His main point was that using Modern Portfolio Theory (MPT) is “the old way of doing things” because in 2008, assets that should have zig-zagged independently all dropped last year.  The implication, of course, is that diversification failed when it was needed most, and that asset allocation doesn’t work. 

I find this to be a typical gimmick to lure people (new customers) who got slaughtered by investment markets last year and are searching for better ways to invest their money.  But allow me to pick apart their main arguments:

Their Point: Correlations are not stable and go to one (1) during a crisis; so regardless of whether you have real estate, international stocks, or small cap stocks, it will not do you any good. 

My Counterpoint: Many studies show that this conclusion is not true.  Work by Loretan & English as well as Kim & Finger and Ragea show that higher correlations are simply a result of higher volatility, not because of some “contagion” spreading across equity investments; that correlations apparently increase, but don’t actually change.

If they really believed this claim, their portfolios would only include two assets, the market index (S&P 500) and US treasury bills; however, their sample portfolio included allocations to real estate and hedge funds.

Their Point:  You should create a cash flow immunized portfolio to minimize the potential shortfall.  In other words, treat your portfolio like a pension fund.

My Counterpoint:  This strategy may be useful in many situations, but equally inappropriate in just as many others.  If you knew with a high degree of confidence that the objectives, timing, and risk tolerance would not change over time, or with changes in market conditions, then you have a much better case with the immunization strategy.  The reality is that life happens, goals shift, tax laws change, and among other things, people change.

Their Point:  Diversificaton failed, MPT is dead. 

My Counterpoint:  Modern Portfolio Theory has long been abused by many practitioners; particularly by those who rely on mean-variance optimization software – as if mean returns and variance are the only important factors?!  What does it say on all investment literature? Past performance is no indication or guarantee of future performance.  Yet, many practitioners plug in historical return information into their software to finalize an asset allocation model:  Garbage in, Garbage out.

In the end it’s just a theory; so what happens in practice?  When the father of MPT, Harry Markowitz, was asked how he would invest among stocks and bonds, instead of making intricate calculations, he replied, “My intention was to minimize my future regret… So I split my contributions 50/50 between bonds and equities.” 

Markowitz chose to minimize his regret instead of minimizing portfolio variance!

He estimates he spent over 1,100 hours of study to pass the exams to attain the coveted CFA designation. Because of the rigor of the curriculum, only about one in five candidates who enter the program pass all three 6-hour examinations and successfully complete the requirements to earn the charter. 

So why would Mr. Jaccard, who already obtained the CFP® mark over eight years ago, put himself through such a grueling process? 

“In the last decade, the number and complexity of investment products offered to individuals has mushroomed, which makes choosing between them more difficult than ever,” Jaccard said. “The CFA curriculum has helped me do a better job of understanding and utilizing the drivers of valuations, investing tools, management techniques, and the broader economy.”

With a program that takes an exacting, analytical look at stocks, bonds, derivatives, and alternative investments, among other subjects, many who achieve the CFA designation go on to manage institutional money or work in corporate finance.

In contrast, the CFP® certification is more about comprehensive financial planning, helping individuals with various facets of their financial life, from personal income taxes and retirement to college and insurance planning.

The education behind the CFP® mark enables an advisor to take a big picture approach, while the CFA charter demands a much deeper understanding and application of investment tools and techniques.

Of the 59,000 CFP® certificants in the U.S., it’s estimated that only about 1,300 can also claim the CFA charter.

“A record number of individuals enrolled for the CFA exams this year,” Mr. Jaccard says. “This speaks to the unparalleled level of mistrust and uncertainty people have concerning our economy, government regulation, and the financial markets”.

About CFA Institute

CFA Institute is the global, not-for-profit association of investment professionals that awards the CFA and CIPM designations. The mission of CFA Institute is to lead the investment profession globally by setting the highest standards of ethics, education, and professional excellence. 
www.cfainstitute.org

About CFP Board

The mission of Certified Financial Planner Board of Standards, Inc. is to benefit the public by granting the CFP® certification and upholding it as the recognized standard of excellence for personal financial planning. The Board of Directors, in furthering CFP Board’s mission, acts on behalf of the public, CFP® certificants and other stakeholders.
www.cfp.net

About Financial Alternatives, Inc.

