The Big Investment Lie

SEC hires purveyor of Suckers of the Future game

I wrote earlier about financial literacy, and how it was a good idea but could too easily be captured by the sales culture of the financial industry and bent to its own objectives.

Susan Antilla of Bloomberg.com highlights just that concern in an excellent article, titled "Suckers of the Future Groomed With Stock Game". Antilla points out that the Securities and Exchange Commission's new deputy director of investor education, Kathleen M. Floyd, was formerly executive director of the Stock Market Game, "a virtual-investing program that’s given hundreds of thousands of students a $100,000 make-believe portfolio to play with."

"Her employer was a foundation financed by the Securities Industry and Financial Markets Association, Wall Street’s main lobbying group. Floyd’s hiring brings new attention to the popular Stock Market Game, which gets money from donors like Morgan Stanley, Merrill Lynch and A.G. Edwards."

This game, however, educates students not to be investors, but gamblers on short-term stock prices -- in other words, to be brokerage firms' dream customers, their Suckers of the Future.

One commentator in Antilla's article says, “You could teach kids the basic rules of blackjack and have a more lasting and beneficial impact.” Well yes, more beneficial for the kids perhaps. But teaching the game will have a lasting and beneficial impact for its Wall Street sponsors, providing them with an endless parade of future suckers.

Not so fast on those Roth IRAs

The concerns of our colleague Dave Loeper, writing in Advisor Perspectives, about the rush to invest in Roth IRAs (precipitated by the advice of many advisors) are well-founded. There’s too much excitement about Roths going around without adequate justification.

Furthermore, there are an amazing number of flat wrong calculators out there—even several well-respected providers that should know better offer access on their web sites to Roth IRA vs. Traditional IRA calculators that are wrong.

Given the huge uncertainties about future projections, complicated calculations are mostly a waste of time, unless to refute other complicated—or mathematically incorrect—calculations that tell you to do the wrong thing. The simple prescription is that if you’ve got a very good and sound reason to believe your tax rate will be higher after retirement than it is now then the Roth is a good way to go; otherwise not.

Some advisors ostentatiously give detailed advice (to make their expertise seem important to you) on tax-deferral options that make little difference in your after-tax rate of return (given that skipping tax loopholes and just investing in a naturally tax-deferring index fund costs you only 70 basis points/year over an investing lifetime). This often obscures the fact that their high fees obliterate the benefits that their tax-deferral advice provides, even if it’s right.

Bent only on amassing a fortune

Theodore Roosevelt, Republican, 26th President of the United States, 1901-1909, said it sharpest and truest:

There is not in the world a more ignoble character than the mere money-getting American, insensitive to every duty, regardless of principle, bent only on amassing a fortune.

Somehow people in the financial world -- who are exactly those ignoble characters, as anyone who observes them up close can see -- have convinced themselves (and to a great degree the rest of us as well) that by being bent only on amassing a fortune, they are somehow performing every other conceivable duty as well.

This is the ultimate perversion of the doctrine of self-interest. It takes only common sense to realize it is not true.

Gillian Tett, in the final reflection of the Epilogue of her book "Fool's Gold", identifies this insensitivity to duty and principle -- a "silo" mentality -- as the problem of the financial industry that needs to be fixed:

The finance world's lack of interest in wider social matters cuts to the very heart of what has gone wrong.

...A "silo" mentality has come to rule inside banks, leaving different departments competing for resources, with shockingly little wider vision or oversight... Most pernicious of all, financiers have come to regard banking as a silo in its own right, detached from the rest of society. They have become like the inhabitants of Plato's cave, who could see shadows of outside reality flickering on the walls but rarely encountered that reality themselves. The chain that linked a synthetic CDO of ABS, say, with a "real" person was so convoluted, it was almost impossible for anybody to fit it into a single cognitive map...

...And locked in their little silos, almost nobody could see how the pieces fitted together as a whole or how overbloated finance had become.

...In the last two decades, as finance spun so out of control, it stopped being a servant of the economy but became its master. That must be reversed.

TIPS hedge against interest rate volatility

Suppose in October, 2009, you buy a 10-year TIPS contract (Treasury Inflation-Protected Security) for $1,000, and its real interest rate is 2%. That is, it will pay you a 2% coupon on its value each year, but its value will rise with inflation.

Suppose the general expectation is that inflation will average 2% over those 10 years. So you expect a 4% return (2% inflation + 2% coupon). The interest rate on non-inflation-protected Treasuries will probably be about 4% too.

Now suppose that by January, 2010, the general expectation of future inflation has risen a lot, to 5%. The Treasury issues a new 10-year TIPS contract you can buy for $1,000, again with a 2% coupon.

Now what is the value of your old TIPS contract, the one you obtained when the inflation expectation was only 2%?

