Misunderstanding Asset Allocation

Diversification is one of the most often used and most often misunderstood concepts in investing.  Investors are frequently advised to diversify their portfolios.  Most people are rarely told what true portfolio diversification is, how to correctly construct a diversified portfolio or what to expect from the portfolio in terms of risk and rewards.

The idea of using a diversified investment portfolio is usually attributed to an article published by Prof. Harry Markowitz in the Journal of Finance in 1952. The article gave birth to what has been called “modern portfolio theory” (MPT).  It is widely accepted but I think it fair to say most people who claim to understand MPT do not.  If they did they would not invest as they do.

Markowitz was, first and foremost, a mathematician who applied mathematics to investment portfolios. The calculus that he used is not that complex if calculus is your thing but most people who swear by MPT cannot do the math themselves nor do they understand it.

The goal of MPT is not to get the highest return but to get an efficient return for the amount of risk that the investor is willing to assume. In a nutshell, Markowitz believed that by constructing a portfolio with a number of stocks, the winners will balance out the losers. Deciding upon which stocks to buy and how many has always been the vexing problem.

There have been a number of studies over the years that suggest the correct number of stocks to buy to gain diversification of the risk of a catastrophic loss is somewhere between 15 and 20.  Some people believe that they should buy a much larger basket, such as an index fund that tracks the entire S&P 500.

The large basket, index fund approach is the result of the capital asset pricing model (CAPM) which suggests that maximum diversification comes from buying a pro rata share of all available assets. The CAPM was introduced by Prof. William Sharpe in 1970.

Both Markowitz and Sharpe are trying to solve the same problem, constructing a portfolio that efficiently deals with the risk of loss. Understanding the significant difference between the two approaches is where most people get lost.

Markowitz suggested that one way to mitigate the risk of investing was to create a portfolio that contained a mix of non-correlated assets.   Non-correlated assets perform differently during periods when market conditions change.

A classic example of non-correlated assets might be an oil company and an airline. Oil company profits tend to rise when oil prices go up because the companies can get increased prices and margins.  Airline company profits tend to fall when oil prices increase as their operating expenses increase. Oil prices and other commodity prices fluctuate up and down with supply and demand, weather, political decisions and other macro economic factors.

This economic see-saw is usually felt in the credit markets. Fixed income securities are generally safer than equities.  Investors generally seek safer investments and like steady income.  But investors will move out of fixed income securities and into equities when interest rates are low as they have been in recent years.  Low interest rates often translate into higher profits for companies that borrow money pushing the price of their shares up.

That is why it is fairly easy to predict that people will begin to take the profits that they have made in equities in recent years and put their funds into fixed income securities as interest rates begin to rise.  Remarkably, a lot of people who are in the business of asset allocation simply ignore that fact.

A great many portfolios, especially those prepared by robo-advisors, construct portfolios allocated between equities and fixed income securities based upon the investor’s age. They argue that younger people can assume the risk of investing more aggressively into equities.  Neither Markowitz nor Sharpe ever considered an investor’s age as part of their analysis. The focus should not be on how old the investor is today, but what the markets are doing today and what do you anticipate that they will do in the near term.

Markowitz believed that portfolio construction should begin with observations and beliefs about the future performance of the available securities. That means that you should buy securities whose price you think will appreciate. You may be wrong due to market or other factors but if you are buying stocks that will react differently to those market factors you should not suffer catastrophic losses.

The CAPM on the other hand looks primarily at a stock’s volatility or beta. The beta is determined by how much more or less volatile a company’s stock is than a broader index. A stock whose volatility is the same as the index has a beta of 1. That is why people are encouraged to purchase an index or other large basket of stocks to get their portfolio’s beta closer to 1.

The essential difference between these two approaches is that Markowitz was looking at the fundamental factors that contributed to each company’s performance.  This fundamental securities analysis looks at a company’s business, management, competition etc. and tries to determine if the company will be profitable in the future and if so, how profitable.

CAPM on the other hand, looks at the how the company’s shares have performed versus the index in the past.  It is grounded in technical securities analysis which specifically looks at how a stock’s price has acted in the past and projects how that stock will trend into the future.  Technical analysis looks at the market rather than the company. It suggests that everything that anyone would want to know about a company is reflected in the current price of its shares.

I learned basic technical analysis in the commodities markets years ago where most traders charted the markets which were governed more or less by supply and demand for the underlying commodity.  I know many short term traders who swear by technical analysis but not so many who would use it to predict long term trends for investment. Past performance, after all, is never an indication of future performance.

