Barriers to Financial Security – a Series of Articles

Barriers to Financial Security

An article series written by Mark Thomas, principal of Capstone Wealth Management. Copyright 2010, All rights reserved, Registered with The Library Congress. Click here to read a Billings Business Journal article written by Mark


When you consider the current economy, the last thing you are probably experiencing is “irrational exuberance.” Federal Reserve Chairman Alan Greenspan was the first to use this phrase in the mid-1990s. Only a few years later,, once merely a retail book company started in a garage, was trading at $91 a share with a history of negative earnings (Market Watch, 2002). In other words, people were willing to invest in a company by purchasing stock that had and would continue to lose money. If you contrast this level of performance with that of the average stock in the S&P 500, you can see how those Amazon investors were gambling with their money in response to irrational exuberance. When Greenspan coined the phrase, the stock market was booming, so few people were likely to heed what we now recognize was a warning. Shortly after he made the comment, world markets slumped. During global economic crises, we read alarming headlines. Consider the following:

Recession Starts Taking a Toll: Will it lead to another crash? “Worries are building that today’s sagging economy may be on the brink of collapse.” U.S. News and World Report

The Death of Equities “7 million stockholders have defected fromthe stock market [this decade], leaving equities more than ever.” Business Week Running Short of Cash “The United States and its allies scrambled to head off a global financial disaster. Finance ministers from the United States, Britain, France, Japan, and West Germany met last week near Frankfurt to find a way to avert a global economic collapse.” Newsweek These were not pulled from today’s headlines. They come from November 1974, August 1979, and December 1982 when investors were experiencing great fear in the midst of bear markets. Fortunately, the financial world did not come to an end at any point, not in 1974, 1979, nor 1982. And though national and international efforts certainly played a role in the investors’ returns, Investor behavior does matter, and it arguably poses the greatest risk to successful long-term investment experiences. Furthermore, the outcomes of investor behavior are even more dangerous to the financial security of people transitioning into or living in retirement.
Why is Investor Behavior So Important?

Why is Investor Behavior So Important?

PERHAPS THE MOST IMPORTANT INGREDIENTS TO long-term financial security are the decision-making abilities and behavior of the investor. DALBAR, Inc., a company that provides standards, research, and ratings for those in the financial industries, published a report in 2008 that shows the effect of investor behavior on financial investments. According to that study, the S&P 500 earned an annualized return of 11.81% during the 20 years ending in December 2007, which was a period of strong bullish markets, while the average equity investor only earned 4.48%. Despite the opportunities, in other words, the average investor earned only 38% of the available return as a result of making poor decisions throughout the twenty year period. To better understand the practical implications of these numbers, consider the following: assume an investor had put $100,000 into an S&P 500 mutual fund in 1988 and earned its average return of 11% between then and 2007. Even after the bursting of the 2000 – 2002 Tech Bubble, the value of that investment would have grown to $806,231. Hampered by flawed decision-making abilities, however, the average investor actually achieved a 4.48% return during the same period. That hypothetical investment of $100,000 would only have grown to $240,249. The behavior of our hypothetical average investor ended up costing him a difference of over $560,000. This is a loss of 69% of the available return of $806,231. Unfortunately, most investors fall prey to a thought process that prevents them from always making logical decisions instead of decisions based more on emotional responses. The consequences may mean the difference between retiring with financial security, peace, and confidence and the alternative of retiring in what would feel like relative poverty.
Your Portfolio’s Worst Enemy

Your Portfolio’s Worst Enemy

THIS YOUNG CENTURY HAS ALREADY FELT THE POPS and drops of two investment bubbles – one in 2002 and the other in late 2008 and early 2009. Some investors may have mostly escaped the impact of one, or perhaps both of them, but behavioral finance, a relatively new academic field, teaches us that investors can still be vulnerable to the momentum created by fear and greed, even if they are not hit by each downturn in the market. In order for investors to continue to be safe from this momentum, they have to understand how their behavior impacts portfolio performance. In their efforts to achieve long-term security, they may find it helpful to recognize that during the extraordinary expansion of the housing bubble and the most recent sell-off in the stock market, many responded emotionally and with at least some disconnect in logical reasoning. At an extreme level, this disconnect can lead to a suspension of the traditional benefits of business acumen and fundamental and technical analysis. To help investors bring the challenge of emotionally-driven behavior into perspective, future articles will attempt to explain some of the challenges presented by psychological forces that impede our financial success, and they will cover the following aspects of investing:
  • A historical journey to better understand economic cycles;
  • Psychological tendencies and the challenge of overcoming these tendencies to become good investors;
  • How our financial survival depends on our ability to identify these challenges;
  • Hard and fast solutions.
Historical Perspective

Historical Perspective

EVEN THOUGH EACH BEAR MARKET SEEMS UNIQUE, investors can gain some perspective if they review the similarities of bear markets over the last fifty years – a period during which we have faced ten particularly challenging intervals in market conditions, including the one we are now experiencing. Approximately every five years, the market enters a period of correction that is a natural process of the risks and rewards of capitalism, and each time, we have recovered from the slump in the cycle. To better understand these patterns from a historical perspective, consider three of the most recent bear markets:

January 11, 1973 to October 3, 1974

The causes of the economic fright experienced by Americans in the 1970s include the Vietnam War, Watergate, an oil embargo, a double digit unemployment rate, and a 16.8% increase in the cost of living. Over the course of 23 months, the market lost 45% of its value, and many investors eventually turned to the safety of CDs and bonds. Such extreme conditions had not been experienced in the United States since the Great Depression. A 1974 Time magazine cover stating “Recession’s Greetings” reflected the fear of the nation, and the cover story’s title prophesied “Gloomy Holidays – and Worse Ahead.” The article begins, “Not for many years has a Christmas season begun with so many tidings of spreading discomfort and lack of joy about the U.S. economy. Already wracked by a devastating double-digit inflation, the nation is now also plunging deeper into a recession that seems sure to be the longest and could be the most severe since World War II.” Despite Time’s grim predictions, economists now agree that December 1974 actually marked a turning point in the U.S. market: the S&P 500 soared 37.2% and 23.9% in 1975 and 1976 respectively.

