The Purely Passive Permanent Portfolio

My nephew recently asked me to recommend a good book on investing for someone who was just starting to make contributions to his retirement plan.  Somewhat reflexively, I recommended Prof. Malkiel’s “A Random Walk Down Wall Street” as a good place to start.

I first read “Random Walk” in the 1980s and it was an eye-opener for me at the time. I was and continue to be a dyed in the wool Graham and Dodd fundamentalist. I had met and followed quite a few research analysts when I worked on Wall Street. Their opinions were coveted by institutional investors. The brokerage firms were justifiably proud if one of their analysts was named to the annual “All-American” institutional research team.

The random walk theory was not original to Prof. Malkiel. He popularized it in layman’s terms. He used a coin flip to create a trading pattern for a fictional stock and then attempted to have an analyst apply technical analysis to the resulting chart.  When the technician told him to buy the fictional stock he concluded that analysts could not accurately predict the future price of a stock, so why bother?

In Malkiel’s view, simple asset allocation with periodic rebalancing will outperform the overall stock market. The standard allocation, 60% stocks and 40% bonds will never increase as much in a bull market as stocks alone, but the bonds will buffer loses in a bad market.  Many people believe that this type of allocation is fine for investors over the long term.

Asset allocation requires the construction of a portfolio with non-correlated assets. The stock portion of the portfolio must be selected carefully or the entire purpose of the allocation will be defeated.  Prof. Malkiel currently shills for one of the large robo-advisors that does not perform asset allocation very well.

Correlation is a tricky concept. The idea is to purchase investments that are affected differently by shifts in macro-economic conditions.  A truly diverse stock portfolio should have stocks from at least 15 non-correlated sectors.  You cannot create a truly diverse portfolio by investing in large cap, small cap and emerging market funds or ETFs. The stocks in these funds are correlated to each other in too many ways.  Capitalization does not define a sector for allocation purposes.

If you buy an index fund or ETF such as the Standard and Poor’s 500 you get the average market return in good years and in bad years. If the market happens decline for the 3 years just before you need your money, such as the 3 years before you retire, your portfolio may be worth the same as it was worth ten years earlier. You may have earned nothing during the last 10 years that you were working.  That is ten years in which you could have easily doubled your portfolio’s value if you were 100% invested in income producing investments.

Many people want a portfolio that will give them “higher than average market returns with lower than average market risks.”  It clearly is something that can be accomplished but it takes work to get there.

You can beat any index or sector fund by identifying the “dogs” that are in it. Some of the stocks in an S&P 500 fund are not expected to do all that well in the next 12-24 months. Certainly if you constructed a portfolio of the 250 stocks most likely to do well and leave out the dogs, you should beat that index every year.

Eliminating the dogs requires analysis. Fundamental analysis works and is still the primary way in which most professional investors make their investment decisions.

The “problem” is that a lot of people do not think that anyone can actually analyze individual stocks and pick the winners over the losers. That, of course, is not true.

There are a great many securities analysts and portfolio managers out there who are more than competent. The problem is that the best investment advisors are mixed in with a lot of advisors who are more adept at sales than analysis.

Rather than take the time and put in the effort to understand investing well enough to choose a good advisor, people have fallen back on the idea that they can buy a few index ETFs, rebalance periodically and all will be well. That is the investment philosophy behind robo-advisors. It is an investment philosophy I call “cheap and stupid.”

This brings us to Harry Browne.  Browne developed what he called the “permanent portfolio” back in the early 1970s.  He introduced it to the world in a well received 1987 book called “Why the Best-Laid Investment Plans Usually Go Wrong”.

I came across this book when I started teaching Law and Economics in the early 1990s.  Much of the literature around Law and Economics at the time came out of the University of Chicago and had a very libertarian bias.  Browne was a Libertarian and later became the Libertarian Party candidate for President.

Browne’s book described the virtues of a diversified portfolio whose composition would stay constant year in and year out — permanent, in other words, except for annual rebalancing. Browne’s idea of diversification into non-correlated assets was different from what you might think and very different from the diversified portfolio that you will get with any robo-advisor.

Browne’s portfolio divided your funds into only four asset classes. The portfolio was equally divided between aggressive growth stocks, which do well in times of prosperity; gold which does well in times of inflation; long-term Treasury bonds which increase in price during times of deflation and Treasury bills which do well in times of tight money/recession.

