Government-Provided Economic Security Is an Illusion (2009-02-23)

Government-Provided Economic Security Is an Illusion

(2009-02-23) by David John Marotta

The various congressional bailouts have been touted as essential to the nation's economic security. So long as the notion of economic security remains vague and abstract, it has wide support. But anyone who examines the details should realize this so-called security threatens our freedom and stability.

Security can be understood in two different ways. The first is having enough to eat, a place to live and clothes to wear. We all can agree that in our affluent society we can afford to provide every citizen some minimum standard of living so those falling on hard times may be given a hand back up.

The second way to understand security is the assurance that whatever salary or assets you have earned, including your current position and rank in society relative to others, are yours to keep. Often this second type of security is overlaid with a moral judgment that the people benefiting from this support are more deserving than the rest of society.

With today's level of productivity we can provide the first type of security without endangering freedom or promoting corruption and preferential treatment. Even so there is still serious debate about this support. We should question if government is the best vehicle to deliver it or if private charities do a better job. With increasing globalization, we should also ask the moral question if our safety net should provide a level of support well above 95% of the world's population.

Nevertheless, security of this first type generally protects people against calamities they would naturally want to avoid under any circumstances. It helps them preserve their health, ability to work and the possibility of regaining a foothold if needed. In other words, it gives them a safety net, not a hammock.

The second type of economic security is much more of a threat to freedom and certainly more prone to corruption. Under this type of security, society tries to protect certain sectors of society from the natural and regular fluctuations of economic activity by subsidizing some or all of their losses from failed ventures. Some automakers get money, and others do not. Some banks are subsidized, and others are allowed to fail.

This form of economic security is ultimately designed to protect certain classes from loss of either their annual income or their accumulated wealth. In a free-market economy, people spend their money on those goods and services they believe are the most valuable. They are free not to spend money on things they deem less valuable. The behavior of consumers is an objective way to measure the value placed on particular goods and services.

Any supplement of the value that people are actually willing to pay for goods and services can only be based on subjective bias away from the fair market value. It may correspond to some perception of effort and intentions, but it will still be subjective bias, trumping an objective willingness to pay freely.

To understand these two kinds of economic security, consider that people are more willing for the government to bail out the consequences ensuing from a large disaster than a personal tragedy. The more people who are killed or inconvenienced, the easier it is to garner public support, even though a family is no less devastated by a single fatality in a car accident or a lightning strike. Helping people in need is always a kind and gracious act when freely given. But making it an entitlement of public policy is not.

Again, I'm not talking about efforts to help rescue families subject to the misfortunes of market forces by providing basic needs. I'm questioning the wisdom of bailing out the industries themselves so those who are employed keep their middle- and upper-class lifestyles. Ensuring security in some sectors of the economy comes at the expense of other sectors. Securing one sector against market fluctuations destabilizes all the other sectors, causing the latter to bear the brunt or needlessly fail themselves.

When a few receive the largess of a specifically targeted bailout, the rest of society is left to pay the consequences. The cost of the resources bestowed on the privileged drives up the cost for everyone else. The tax revenues directed toward the enfranchised are often taken from those of lesser means. And the trillions spent devalue the accumulated savings of those who received no government boon.

This problem is not simply that the free market gives people an incentive to do their best. Rather, the bailout removes any yardstick by which they can even judge what is best. The bailout changes a private mistake into a public crime. When private businesses fail, it need not be a public matter. The business goes under because of poor management, and the assets are sold or distributed as part of the company's liquidation. If there are fewer banks in town, I am not hurt. If one car company stops production there will still be competition to sell me a new car. But if the government guarantees the enterprise, then it becomes a crime against society for the company to fail. Failure now becomes a political scandal.

There must be charges of mismanagement. There must be an inquiry. Those responsible must be held accountable. Those innocently injured must be made whole. And all of this must be accomplished by government.

It doesn't matter that other companies, perhaps even in the same industry, were well managed. They will not receive support. And worse, they will experience an unfair disadvantage in the marketplace when their direct competitors are subsidized. To every grant of security bestowed on one group, every other group grows more unstable and finds its freedom compromised.

Government spending is often taken to have a wholly positive effect on the economy. It is assumed that as the money is spent, jobs are created, companies become profitable and the money received in taxes is spent again, creating a higher gross domestic product and a higher tax base. Such thinking is obviously false. No family can spend their way out of debt or financial troubles. Neither can society as a whole.