August 26, 1987 to December 4, 1987

This bear market was as extreme as it was short. On a day known as Black Monday, the crash of markets around the world on October 19, 1987 also sent the Dow Jones Industrial Average plummeting 22.61%, which is still the largest one-day percentage decline in history. (In contrast, the stock market crash of 1929 included only a 12.82% decline on its Black Monday.) As in 1974, the plummet of the Dow panicked many investors who desperately looked for financial safety elsewhere. Again, Time magazine provided another cover story depicting Americans’ dismay. One story presented an hour-by-hour account of events, and another argued that “the U.S. …could not go on forever spending more than it would tax itself to pay for, buying more overseas than it could earn from foreign sales, and borrowing more abroad than it could easily repay. There had to be a day of reckoning, and it could unhinge the whole world economy.” The disapproval and pessimism of this seemingly timeless statement gave investors little hope for the immediate future. However, almost half of the Black Monday losses were recovered in the days following the sell-off, and less than 3 months later, the S&P 500 finished the year up 2.3%. Overall, the 1980s ended with a compound return of the S&P 500 of 17.6%.

March 24, 2000 to October 19, 2002

While many people remember the crash of the stock market following the September 11 terrorist attacks, this multi-event decline actually began with the earlier bursting of the technology bubble in 2000. By October 2002, at the end of an exhausting 28 month period, the S&P 500 had lost 49.2%, and a young generation that had previously felt indestructible suddenly felt very vulnerable. The September 14, 2001 Time magazine cover depicts the World Trade Center’s Twin Towers in the final moments before their collapse. One of the many signs that our country had come to a complete halt was the closure of the New York Stock Exchange for 4 days after the attacks. Once the markets reopened, the Dow Jones Industrial fell more than 17% over the course of a week. In 2001 the United States and its economy was vulnerable to outside forces and to the loss of its strong technology sector because of the exposure of hidden greed in corporate America. 2002 was defined as the year corporate titans WorldCom and Enron collapsed and the year that $2 million birthday parties funded by the corporate dollars of Tyco ended. As dark as the outlook was following the collapse of the technology bubble and the devastation of September 11, the markets eventually recovered: the S&P 500 appreciated on average 14.3% in value per year between early 2003 and late 2007. Despite oil embargos, double-digit inflation, the burst of the 1990s technology bubble, and September 11, the past 35 years have produced a whopping appreciation of 3,725% in the S&P 500. Investors cannot invest directly in the S&P 500, but if they could have invested $100,000 in the early 1970s, their investments would potentially have appreciated to over $3.7 million during those 35 years, assuming that our hypothetical investor had not fallen victim to the greed and emotionally-driven behavior that plagues the average investor. Though a natural response is to panic when facing a challenging bear market, we are less likely to make faulty decisions if we can keep such market fluctuations in perspective. This article is the fourth in a series of lessons about the barriers investors face as they work to achieve financial security. Previous articles introduced the series and outlined the ways investors’ behavior impacts their decisions. The next article will explore the psychological tendencies of investors and the challenge of overcoming such tendencies as we explore the emotional and intellectual responses a number of investors experience as part of the investment process.
Our Money and Our Brains

Our Money and Our Brains

TO FEEL EXCITED WHEN OUR PORTFOLIOS INCREASE in value and to experience fear when they decrease in value is perfectly normal and acceptable. However, these emotions become problematic once we start making decisions based on emotional entanglements that limit our ability to reason. To prevent ourselves from making such decisions, we first have to recognize our capacity to make poor financial decisions based on emotions in order to then recognize the emotions that drive them. In response, we can then take a more defensive stance that could potentially limit the risk of damaging our long-term financial security. First, identify the enemy. We are our own worst enemies when it comes to managing our finances. When we understand how we tend to respond in certain circumstances, we can develop a plan to defend our finances from our emotional responses the next time we have similar experiences. Second, recognize the challenges. You are likely very familiar with the excitement of financial gain and the fear of financial loss; however, you probably are not aware of how your brain’s wiring influences those responses. Investing affects us not only emotionally and psychologically but physiologically as well. Neuroeconomics, the study of neuroscience, economics, and psychology, shows that any thoughts or decisions about financial profit use the same part of our brains that is hardwired to pursue pleasure. In contrast, the experience of financial loss is processed by the part of our brain that triggers a full reaction to pain or danger and causes fight or flight. Your brain is so sensitive in such situations that it even responds differently if you are planning for short-term monetary rewards than if you are planning for long-term ones (Technology Review, May 2005, Huang). In other words, your responses to investment plans and outcomes are very complex. Once you recognize these responses in your own behavior patterns, you will have a better chance of achieving financial security. Recognizing them will also help you keep your emotions in check the next time we face a bear market, which is a part of every five year cycle. Jason Zweig, a columnist for the Wall Street Journal and editor of the revised edition of Benjamin Graham’s The Intelligent Investor (2003), expands on this mental response with an analogy: “There is not much difference in the brain between having a rattlesnake slither across your living room carpet and having some stock you own go down by 40% or 50%.” Recognizing that you may not have much of a chance battling a rattlesnake barehanded, you might resort to a flight response because you merely hope to get out alive. Not surprisingly, you may feel similarly in response to a disastrous drop in the value of your investments. Additional psychological forces include personal biases, emotions, and past experiences, all of which can influence even experienced investors. Some psychological forces are quite obvious while others are very subtle. Nevertheless, there are psychological pitfalls you can be aware of and straightforward advice you can use to help mitigate their impact. A few of these include a fear of regret, myopic risk aversion, overconfidence, and the “herd mentality.”

Fear of Regret

Investors who are affected by fears of regret put off financial decisions because they hope to get even more information and feel even more confident before having to make decisions. Consequently, these investors sometimes hold on to losing stocks for too long or sell winning stocks too quickly. They hold on to losing stocks rather than accept a loss for two reasons: they hope the investments will eventually make gains, and they feel as though selling them confirms that they had made a mistake by buying them in the first place. Those with winning stocks sell too quickly because they want to do so before the stocks start to lose value – they hope to “quit while they are ahead.” If you tend to worry that you will regret similar investment decisions, listen to Deena Katz, a chairman for Evensky and Katz Wealth Management: “My mom always said, if you’re going to do it, don’t worry; if you’re going to worry, don’t do it. You’ve already made the commitment to be where you are invested . . . You’re there. And unless you need to get out, you’re committed” (Money, May 2008).