Browne was a “gold bug”. He recommended that you hold the gold portion of the portfolio in bullion or gold coins. This was fairly common advice at the time.

At the time the book came out, Browne reported that the portfolio had produced an annual return equal to 12% over the preceding 17 years. Much of that return was due to the doubling and re-doubling of the price of gold. Gold was still pegged at $35 per ounce when the portfolio began.  The latter half of the 1970s was a period of high inflation which helped the price of gold to move up.

Browne’s permanent portfolio continued to do quite well in its original form until his death in 2006. A number of books and articles have been written about it and several people have modified it with funds and ETFs.

There is a mutual fund called the Permanent Portfolio fund (NYSE: PRPFX) which uses a modified permanent portfolio including real estate and Swiss Francs. The fund holds about $3 billion in assets. If you are really determined to be a passive investor and appreciate that those robo-advisors are a scam you might take a look at this fund.  You will discover that it has done quite well since 2006, when Browne died, until the present.

As always, I do not know anyone at this fund and no one has offered to compensate me in any way for recommending it.

Browne’s permanent portfolio has apparently produced positive results continually since 1970 through the present. It can do so because growth and recession, inflation and deflation are opposites and assets that perform well in each cycle are non-correlated by definition.

Will Browne’s permanent portfolio continue to do well, year in and year out?  It should. It represents asset allocation and diversification in its purest form.










What is Wrong with FINRA Arbitration? Nothing.

FINRA arbitration provides a simplified procedure for a customer to resolve any dispute that they may have with their stockbroker or stock brokerage firm. The rules of evidence are relaxed and arbitrators will often ask questions of the parties and witnesses to make certain that they understand what has occurred. That should benefit any skilled litigator representing a customer in this forum.

Notwithstanding, I constantly read articles about how FINRA arbitration is unfair. Lawyers who represent customers claim that the arbitrators favor the industry.  Some complain that arbitrators are not required to follow the law nor give reasons for their decisions. Others argue that they cannot conduct adequate discovery because depositions are not allowed.

Many stockbrokers also think that FINRA arbitration is unfair. More than one stockbroker has referred to the arbitration forum as a “kangaroo court”.

There are a handful of elite lawyers who regularly practice in this forum on both sides of the table. There are many more who are competent (if not inspired) and then there are those who complain because they frankly miss the point. The lawyers who complain the loudest about the arbitrators are the lawyers that cannot put the facts in their proper context.

Many lawyers who practice in this forum, on both sides, have no real understanding of the day to day functioning of a brokerage firm or the actual relationship between a broker and a customer. They often cloud the proceedings with irrelevant information and misguided assertions.

Arbitrators are fact finders, not judges. Lawyers should explain the dispute to arbitrators in the way arbitrators understand it, rather than complaining that the arbitrators do not understand the claim the way the lawyers want to present it.

I was trained in broker/dealer compliance. Arbitrators are frequently concerned with the same thing that concerns compliance officers; was this a “good trade”? Whether or not Rule 10b-5 was violated is usually irrelevant.  That is why you cannot approach FINRA arbitration in the same way that you would approach a case being filed in court.

When a lawyer drafts a complaint for court, the focus is on the legal causes of action. They make certain that the complaint is legally sufficient because failure to do so will get the complaint dismissed long before the hearing.  FINRA arbitrators rarely dismiss a claim except under limited circumstances, so customers are almost always assured of getting their claim heard.

When I draft a claim for FINRA arbitration I tell the panel what happened in a narrative form.  I focus on what the broker did wrong or why the investment product was defective.  And I tell the arbitrators why those facts caused the loss that the customer suffered.

Many customers want to file claims against their broker because they feel that their trust in the broker has been violated. Trust is hard to prove and often not relevant to the facts at hand.

The securities laws are grounded in the idea of “disclosure”, not trust.  Customers must be told everything they need to know. Like all financial institutions, the brokerage industry has systematized this disclosure into the fine print that is included in the customer agreements, margin agreements, confirmations and monthly statements. All of these disclosures have been approved by the appropriate regulators.

Products like variable annuities and private placements which are the subject of many of the arbitration claims usually require a customer to sign a form declaring that they have received everything they are entitled to receive. With private placements customers sign a form that states that they have read the disclosure documents, had an opportunity to ask questions and were told to review the transaction with their own attorney and tax advisor before they make the purchase.  Obviously, that makes it more difficult for customers to claim that they did not get the disclosures that they should have gotten.