If the government had allowed the money to remain in the hands of the taxpayers, they too would have been able to spend the money, creating jobs and empowering the economy. Although you can argue that governmental choices are superior to the choices that individuals might make, you can't argue with the fact that individuals, free to make their own choice, would have chosen to spend their money differently.

In free markets, transactions are voluntary. They do not continue unless both parties believe they are better off making them rather than not. But government policies are not voluntary. They can continue indefinitely even if they impoverish society as a whole. Government doesn't have any productivity of its own. It can simply take money from some and give to others. And because government's pie is fixed, if it guarantees a set portion to one group of constituents, it inevitably diminishes the share apportioned to everyone else.

As a result, security becomes a political privilege and more difficult to achieve. We can only look to politicians to provide it. As a scarce and thus more valuable commodity, security soon overshadows other measures of success. Controlled areas of the economy cause other sectors to fail in an increasing spiral. And when they do not succeed, it is perceived as a failure of the free markets. Unregulated parts of the economy won't be able to take risks. And both the risk of failure and the potential windfall profits are then viewed as moral failings.

Put another way, the very engine of entrepreneurial capitalism is increasingly implicated as the problem. Lack of regulation is blamed until security is imposed on more parts of the economy. It doesn't matter that government intervention in the free markets provoked the failure. Government causes the problem in the first place and then gains sweeping powers as society relies on it to solve the crisis.

Unquestionably, both the Bush administration and the Congress dominated by Democrats are to blame for poor bailout legislation packages. We need a new political paradigm, one humble enough to acknowledge that regulation caused many of the crises we are currently facing. Intervention is prone to all that is worst in Washington special-interest lobbying. And intervention disrupts much of the equilibrium in the markets and makes security less likely. We must recognize that attempts to impose security are apt to destabilize rather than ensure people's security.

from http://www.emarotta.com/article.php?ID=325

Safeguard #6: Recognize and avoid financial hooks (2009-02-16)

Safeguard #6: Recognize and avoid financial hooks

(2009-02-16) by David John Marotta

To safeguard your money, you must be able to extricate yourself from any bad investment quickly. Of course, the companies that sell mistakes don't want you to be able to do that, so they use financial hooks to hold your money captive.

Any financial product with a surrender value significantly different from the net asset value has financial hooks. For example, take the different classes of mutual funds from the giant American Funds: Growth Fund of America.

Shares come in five different sales classes. Class A shares have an expense ratio of 0.65% in fees and expenses. Additionally, there may be a front-end load of 5.75%.

If you invest in class B, there is no upfront sales charge. But if you sell shares before you have owned them for seven years, you must pay a sales charge that starts at 5%. And while you are holding class B shares, the expense ratio is 1.39%.

Class B shares are the most gut wrenching. If investors have been holding them for nearly three years, they are still hit with a 4% redemption if they sell them early. It doesn't matter if they should sell large-cap U.S. stocks and diversify into another asset class. It doesn't matter that the company has already collected 4.17% in ongoing expense ratios.

Investors are still faced with the decision of holding the fund another four years, at an ongoing expense of 5.56%, or selling the fund and paying a contingent deferred sales charge of 4.00%. The angst of these kinds of hooks in their investments deters many people from selling, even though they know diversification is critical to their portfolio.

In this example, because the fund has been held just under three years, waiting a few months until the third anniversary lowers the redemption charge to 3%, probably the wisest decision. There is an obvious 3% hook if you sell, and a hidden 5.56% hook if you hold the investment.

Class C shares have a contingent deferred sales charge of 1.00% in the first year and an even higher expense ratio of 1.44%. Needless to say, we don't recommend A, B or C shares. These are all loaded shares, meaning they are laden with sales charges.

Fee-only financial planners recommend two classes of shares at American Funds that are no load. The F1 class has no front- or back-end sales charges and an expense ratio of only 0.63%. The F2 class is used in retirement plans and eliminates the 12b-1 marketing fee. It has the lowest expense ratio, only 0.43%. A fair comparison can be made between C shares with an expense ratio of 1.44% and F1 shares with an expense ratio of 0.63%. The savings of F1 shares is 0.81%.

Mutual fund salespeople claim this difference is less than the 1% of assets under management that many fee-only financial planners charge. But you are not getting any real value for a mutual fund sales charge. A different way of looking at it is that fee-only financial planners could earn 81% of their fee simply by reducing your expense ratios. Given an 81% discount, that would make their comprehensive financial planning available at a cost of the other 19% of their fee.

