Suing Your Broker After the Crash

When the stock market corrects again it will be the seventh or eighth time that it has since I began working on Wall Street in the mid-1970s. Corrections are always studied and talked about after they occur.  Corrections really need to be identified before they occur because they  always result in losses in accounts of smaller, retail investors. And they always result in a spike in litigation by those customers who wish to blame their brokers for their losses.

One of the reasons that the number of customer claims will go up is that in a rising market customers have fewer losses. That does not mean that the broker’s conduct was correct, just that it did not cost the customers money or that they could not see the losses or bad conduct until the market went down.

In the normal course, customers that have disputes with their stockbroker do not end up in court. Almost all of the cases are resolved by a panel of arbitrators at FINRA. It is a lot quicker and cheaper and in the vast majority of the cases, the customer walks away with a check for at least a portion of the amount lost.

Securities arbitration was the one consistent part of my professional practice. I worked on my first claim while still in law school. I represented mostly the brokerage industry for the first 15 years that I was in practice and mostly customers for the last 25 years. In all I represented a party or served as an arbitrator in almost 1500 cases. Some were unique and interesting; most were fairly mundane.

There are a few hundred lawyers around the country who specialize in securities arbitration representing customers.  Arbitration is intended to be simple enough that any customer can file and prosecute a claim themselves. But in every case the brokerage firm is going to be represented by a good lawyer and put on a competent defense. Even if you have the most mundane claim you need proper representation.

I have worked closely with about 2 dozen customer representatives over the years and like any other profession, some were better than others.  The best have all spent some time working in house for large brokerage firms.  They understand how the firms operate, what records the firms need to keep, how brokers are actually supervised and what defenses the firms are likely to have.

Do not be afraid to hire a representative that is not an attorney.  My fellow lawyers refuse to acknowledge that a retired branch office manager can often question the conduct of a broker better than anyone else.  For most of the claims that I handled I worked with a team that included both a lawyer and a non-lawyer who had worked in the industry for many years.  The latter was invaluable to every successful outcome.

Many lawyers think that securities arbitration is about the law, which it is not, nor has it ever been.  Arbitrators are not judges. They are not required to know the law, follow the law or to read legal briefs. Arbitrators are fact finders. They want to know who did what and why.  Too many lawyers approach securities arbitration as if they are presenting the case in court. It is the single biggest mistake and the single biggest reason why customers lose these claims.

Beginning in the late 1980s there began to be a lot of product related claims where the investment was itself defective.  Prudential Securities for example put out several billion dollars worth of public and private limited partnerships. Some were defective because the disclosures were not accurate or the due diligence was shoddy; others because the advertising and representations minimized the risks or projected returns that were unsupportable.

Over the years I have seen real estate funds where one appraisal of the property was sent to the bank and a second, higher appraisal went to the investors. I have seen “North American” bond funds full of bonds issued by South American companies and funds and ETFs full of derivatives that no investor could understand. Those claims are relatively easy to win. But it does help if you have a clear understanding of what the proper disclosures should have been.

There are always claims that stem from an individual broker’s bad conduct. Sometimes a broker will place an order without calling the customer for permission first. That is clearly against the rules and a customer is entitled to be compensated for any loss that occurs. If it happens it is easy to prove as the telephone records and the order are both time-stamped. Either the phone call preceded the order or it did not.

Sometimes a broker will help a customer trade an account or recommend a lot of buys and sells in a short period of time. Trading is not the same thing as investing.  Most traders, because they are making a lot of trades are concerned about how much commission they are paying on each one. That is why most traders gravitate to one of the low commission discount firms.  When you see a trader paying high commissions per trade and making a lot of trades it is usually a problem.

When the market comes down again, some of the losses will be the result of bad products and bad brokers.  However, most of the losses that the customers will suffer will be the result of staying in the market too long.  They will not be the victims of fraud but of simple negligence, as the claims will be based upon violations of the brokerage industry’s suitability rule.

The suitability rule is something that stockbrokers and their supervisors deal with every day. Notwithstanding, lawyers representing customers seem to have a hard time explaining it and how it is violated to arbitration panels.