Myopic Risk Aversion

Myopic risk aversion certainly sounds like something you would hear in an eye doctor’s office, and it actually does relate to a type of “vision.” People exhibiting myopic risk aversion cannot focus on long-term gains because they are too fixated on short-term losses. Such a focus makes sense psychologically, but it could be an exceptionally dangerous pitfall for investors right now. Even those who are usually confident about their long-term investment goals may become anxious about recent fluctuations in the market and might end up losing money unnecessarily because they can only focus nearsightedly on the immediate future. To avoid this pitfall Robert Arnott, the founder and chairman of Research Affiliates (a developer of investment products) suggests that rather than ask yourself what you can do to make money in the next three months you should ask yourself, “What would I want my portfolio to look like over the next 30 years?” (Money, May 2008).


Overconfidence is somewhat the opposite of myopic risk aversion. Recent research indicates that many investors, especially men, overestimate their own abilities as well as the accuracy of the information they gather prior to making financial decisions. As a result, overconfident investors tend to overtrade, which usually leads to lower returns. An article in the February 2007 issue of Inc. explains that “overconfidence is one of the worst failings an investor can have.” Despite the temptation to guess the future or try to control what will happen (both of which are forms of overconfidence), investors have to admit that neither is possible to do, no matter how confident they may feel in their abilities.

Herd Mentality

As Niccolo Machiavelli explained, “[People] nearly always follow the tracks made by others.” Such behavior causes us to go along with the collective wisdom and tastes of the larger masses in a variety of situations. Clothing fashions, community circles, automobile selection, and even investing habits reflect that humans are social creatures who are very likely to “follow the herd.” When it comes to investing, social environments and the media heavily influence people into jumping blindly on the investment bandwagon without employing sound reasoning and research. Therefore, unfortunately, investors will unwittingly follow the herd even if the herd’s direction is to the detriment of the investors’ personal and financial goals and even if doing so goes against their individual reasoning abilities. The Madoff Scandal illustrates this tendency perfectly. Many people, who had long been successful investors, forgot about the importance of research, prudence, and diversification in large part because they followed peers who were investing with Bernard Madoff. Recognizing the role societal influences played, David Zarolli reported in a December 2008 story for NPR’s “All Things Considered” that “it was prestigious to invest with him.” In fact, people even joined his country club in Florida merely to meet him and get a personal invitation to invest with him. In addition to a prestige factor, behavioral finance experts explore other key reasons we are willing to follow the herd. The Market Analysis, Research, and Education group, a unit of Fidelity Management’s research company, explains that an “investor may follow the herd because he or she feels an intuitive sense of conformity, whereby aligning oneself with the consensus of a large group going in the same direction is more comfortable than making an alternative, less-popular choice.” If we follow the direction of a larger group of investors, we can act based on the assumption that many others must have access to superior knowledge. And how could so many others be wrong? Conversely, we tend to believe that the groups that we are part of are naturally more likely to be right. (Otherwise, we would not experience the sense of affinity that defines those groups to begin with.) Including the original Ponzi Scheme, there are quite a few historical examples when a number of individuals have fallen prey to the herd mentality. One, Tulip Mania, caused wealthy Dutch investors to spend obscene amounts of money on tulip bulbs or on shares of bulbs. Some even went so far as to trade houses so they could invest in one or two tulip bulbs! Such examples are evidence of the irrational behavior humans are capable of exhibiting, and we seem to be especially vulnerable when we are following others. An investment trend in the late 1990s also demonstrates a similar but complicated example of herd mentality. During the emergence of the “New Economy,” Warren Buffet was ridiculed for his arcane investment theory because others believed that the New Economy marked a period when globalization and the acceleration of developments in information technology began to change economic trends. The mainstream media extolled the possibilities offered by this New Economy. As early as June 27, 1994, John Huey of Fortune wrote, “The advent of the new economy is unequivocably [sic] good news for the U.S., which holds a wide lead over the rest of the world in developing, applying – and now exporting – technology.” When referring to the New Economy, a September 27, 1999 Time magazine article titled “Get” asked, “If you’re an entrepreneur, why waste your time in the old world, worrying about manufacturing things and dealing with unions and OSHA inspections, when you can put your company online in three months?” If only people had listened more to Warren Buffet and less to the media’s promotion of the New Economy. One way to better appreciate the investment trend in the late 1990s is to study the relationship between net sales of equity mutual funds. During the first quarter of 2000, as seen at Point 1 in the graph on the next page, the stock market was coming off of five straight years of double digit gains, and many of those gains were led by technology stocks. Between 1995 and 1999, the S&P 500 advanced 251% while the tech-heavy Nasdaq advanced 457%. In January 2000, at the peak of this multi-year rally, a record number of media headlines alluded to a “bull market.” Then, as it turned out, the first quarter of 2000 ended up being the peak of the market: over the next three years, the Nasdaq plummeted 67%, which meant devastating losses for those investors who had concentrated heavily on technology stocks. Those who had followed the herd and entered the market during the later stretches of the metaphorical stampede likely suffered the greatest losses because they had joined the herd at the riskiest time. Joining the herd as it ventures into new territory and takes new risks can be just as costly as joining it too late because those who follow the herd to supposed safety allow themselves to be led out of the stock market at the wrong times, too. In the final quarter of 2002, for example, after nearly three consecutive calendar years of downturns in the stock market, the number of headlines that suggested the possibility of a continuing bear market rose significantly. In response, investors became increasingly fearful and anxious before finally reaching the point of capitulation. Between June and October 2002 (Point 2), the S&P 500 declined 16% and the Nasdaq declined 18% – in just five months. Investors pulled a monthly average of $13 billion out of equity mutual funds compared to the average monthly inflow of $19 billion that had continued during the previous five months. As the above graph shows, people were buying when it would have been a better time to sell (Points 1 and 3) and were selling when it would have been better to buy (Point 2). It is worth noting that some investors did act individually and may not have focused only on long-term investments. Regardless, both types of investors lost money because of poor decisions and bad timing. Just as these investors retreated from equities during the second half of 2002, many also shifted their money into money market funds because of their relative safety. In November 2002, a record of $136 billion in net sales flowed into these money market funds suggesting that many investors were turning away from stocks near the bottom of a three-year bear market. In fact, by the end of 2002, the level of ownership in money market funds reached an all-time high of nearly 35% of all outstanding United States mutual fund assets. At roughly the same time, the S&P 500 began a sharp comeback: it rose 29% in 2003, which helped jumpstart a five-year bull market rally. For those who had recently decided to follow the herd by concentrating their portfolios into cash-like investments, the move may have been very costly. If you have ever been misguided because you followed the herd, do not be too hard on yourself. Stephen Greenspan, the author of the book Annals of Gullibility, accounted in a recent Wall Street Journal article how even he, someone knowledgeable about what can happen as a result of trust and/or ignorance, lost some of the savings he had accumulated from his book sales to Bernard Madoff. Greenspan explains in the article how “some risks are more hidden and, thus, trickier to recognize than others” (2009). Investors of all experience levels need to always be cognizant of the aspects of investing that influence their financial decisions.