Our example only looked at the five different share classes of Growth Fund of America. A fee-only financial planner has the entire world of investment options to choose from and may find better selections available at even lower expense ratios.

B shares are just one example of the many investment choices with financial hooks. Whole life insurance also has a surrender value significantly lower than its fair market value. And annuities are sold with financial hooks that can lock your money up for several years.

Private equity investments require even longer commitments of capital. Once you are invested, it is very difficult to get your money out until the fund liquidates many years later. During those years you may not even know if your investment was a good one.

Because no public pricing exists for private equities, they continue to be priced to investors at their initial cost. That cost, minus fees, expenses and write-offs, typically produces a negative return over the first half of the investment. Private equity also may require you to commit to additional investments through the life of the investment. So not only is your initial investment held captive, but you must keep a sizable chunk of cash liquid to pay the private equity's capital calls. Finally, the fees are charged on the basis of this committed capital, not just the amount you have already invested.

It was these capital calls that recently hurt the investment strategy of the University of Virginia endowment. Having had significant investments in private equity, after the drop in their regular investments, much of the remainder will be needed to satisfy capital calls on their private equity. The result will be a much higher than desirable portion of the endowment in private equity investments.

Private equity may be acceptable for an endowment with an infinite time horizon, but it is not for average investors who want access to their money during retirement.

Hedge funds are poor investments for similar reasons. They typically require your investment to be committed for years, called a lockup period. During that time, managers not only take 1% to 2% of assets annually, but they also collect 20% of returns, both realized and unrealized. These extra fees are collected any time the fund exceeds its high-water mark.

This compensation scheme is ripe for abuse. Many of the hedge funds that opened after the fall of 2002 hit their high-water marks in the summer of 2008. When the markets are behaving themselves, hedge fund managers enjoy the ride up, gaining 20% of the profits of markets trending upward. During this time, your money is held captive during the lock-up period, and redemptions are not allowed.

If a typical fund charges 2% plus 20% of profits, and gains average 10% to 12% because the markets generally go up, the average fees being paid are in excess of 4%. You might imagine that would be enough money to keep hedge fund managers loyal to their captive customers, but it is not.

But when the market winds blow south, fund managers defect. Many hedge funds are now closing. There is no sense running a fund that is 50% below its high-water mark. Without the incentive of proximity to the high-water mark and a good chance of making 20% of the profits, many hedge funds are not interested in merely serving the client.

So hedge funds can hold your money captive when they are making high fees and abandon you and start a new fund after a significant market correction. This explains why hedge fund companies often have several different hedge funds, each with a different inception date. They can drop those that have poor returns and advertise those with good returns.

As a result, the average life of a hedge fund is only three years. Every three years a market downturn provides the incentive for hedge fund managers to close the current fund and reboot to a lower high-water mark. Three years is also the average lockup period after which disappointed investors can finally get their money out.

To add insult to injury, hedge funds are unregulated, which means the reporting of a hedge fund's return is completely voluntary. There is a hedge fund index that aggregates these voluntarily reported returns, but the number isn't reliable. Hedge funds with poor returns don't report, and hedge funds that fold and go out of business stop being included.

Unrealistically high reporting of returns to attract customers, a three-year lockup period and exorbitantly high fees sounds like a way to make money for the fund but certainly not for the average investor.

My final example of financial hooks involves captive trustee accounts. Sometimes estate trusts are established in legal documents that name a bank or other financial institution as the trustee with no method to change that trustee. The banks call these "captive" accounts for a good reason. Beneficiaries cannot take their business elsewhere and may have to suffer poor service or high fees.

Banks may charge fees as high as 4.5% while better service options are available for a fraction of a percent. A bank here in Charlottesville pushed one of our clients to get their estate documents drawn up by an attorney who charged the client thousands of dollars and then wrote the bank in as the trustee in the estate's legal documents.

I've learned through experience that the more financial hooks keep you captive to a particular financial services company, the poorer the service. And without a way to extricate your investment, you are stuck receiving inferior returns for years. It's a simple but powerful lesson: Avoid anything that puts financial hooks on your investments.

from http://www.emarotta.com/article.php?ID=324

Safeguard #5: Understand Your Investment Strategy (2009-02-09)

Safeguard #5: Understand Your Investment Strategy

(2009-02-09) by David John Marotta

I often write about the importance of a financial advisor being a fiduciary and the responsibilities accompanying that legal obligation. But clients also have their part to play in financial planning. Certain responsibilities cannot be delegated to others. Understanding and maintaining your role in the process is critical to safeguarding your money and consequently your financial freedom.