Simply stated the suitability rule requires that a broker have a reasonable basis every time they make a recommendation to a customer to either, buy, sell or hold onto a security.   As it is written the rule sets forth a course of conduct for stockbrokers and requires them to get pertinent information about the client’s financial situation and tolerance for risk.

The typical defense is that the customer checked the box on the new account form that said he was willing to accept some risk or was willing to accept something other than conservative, income producing investments. This customer-centric view gives defense lawyers a lot of latitude to confuse arbitrators and will befuddle a lot of claimants when they file claims after the next crash. The proper way to view the suitability rule is to focus on the investment and the recommendation, not the customer.

In the normal course the only reason for a broker to recommend that a customer purchase any security is because the broker believes that the price of that security will appreciate in value. When they think the price will appreciate no further, they should recommend that the customer sell the position and move on to something else. The broker does not have to be correct, but he must have a reasonable basis for his belief.

Brokers and investors all over the world have for decades used the same methods to determine which securities will appreciate and which will not. It is called fundamental securities analysis and it is taught in every major business school.  Most of the large firms have cadres of analysts who write research reports based upon this type of analysis. Most of those reports set forth the analysts’ opinion of a target price for the security they are reviewing.

Deviating from that analysis will always get the brokerage firms in trouble.

That is what happened in the aftermath of the crash in 2000-2001.  Many of the claims from that era were the result of conflicted research reports. The firms were competing to fund tech companies and were funding companies that had few assets other than intellectual property and fewer customers if any.

I had several prominent research analysts on the witness stand who basically explained to arbitrators that they had to make up new ways of analysis because the internet was so new. That was BS, of course, and those “new” formulas were never disclosed to the investors or for that matter, never the subject of an article in any peer-reviewed journal.

Markets never go straight up for as long as this one has without a correction. I think that a lot of people seriously believe that a market correction or a crash is coming sooner rather than later. It may happen next week, next month or next year but it will happen.  I can say that because there is a lot of empirical data to support that position.

For example: 1) price/earnings ratios of many large cap stocks are at the high end of their ranges and when that happens prices come down until they are closer to the middle of the range; 2) employment is very high meaning wages should go up impacting the profits of many companies; 3) interest rates are rising which will cause people to take the profits that they have made in stocks over the last few years and convert them to safer, interest paying instruments; 4) rising interest rates also curtail borrowing, spending and growth; 5) an international tariff/trade war came on the markets suddenly and its impact has yet to be shown; 6) the global economy is not that good which should decrease consumption and prices; 7) oil prices keep rising and gas prices along with it because of international political uncertainty which adds to the cost of everything that moves by truck, which is virtually everything; 8) there is a lot of bad debt in the marketplace (again) including student debt, sub-prime auto loans and no-income verification HELOCs; 9) real estate prices are very high in a lot of markets and in many markets the “time on the market” for home sales is getting longer; and, 10) the increased volatility of late is itself never a good sign for the market because investors like certainty and stability.

None of this means that the market will necessarily go down but all of it needs to be considered. And that is really the point.  Many so-called market professionals urge people to just stay in the market no matter what. They claim that they cannot be expected to call the top of the market. They argue that the market will always come back, so what does it matter if you take some losses now.

Any investor who has made money during this long bull market should want to protect those gains. Any broker who is smart enough to advise clients when to buy a security, should be smart enough to tell them when to sell it.  Any advisor who keeps their clients fully invested when there are indications that a correction may be imminent is going to get sued and frankly deserves it.

The brokerage industry has always had a prejudice that suggests that customer should always be fully invested.  Brokers who work on a commission basis are always instructed that any customer with cash to invest should invest. Likewise, as the industry has morphed away from commissioned brokers to fee-based investment advisors, those advisors want to justify those fees by having a portfolio to manage not just an account holding a lot of cash.

Registered investment advisors are likely to be especially targeted by customers seeking to recover losses they suffer for a number of reasons. Many are small shops that do not employ a large stable of research analysts.  Many advisors just buy funds and ETFs and allocate them in a haphazard way because they really do not understand how asset allocation actually works. This is especially true of robo-advisors that are not programmed to do any analysis at all or to ever hold a significant amount of cash in their customers’ accounts.

