Monday, January 05, 2009

December 2008 Newsletter

Avoid the Bernie Madoffs in the world![i]

[1] Thanks to Tom Posey, of Posey Capital Management for help with this portion.

The buzz on Wall Street is still the Bernard Madoff Ponzi scheme, which appears to have vaporized $50 billion.

What did he do? He allegedly collected money to invest from clients, made up false statements to show that they were doing well, and used new clients' money to pay interest and withdrawals to existing clients.

The majorities of his clients were thought to be very sophisticated, but didn't see this coming. Could they have? Let's look at three key safety tips that would have prevented this from happening.

1. Stick to stocks, bonds, ETFs, and mutual funds that are publicly traded and listed on major exchanges like the New York Stock Exchange. They are valued independently at least daily, if not minute-by-minute, while the exchange is open. You can check their reported returns against your own portfolio. If you can't look up the prices and performance in the newspaper or on the Internet - that's a red flag - ask a lot more questions.

2. Be sure your advisor uses an independent account custodian. Madoff held his client assets, managed them, and priced them, too. See the conflicts of interest? Investment performance can look better if the prices reported to clients are manipulated, which is allegedly how Madoff showed winning year after winning year despite market turmoil. At Creative Financial Design, our client assets are held by an independent third party, Charles Schwab. We have no input on investment pricing and that separation is a very good thing. The only power we have over those accounts is to make trades and deduct fees. Clients also get an independent statement directly from Charles Schwab each month.

3. Check on insurance. Our clients benefit from fraud insurance. The first part is the Securities Investor Protection Corporation (SIPC) coverage for $500,000 per account. Then Charles
Schwab buys additional coverage from Lloyd’s of London that provides protection of securities and cash up to an aggregate of $600 million, and is limited to a combined return to any customer from a Trustee, SIPC and Lloyd’s of $150 million, including cash of up to $1 million. Fraud insurance does not protect against market declines, but it does protect against theft of securities and/or related fraudulent transactions.

If an investment sounds too good to be true, it probably is. Reportedly, Madoff claimed consistent monthly returns of 0% to 2% (annual returns of 10-12%) with little volatility and no annual losses. This claim of making money in up-markets while not participating in declines is impossible.

My final Madoff thought is this: I have seen this same type of Ponzi scheme pulled off in Lansing and Flint three times. The first time I was in competition with the gentleman who pulled it off. He got the business and the customer got the shaft.

Which type of planning advice do you want in 2009?[i]

The following is my overview of a white paper by Dave Loeper, CEO of Wealth Capital Management in Richmond, VA. Dave was one of the very early adopters of the Monte Carlo modeling technology in building portfolios and communicating volatility more meaningfully to clients.

Dave is attempting to calculate the benefit of a financial planner who tends your investment portfolio, and constantly rebalancing back, not just to the original tolerances, but to the equity exposure you would need in order to achieve your goals. This exposure is a moving target; in times like these, when the markets have put many of you behind your retirement goals, there would need to be a higher allocation to equities. Other times, when you are ahead of the game, the planner would give you a reasonable chance of success with fewer equities. The net effect is to broaden clients’ exposure during down markets, when there is an expected recovery, and reduce clients’ exposure as they achieve their goals and effectively take them out of the way of whatever bear market might set them back.

The paper runs to 40 pages, so I'll offer a quick summary of the high points. If you would like to see the total paper, let me know and I will send it to you.

Dave's central thesis is that advisors should manage client wealth instead of client returns, and that they should make their asset allocation decisions on an ongoing basis based on their evaluation of where a client is relative to his/her funding goals. In many cases, he says, clients are already overfunded, and should not be heavily weighted in equities; the advisor should lock in their achievement of the goal. Clients who are underfunded should be encouraged to save and invest more money in the markets, to freeze spending and/or raise the allocation to equities. The asset allocation decisions are based on each client's funded status, with the full recognition that we don't know what the markets will do in any given year or decade.

The test Dave chose is a woman who happened to be widowed in 1926. She needs to generate $5,000 a year in real (inflation-adjusted) income (about $50,000 in today's dollars), from the proceeds of a $100,000 life insurance policy left to her by her deceased husband. As it happens, she will live to the year 2006; as Dave puts it, her blood pressure runs out when she turns age 100.

At the moment the life insurance settlement is paid out, the universe splits into five different branches, and in each branch the woman works with a different money manager.

  1. The first checks out the widow's risk tolerance and creates an asset allocation which will run more or less constantly throughout her life.
  2. The second adopts a target-date equity allocation which Dave sets as 100 minus the widow's age--starting at 80% and dropping from there.
  3. A third manager decides to put the entire portfolio into stocks.
  4. The fourth sets a long-term asset allocation and then manages to beat it by 1.5% a year.
  5. The fifth runs a Monte Carlo analysis with historical inputs, and decides to set the portfolio at an allocation which produces an 82% confidence rate of reaching the widow's stated long-term goal. Each year, this manager will re-run the analysis, and over the next 100 years, he will be required to make nine changes to the allocations--all in the first 20 years of her life. A table in the white paper shows these changes, but basically the percentages shift from 80% equities in the first two years to 45% in 1928, to 30% in 1929, to 80% in 1930 (we're now in catchup mode), to 100% in 1931, back to 30% in 1938, back to 45% in 1942, to 60% in 1943, and then back down to 30% in 1945, when the portfolio appears highly likely to meet the widow's funding goals.