Advisors are coaches, not players. They motivate and assist their clients in completing all the actions necessary to implement the plan and thus achieve their financial goals. Most clients have a vague list of worries that reflect more anxiety and frustration than direction. A good coach on your team can make a big difference in the outcome of the game, but the contest is still ultimately in the hands of the players. Your active participation is necessary to secure your financial future and cannot be delegated.

As fiduciaries, we strive to act as you would if you had our time and expertise. But without you taking a real role in the process, we would be unable to gather the information and resources needed to help you set and meet reasonable and realistic goals. Without committed participation, the process of assisting clients to meet their stated financial goals can end up frustrating both parties.

This scenario is very different from dealing with brokers or agents, who may only be interested in satisfying the suitability rule in order to sell their products and services. Without the burden of acting in their clients' best interests, they may be personable to work with, but wealth management isn't just about the relationship. It is about reaching your goals, and sometimes the most effective coach can't be your best friend too.

The best advisors are quantitative and analytical. They may buy you lunch or send you a birthday card, but their genuine strengths lie elsewhere. Expert advisors have substantial knowledge and offer sophisticated services.

To extend the sports metaphor, if a fiduciary advisor is a coach, then brokers and agents are there just to sell you equipment. But a shin-guard salesperson isn't going to help you play a better game of soccer. Personality can be an effective sales tactic because salespeople know you are most likely to say "yes" to someone you like. In contrast, a good coach is not your buddy but rather someone who asks things of you. But he or she is also going to support you with a winning team and help you interact with that team to score goals.

A player can't sit back in the bleachers like a fan and cheer the team on. When you as the client are not interested in understanding enough of the investment strategy to play your position, you won't be able to achieve your goals.

Don't trust any investment strategy you don't understand, and don't trust any advisor who won't or can't take the time to explain exactly why and how he or she operates. An advisor's investment philosophy is the most important and valuable resource you are purchasing. If you don't trust your advisor's knowledge and techniques, you shouldn't entrust your financial future with them. In other words, don't invest in anything with anyone that you either do not understand or with whom you feel uncomfortable.

"Distressed emerging market risk arbitrage" may be a surefire way to make loads of money, but if you don't understand the process and feel at ease being part of the team that executes that move on the field, you would be better off sitting on the bench and investing in Treasury bills.

Note that I am not advocating "invest in what you know," which is called familiarity bias and can cause your portfolio to be inadequately diversified. Only investing in what you know may help you avoid some crazy investment schemes, but the resulting concentration can be dangerous in other ways.

Instead, the better rule of thumb is "know what you are investing in," which requires active participation by both you and your advisor. It is best to have an advisor who is a patient and skilled teacher or mentor at heart. And to be a good coach, your advisor should be willing to contradict you when it will help you better meet your goals. At the end of the day, your coach will still be your coach, but you should also be a better player as a result of the relationship.

With a good advisor, your investment approach should be simple and straightforward enough that you understand why the approach is being taken and how it is being implemented. It should never be a black box where you put your money in the top, let the advisor crank the handle and hope the return that comes out the bottom is good enough to meet your goals.

The box should be sufficiently transparent so you know these three simple pieces of information. You know how others are making money off your investments, you know what your investments are composed of and you know how and by what measure your portfolio will be monitored and reviewed.

Sales pitches are notorious for trying to confuse investors about the real composition, execution and compensation structure of the underlying investment. They generally ask investors not to worry about the details and to trust the reputation of brainy academics or else look at the pictures in the glossy four-color brochures instead.

Don't be fooled and don't be foolish. Understanding your investment strategy is critical to safeguarding your investments against reckless schemes. With a good coach and mentor, you can become a better team player and help your family achieve both their financial goals and peace of mind.

from http://www.emarotta.com/article.php?ID=323

Safeguard #4: Buy Investments That Trend Upward (2009-02-02)

Safeguard #4: Buy Investments That Trend Upward

(2009-02-02) by David John Marotta

Crazy volatile markets push people toward irrational investment schemes. Methods to safeguard our investments won't prevent loss, but ideally they will prevent us from putting our money in investments where we should have known better. Let me give you an example.

There's always a way to make money in the markets. I'm going to tell you how you could have made a lot of money last year. Some investors used this technique to capture huge gains in 2008 while most investors were losing their shirts. What was their secret? Halfway through the year they bet oil prices would drop.