Answer: $1,000. It does not change. Its terms are exactly the same as the terms of the new TIPS.

But you know what surely has changed: interest rates.

Prevailing interest rates reflect, more than anything else, the expectation of future inflation.

If the nominal interest rate climbs but the real interest rate stays the same, the value of your TIPS will stay the same.

The same cannot be said for non-inflation-protected securities -- far from it. If you had bought 10-year non-inflation-protected Treasuries in October when the prevailing interest rate was 4%, their value has probably dropped about 21%. That's because the interest rate rose from 4% to 7% in anticipation of a 3% hike in the expected future inflation rate.

Hence, TIPS protect you not only against future inflation, but against future fluctuations in the interest rate. They won't protect you against volatility in the real interest rate -- that is, the interest rate adjusted for future inflation -- but that is usually less volatile than the nominal interest rate anyway.

What does rebalancing do for you?

Like so much prescriptive advice in the investment advisory field, the admonition "You should rebalance your portfolio" has been repeated so often, without full and clear explanation why, that it has acquired the character of a shibboleth.

"Rebalancing" means restoring the asset allocation of a portfolio -- mainly the allocation between stocks and bonds -- to what you set it to in the first place. Why should you do this? What are the arguments for rebalancing?

There are basically two arguments for rebalancing, a risk argument and an expected return argument:

1. You decided on the risk level you were comfortable with when you first established your portfolio's asset allocation; you need to reset it to that allocation periodically to make sure you don't exceed your risk level.

2. A rebalancing discipline buys an asset class when its price is lower than it was, and sells some when it is higher than it was -- buying low and selling high, and taking advantage of "reversion to the mean".

Unfortunately, both of these arguments are questionable.

Argument 1.

In the first case, the assumption is that you measure risk using something like the short-term volatility of your returns. If that is indeed your measure of risk, then if you don't rebalance, your risk will drift out of its bounds.

But what if your risk measure is the chance of unacceptably low cash flows in 30 years? And what if you control that risk by holding part of your portfolio in 30-year Treasury bonds to provide a secure safety net?

If you rebalance periodically you won't maintain your risk hedge, you'll destroy it. Suppose, for example, you start out with 50% stocks and 50% Treasuries, which you will hold to maturity. Suppose the market drops 20%. Rebalancing means you'll have to sell some of the Treasuries that provide your safety net.

Argument 2.

Let's address Argument 2 with a little data study. An alternative to rebalancing is set-it-and-forget-it, or buy-and-hold; that is, let the stock-bond mix readjust naturally as markets fluctuate.

Which yields the better risk-adjusted return, rebalancing or buy-and-hold?

The answer is, it comes out the same. We ran the two strategies, beginning with a 60/40 stock-bond mix, for all 20-year periods between 1926 and 2008. The average return for rebalancing was 9.3% with a standard deviation of 2.4%, and the average return for buy-and-hold was 9.9% with a standard deviation of 2.8%. (You'd expect buy-and-hold to have higher average stock allocation and therefore higher return and volatility.) The average risk-free Treasury-bill return was 4.1%. Using these statistics, the Sharpe ratio -- a measure of risk-adjusted return -- was 2.2 for rebalancing and 2.1 for buy-and hold, virtually the same.

Stocks are riskier in the long run

In 1995, Boston University finance professor Zvi Bodie published a paper in the Financial Analysts Journal, "On the Risk of Stocks in the Long Run." The article should have been immediately regarded as a seminal work. Instead, it was largely ignored -- confirming that academia, too, tends to throw its weight toward bandwagon-bubble phenomena.

Bodie peformed a calculation showing that the cost to insure a stock portfolio against poor performance grows over time. If the portfolio underperforms the risk-free rate, the insurance makes up the difference in wealth accumulation.

A poor -- and poorly-specified -- measure of risk has become entrenched in the finance community: the annualized standard deviation of returns. It is poorly specified because there is no universally-accepted standard as to how it should be calculated. It is a poor measure because it measures poorly how much money an investor risks.

Bodie used a superior measure. How better to compare two risks than by the cost of insurance to avert them?

By that measure, stocks are riskier in the long run than in the short run.

Misled by the wrong measure, most academicians and advisors thought stocks were more risky in the short run -- that is, more "volatile", having a larger annualized standard deviation -- than in the long run.

But Bodie's calculation shows that while the chance of falling short of the risk-free rate may be smaller in the long run, the cost of that shortfall is likely to be larger. When you consider the cost to make an investor whole after poor long-run returns, it turns out that the risk of poor long-term stock market performance is greater than the short-term risk.

That is why we often recommend taking the edge off the potential long-run downside by investing a bedrock portion of the portfolio -- enough to ensure at least the bare essential minimum income stream in the future -- in safe long-term assets like TIPS (Treasury Inflation-Protected Securities), held to maturity.

