 24.3%. Meanwhile, if you didn't buy until three months after the market bottom, your gain was just 14.8%

So what do we do?

I have no idea whether we're headed for a recession or a prolonged bear market. I don't have a crystal ball, and I'm not in the business of predicting the future direction of the stock market. What I do know is that the stock market is the best place for long-term growth over time, just not all the time. Trying to time the market is a fool's errand.

Any advisor who tells you otherwise is either lying or sadly misguided.

SOURCES:

1. Dalbar Inc., Quantitative Analysis of Investor Behavior, 2004.

2. "It's Time to Prepare Yourself for an (Inevitable?) Bull Market." Getting Going, The Wall Street Journal, Oct. 23, 2002. http://online.wsj.com/article/SB1035309775900025391.html?mod=googlewsj (accessed April 30, 2008)

3. Sherden, William A. The Fortune Sellers: The Big Business of Buying and Selling Predictions. New York: John Wiley & Sons Inc., 1998.

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Kim Snider is the President and Founder of Snider Advisors, an SEC Registered Investment Advisor, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method and how to stop enriching your investment advisors at your expense, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.

Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.

Lunch Bunch for Saturday, April 26

This week's "After-Show Lunch Bunch" will be at Paradise Bakery and Cafe in North Dallas after the radio show on Saturday. The address is 13710 Dallas Parkway, which is the northeast corner of the Tollway and Alpha (across from the Galleria). The phone number is 972-503-1800, and they're reserving several tables for us; just look for the signs. As always, anyone and everyone is welcome.

We started the Lunch Bunch a few weeks ago when, on a whim, I went on the show and invited our listeners to join me for lunch. More than a dozen showed up, so we tried it again the next week. About 25 came out!

It's nothing formal -- just a continuation of the conversation we start on the air. Anything you want to talk about is fair game.

We plan to do this every few weeks, and we'll move it around to make it convenient for as many people as possible. 

So please tune into the show tomorrow (Saturday) at noon on KRLD 1080 AM in Dallas-Fort Worth, then join us for lunch in Paradise... er, at Paradise Bakery around 1:30!

Lack of a financial education hurts the super-rich, too

Conventional wisdom holds that the ultra-wealthy have many more investment advantages than you or I. After all, they have access to highly selective hedge funds. It’s an exclusive club where the stakes are high and the rewards are out of this world.

Or that’s what they want us to believe.

The big hedge funds claim to offer much higher returns than what the normal investor can get through mutual funds. That’s why the buy-in is so high. But it turns out, hedge fund performance isn’t much better than that of run-of-the-mill mutual funds. What’s more, the incentive programs given to the managers leave hedge funds open to fraud and chicanery.

As with so many problems on Wall Street, this has to do with the compensation system. The manager of an ordinary actively managed mutual fund may take a fee of 1-2%. That’s bad enough, but it’s chump change compared to what the hedge fund manager gets. The typical fee arrangement for a hedge fund manager is usually 1 or 2% of the assets PLUS 20 percent of the returns that exceed some benchmark. So let’s say a fund has $200 million in assets and has a benchmark rate of return of 7%. After the first year, the fund was up 10%, or worth $220 million. The manager would earn $4.4 million for the management fee, plus $1.3 million for beating his benchmark (20% of the 3% extra gain).

You can imagine how this incentive arrangement just invites manipulation – and leaves hedge fund investors exposed to tremendous risk.

According to a study from the University of Pennsylvania's Wharton School:

…[I]t is very hard to set up an incentive structure that rewards skilled hedge fund managers without at the same time rewarding unskilled managers and outright con artists. Furthermore, any incentive scheme that does not directly penalize underperformance can be gamed by the manager so that his expected fees are at least as high, relative to expected gross returns, as for the most skilled managers.

The authors show how an enterprising hedge fund manager can use the derivatives market to generate what look like above-average returns. By placing highly leveraged bets on unlikely events, the manager can generate enormous amounts of cash. If his bets are right, the fund investors are very happy. If he's wrong, the fund collapses and the investors lose almost everything. Either way, the manager stands to make a fortune regardless of how the fund performs. This is a process the authors call “piggy-backing.”