Overall, advisor 1 maintains a stock allocation of 38%, and achieves a compound return of 8.29% each year.

Advisor 2 is gradually lowering exposure, but over 80 years, he/she has an average stock allocation of 41% and a slightly higher compounded return of 8.42%.

The third manager, who owns nothing but stocks (I won't calculate the average annual stock exposure for you) generates an impressive 10.36% rate of return.

The fourth manager has the same average allocation as the first one, but because he can beat this index each year, he manages to achieve a 9.8% compounded yearly return.

The wealth manager has an average annual allocation of 38% and a very low 30% allocation for all of the Post-WWII years, and manages to generate 8.58%, compounded, a year.

You might think that the terminal wealth of the portfolios can be sorted neatly according to the compounded annual return, but that wouldn't take into account the sequence issue; the sequence of returns matters greatly to overall wealth.

Now here's the punch line: If the widow continues to take her inflation-adjusted income out of the portfolios:

1. In the universe of the first manager she will be broke at age 51.

2. She spends her last dime at age 50 in the universe of manager two.

3. She runs out of money at age 55 with manager three.

4. The fourth manager, who can consistently beat the market, fares much better; the widow dies leaving an inheritance of $1,072,678.

5. The fifth manager? With him watching over the portfolio, adjusting the stock allocations up a bit when the market is down, down a bit when the market has taken her closer to her funding goals, she dies with $4,878,522 in her portfolio.

His allocations never produced superior returns in any one year, never beat the indices, but it did manage to capture a bit more of the upside, a bit less of the downside, and basically iced down the portfolio when the widow had essentially achieved her funding goal. Of course, the other managers contributed to their own defeat, by continuing to invest aggressively when they could have taken the widow's risk off the table, and by refusing to become more aggressive themselves when the funding goal was slipping out of their reach.

I think the results would have been much more dramatic if Dave had assumed that the widow had earned some income during this 80-year time period and managed to save a bit more and increase funding during times when the portfolio returns had threatened her funding goals. This, of course, is the kind of flexibility that pre-retired clients have and, in fact, the opportunity that clients have at this very moment, when more money could be deployed when virtually every asset class is on sale, often at screaming bargains.

Do you know the difference between an Elderly Lady and an Old Woman? Money!

Goodbye 2008![1]

[1] Thanks to Bob Veres, The National Association of Personal Financial Advisors (NAPFA) and Bob’s readers for helping us all communicated better with our clients during these troubled times.

We certainly live in interesting times. We did foresee, in the fall of 2006, the financial and economic turmoil that has resulted from difficulties in the real estate, credit and derivative markets. That is why the majority of our clients are now holding cash and short term bonds. However, we did not foresee the extent to which things would fall apart. Since October 2007, the world seems to have been turned on its head. The pessimistic outlook so commonly held today will not be reversed until there are reasons to be optimistic. Capitalism depends on confidence. Without it, transactions cannot take place. And confidence is in very short supply today.

It is our belief that the current decline in the stock market is being driven by two other types of sellers as well: Those who are forced to sell to meet cash needs or liquidation requests, and those investors who are driven to sell out of fear or a sense of panic. Forced or panicked sellers are not selling with economic justification. Therefore, they push prices down to such an extent that they actually set the stage for a significant price recovery. The majority of investors buy high and sell low! Yes, you read that correctly.

Although there are no guarantees, those of you who took our advice are now ready to buy really low and participate in what could be the greatest worldwide investment recovery in 78 years. No one is sure when this recovery will start or long it will last. We just need to be patient. Financially, we know you can do it. Emotionally, we know you can too; you just may need our help.

For now, we want you to lead your lives in as normal a fashion as possible. None of us knows how long our stay on this earth will be. We encourage you to continue to spend money on things or services that increase the quality of your life or the lives of loved ones within reasonable spending limits. However, if we have cautioned you about your spending level being higher than what would be prudent given your portfolio size, recent investment declines will only magnify the importance of a spending reduction.

It is very important for all of us to be mentally prepared for additional bad economic news as the nation and the world work through this. There will be no quick solutions. As dark as it is, it could, and probably will, get worse. If the markets decline from here, they will only increase the potential of your future profits. That is if you don’t spend your money before it gets a chance to once again work for you.

Many of you grew up in small towns or cities, and you may remember that some of the most beautiful springs followed some of the harshest winters. I can tell you with certainty, after having watched the market for 35 years, that spring is coming. We have been given one day at a time, so I cannot predict with accuracy when spring will bloom, but I can tell you that it will arrive. At that point, this harsh winter will become a memory.

Finally, with all that is going on today when you are done with this newsletter, pass it on to someone you think would benefit from it, be they family, friends or business associates.

Thank you in advance for your courage and patience during these difficult times. We take nothing for granted, and are honored by your decision to retain us as your trusted financial counsel.

Ted Feight