Financial literacy courses

Financial literacy courses are an excellent idea. But the design of financial literacy curricula could become a fierce fight between real experts and those imbued with the sales culture of the financial industry.

Economist Bob Shiller of Yale advocates government-sponsored financial advice for those who can’t afford to pay for it in his recent book "Subprime Solution". The presumption is that it would have prevented people from taking on more debt than they could afford.

The big problem about teaching financial literacy in schools will be how to agree on a curriculum. The better part of the information currently dispensed by financial advisors is of extremely low quality, designed to sell products and maximize revenue rather than to correctly inform the public.

Much of the conventional wisdom of “experts” in the field is either wrong or meaningless. So the courses really can’t be designed by the major financial services houses (at least most should be disqualified).

And if popular authors such as Robert Kiyosaki were regarded as experts then financial literacy courses would train people to go deep in debt and flip houses—as his book "Rich Dad, Poor Dad" did.

So while financial literacy courses are an excellent idea in principle, how good they are in practice will depend on their content—and therein lies the danger.

To convert or not to convert -- is that the question?

The recent change in rules for Roth IRAs has brought a plethora of articles about how to convert your traditional IRA to a Roth IRA and whether you should convert. One of the most informative appeared recently in The Wall Street Journal.

A common problem with these articles is that they make it sound very important that you make this decision correctly. But, as is frequently the case in the investing world, if a decision seems very complicated then it's often not worth bothering to think about -- or, it's sufficient to think about it in very simple terms.

The decision whether to convert a traditional IRA to a Roth IRA can be thought of in very simple terms. If your tax bracket is likely to be significantly higher later, in retirement, than it is now then a Roth IRA is the better alternative. If your tax bracket is likely to be significantly lower later than it is today then the traditional IRA is the better alternative.

Beyond that simple prescription, it's probably not worth thinking about, because although you can do complex calculations to decide whether to convert from a traditional IRA to a Roth IRA, the bottom line is that it's not likely to make much difference either way. It's not worth the trouble to come to an inconclusive result when there are other things you can do that make much more of a difference -- keep fees low for example.

Have the conventional wisdoms been proved wrong?

Lots of articles have appeared recently speculating that the old conventional wisdoms of investing are dead. These have included declaring dead such things as buy-and-hold, diversification, asset allocation, and index funds.

Sure, there are lots of conventional wisdoms in the investment world that ought to die. But these are not the ones. Apart from the question of what exactly these articles mean by saying that these concepts are now dead, there is the question of what should replace them that would somehow be better.

Every time the stock market falls precipitously there is an outcry to the effect that everything is different now and the old theories are dead. But that is wrong. The simple theory about the stock market is that in the short run it can take unpredictable swings but in the long run -- 20 years or more -- it's very likely to yield excellent returns.

That's still true. In the year 2008 the stock market lost 40.5%, but in the 20 years from 1989 all the way down through the awful year 2008 and including the abysmal years 2000-2002 it gained 386%, averaging 8.22% annual return. That's a good return. It's quite reasonable to assume that in the next 20 years the stock market will produce as good a return, perhaps better, even though it will take some huge dips along the way.

The wisdom that does hang in the balance is the "Efficient Market Hypothesis" -- the belief that market prices always get it right, and that it's impossible for an astute observer to discover a mispricing made by the market as a whole. Let's call this debate Friedman versus Minsky, for the diehard believer in market forces as a corrective on the one hand and the Keynesian disciple who believed markets could sometimes err in unison on the other. That debate will continue.

Is Monte Carlo simulation a bad methodology?

A Wall Street Journal article this weekend begins this way:

If one had asked a financial adviser 18 months ago for retirement-planning guidance, there is a good chance he would have run a "Monte Carlo" simulation. This calculation method, as it is commonly used in financial planning, estimates the odds of reaching retirement financial goals.

But there is little chance your Monte Carlo simulation, named for the gambling mecca, would have highlighted a scenario like the market slide just seen.

Does that mean there's something wrong with Monte Carlo simulation? No, not necessarily.

Many Monte Carlo simulation models that have been used by "risk managers" to estimate probabilities of extreme events have in fact been flawed. Not only do the models not accurately reflect the probabilities of extreme events, they don't take into account real-world phenomena, such as the fact that periods of high or low volatility tend to persist.

These flaws can be corrected, making the models more useful as tools to estimate the probabilities of extreme negative events (but still not to be taken too seriously).

But even without such corrections, Monte Carlo models can still be more useful than any other method for estimating the probability that an investor's lifetime saving/investing/spending plan will be successful -- that is, that the investor will not run out of money. Like any other model, though, it is no better than its inputs and assumptions. If, for example, major influences like fees and taxes are not taken into account, then the results will indeed be useless.