MOST PEOPLE UNDERSTAND THE BASIC CONCEPT behind diversification: do not put all of your eggs into one basket. However, even people who are sophisticated investors can fall into investment traps. For example, many people have suffered losses because they placed a large percentage of their investment capital in their employers’ stock only to lose much of it during the recent downturn. Even though the employees may have understood that they were taking too much of a risk in doing so, they did not do anything to change their situations. Instead, they justified holding the position they had established because of the large capital gains tax they would have to pay upon selling the stock, or they imagined that the stock was just on the verge of taking off. In such instances, investors are too close to a particular stock, and they develop a false sense of comfort and overconfidence. They may rationalize that everyone with whom they work has invested in the company, and how could so many people be wrong? Similarly, they rationalize the importance of their investment in the company’s stock because they are professionally invested in the company and feel a certain sense of loyalty. Over the past year alone, many of these investors have felt the pain of such imprudent investment practices. In much the same way, other investors believe they have diversified their portfolios effectively because they own a number of different stocks. What they may not realize, however, is that they are in for an emotional rollercoaster ride if these investments all belong to the same industry group or asset class and therefore share similar risk factors. For instance, investors in the late 1990s and early years of this decade learned that diversification among a variety of high tech stock companies was really not diversification at all. When a number of prominent technology stocks, including Cisco, Dell, and IBM, experienced billion dollar sell-offs between Friday, March 10 and Monday, March 13, 2000, the resulting chain reaction hit the entire tech industry. Included with this article are charts that will help investors understand how diversification dramatically impacts a portfolio. (It is important to remember, however, that one cannot directly invest in the S&P 500. This chart uses it as an index for illustration purposes only.) So, imagine someone whose hypothetical portfolio consisted of a 100% investment in the S&P 500 (Portfolio 1). Between 1998 and 2007, he would have achieved a 4.38% annualized compound return and for every $1.00 invested, he would have ended up with $1.47. However, if he had merely invested 40% in a 2-Year Global Fixed Income Fund with the remaining 60% still in the S&P 500 (Portfolio 2), his annualized compound return increases to 4.72% and each dollar is now worth $1.51. Portfolio 5 shows additional diversification including investments in U.S. small and large value companies as well as in real estate. The annualized compound return of Portfolio 5 jumps to 8.9% while the growth of $1 reaches $2.15. Adding international stocks to Portfolio 10 even better demonstrates the potential of diversification because it achieves more than double the annualized compound return of Portfolio 1 (10.08%), and our investor’s $1 has now reached a value of $2.37. Explained this way, the benefits of diversifying are obvious; however, many people fail to take advantage of the potential of diversification.
Hard and Fast Solutions

Hard and Fast Solutions

WE WILL DISCUSS SOLUTIONS MORE EXTENSIVELY in a future volume of articles, but they are worth summarizing here as well. Investor Behavior & the Buy-Sell Cycle: Investors frequently engage in a buy-sell cycle that can be destructive to their portfolios as long as they are not aware of their behavior nor able to modify it. Quite simply, this cycle begins with the purchase of stock that an investor believes will be particularly lucrative. Greed kicks in and all is well until the stock begins to lose value. As soon as this happens, the investor experiences fear, regret, and, eventually, panic if the stock’s value continues to decline. The investor sells the stock just before new information comes out that will send its value soaring. Recognizing and understanding this potential behavior will help investors avoid it. Cash Flow Models: As investors assess where they are financially and where they would like to be, they will find cash flow models to be incredibly helpful tools. Whether trying to focus on the immediate future or trying to plan for retirement, investors who utilize cash flow models can avoid making rash, costly mistakes. An informed investment advisor, and even online tools, can help you develop an accurate cash flow model. Managing Investment Costs: A valued advisor can manage clients’ investments objectively and can assist clients in making research-based decisions, which is important since investors can only control those factors of which they are aware. Similarly, such an advisor can also help clients limit the cost of investing, which in turn increases the amount of the investment return that clients keep in their pockets. Managing Risk and Reducing Volatility: Investors will manage risk and reduce volatility more effectively if they have an efficiently designed portfolio. For every level of risk, the portfolio should take into account the optimal combination of investments that will give the highest rate of return. To do so, investors can utilize a variety of resources to stay informed and may also benefit from working with a valued advisor.