All investment advisors including robo-advisors are held to the highest standard of care, that of a fiduciary. Any fiduciary’s first duty is to protect the assets that have been entrusted to their care. Any customer of a stockbroker or investment advisor should have a reasonable expectation that the profits they have earned will be protected.

I am posting this article on the evening before the US mid-term elections and on the day that the US re-imposed economic sanctions on Iran. Both may have significant effects on what will happen in the stock market in the next few months and beyond. Analysts may differ on what they believe those effects will be. But that is not an excuse to do no analysis at all.

The markets are driven by numbers and any broker or advisor who believes that they can offer advice without looking at those numbers has no business calling themselves a professional.  To the contrary, any advisor who tells you to stay in the market because no one can know when it will stop going up or that it will come back if it goes down is just playing you for a fool.



Defining Investors’ Best Interests

In the spring of 2016 the US Department of Labor (DOL) issued new rules which sought to change the landscape for investments held in retirement accounts.  The DOL sought to extend the rules governing how large pension plans and 401(k) accounts were managed to every IRA account held by individuals.

The regulations were a thousand pages long, the result of 6 years of discussion and millions of dollars of lobbying by various players in the financial services industry.  To no one’s surprise that lobbying paid off and the final rule was a watered down version of prior drafts that had actually excluded some of the riskiest investments from all retirement accounts.

The final rules also allowed brokerage firms to create exemptions if the rules did not fit specific individual accounts that were called “best interest of the investor” exemptions. The current administration in Washington and several courts have stopped these rules from being implemented.  The discussion of what investments and investment strategies are in the “best interest of investors” continues.

At no point along the way did the regulators, industry or consumer groups ask investors what they thought would be in the best interest of their retirement accounts. Had anyone done so, they would have been told that investors would be very happy if their retirement account was worth more today than it was a year ago and worth more in one year than it is today.

Before you scream “impossible” I think you should consider that even though no one can win every year, it is important that you at least try.  If you clear your head of all the BS that you hear about the stock market and investment advice and start at the basics, you will see it is not as difficult as many people think.

The primary reason that anyone ever buys a stock is because they believe that the price of that stock will go up.  When the price does go up to where you think it will go no higher you sell the shares.  You may not be right every time but you can certainly be right most of the time and you should be happy with that.

Selecting investments takes time, effort and skill.  The large brokerage firms and investments banks will usually have a fairly large research department and the best ones seek out and hire the best analysts in each industry. In order to “cover the market” a firm may have analysts that will be analyzing companies from 15 different industries if not more.  An analyst with expertise in the automotive industry might not understand the banking industry and neither might be able to understand the value of drugs that the large pharmaceutical companies have in the development pipeline.

The truth is that no one firm has the best analysts in every industry.  That is one reason large institutions frequently deal with multiple firms so they have access to research reports prepared by the analysts they think are the best in each industry.

Beginning in the mid-1990s a lot of stockbrokers began to abandon the traditional business model and the large firms and transformed themselves into self employed Registered Investment Advisors. This was a result of their commission income being under attack from discount brokerage firms that charged much less. It was not unusual for a customer to have an account at one of the wire houses to get access to the research, buy 100 shares through that firm and 900 shares of that stock through their account at a discount firm.

After the tech wreck in 2001 it became clear than many of the “best” analysts covering the tech industry were conflicted.  They were following companies that were grossly overpriced but which were bringing in large underwriting and investment banking fees, so the firms found ways to “value” companies with no revenue claiming it was appropriate for them to do so.

The result is that many of the newly minted investment advisors were willing to leave the research analysts behind. They convinced themselves and their customers that they could be portfolio managers even though they lacked the most basic tools to do so.

This led to the rise of asset allocation using mutual funds and ETFs. The argument was that the losses from the tech crash arose because people had too much of their portfolio in tech stocks. Diversify your portfolio became the new mantra of the market. Buy large baskets of stocks and you will never have to worry again. 

Asset allocation had been around since the 1950s. The purpose of a diversified portfolio is to reduce overall portfolio risk.  If one or two market sectors do poorly, your losses would be balanced by those sectors that would profit.

As applied it is often an attempt to mitigate all risks which it cannot do. If you are trying to manage risk without defining what that risk is, asset allocation will never be the optimal method for any investor.