In mutual funds and hedge funds, the term “alpha” is used to explain the part of a fund's performance that isn't explained by market forces. In other words, it's the result of the manager's supposed skill. By piggy-backing, an unskilled manager can fake alpha. By writing a number of covered calls using his investors' money as collateral, “it allows an unskilled manager to mimic a target series of excess returns without having the slightest idea about how a skilled manager would actually generate them.” [emphasis in original]

Dean P. Foster, one of the authors of the study, gives an example of this strategy at work:

An enterprising man named Oz sets up a new fund with the stated aim of earning 10 percent in excess of some benchmark rate of return, say 4 percent. The fund will run for five years, and investors can cash out at the end of each year if they wish. The fee is the standard '2 and 20': 2 percent annually for funds under management, and a 20 percent incentive fee for returns that exceed the benchmark.

Although he has no investment track record, Oz has a smooth manner, a doctorate in physics and many rich acquaintances. He raises 100 million and opens shop. He then studies the derivatives market and finds an event on which the market places fairly long odds, say 9:1. In other words, it costs .10 to buy an option that pays 1 if the event occurs and 0 otherwise. The nature of the event is unimportant: it might be a large fall in the stock market, Florida getting hit by a Category 5 hurricane or Russian President Vladimir Putin dying before the end of the year.

Next Oz writes some covered options on this event and sells 110 million of them in the derivatives market. This obligates him to pay the option holders 110 million if the event does occur and nothing if it does not. He collects 11 million on the options. To cover his obligations in case the 'bad' event occurs, he uses the investors' money plus the proceeds from the options to buy 110 million in one-year Treasury bills yielding 4 percent, which he deposits in escrow. This leaves 1 million in "pocket money," which he uses to lease some computer terminals and hire a few geeks to sit in front of them, just in case his investors drop by.

The probability is ninety percent that the bad event does not occur and Oz owes nothing to the option holders. With a gross return (before expenses) of 15,400,000, the investors are thrilled, and so is Oz. He collects 2 million in management fees (of which he has only spent 1 million), plus a performance bonus equal to 20 percent of the 'excess return', namely, 20 percent of 11,400,000. All in all, Oz nets over 3 million for doing absolutely nothing.

Foster says Oz can repeat this scheme next year. If his bets continue to pay off, he'll attract more investors and pocket more money. If the fund collapses, Oz can simply close the fund early and start a new one next year.

This scheme is not illegal, but it is risky – risky for his investors, but not for himself. In no scenario will Oz actually lose money. Actually, the more risk he takes with this investors' money, the more he stands to profit. That's the way his incentive structure works. You may get screwed if the fund collapses, but he walks away with millions.

This is yet another example of how Wall Street’s compensation system puts the interest of brokers and fund managers ahead of the investor. No matter how much money you’re working with, unless you know what’s really going on, you’re just asking to be taken advantage of.

That’s why it pays to learn as much as you can about how Wall Street really works, and why you ultimately should be in control of your own investments. Wall Street is set up to take advantage of the little guy, even if that little guy has millions and millions of dollars.

SOURCES:

1. Foster, Dean P. and H. Peyton Young, “The Hedge Fund Game: Incentives, Excess Returns, and Piggy-Backing.” March 2008. http://www.brookings.edu/~/media/Files/rc/papers/2007/1114_hedge_fund_young/1114_hedge_fund_young.pdf (Accessed April 23, 2008).

2. Foster, Dean P. and H. Peyton Young, “Hedge Fund Wizards,” Washingtonpost.com, December 19, 2007. http://www.brookings.edu/opinions/2007/1219_hedgefunds_young.aspx (Accessed April 23, 2008).

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Kim Snider is the President and Founder of Snider Advisors, an SEC Registered Investment Advisor, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method and how to stop enriching your investment advisors at your expense, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.

Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.