Now that you have some historical context, consider where we are today. During the first quarter of 2009, investors moved $285 billion in new net capital into money market funds and withdrew a net $31 billion out of equity funds. Do these changes suggest herd behavior? Perhaps. However, what long-term investors need to recognize is that if they radically alter their well-diversified portfolios, they also need to be prepared to assume a higher tolerance for risk. For example, investors who may have significantly lightened their exposure to risk by selling stocks in late 2008 and early 2009 might not have moved back into the market to participate in the 38% rally that took place between mid-March and mid-June of 2009. (On March 9, the S&P 500 was at 676.53, and by June 8 it was up to 939.14.) Though it begins to sound like a broken record, maintaining a diversified portfolio with exposure to multiple asset classes throughout a variety of market cycles really is the strategy that has provided investors with the least volatility in their returns. And these returns also end up being the most consistent with investors’ expectations. Investors face a number of challenges if they plan to have successful investment experiences over the years. Of primary concern are the psychological impediments that make it difficult for us to make good decisions consistently. Investors also face the uncertainty of market volatility, as evidenced by historical trends. Therefore, they should utilize the resources necessary to manage investment costs and to process current academic research on corporate stock pricing, portfolio construction, and management. Take the time to remember the impact your emotions can have on your decision-making abilities when you are making financial decisions. Consider carefully not only the decisions you are facing, but also why you are contemplating them in the first place. Just being aware of the emotional complexities of making financial decisions will help you achieve financial security.
Investor Behavior and a Buy-Sell Cycle

Investor Behavior and a Buy-Sell Cycle

TO BETTER APPRECIATE HOW PSYCHOLOGICAL FORCES impact the decision-making process, it helps to understand the various aspects of a buy-sell cycle for an individual investment, in this case an investment undertaken following a hot tip on a stock. You may have lost money on similar investments and did not enjoy the experience. Therefore, you are not immediately going to buy a stock based merely on a hot tip, even if the tip comes from a trusted friend or business associate. Instead, you are going to follow it for awhile to see how it does first. Now, let us assume for a moment that the stock starts to trend upwards. You continue to watch it to see how it does for a little longer. At this point, how would you be feeling emotionally? Hopeful that this might be the one investment that could help you make a lot of money? Now, imagine that the stock continues on its upward trend. As you begin to believe that this just might be The One, you start experiencing a new emotion: greed. And at that moment you decide to buy the stock. You know what happens next of course: soon after you invest in the stock, it starts to lose value. In turn, you experience a new combination of emotions: fear and regret. You begin to fear that you have made a terrible mistake. You promise yourself that the moment the stock goes back up to the price at which you had bought it, you can sell and will never buy like this again. Suddenly, you do not care about making money anymore. (And you just hope that maybe you can get away without having to tell your spouse or significant other about it.) However, the situation gets worse: the stock continues to drop in value, and you experience yet another new emotion. This new emotion is panic. As a result of this panic, you sell the stock. And what happens next? New information comes out and the stock rises to an all-time high. And this may explain why a DALBAR, Inc. report from 2008 shows that the S&P 500 earned an annualized return of 11.81% during the 20 years ending in December 2007 while the average equity investor only earned 4.48% during the same period. This article is the first in the second volume of a series. The first volume introduced the barriers to financial security that investors face, and this second volume will explore concepts that are important to having successful investment experiences.
The Building Blocks of Financial Security

The Building Blocks of Financial Security

THERE ARE FOUR BUILDING BLOCKS OF FINANCIAL security that increase the probability of investment success and personal independence.
These four building blocks require you to
  1. Create a cash flow model;
  2. Identify and reduce your investment costs;
  3. Manage risk and reduce the volatility of your investments;
  4. Delegate financial research to your personal financial consultant.
The first article in this volume explained investor behavior and the buy-sell cycle, and though this article merely introduces the building blocks of financial security, subsequent articles will explore each of these aspects of investing in more depth. As a result, you will hopefully have the tools necessary to avoid the emotional extremes that we explained in the first article in this volume.
A Cash Flow Model

A Cash Flow Model

CASH FLOW MODELS ARE INCREDIBLY HELPFUL DESPITE being relatively simple tools. The concept of using this type of financial model to measure the impact of today’s choices is similar to the “cause and effect” experiences we have throughout life. For example, imagine a teenager learning how to drive by practicing on a quiet country road. At first she watches the road as it disappears under the hood of the car. Consequently, she ends up meandering from one side of the road to the other, overcorrecting after each mistake. However, when she learns to lift her eyes and focus on what is out in front of her and in the distance, she realizes that she only needs to make small adjustments to stay on a direct course. Investors who develop cash flow models and then review them annually can similarly focus on the distance and avoid rash, costly mistakes. Instead of overreacting and making drastic changes, these investors understand that only minor adjustments are required to reach their long-term goals. You should approach retirement with a similar long-term perspective because it is not an event but is instead a process. If you are nearing retirement, a cash flow model is a tool that will help you understand the income you will need in the near future as well as in the years to come. Or explained another way: creating a cash flow model can be very helpful because it outlines your current financial objectives and helps ensure your long-term financial security. The visual perspective provided by a cash flow model also lets investors see the impact of actual and projected investment returns. It includes adjustments for inflation, and it will take into account any income sources that you are expecting such as social security and pension, investment income, and any money you may get, for example, from rent payments you receive for properties you own or from any sale of assets. A cash flow model should also take into account those expenses you anticipate, including debt repayment, gifts to family members or charities, and what you will need to cover your monthly lifestyle expenses. You may find the insight from an experienced financial advisor to be helpful when constructing a projected cash flow. An advisor’s outside perspective can prove valuable when considering investment returns and potential opportunities and pitfalls. To begin with, the preparation of a cash flow model should include a review of your past two years of living expenses. Also, consider that when preparing for retirement most people anticipate that they will have a 20% reduction of expenses from their pre-retirement earnings. However, most retirees spend 20% more in their first two years of retirement than they had originally budgeted for. This may happen in part because they spend more money simply because they have more free time. Retirement also offers opportunities to do such things as travel or spend more time with grandchildren. After the first two years of retirement, however, spending will most likely return to normal levels and will mirror the cash flow retirees had experienced during their pre-retirement years. The online retirement planner at Fidelity will walk you through the process of creating a retirement cash flow model. (Visit and choose “Plan.”) This tool can help you establish realistic expectations about the cash flow potential and level of risk of your investment portfolio. The model is also helpful when you utilize it to determine your spending trends and to calculate the appreciation and depreciation of your assets. Additionally, when you update your cash flow model at the beginning of each year, you will become aware of trends and will be able to identify potential red flags. For example, a portfolio that is distributing too much income in relationship to the growth of its assets may show a decrease in investment value over a number of years. Investors may also notice that they are actually spending too little money because they are afraid to run out of money. While this may not sound like something to be concerned about, it actually means that an investor is missing an opportunity, and it is an opportunity that will create a balloon in investment value down the line. By not spending enough during retirement, people often end up leaving behind a significant portion of investment assets payable to the government because they expanded the size of their estates unintentionally. In conclusion, cash flow models are very practical and effective tools, and as introduced in the last two articles, they are an important part of establishing financial security. The next article will explain ways to limit the costs associated with investing.
Keep Investment Costs Low