Asset allocation did not work very well in 2008-2009 as the sectors that were most affected and took the largest losses, banking and real estate touched virtually every other market sector. The losses, especially in the home value portion of investors’ net worth reduced consumer spending, led to increased unemployment and just about all portfolios took some losses.

All of that has apparently been forgotten in the ensuing bull market. Forgotten is the idea that asset allocation does not work in all markets. Forgotten is the idea that loading up a portfolio with mutual funds or ETFs full of stocks is a recipe for disaster unless you have some good reason to believe that market will continue to rise.

Advisors, because they had no good research to support their portfolio selections, told investors that they did not need research.  The rise of robo-investment advisors is indicative of how foolish the investment world has and will become.

Investors are now told that they should invest based upon their age as if an investor’s age had anything to do with how the market will perform.  Younger investors are directed to select portfolios with more stocks because they had the time to could “make up the losses” if losses occurred.

No robo-advisor suggests that it would be better to not take the losses in the first place.  None suggests that the basic tenets of the “investment pyramid” which would have younger investors build a solid base of more conservative investments first might be more appropriate.

Most importantly no robo-advisor seems to think it is important to tell investors when they should sell.  That advice is as important as any advice to buy anything because no stock and certainly no market can go up forever.

At the end of the day, the discussion about what is in the “best interests of investors” boiled down to a discussion of cost.  Investment advice has become commoditized and therefore the argument goes, consumers should be charged the cheapest price.  This is one of the largest crocks of BS that has ever been foisted on investors.

Goldman Sachs, JP Morgan, the largest pension plans, endowments and serious professional investors all rely upon research and analysis to make investment decisions.  The best analysts earn 7- figure salaries because they are the best.  All that smart money pays dearly for advice. At the same time, regulators and others are telling individual investors that it is their best interest to get the cheapest advice or none at all.

If the person offering you investment advice is suggesting stocks, bonds,mutual funds or ETFs without some reasoned opinion about what those investments will be worth in 90 or 180 days, that advice is useless and you should not pay anything for it.  If they tell you that they construct portfolios that use an algorithm, ask them if the algorithm is aware that the US government is imposing new tariffs on imports or that the Federal Reserve is raising interest rates.

The SEC, DOL and other regulators would do investors a favor if they required those giving investment advice to always share with their customers why they bought and why they sold every position.   A little transparency is always in investors’ best interests.

When I was diagnosed with cancer I wanted the best doctors, not the cheapest. When a neighbor or friend called me in search of a lawyer because their kid was picked up on a DUI, I declined to handle the representation because it was not my field of law and they really needed a specialist. And guess what, specialists cost more.

People need investment advice because bad investment advice or no advice will severely impact their retirement and they should be willing to pay more not less for good advice.  Good investment advice will always be in the investors’ best interest. The discussion really needs to stop with that.


The Future of Investment Advice

In order to understand the future of investment advice I think it is essential to understand how the industry has developed to where it is today.

When I started in the financial services industry back in the 1970’s retail customers got advice about what to buy and sell from their stockbrokers.  At the larger brokerage firms that usually meant that your broker would call you and tell that they or the firm’s research department had identified a stock that was a “buying opportunity”. This was often accompanied by a recommendation of what you should sell to pay for your new purchase so your broker would make not one, but two commissions from the recommendation.

When the stock market suddenly crashed in 1987 a lot of customers asked their stock broker why the broker had not seen the crash coming. The brokers really had no good answer. The crash took a lot of money out of the market and caused a lot of customers to lose faith in their broker’s ability to select investments for them.

Partially to placate those customers with something new and partially to make more money the industry introduced wrap accounts. A wrap account places the customer’s account into the hands of a professional money manager for an annual fee which is shared with the introducing stockbroker.

Wrap accounts introduced the idea that the individual brokers would be compensated on the customer assets under management (AUM) rather than the commissions that their accounts generated. This let the brokers do what they do best (sell) and let the professional money managers manage the accounts.

It also created a conflict of interest. Managers kept investors fully invested because that is what they had been hired to do. If the managers started to accumulate large cash positions in customers’ accounts, the customers might withdraw the cash. That would be counter-productive to the brokers who were being paid to bring in more and more new assets.