Financial Alternatives provides wealth management services to successful individuals and families – collaborating with CPAs, attorneys, and insurance brokers to create unique solutions.  Services are offered on a fee-only, fiduciary basis; advisors always act in the client’s best interest.
www.financialalternatives.com

Contact:
Chris Jaccard, CFA, CFP®
chris@financialalternatives.com
7734 Herschel Avenue / Suite L
La Jolla, CA 92037
858 459 8289

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Millenials are often described as super-confident; carrying a sense of entitlement about them.  They demand rigorous structure, frequent positive feedback, and believe themselves to be truly unique and special (talk about high maintenance).  Expecting to land a leadership job with meaningful work and a career track when just out of college weren’t uncommon.  In recent years, I noticed that some of these characteristics were rubbing off on the rest of us, myself included.

There’s nothing like a healthy recession to curb that sense of entitlement and serve to remind that yes, indeed, you have to work hard in order to meet your goals.

Hyper-stagflation, future real estate crises, and other meltdowns notwithstanding, I trust that we will all (re)learn a little humility as we struggle through this downturn.

How to Monitor Your Financial Advisor

Madoff case adds to lack of investor confidence in financial services industry and increases the need for the Securities and Exchange Commission to proactively protect investors

ARLINGTON HEIGHTS, IL (December 16, 2008) – Bernard Madoff’s Ponzi Scheme, which allegedly helped defraud investors of $50 billion, is the latest example of how the financial services industry fails to protect those they serve. The market chaos coupled with this case and apparent inability of the Securities and Exchange Commission (SEC) to monitor large financial businesses highlights the intensifying need for tougher regulation.

Until this regulation is in place and agencies in place are cracking down on unethical, fraudulent practices, investors must take the necessary precautions to ensure they are not at risk. The National Association of Personal Financial Advisors (NAPFA) offers the following advice on how to protect yourself as you work with a financial advisor.

• Know where your money is. Whether your advisor is managing your money or you are the person who signs-off on each financial decision, an independent financial institution will hold your money. This company has “custody” of your money. Make sure you know which company it is; how to contact the company, and what your account numbers are.
• Read your monthly or quarterly financial statements. The firm that has custody, typically a broker/dealer, bank or trust company (known as the “custodian firm”) is required to provide you with at least quarterly financial statements and most will provide them monthly. Read them. Most importantly, make sure that these statements are coming to you directly from your custodian firm – not from your advisor.

See the rest of the press release…

The mandate of money market funds is to maintain a $1 price (net asset value) every day and earn some interest buying short term corporate debt, CDs, treasuries, etc.  Funds run by the above mentioned manager are now worth less than $1 — thanks in part to Lehman’s collapse yesterday.

In recent times, many of these so called “conservative” funds have had to dip into less secure debt in order to pump up their yields and attract more investors.  In the past, a fund or two have had the parent company (like the big institutions that are failing at the moment) pump in some cash to avoid breaking the $1 threshold.  There was no bailout for the folks at the Reserve and their investors.

The lesson here is that not all money funds are alike — if you’re really worried about this happening to you, try a money market fund that only invests in US treasury securities.  You may get a lower yield, but at least you’re going to be in a default risk free asset.

The recent failure of SemGroup as described by the WSJ comes to mind.  This little known, privately held company had apparently gotten carried away with it’s futures contracts by making speculative trades (instead of hedging like it should do).  It lost over $2.4 Billion on energy contracts (yes, that’s a “B” not an M).

The company just didn’t have the liquidity to cover the losses so it folded and is now run by it’s creditors.