As oil approached $147 a barrel and everyone else thought it was going to $200 a barrel, these wily investors sold it short. That is, they bet on oil going down. Because they were right, their investment earned sizable returns.

They accomplished this feat by purchasing "put options," the right but not the obligation to sell a certain number of barrels of oil for a certain price for a specified period of time. If the price of a barrel of oil drops significantly, as it did, they could sell their put options for a profit.

Does this scenario sound enticing? Do you find yourself wishing you had your investments in oil puts last year? Envy and regret are powerful motivators in the investing world. But you must tame these emotions if you are going to learn how to safeguard your money.

Just because some investors made significant gains in commodity futures doesn't mean that is where you should have been invested. Most of the time when you purchase a put option, the underlying commodity does not drop significantly in price and your put option expires as worthless.

On average, commodity prices rise rather than fall. If you stop and think for a minute, you could assume that commodity prices would at least increase along with inflation every year. They rise reflecting inflation and they fluctuate along with the supply and demand of economic expansion and contraction.

If a commodity rises an average of 5% just for inflation, most of the time investments in commodity puts will lose money. You can purchase put options at various prices, but they all have to overcome strong tailwinds to move backward. The commodity has to drop more than inflation plus the price of the option itself just to break even and start making money. Just because they sometimes make money doesn't make them a good bet.

Imagine you are standing next to the roulette wheel in a Las Vegas casino trying to decide which bet you want to make. You can either bet on red or black, but you are getting confused because the last spin came up green: zero.

Just because the ball happened to land in zero the last turn doesn't mean zero is a good bet. On average, it is a losing bet. In fact, on average, so are red and black. Never invest in something that on average is a losing bet. Never invest in something that on average goes down. You don't want to be a gambler in Las Vegas at all.

Instead you want to be the house.

The house loses lots of bets. In fact, the house loses more bets than investors do over a year in the stock market. The house edge is small, but on average the house wins a steady stream of gains.

Any investment that, on average, doesn't go up shouldn't be an asset class in your portfolio. There are a lot of so-called investments that fit this description. They are best described not as "investments" but as "speculations." I concede there is a place in specific portfolios to invest in something that doesn't go up on average. But this situation is the exception, not the rule, and these decisions are warranted most commonly because of a large investment that needs to be protected. In this case, what you are really buying is "insurance," not an "investment."

Here's another way to look at short investments. If the markets appreciate 10% per year, then investments against the market lose 10% per year. Predicting market drops with such accuracy as to overcome a 10% headwind plus the transaction costs of shorting the market is difficult, to say the least.

And whereas investments that are long in the market can only drop a finite amount (to zero), short investments can lose an infinite amount because there is no limit to how much a stock can rise.

Gold is another example of an investment that on average does not appreciate in value.

Jeremy Siegel, author of "Stocks for the Long Run," analyzed investments over the past 200 years. Gold, on average, maintains its value over time. If you bought a dollar's worth of gold 200 years ago, after adjusting for inflation, it would be still be worth about $1 today.

Although gold generally holds its purchasing value, it still fluctuates wildly based on other factors of supply and demand. While it does so, the part of these movements that is not just random noise is simply an inverse reaction to the value of the dollar.

Over the long term, gold holds its purchasing power, but it has not for almost three decades. In January 1980, gold reached its high of $850 an ounce. The following year my wife and I became engaged and chose modest wedding rings that were still very expensive. Note that $850 in 1980 had the same buying power as $2,191 in today's dollars. Gold trading at $850 an ounce then was like gold trading at more than twice its current price. In other words, those people who purchased gold in 1980 have lost more than half their buying power during a 28-year investment. Even considering the October 2008 stock market drop, the tailwind of appreciation pushed stock investments to significant gains over the past 28 years. That tailwind is a powerful force for investment growth.

Investments that bet on stock market corrections are more dangerous than the market itself. Perhaps they should come with the following warning: "The stock market can go up as well as down!"

Holding investments for the long term makes sense because millions of people are working in thousands of publicly traded companies on your side of the investment. Your interest is congruent with theirs, and their very livelihood depends on your investment making a profit.

So look for great well-financed companies that deliver products or services of real value in order to make the trend of the investment upward. If the investment bets against that trend or simply holds its value, it should not be a major component in your allocation. There may be a place for options like insurance, but these are rare. As a rule of thumb, put your money only in investments that on average go up.

from http://www.emarotta.com/article.php?ID=322