By the mid-1990s the market had recovered nicely and people started asking how long the boom would last.  At the end of 1996 Fed Chairman Alan Greenspan attributed the sharp run up in stock prices to “irrational exuberance”.  Neither the brokers nor the money managers advised the customers to sell when they had large profits and maintain a cash position

Much of the run-up in the 1990s was attributed to new tech companies that not everyone understood. Consequently, the firms hired highly qualified research analysts to parse through the various issues and recommend what they considered to be the best.

At the same time, the brokerage firms were making a lot of money by underwriting new issues of these tech stocks. In many cases the research analysts were working to support the efforts of the firms’ investment bankers. They only wrote reports describing why their firm’s banking client’s offerings were a “buying opportunity”.

That also created conflicts of interest.  When the market finally crashed it was revealed that some analysts had never suggested that the price of any of the stocks they covered would not go higher. Some analysts never recommended a “sell” on any stock they followed even when fundamental analysis told them that they should be selling.

Again, when the market crashed in 2001 a lot of people asked their broker why they did not see the crash coming or take some defensive action to protect their profits.  And again, the brokers did not have a good answer other than “no one can really predict the market” which, of course, is exactly the skill that the stockbrokers and money managers had been espousing to customers all along.

The brokers themselves got more than a little frustrated with the large wire houses and many jumped ship. Sometook their clients and set up shop as independent investment advisors.

The accounts were still housed at a brokerage firm that got paid a commission on each trade but the advisors now kept all of the annual account management fees. This was a better deal for the advisor even if they now needed to pay their own rent and overhead. The idea that no one can really predict the market suited these independent advisors well because they were more interested in acquiring new customers and assets than picking good investments.

That led to a concept that as long as a portfolio was diversified it really did not matter which stocks were in it. By diversifying the stock portion of the portfolio into different asset classes the advisors were trying to avoid what had happened in the tech wreck. The theory was that if you bought stocks in different asset classes, the collapse of one sector, like tech, would not hurt you too badly.

This did not help investors when the market crashed in 2008. This crash was caused by a bubble in real estate and foolish lending in the financial sector. Most companies are affected by what occurs with banks and real estate as both effect business and consumer spending. Diversification only mitigates certain risks. This crash involved a systemic risk, not an asset sector risk, a fact that many brokers never understood.

It should not surprise anyone that investors again asked their advisors why they did not get them out of the market before it crashed.  Again the response was “no one can predict the market”.

Since 2008 the advisor industry has seen the rise of robo-advisors.  These are popular with millennial investors who do not trust the Wall Street professionals after 2008.  Robo-advisors select portfolios based upon algorithms. This makes as much sense as throwing darts at a list of stocks and bonds even if you are a champion dart thrower.

Robo-advisors are not even attempting to predict the market and they are not programmed to ever sell the portfolio if the market starts to crash, which we all know, it will. They are just selling diversification at a lower price. They achieve “diversification” by buying mutual funds or ETFs. These contain so many stocks that mathematically, there is no actual diversification.

Robo-advisors advertise that people pay too much for investment advice. I would argue that most customers pay too little.  My current advisor spends countless hours poring over financial statements and research reports to pick individual stocks.  He gets the same 1% of AUM as advisors who put all of their clients into pre-selected diversified portfolios of various funds and ETFs without really knowing a lot about them or how they might be expected to perform. With investment advice, like everything else in life, the rule should be that you get what you pay for.

What I think may be an intelligent alternative going forward is for people to just put their investment advisor on a fixed monthly or yearly retainer.  It would cost more for a larger portfolio than a smaller one because all portfolios need to be constantly monitored and larger portfolios require more time. Advisors would keep their customers and get referrals by keeping their customers happy.

And what makes customers happy?  They want to have more money in their accounts at the end of the year than they had at the beginning of the year. That is true even if the market crashes because there is nothing more foolish than staying in the market when the market is going down.

The customers will never truly be happy and get the results they truly want until advisors thoroughly analyze and review the stocks they recommend and purchase and hold only those that they believe are likely to appreciate. They will never get there if advisors refuse to take profits and move to cash when the market indicates that they should. They will never get there if advisors diversify to mitigate some risks, but not all.