When I read this, a few ideas came to mind that may be worth exploring further:  Maybe the talking heads on TV are right about oil prices — that the reason they are so high is because of all the traders/speculators, and not global supply and demand imbalances;  and we, as individuals, can’t do anything about macroeconomic issues or control Wall Street, but we can curb the impact of high gas prices or a job loss by stockpiling cash in a “rainy day” fund and maintaining a suitable budget.

I’ve seen that quotes for insurance have come down but not in a ‘wholesale’ type of fashion. Generally the change will only have a small impact on the average consumer, and I would be wary of anyone that told me I should replace my existing (life insurance) coverage because this new table is being adopted. There are other factors that should be considered irrespective of the table.

However, if you are in a situation where a cash value life insurance product (e.g. VUL) makes sense, you will want to be sure to evaluate your options before insurance companies stop selling 80CSO (old) insurance products December 31, 2008. This is because the definition of life insurance cost and modified endowment contract definitions are based on the prevailing table (soon to be 2001CSO).

Basically if you want to pump a lot of money into one of these policies (overfund), you should look into the old contracts while you still can. Again, I would be very wary of information you come across on this; remember, most life insurance is “sold” not bought by people.

Finally, consider that insurance companies and brokers are always trying to squeeze out as much profit/commissions as they can from the (life insurance, and other) products they sell. As the transition to the new table concludes, companies may over/under price their new insurance products – so be sure to shop around!

He points out that the 60 year average P/E ratio for the S&P 500 is 16x. When you look at the earnings for the last 12 months, the P/E ratio jumps to 21x. Thus, stocks must be “getting pricey”.

I think most savvy investors take this assertion lightly; however, others should be conscious of the fact that one line generalizations about the valuation of the Stock Market are dangerous.

A different way to look at the P/E ratios referenced in the article is one attributed to Nicholas Molodovsky called the Molodovsky effect. He posits that in mature, cyclical industries, the P/E ratios will actually go up in bad times… and P/E ratios will go down in good times. It seems counterintuitive because most people agree that low P/E stocks are “cheap” and high P/E stocks are “expensive”. Once you think P/E ratios trending up or down over time instead of a snapshot of value, the effect makes some sense, but here’s a hypothetical example:

MG Motor Company sells much fewer cars during a recession than when times are good (all things being equal), so it’s certainly in a cyclical industry since company earnings are tied closely with the economy. Let’s assume their stock is priced at $30 in 2006, and $23 in 2007. Earnings go from $1.50/share in 2006 to $.90/share in 2007. The 2006 P/E is 20x and jumps up to 26x in 2007.

In this example, the earnings decline boosts MG stock into “expensive” territory, even though the share price dropped $7. This is because the percentage decrease in the denominator (earnings) is greater than the decrease in the numerator (price) from 2006 to 2007.

The point here is that one line arguments of valuation should at least be narrowed to a particular industry and not applied market wide. Very often there are opposing interpretations of commonly accepted measures of value such as P/E ratios — depending on the assumptions made, you could make a case that stocks are expensive or cheap!

It’s more important than ever to ensure you have the highest FICO (credit) score possible. The typical recommendations for improving your score are:

• Avoid using too much of your available credit card debt
• Remove errors on your credit report (get reports free at www.annualcreditreport.com)
• Avoid making late payments
• Shop for auto/mortgage loans all during the same month
• Maintain old credit card accounts and if necessary, use them on occasion to keep them open

However, there are additional recommendations given what we know about the new scoring methodology:

• If you’re an authorized user on someone else’s credit card, you need to drop that and get your own card. FICO will no longer count authorized users toward good credit.
• Try to have a mix of loan types on record. You should have a better score if you have installment loans (student, auto, mortgage) and revolving accounts like credit cards.
• Pay your bills on time! More weight is being placed on billing issues (delinquencies) compared to the old FICO calculation method.

There are of course other credit rating systems out there, but these systems (including FICO) are all black box calculations that look at similar factors. Most of this work to repair or protect your credit is pretty straightforward, and if you maintain good habits around debt you’ll be in good shape. For those with problems, you will have to be patient since improvements take a while to “stick”; don’t be tempted by quick fixes or credit repair firms!