Keep Investment Costs Low

WHAT YOU PAY IN INVESTMENT COSTS MATTERS, EVEN though the amounts may seem negligible. According to Tom Connelly, whose firm Versant Capital focuses on providing “low-cost investing and indexing strategies,” if you lose just one percentage point to expenses each year, the long-term effects can be startling. As Connelly recounts in an interview with Andrew Gluck of Investment Advisor Magazine, that one percent loss adds up to a tremendous amount of money over a nearly 30 year period (“Why Investment Cost Matters,” 2005). Consider the following numbers offered by Connelly:
  • The S&P 500 showed a 12.19% average annual return between 1974 and 2003.
  • An investment of $10,000 in 1974 would have grown to $315,000 in 2003 with that average annual return.
  • That same investment of $10,000, however, would only have grown to $241,000 if earning one percentage point less annually, or 11.19%.
In reality, unfortunately, people lose four percentage points annually. Again, consider the following potential investment expenses:
    • According to the Investment Company Institute, the average expense ratio of all stock mutual funds is 1.54% (2006).
    • Edelen and Kadlec, financial institute academics, estimate that the average trading cost of equity mutual funds is 0.8% (1999).
    • Vanguard estimates that the cash that mutual funds hold for investor redemption (or cash drag) is 0.4%.
    • Vanguard also estimates that taxes cost 1.6% each year. (And a 2003 Lipper study cites tax costs to be as much as 2.5% per year.)
    • A conservative estimate of total costs is well above 4%.
(1.54+0.8+0.4+1.6=4.34) Connelly’s advice? “Picking good managers is a skill or requires luck. Whichever way you look at it, it is adding uncertainty to investing. But I know with certainty that if I can control costs, I can improve a client’s terminal wealth.” Whether as an investor managing your own portfolio or as an investor working with an advisor, you need to first identify costs and then control those costs, especially since many other aspects of investing are uncertain and uncontrollable. Even though controlling investment costs does not add return in relationship to the investment risk, it does increase the amount of the return that investors keep in their pockets. Mark Hulbert explains in the New York Times article “The Prescient Are Few” that “index funds are the only rational alternative for almost all mutual fund investors” (2008), or at least for the average amateur investor, and this conclusion is based on a study authored by Laurent Barra, a researcher at Imperial College’s Tanaka Business School in London; Olivier Scaillet, a professor of financial econometrics at the University of Geneva and the Swiss Finance Institute; and Russ Wermers, a finance professor at the University of Maryland. The study examined the abilities of mutual fund managers to achieve “genuine market beating ability,” and it included funds that had been managed between 1975 and 2006. After expenses were taken into consideration, only 0.6% of the mutual fund managers had beaten the market. (This percentage is so small that it is the equivalent of 0% in the eyes of research.) In other words, those few who had beaten the market had simply gotten lucky. To find a manager who can consistently beat the market in all eleven asset categories of a well-diversified equity portfolio would be nearly impossible. A valued advisor can manage clients’ investments objectively and assist them in making research-based decisions. An advisor can also minimize investment costs and provide the opportunity to maximize the growth of the clients’ portfolios. Therefore, investors may find improved portfolio performance when they delegate financial research to those who are the most knowledgeable and the most likely to help them at least control the cost of their investment strategies.
Managing Risk and Reducing Volatility