Many claims invoke FINRA’s suitability rule which requires brokers to have a reasonable basis for any investment recommendation that they make.  It rarely comes into play where the customer is self directed using an account at a discount brokerage firm.

You also need to appreciate that a reasonable basis for recommending a stock is that the broker thought that the price would go up.  A recommendation can often be justified by good news or bad news about the company or the market. No broker has a crystal ball.

Brokers are required to only make recommendations in accordance with the customer’s “risk tolerance”.  At the hearing this is going to come down to a simple question that will be asked of both the broker and the customer: “how much money was the customer prepared to lose?”

Once the answer to that question is ascertained, defense counsel will invariably bring out the monthly account statements.  Arbitrators have little sympathy for customers who do not read the monthly statements or who claim not to understand them.

Everyone knows that the stock market goes up and down and sometimes crashes. Customers are often asked: “your account went up 20% from where you started, didn’t it occur to you that it might go down by that much or more?”

Not every customer who has a loss has a cognizable claim. The firm or the broker must do something wrong and the wrong must be the cause of the loss.  A suitability claim is essentially a negligence cause of action and legal defenses to negligence such as “comparative negligence” and “last clear chance” come into play even if they are not expressed as such.

Beginning in the late 1980s, more and more “product” cases began to surface. These were easier to prove because there was always a prospectus or similar disclosure document which either made all of the material disclosures or did not.  But finding facts that were not disclosed takes work.

In the mid-1990s I worked on about 2 dozen claims against a number of firms that had sold notes issued by a large Ponzi scheme. The operators of the scheme had been indicted by a state regulator. At that time court documents were not available on the internet.  I contacted the prosecutor and obtained an affidavit that had been sworn by a Deputy Attorney General that had been submitted to the Court as part of an asset freeze in the criminal case.  It laid out the whole scam in great detail.

I would attach the affidavit to my pre-hearing briefs. Most of the defense lawyers who handled multiple claims for their brokerage firm clients had never seen it before, meaning many of the other customers’ lawyers had not bothered to pick up the phone and contact the prosecutor.

I had a similar experience during the tech wreck/research analyst cases. My partner and I flew back to New York and spent two days in the windowless basement of a mid-town office tower reviewing documents that had been produced in one of the class actions.  We came away with enough to prove what we needed to prove in our arbitration claims but it took time and effort to do so.  I know that a lot of other lawyers representing customers had never bothered to make the effort.

Discovery is the key part of any FINRA arbitration and FINRA has established lists of documents that are presumed to be relevant to different types of claims. These are usually exchanged without incident or discussion although I have seen instances where defense lawyers claim that some of the requests are “vague and ambiguous” even though they have responded to these same requests many times before.

Supplementary discovery requests are permitted but not depositions or interrogatories.  It helps if the customers’ lawyer understands the paper flow and record retention requirements of the brokerage industry.

Every single order (buy or sell) that is entered by a broker on a customer’s behalf is approved by at least one supervisor at the firm and a record of that approval is kept.  Orders that fall outside of pre-established guidelines become the subject of exception reports and are further reviewed by the compliance department.  All marketing materials that a broker hands out and all outgoing correspondence are reviewed and approved as well.

I am frequently amazed how little of a paper trail the industry produces in many cases. The most important documents, such as the broker’s notes setting forth why he told the customer to buy XYZ at $100 per share never seem to find the light of day.

The most outrageous abuse of the arbitration discovery process, in my opinion, was committed by Morgan Stanley which claimed, falsely, to have lost millions of e-mails when its headquarters in the World Trade Center was destroyed on 9/11.  Morgan Stanley was fined and a fund was set up to repay customers whose arbitration claims were tainted when its duplicity was ultimately uncovered.

Product cases often become “battles of the experts”.  FINRA rules require a high level of pre-offering due diligence by the firm. The customer needs to prove that the firm acted below the industry’s standard of care which usually means setting out the facts that were not disclosed or demonstrating how little due diligence was actually done.

There were a great many claims that were the result of losses from real estate private placements after the real estate crash in 2008.  The more successful claims involved private placements or private REITS where the disclosure documents were deficient. But again, you have to prove what is missing. The best experts are people who have written disclosure documents themselves.