I also take issue with the idea that everything that anyone would want to know about a company is reflected in its share price.  I buy a stock it is because I believe that the price will appreciate. The person who is selling that stock to me generally believes that it will appreciate no further or else logic suggests that they would not sell it.

Neither approach is right or wrong. Both are trying to predict the future which will always be an imperfect science. Both Markowitz and Sharpe are Nobel Prize winners.

Over the years I would carefully research the companies in which I invested. I would read multiple research reports on each company, some positive, some negative, published by analysts whose opinions I came to trust.  Research is a time consuming project. I now have an advisor who does this for me.

My advisor suggests that I only invest in companies thathave a history of paying regular dividends. That fact alone usually reduces volatility.

Robo investment advisors are firmly rooted in CAPM. They ignore fundamental facts about companies and markets.  If you buy an index fund, then the results you will get will mirror whatever the market does. This is fine when the market is going up. I have continually advised anyone who would listen that robos are a bad idea and when the market turns down, which it eventually will, people who are in robos and who stay invested in robos will take losses that they should not have to take.

 

Crowdfunding – Letter to the SEC

The SEC and New York University recently held a dialogue on securities crowdfunding.  SEC Commissioner Kara M. Stein offered closing remarks and asked some questions that need to be answered. https://www.sec.gov/news/statement/stein-closing-remarks-sec-nyu-dialogue.html. These are my thoughts and responses to Commissioner Stein’s remarks.

Dear Commissioner Stein:

By way of background I am a securities attorney with 40 years of experience representing broker/dealers, issuers of securities and large and small investors.  I have also taught economics and finance at a well reputed business school.

My interest in securities offerings that are made directly to investors over the internet goes back to the late 1990s when the first offering was made by the Spring Street Brewery company. I have spent the better part of the last two years studying and writing about crowdfunding under the JOBS Act.

I currently advise clients who are issuers, Title II platforms and Title III portals.  I believe that crowdfunding can work and that it can be a valuable tool in aid of the capital formation process especially for smaller companies.

To this point in time, a large percentage of successful offerings involve various forms of real estate investments. The vast majority are being offered under Regulation D. Several real estate funds have raised $25-$50 million from accredited investors on Title II platforms. Thousands of smaller real estate offerings have also been successful. These offerings are proof that funding is available outside of the traditional broker/dealer sales network.

Small companies and start-ups on the other hand, have had a much more difficult time attracting investors.  Start-ups, of course, are far riskier investments than most real estate offerings.  There are far fewer investors in the market place who are looking for that risk.  Some will take on the risk if they are satisfied with the potential for the company’s success.

There has been a push to offer securities in these companies to smaller investors under Regulations A and CF on Title III portals. The question that you asked in your remarks at the SEC-NYU dialogue: “Are registered portals appropriately considering the companies and offers hosted on their platforms?” is the appropriate question to ask.

There are fewer than 2 dozen registered portals today. I have reviewed offerings on most and have had direct contact with several. The answer to your question is that some of the portals do indeed act appropriately and several clearly do not.

You can easily identify those portals that do not comply with the rules. Most of those do not have a well trained and experienced professional in the role of compliance director.  The compliance director at any Title III portal should, at the very least, have a complete familiarly FINRA’s due diligence and advertising rules.

There are several portals who do not even attempt to conduct a due diligence review. There are also several consulting firms that provide due diligence investigations to the crowdfunding industry that lack the experience or expertise to do it correctly. These consultants get a lot of work from the portals because they charge very little.

You asked whether there should be minimum and uniform standards for vetting companies seeking to be hosted on a portal.  FINRA already has very specific rules for due diligence that require the member firm to verify the facts that the issuer is presenting to investors.  New rules are not needed; just compliance with and the enforcement of the existing rules.

One FINRA member portal in particular that has specialized in Reg. A offerings has listed several issues which are questionable in terms of their disclosures and economic viability. That portal makes no attempt to vet the offerings it lists.  One of these offerings is currently the subject of an SEC enforcement action.  I cannot know if the Commission’s enforcement staff intends to sanction the portal for its participation in that offering.  In my opinion, it should.  This portal unfairly competes with the portals that take their responsibilities seriously.

This portal does not spend money on due diligence. It does not care whether the issues it lists misrepresent their prospects for success to prospective investors.  It has a track record of successful offerings because the issuers are making promises to investors that they are unlikely to keep.