Managing Risk and Reducing Volatility

MOST INVESTMENT ADVISORS AGREE THAT THE GREATEST determining factor of performance is asset allocation – or the process of dividing a portfolio among different asset classes. Asset classes are grouped according to the securities’ characteristics, the laws and regulations they are subject to, and their performance. Equities (stocks), fixed-income (bonds), and cash equivalents (money market instruments) make up the three main asset classes. And you can accomplish effective asset allocation only if the investments in your portfolio maintain a consistent asset allocation. This means that your investments need to stay within their target asset classes. The more consistent the asset allocation, the less the volatility, and this can ultimately lead to a greater return. Though we advise a long-term investment horizon, the impact of volatility can be seen in the short-term hypothetical example in the following graphs. Both portfolios achieve the same average return of 8%, but the ending value of Portfolio A clearly demonstrates the advantages of minimizing peaks and valleys. Unfortunately, most actively managed mutual funds and separate accounts have you relinquish control, in effect, of your asset allocation. The investor follows the fund manager who is chasing returns and relying on economic forecasting. In one instance, Harry Dent, the author of The Great Boom Ahead (1992), included “An Economic Guide for Effective Financial Decision Making” in his headline article. Its title – “Dow, 15,000 by early 2008 and 20,000 by late 2009” – is an excellent example of the faulty forecasting that lures investors and fund managers. Dent led investors off-track with futuristic claims that have, to date, fallen quite short of expectations. Jumping on the bandwagon of faulty forecasting, as a consequence, was AIM Investment’s offer of the AIM Dent Demographic Fund in the late 1990s. The opportunity for the investor to solidify this third block of financial security (managing risk and reducing the volatility of investments) is in the design of an efficient portfolio. So how should you decide which investments to use and in what combinations? Since 1952, major institutions have been pursuing a money management concept known as Modern Portfolio Theory. This theory was developed at the University of Chicago by Harry Markowitz and Merton Miller and was later expanded by Stanford professor William Sharpe, all three of whom consequently won the Nobel Prize in Economic Science for their contribution to investment methodology. The process of developing a strategic portfolio using Modern Portfolio Theory is mathematical in nature, and it can appear daunting. However, investors should remember that math is nothing more than an expression of logic, so as you examine the process, you can readily see the logic, common sense, and thoughtfulness of this approach. Markowitz states that for every level of risk there is some optimal combination of investments that will give the highest rate of return. The combination of investments exhibiting this optimal risk/reward trade-off forms an efficient starting point. By plotting each investment combination or portfolio to represent the given levels of risk and expected returns, investors can describe a series of points or efficient portfolios mathematically. This plotted line forms the “efficient frontier,” which indicates the portfolios that have the lowest risk for a given number of returns. (Expected returns are not actually observable, so any estimates of expected returns can contain errors. However, these estimates do provide helpful and relatively reliable information.) Most portfolios fall significantly below the efficient frontier. Similarly, portfolios such as the S&P 500, which is often used as a proxy for the market, fall below the line when comparing several asset classes. However, investors may have the same rate of return as the S&P 500 with an asset class portfolio with much less risk or with higher rates of return for the same level of risk. The graph on this page illustrates the efficient frontier relative to the market. Rational and prudent investors will restrict their choice of portfolios to those that appear on the efficient frontier and to the specific portfolios that match up with their own levels of risk tolerance. By applying this principle, investors may be able to build a diversified portfolio that beats the S&P 500 over a period of time. For example, the S&P 500’s annualized compound return was 4.38% with a risk measurement of 13.06% between 1998 and 2007. When the investor makes a few adjustments by adding 40% bonds and 11 additional asset classes over the same period, the return increases to 10.08% with a risk measurement that drops to 7.55%. The growth of a $1.00 investment increases to $2.37 compared to the $1.47 earned by the S&P 500. For the informed investor, the challenge of building a portfolio is reduced to the decision of which optimal fund best represents each asset class. However, Morningstar, a Chicago-based financial research company, provides insight into the fund selection process. Don Phillips, Morningstar’s Managing Director, states that “a dollar-weighted return measurement of a fund family’s performance is a more accurate representation of the investor’s experience opposed to a measure of individual funds.” In an article published in The Financial Advisor Magazines, Morningstar publishes the ranking of fund families based on investors’ experiences. Phillips explains that “DFA [Dimensional Fund Advisors] funds are an example of a fund family that has successfully managed investors’ expectations as well as the investments.” For the ten-year period ending December 31, 2005, the Morningstar study lists the following companies as having delivered the highest investment returns as realized by the investor:
  • DFA Funds, 109%
  • Dodge & Cox, 98%
  • American Funds, 95%
  • Franklin Templeton, 94%
  • Fidelity, 91%
  • Vanguard, 86%
Among the poorest dollar-weighted performers were the fund families Putnam at 67% and Janus at 5%. Looking at these numbers, investors are likely to ask how there can be such discrepancies. Imagine the following scenario: 100 people invest in a fund and earn a 100% return over 8 years. Following a glowing report about the success of the fund in a money magazine, 6,000 new investors decide to add the fund to their portfolios. The mutual fund manager, who struggles to manage the sudden inflow of cash, fails to invest the money effectively. As a result, the fund earns nothing over the next two years. The fund and its original investors did fairly well over 10 years, but the 6,000 people who only invested in it over the last 2 years had a very different experience. How should the fund’s average return be calculated? And how closely does that average represent what investors actually experienced? These considerations demonstrate why Morningstar’s study provides a more accurate representation of the average investor’s experience. For example, the Morningstar Report shows that those who invested in DFA funds actually experienced better returns than what DFA reported, and the others with significant weighted returns also performed at high levels. Janus, in contrast, reported a significantly better (but inaccurate) return percentage than that which most of its investors actually experienced. Consequently, investors can conclude that the investment performance of each fund representing each asset class is likely to improve when the fund management is selected from the class of high-performing managers represented in the Morningstar research. It is also interesting to note that the funds that achieved high ranks in the Morningstar research are either “no load” (commission) or “low load” investment fund families. This article presents some complex investment concepts, so don’t worry too much if you don’t understand them after an initial reading. Managing risk and reducing volatility make up the third block of financial security, as presented in this series of articles. The next article will explain the fourth block of financial security by exploring the importance of utilizing financial advisors as helpful resources.
Delegating the Research