Customers’ lawyers have already begun to file claims due to losses on oil and gas offerings as the price of oil has tanked.  As these programs cut dividends or file for bankruptcy fraud and other problems are frequently revealed.

These claims should be easier for customers’ lawyers because a due diligence investigation of an oil and gas investment is more complicated and costly than an investigation of a real estate offering.  In many cases, the smaller FINRA firms that sell these offerings do not want to spend the money to perform a due diligence investigation properly.

One issue that frequently draws negative comments about FINRA arbitration is the subject of damages. Arbitrators will often apportion the loss between the parties. In times of a market decline, they will often consider the fact that if the broker had done everything correctly or purchased different investments the customer might still have lost money.

Have I ever had a bad arbitrator? Yes. I have been in front of arbitrators who fell asleep, were preoccupied with other matters or just did not understand what was going on.  It is rare, but it has also happened with judges.

The organized investors’ bar association has reformed the FINRA arbitration to allow panels to be constituted without any member who has worked for the industry. Personally, I always want someone on the panel who understands how a broker or brokerage firm is supposed to act.

The complaints against FINRA arbitration are part of a larger movement to move many kinds of consumer disputes away from arbitration.  That would send these disputes back to courthouses that are already swamped. In many parts of the country consumers can wait 5 years for their case to be heard and spend tens of thousands of dollars in deposition and other preparation costs.

Investment cases are difficult to win because investors are not ordinary people who get struck in  by a car in a crosswalk. They know that they can lose money every time that they invest.

Investors are usually given all of the disclosures that they are supposed to get. They certainly know what they are buying, how much they are spending  and how much their account is worth, every month. Does it surprise you that defense lawyers frequently ask: “if you were unhappy with the losses in your account, why didn’t you just tell your broker to sell everything and quit before the losses doubled?”

The fact that many of these cases are difficult to win is not the forum’s fault.

I cannot be the only person who regularly practiced before FINRA arbitrators who believes that the system works well enough to be left alone. Well meaning consumer groups should think twice before they argue that investor claims are better heard in court.  And lawyers representing investors should consider that the arbitrator bias and other problems they keep complaining about may actually not be as prevalent or as harmful as they seem to think.

How Much is One Hour of Your Time Worth?

More and more people in the service sector of the economy are independent contractors setting their own hourly rate. For many self-employed people, it is one for the most important business decisions that they make.  It is also often one of the most difficult.

I worked as a lawyer for many years and I would periodically adjust my hourly rate upward, usually on the first of the year, to reflect the added expertise I had acquired during the year. Being self-employed allowed me the luxury of setting my own rate.

My hourly rate took into consideration that I had office rent and employees to pay as well as all of the ancillary expenses that come with running a business. However, that does not mean that I reduced my rate when I moved out of a pricey financial district office tower and into a lower rent office in the suburbs.

I was recently contacted by a very large international consulting firm that wanted to add me to their stable of experts. They had a client in need of a consultation about a fairly new regulation that I had written about and they invited me to call in and sign up.

The person with whom I spoke had all of my information from Linked-in and was happy to sign me up and explain their procedures. The assignment was a one hour phone call with an executive at one of the large Wall Street investment banks.

The last question the interviewer wanted to know was the most important; she wanted to know my hourly billing rate. Now that I am semi retired, I have even lower overhead and fewer expenses. I intended to handle this consultation sitting in the shade on my deck.

I asked my interviewer what she thought the right hourly rate would be.  We settled on a rate that she felt was appropriate.  The rate was the same that other experienced lawyers who were still working and paying overhead expenses would charge. I could have charged less because I had no overhead. Because I had written about the regulation I had demonstrated expertise and did not need to charge less.

Three factors will always come into play when setting your hourly rate; how good you are at what you do, your overhead and expenses and what the market will bear. It sounds much easier than it is.

In a perfect world, if you are very good at what you do, you should be able to charge more. That is not always the case.

In a great many cases, the customer is not looking for the best of the best. The customer is looking for someone who is good enough to get the job done.  I call it the good enough economy and there is a lot of it going around.

Basic economics teaches that the one universal factor determining how much you can charge per hour is what your competition charges. Price matters and it is going to throw the old idea about hiring the best people who went to the best schools and then worked at the best companies out the window.