You suggested that some people have registered their concern at what may be a “race to the bottom” as portals compete for offers. That is exactly what is happening.  That same portal is currently offering a one day Reg. CF workshop that provides issuers with accountants, lawyers, copywriters and other vendors to get their campaign to “go live” on the same day as the workshop with no cost.

I cannot imagine that the SEC staff or FINRA would believe that adequate due diligence is being done if the offering is going live on the same day that the portal is first introduced to the issuer. I cannot personally believe that a competent securities attorney would participate in the preparation of these offerings or that the attorney’s professional liability carrier would approve.

Your presentation also noted that FINRA had expelled a portal for listing 16 questionable Reg. CF offerings. Those offerings were essentially done with a “cookie cutter” approach. What besides a cookie cutter approach can be expected when a portal is proposing to create and list multiple offerings on a single day at a workshop?

I have singled out this portal because its conduct is so egregious that I suspect that the Commission staff has already taken note.  I am not the only person in the crowdfunding industry who would understand if FINRA or the Commission did its job and closed this portal down.  If the crowdfunding industry is to succeed, investors must be able to look to this market with confidence.

You also asked what needed to be done to ensure that crowdfunding opportunities are accessible to everyone from the businesswoman in Missouri to the immigrant in West Virginia.  I have personally been contacted by potential issuers from all over the country. I know that Title II platforms exist in many states and several portals are “under construction” outside of major money centers.

Many of these issuers lack the knowledge and skills to put together an offering that might attract investors.  They lack experienced managers, quality boards of directors and well thought out business plans.  The Small Business Administration (SBA) has an existing mentoring program (SCORE). The Commission would be doing the marketplace a service by partnering with the SBA to make accurate information about crowdfunding available to more potential issuers.

There is currently a lack of good information about crowdfunding in the marketplace and much of the information that is available is inaccurate.  Much of the information about crowdfunding is being disseminated by a remarkably small group of people.  Many of these people have no experience selling securities and treat the process as if they were selling soap powder.

You expressed a desire on behalf of the Commission to improve this marketplace. There are those who are advocating making these very risky investments more accessible to small investors. I urge the Commission to reject that approach.  The risk should be allocated to those investors who can afford to absorb the loss.

As you noted, “portals that are effective at vetting issuers and offers are important as both gatekeepers and facilitators of repeat investment.” Keeping the portals focused on that task is the best thing that the Commission can do for this market.  Investors will come when there are better offerings. Better offerings will come when the portals insist that issuers demonstrate that they have real potential for success.

Respectfully,

 

Irwin G. Stein, Esq.

 

 

 

FINRA Arbitration – Why Customers Lose

There are a number of commentators, including some consumer groups, who believe that FINRA arbitration is inherently unfair to public investors.  I have heard these commentators refer to FINRA arbitration as a “kangaroo court” where investors do not get a fair hearing because arbitrators are biased.  Evidence of that bias has never been presented.

Surprisingly, some of the most fervent critics are lawyers who regularly practice in these forums.  I can only wonder if they voice their concerns or make a written disclosure when they are asking new clients to engage their services for arbitration at FINRA.

For many years, both parties were required to state on the record at the end of the hearing that they had been afforded an opportunity to fairly present their evidence to the panel. It was rare when someone on either side of the table refused to state that they had.  I think that I refused once in 40 years practicing before FINRA arbitrators and their predecessors.

Much of the “evidence” of bias and unfairness is based upon statistical research.  The researchers start with the mythical assumption that customers should win at least one half of the claims that are brought. That assumption has no basis in fact and belies the fact these claims are far easier to defend than to prosecute.

I was a pretty good defense attorney when I was representing firms for the first 15 years of my career. I learned a lot more about how to defend a brokerage firm from the defense lawyers with whom I tangled during the last 25 years representing customers.  The brokerage firms are almost always well represented and the critics of FINRA arbitration should give some credit to the defense where it is due.

Investors are generally better educated and more aware than average consumers.  A claim against a stockbroker is not the same as a claim against a drunk driver.  Investors usually know that the stock market goes up and down and that they can lose money every time that they invest.

“I lost money” or “I lost more money than I thought I would” may not be the basis for a claim without some affirmative bad act by the broker.  To be successful in a claim the customer may have to prove that the broker or brokerage firm did something out of the bounds of appropriate conduct and that the losses are a direct result of that conduct.