Delegating the Research

INVESTORS FACE A NUMBER OF CHALLENGES IF THEY PLAN to have successful investment experiences over the years. Of primary concern are the psychological impediments that make it difficult for us to make good decisions consistently. Investors also face the uncertainty of market volatility, as evidenced by historical trends. Therefore, they should utilize the resources necessary to manage investment costs and to process current academic research on corporate stock pricing portfolio construction and management. It would be an understatement to say that these recommendations present significant challenges to the average investor working on his or her own. Therefore, it is no surprise that affluent investors want to work with financial advisors. In fact, 92% of them prefer to get assistance in managing their investments (Merrill Lynch – Investment Managers Analysis, 2004). Russ Alan Prince reiterated this in his 2005 research with Karen Maru File when he concluded that the affluent do not want to navigate the financial environment on their own (2005). In Prince’s research, he discovered that when selecting an adviser, investors maintain two strong beliefs:
  1. The process of selecting an advisor is more important than the process of selecting investment products.
  2. Advisors need to offer independent, tailored advice that makes the client’s interests the top priority.
Unfortunately, however, we are all aware of the conflicts and scandals that have wracked the commission-based brokerage industry. One such instance was that of stock analysts giving research recommendations to sales departments down the hall in major wirehouses in the late 1990s and early 2000s. The consequences for these actions were $1.4 billion in industry fines. In another the National Association of Securities Dealers found that one in five investor transactions does not benefit from a deserved break point discount. (For instance, if the commission for a $19,999 transaction requires a 4% commission, then a firm might offer a $20,000 transaction for a 3.5% commission.) Investors should be aware of conflicts that exist in “advise-for-a-commission” brokerage relationships. Representatives from publicly owned wirehouses and insurance companies assume the title “wealth managers,” but they are also under pressure to meet the production expectations of their employers. Mike Patton explains his observations of such practices in his article “Lessons Learned” in Investment Advisor Magazine and explains that a company’s Board of Directors holds sway over the CEO and ultimately over upper management (2008.) Consequently, the decisions that upper management makes are always filtered through the prism of revenue and profit and are meant to bolster the stock price of the firm. Therefore, these sales practices may not always be in the best interest of the client, even though they may still meet “standards of suitability.” In response to these observations, Patton recommends that investors get their advice from an individual who, first and foremost, is a Registered Investment Advisor (RIA) and is governed by the Investment Advisor Act of 1940 and held to a high fiduciary standard. This standard requires more of the advisor than what is required of a broker dealer. The independent advisor’s first priority should always be the client’s best interests, but an RIA should also have:
  • Ten or more years of relevant experience;
  • Relationships with other professionals such as lawyers, accountants, insurance experts, business consultants, and others who can help achieve financial success by utilizing a variety of solutions;
  • Experience with the specific investment challenges faced by financially established families;
  • A practice with a limited number of clients in order to give each an appropriate amount of attention;
  • Payment based on fee, on the assets, or on an hourly rate for specific projects;
  • A clear client orientation and the ability to explain concepts in very understandable language;
  • A comprehensive wealth management approach that employs numerous disciplines and professionals to help clients achieve the goals they have set for themselves and for their families. This approach should include management consulting, budgeting, tax strategies, insurance and legal recommendations, as well as any other relevant aspects that require attention.
Even an exceptional wealth manager will not be the expert in each of these areas, but he or she will have the resources to gather the necessary experts and coordinate everyone’s efforts on the client’s behalf. Then, once you have a comprehensive wealth management plan, you should have a clear sense of whether your investment pool is big enough to allow you to reach your goals. In turn, you should experience piece of mind knowing that you are making prudent decisions and acting as a responsible steward of your family’s financial resources – all while you continue to meet your other current obligations. Put another way, a wealth manager acts as your personal chief financial officer and oversees financial, investment, and insurance planning in coordination with your attorney and accountant. The investor who works with a professional can avoid conflicts in portfolio allocation that may arise between personal savings and corporate retirement plans. Working with a professional will also help you feel confident that you have planned for your future, all without having to spend copious amounts of time trying to navigate the various systems. When you consider the qualities of a wealth manager, you will want to look for a specialist who performs such comprehensive services and integrates various solutions that allow clients to transition into retirement or into another career while maintaining financial independence. Wealth management draws from various practices in investment management, including financial, retirement, estate, and tax planning as well as asset allocation and protection. Perhaps most important, a wealth manager also coordinates all of this planning in order to avoid such conflicts as those you may have heard about relating to the distribution of tax deferred retirement funds or tax saving strategies. Finally, a wealth manager provides an objective, analytical, and research-supported viewpoint on the very specific goals of individual clients – even if doing so means sharing findings that a client may not want to hear. Finally, wealth managers should work with you on a consultive basis. This gives them the opportunity to discover your true financial needs and goals and helps you craft a long-range wealth management plan that will let you meet those needs and accomplish those goals. You should also have the opportunity to develop an ongoing relationship with your wealth manager because doing so will help address your needs as they change over time. This consultive process usually evolves throughout a series of meetings. If you are currently working with a financial advisor and are unsure about whether he or she uses the consultive wealth management approach discussed here, we recommend that you have another advisor complete a diagnostic of your situation so that you can get a second opinion. By delegating financial research to your personal financial consultant and working with him or her to create a cash flow, to analyze and reduce your investment costs, and to manage the risk and reduce the volatility of your investments, you will be well on your way to increasing the probability of investment success and personal independence.


HUNDREDS OF MILLIONS OF DOLLARS ARE SPENT EACH year by brokerage firms, banks, and insurance companies touting their products’ emotional attributes and the solutions they provide. These companies know that financial and investment decisions are made largely within the emotional sphere of the brain and not by intellect. Because of this, even highly intelligent investors are apt to make financial decisions that simply do not pass muster from an intellectual perspective. We all have a tendency to seek better rates, higher yields, and better performing funds, and these possibilities tug on our emotions and persuade us that they will lead us down a path toward our goals. Sadly, this approach almost always fails to work as intended. A pile of disparate investments does not constitute a financial plan, yet many investors believe otherwise. Wall Street, while indeed a physical place, is really a giant marketing machine aimed at separating investors from their dollars through fancy packaging and emotional appeal. Those who work for financial services firms are now called financial consultants, wealth managers, financial advisors, or similar terms despite the fact that they are not advisors or consultants at all. They are salespeople first and foremost with a duty to their employers rather than to their clients. The dictionary definition of the word “client” is “one under protection of another.” It would seem, therefore, that these firms do not have clients at all but instead have customers. This is a critically important distinction. Most of these firms and their salespeople are not registered as advisory firms with state or federal regulators, and they rely on an exemption that allows for “advice that is solely incidental” to the marketing of investment products. That alone should raise red flags, but they largely hide behind the “bigger is better” marketing that blurs these important distinctions. In recent years, “Wall Street” has created a virtual avalanche of new investment and insurance products, many with such significant (and intentional) complexity that investors essentially have to rely on the salesperson’s representations of the products. Furthermore, commissions play a prominent role in the equation. The following chart illustrates the skewed commission compensation system that purveyors of financial and insurance products operate under. Consequently, it is in investors’ best interests to become familiar with how the systems generally function. Quite simply, we tend to sabotage our abilities to be successful investors, and the powerful forces of emotions sometimes cause us to do the very opposite of what we should do. All-too-often, our emotions lead us to buy high and sell low. Investors who follow this pattern over the long-term cause serious damage, not only to their portfolios, but also to their financial dreams. Even in the best of times, investing successfully is a challenge, but it is a challenge you can meet head on by utilizing the many tools available to you. Continue to educate yourself about the psychology and behavior of investing, pay attention to your own personal responses to fluctuations in the market, and develop a relationship with an unbiased financial consultant whose advice you can trust. You owe it to yourself and to your family to make sure that your investment plans and your overall wealth management plans are designed to maximize the probability that you will achieve your financial goals by effectively addressing your very specific financial needs. We wish you nothing but success in achieving all that is important to you.