Monday, November 26, 2012

What Makes a Competent Advisor?

A trusted, competent advisor must provide the knowledge and insight necessary to chart an investment course for his clients – as well as the discipline necessary to keep them invested when markets get choppy. Moving away from the nautical metaphors, I recently heard an advisor’s role compared to a pedestrian bridge over an eight-lane highway. Yes, it’s possible to cross those lanes of traffic on your own, but getting to your destination will be a little more harrowing than if you cross safely over a pedestrian bridge.

In addition to providing investment expertise, getting clients safely over the bridge requires helping them to make good decisions. Naturally, those situations are intensely personal. However, if asked for some generic financial decision-making advice, I would say to avoid “trusting your gut.” In fact, our instincts can lead us astray when it comes to our finances. For example, the primitive “flight or fight” impulse that causes us to flee from danger is the same feeling that prompts many investors to sell on a stock’s downturn, precisely at the wrong time. The flip side, of course, is that, pumped up by what Alan Greenspan referred to as “irrational exuberance,” investors are more than willing to overpay for hot stocks.

The emerging field of neuroeconomics probes these financial decision-making idiosyncrasies—and opens pathways to better decisions. Importantly, neuroeconomics teaches that the instinctive regions of the brain constantly, and more immediately, react to stimuli all day long. Yet, we only intermittently apply the slower, more advanced cognitive part of the brain because it requires more time and energy.

Therefore, the competent advisor must ask questions, listen to clients’ answers, develop thoughtful investment and wealth management strategies, carefully monitor their progress, and serve as his or her clients' personal Chief Financial Officer. This process keeps clients from reacting emotionally in times of market stress and keeps them on the road to reach their goals.

(Note: For a discussion of the six core characteristics--Six Cs--an advisor should have, read What Makes a Great Financial Advisor? and the Six Cs blogs on this topic.)

Monday, November 19, 2012

Is Apple Another Polaroid?

For anyone who wonders if Apple can maintain its creative edge and remain on top without Steve Jobs, Bill Frezza, a fellow at the Competitive Enterprise Institute and a Boston-based venture capitalist, poses another simple question – Remember Polaroid?

As Frezza chronicles in Forbes, Polaroid was once the apple of Wall Street’s eye. Like Apple, Polaroid had a charismatic founder, Edwin Land – who is second only to Thomas Edison in the number of patents he received. “Where Jobs was the impresario of form, function, and business model, Land was the wizard of optics, chemistry, and physics,” writes Frezza. He also notes that Land’s patent victory over Kodak, a supplier that tried to steal Polaroid’s technology to launch a competitive instant camera, is strikingly similar to the recent Apple/Samsung battle won by, you guessed it, Apple.

Yet Polaroid’s time at the top was short-lived because the limited capabilities of Polavision instant movies couldn’t compete with emerging videotape technologies. And, today, little remains of Polaroid.

Could competition take a bite out of Apple’s seemingly untouchable market share? According to Frezza, the day Apple “stops building insanely great products, the day it loses its knack for thrilling loyal customers with new releases, the day a younger generation turns up its nose to chase a brand that’s fresh and new is the day the grim reaper goes to work. And this is as it should be, freeing up the capital and talent necessary to build the next great company, the consumer making the ultimate choice between winners and losers.”

He concludes with a simple statement that rings true throughout the decades. “Capitalism only works if companies are allowed to succeed and fail – on their own merits, in their own time, with their fate dependent on pleasing customers, not politicians.”

Clearly, Frazza is no fan of the notion that some companies are “too big to fail.” He notes, “The death of companies is always painful. But out of death comes rebirth, a cycle we interfere with at our peril.” I couldn’t agree more.

And, if you are interested in learning more about Polaroid’s founder, check out his biography Insisting on the Impossible.

Monday, November 12, 2012

Passive Beats Active, Again

Study after study confirms the same thing – passive investing beats active management. The latest data comes from financial advisor Harold Evensky, president of the financial planning firm Evensky & Katz, in the latest issue of the Journal of Investing. Along with Shaun Pfeiffer, a professor at Edinboro University in Pennsylvania, Evensky, who is also a professor at Texas Tech University in Lubbock, examined 20 years of mutual fund performance data, tracking expansions and recessions separately and collectively.

Specifically, the two researchers were interested in testing the widely held notion that actively managed funds outperform in bear markets. After all, an active manager could make defensive moves to protect portfolios and preserve investor capital in a significant downturn. However, a passive index fund would simply continue to own the stocks in the index and would fall victim to falling prices.

In fact, the researchers found that active fund managers do indeed generate enough outperformance to cover their fees in recessions. However, in bull markets, active managers’ returns do not beat passive index funds. And, in addition to underperforming passive strategies in periods of economic expansion, active managers also fall short of passive managers over longer investment horizons that encompass both expansions and recessions.

The study’s findings further weaken the case for active management by reporting on the wide variance among actively managed portfolios and their inconsistency across business cycles. Generally speaking, the top decile of actively managed funds generated alpha, but the bottom-decile funds performed poorly.

The bottom line is that the alpha generated by active managers in recessions isn’t enough to justify their under performance across full market cycles.

Monday, November 5, 2012

Who are the 1%?

Nina Easton’s recent article “Stop Beating Up the Rich” begins by quoting the French historian Alexis de Tocqueville who chronicled American society’s often contradictory pursuit of both equality and the almighty dollar. “The love of wealth is at the bottom of all that the Americans do,” he wrote.

Between the Occupy Wall Street movement and the Presidential campaign, we’ve certainly heard a lot about the wealthy 1%. All the rhetoric encourages us to conjure images of powerful executives who make hundreds of times what the average worker earns, fly about the country on private jets, and would rather take federal bailout money than pay their fair share of taxes.

But, as Easton points out, it’s inaccurate to categorize the 1% as “greedy, tax-avoiding, selfish capitalists.” In fact, she notes that most of the 1.4 million taxpayers who comprise the top 1% gained their wealth through hard work rather than by inheritance. “This group consists of a large number of doctors, lawyers, engineers, and small-time entrepreneurs, many of whom are working hard to create jobs. To vilify them is the wrong debate,” she writes.

Yes, the number of millionaires has grown over the past decade. In fact, a 2011 study by the Deloitte Center for Financial Services found that over the past decade the number of millionaire households rose from 7.7 million to 10.5 million. And the number of American millionaires is expected to double by 2020.

However, Easton suggests that pitting Americans against one another “distracts from the harder and far more important conversation: how to jump start the escalator for 23 million unemployed and underemployed -- and for those whose incomes were stagnating well before the 2008 recession.” She also shares the perspective of Harvard Business School professor Michael Porter, who studies competitiveness in the United States. Although he is critical of unfair executive compensation practices and corporate America’s failure to invest in the entire American workforce, he says, “It’s not a good idea to declare that people who are successful are bad. The better question is: Do we have a fair system for getting that education and skill? Are people unfairly handicapped? Are we doing enough to open the gateways?”

That’s food for thought.