The easiest example of this is code writers. It is an industry full of freelancers and independent contractors.  I live near Silicon Valley where I have heard many people say that the best code writers congregate.  Except those code writers have priced themselves out of the market.

If you have a fair amount of student loan debt because you learned code writing at Stanford or MIT and you live in Silicon Valley where rents are higher than almost anywhere else outside of San Francisco or Manhattan the amount that you need to earn in order to cover your monthly overhead is substantial.

There are excellent code writers living near Seattle or Austin as well as London, Moscow and Mumbai who will get the job done and charge far less because they need a lot less to pay their bills. I appreciate that Silicon Valley is where the action is, but even the big Silicon Valley companies have been outsourcing overseas for years.

This is not limited to tech jobs.

There are radiologists in India and the Philippines who read x-rays for hospitals and insurance companies in the US and Europe. There are teams of lawyers and paralegals in other countries who handle the volume of documents produced in large cases litigated by large Wall Street law firms. These firms have lawyers and paralegals on staff and would be happy to bill them out to accomplish the same tasks. But the clients do not want to pay Wall Street rates for tasks that they can buy cheaper even if they hire the most expensive law firm to represent them.

The simple truth is that a significant amount of student debt may actually be an impediment to making a lot of money as an independent in your chosen field. It may require you to work at a big company for a big salary. It can restrict your ability to take chances, like working with a start-up that could have a big time pay-off.  It can even rob you of the kind of opportunities, like a business convention in Hong Kong, that could really open up doors for your career.

Self worth is an interesting concept. Many independent contractors have difficulty setting their hourly rate because they do not have a good feel for how they stack up against their competition.  If you post a higher hourly rate you are advertising that you are better than your competitors. Of course, you need to back that up by doing a better job if you are hired.

It seems that a better approach would be to charge a little less and deliver a little more.  I have certainly read articles by many experts who would claim that that is the best way for an independent contractor to build his/her reputation and gain valuable referrals.

Never confuse your hourly rate with your advertising budget.  How you present yourself to prospective clients is still essential. If you want to charge more than your competitors you need to convince potential clients that you are worth more. And you need to reach more potential customers through advertising.

I read business plans and pitch books for start-up companies for free.  I will get on the phone with a budding entrepreneur and spend an hour answering specific questions and offer some suggestions or perspective about their business without charge. I have the experience, a fair amount of free time and I enjoy speaking with people who are starting a business. I often learn a lot more from them about what is going on in the marketplace than I do from reading the business or financial press.

Occasionally, a company wants to hire me to do more.  If I want the assignment, then I often have to charge less than I am worth because the company rarely has the cash to pay me what the NY investment bank paid me.  In most cases the company wants my on-going business and legal advice. In those cases, I usually prefer a monthly retainer to hourly billing.  That way, neither the company nor I are watching the clock.

I was recently approached by a very successful businessman who had started and sold three start-ups.  He had a pretty good idea for start-up number four and offered to give me equity in exchange for my expertise and on-going advice.

He was surprised when I declined because he had spent ten minutes explaining how my small share would be worth millions.  I told him to sell the shares he was offering to me to someone else for a deep discount and use the proceeds to just pay me my hourly rate.

For those of you who think that I was foolish for passing up what may have been a great opportunity, I can only tell you that I have been there before.  If you pay for my advice and then don’t take the advice, well okay, every lawyer has clients like that.  If I have equity and you don’t take my advice then I should not have taken you on as a client in the first place.

Do I really think that my advice is that good?  Yes I do, but mostly I know that advice that is not paid for is often disregarded.

Being semi retired and overhead free, I can give or sell my time to whomever I wish at whatever rate I wish to charge. It is truly liberating.  I only take on clients I like and projects that interest me. I can apply myself to only those projects where my experience and skills will add value.

I am not going to be giving seminars on this but I invite any independent contractor to adopt the same mindset, at least as an exercise.  What would you charge a really nice person who really needs your help?  Someone with a project that you could really enjoy sinking your teeth into even though they cannot pay you what you would like to get paid.

I suggest that amount is your base hourly rate. Charge more for mundane projects or difficult clients. There is no Nobel Prize winning economics behind this but I suspect that you will be happier when you are compensated at above your base rate for work that you do not enjoy and clients that you do not like. I suspect that you will probably be more productive, as well.