Many of the claims at FINRA involve its “suitability” rule.  The rule requires brokers to ascertain whether the customer understands the risk of loss from a particular investment or strategy, whether they want to take that risk and whether or not they can comfortably afford to take the loss should it occur.

A customer who claims at the hearing to be a conservative investor but who checked the box that they would still be comfortable if the account value declined by 20% is going to have a hard time convincing the panel that they were truly conservative. A 20% decline in account value is not a conservative loss.

Likewise, a conservative investor who follows the broker’s recommendation to invest in stocks is not conservative because there is no such thing as a conservative stock or portfolio of stocks.  Truly conservative investors buy bonds because they want to conserve their account value.

The brokerage industry collects information on a new account form and sends out monthly statements as a way of protecting itself, not the customer.  Customers who do not read the account application form, check the boxes even if the boxes do not set forth what they really want or who sign the forms with some items left blank have only themselves to blame.

Customers receive account statements every month but many never read them or claim at the hearing that they could not understand them but never asked for help.  With statements that are delivered on -line or through e-mail the brokerage firm will have a record of when the statement was sent, when it was opened and in some cases how long the customer spent on-line reading it.

When you get an account statement and do not complain about the transactions or positions in your account the firm will assert a legal defense called “ratification and waiver”.  Once the customer is notified and identifies a problem, they cannot just wait and see what happens next.  Invariably, the losses may get worse.

It is not unfair for a defense attorney to ask the customer a question like “Your account declined in value for 6 months, you knew it because you read the monthly statements and you did not complain about it. Why should the panel now believe that these losses were unacceptable to you?”

In many cases the response will be: “I spoke with the broker and he told me to stay the course and the account value will come back.”  Of course, the broker cannot know what the market will do in the future.

The legal term for this is “assumption of risk” which is what the customer is doing. Once informed that the investments have lost value, the customer is assuming the risk that the account may decline further by not demanding the broker sell the investments that they are now telling the arbitration panel were unsuitable because they were too risky.

Some claims assert that the broker committed fraud. This is frequently the case where the customer bought a private placement, such as a non-traded REIT, and all of the facts that should have been disclosed were not. Where the true facts could have been ascertained with a reasonable amount of due diligence, the brokerage firm is usually liable.

But to succeed on a claim of fraud, the customer must show that the loss was caused by the fraud.  This is not always easy to do.  A customer who was suitable for a real estate fund was not always awarded compensation for their loss.  This became evident after the real estate market collapsed in 2009.

In the case of a non-traded REIT that committed fraud by failing to disclose the operator’s many lawsuits, it could still be shown that the fund collapsed because the properties it owned suffered from high vacancy rates.  Defense attorneys will argue, often successfully, that the customer would have suffered the same loss if the broker had sold him any one of a dozen other REITS that the firm was offering which did not misstate the facts about the operator’s history.

Consider that a stockbroker is a trained salesperson who can usually look the arbitrators in the eye and tell a convincing story. They usually testify well and seem to always remember all the pertinent facts that will discredit the customer’s case. Customers, on the other hand, are often not as good on the witness stand.

All of this would be equally true if these cases are brought in court. Judges and juries are far from perfect and can be biased or worse, they just miss the point.  That is less likely to happen where one of the arbitrators is a representative of the securities industry like a retired branch office manager. A good branch manager who has been listening to stockbrokers for years can often ferret out the truth.

The essential difference is that aggrieved investors can wait years to get a jury trial and spend thousands of dollars on pre-trial motions and depositions before they get there.  Arbitration is quick and inexpensive.  The customer’s counsel usually does better if they understand the transaction from the industry point of view.

Finally, there is a tendency by some lawyers to try to prove too much. In a court case, a lawyer will plead all the alternative ways the court might find the defendant liable to his client.  I never recommend doing thatin an arbitration. Too often, there is a lot of testimony about things that arbitrators do not care about.

A customer in arbitration will always do better by telling the arbitrators “I would not have lost this money if the broker had acted appropriately.”  Arbitrators are fact-finders. Stick with the facts.

I am a fan of FINRA arbitration. Over the years I participated in more claims than most other attorneys.  If I thought FINRA arbitration was biased against the customer to the extent that I could not win, I would have stayed on the defense side of the table.

Any lawyer who frequents courthouses will tell you that there are judges that they do not like for one reason or another.  None would think to argue that the entire system is rigged.  The lawyers who complain about FINRA arbitration should do something else. If you cannot make FINRA arbitration  work, leave it to the lawyers who can.