People actually do predict the future performance of individual stocks and the market in general. I doubt that you would be surprised if I told you that the ones who do it well get paid a lot of money by investment banks, mutual funds and large institutions.

The advisor industry needs to understand that parroting the phrase “no one can predict the market” every time the market corrects is the fastest way to be demonstrate that you do not know what you are doing. Providing beneficial investment advice takes time and effort. Advisors are entitled to be paid for their efforts. But first they have to actually do the work and that work is accurately predicting the future price of individual securities and the market in general.



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.


Any Investor Can Beat an Index

People invest money to make money. That may not seem like a profound statement but a lot of investors think that it is a lot harder than it is and there is an ongoing debate that suggests that most professional investment advisors are not worth what they charge. Personally, I do not buy it.  I would not think of investing any significant sum without a competent advisor.

I know that most large institutional investors still use fundamental analysis and good old fashioned research to select investments.  CALPers, the nation’s largest public employee pension plan has several hundred research analysts on its staff.

The best research analysts are specialists who cover a single industry and have much more than a cursory understanding of the companies that they cover.  It is not unusual to find research analysts with degrees in electrical engineering covering tech companies or doctors who went from medical research to covering drug companies.

When I started on Wall Street the firms would release research reports to their institutional clients first and retail clients a day or two later.  With the advent of discount brokerage firms and DIY investors, a lot of the research available to individual investors has been watered down and is not very insightful.

I am not suggesting that every research analyst is great and there are a great many conflicts that color the reports that some analysts publish. What I am suggesting is that if you cannot read a research report and you do not read several before you make any investment decision, you are shortchanging yourself.

No one has to invest. Leaving your money in the bank where it will currently get you about 1% in interest is better than investing it in the market and losing 10% or more. This is especially true if you have only a minimal amount saved up.  Protect what you have before you start taking market risks.

A lot of people believe that they can just buy an index mutual fund or index ETF, hold it for the long term and everything will be fine.  The “common knowledge” is that the markets will likely be higher years down the road and that an index fund captures a large diversified basket of companies. Neither is necessarily true.

The markets today are higher than they have ever been. No one can tell where they will be next week, next year and certainly not a decade or two from now when you may need your money.  Whether your portfolio will be worth more or less than it is today when you retire is something that is best worked out with a financial planner.

Most financial planners will caution you about effects of inflation. Even if your portfolio is worth 20 years from now, its buying power may be less.

The idea that an index is diversified is also flawed. An index like the S&P 500 has stocks of the 500 largest companies.  The Dow Jones Industrial Average specifically excludes transportation companies and utilities.

To be diversified a portfolio needs to hold stocks that have a negative correlation to each other.  If you buy a large cap index, a mid cap index, a small cap index and a foreign index with the idea that they are diversified from each other, you are incorrect. Each is likely to hold airlines, telecommunications companies and financial institutions. That is not diversification.

Assuming that you could analyze all 500 stocks in the S&P 500, rank them to identify those which have the best value and create a portfolio of the top 150, you would probably beat the overall S&P 500 index every year.  If you identify the best and eliminate the clunkers, beating the entire index should not be difficult.

By best value, I would suggest that you include those companies whose shares are trading at the low end of their traditional P/E range.  Many market professionals look at the price/earnings ratio of individual stocks that they own and the market in general.  Price/earnings ratios move within a fairly standard range and when they get to the high end of the range they usually pull back and revert to the norm.  Both the current price and the outlook for near and medium term earnings for publically traded companies are readily available.

If you are a DIY investor and it is too much work for you to analyze 500 stocks or you do not need a portfolio with 150 stocks in it, there are easier ways to beat an index. One of the simplest is a strategy called “Dogs of the Dow.”

The Dow Jones Industrial Average is made up of 30 mature, blue chip companies. The earnings of the companies will vary depending on where in their particular business cycle the companies are and their stock price will fluctuate with the earnings. Most, however, have a fairly stable dividend payout policy.

The theory suggests that when a company is at the low end of its cycle and its stock price is low; its dividend yield will be high.  As the company bounces back, its stock price will rise and its dividend yield will return to its mid–range.

To execute the strategy you would purchase equal amounts of the 8 or 10 highest yielding Dow stocks, hold them for one year, sell them and repeat.  The strategy hopes to allow investors to capture both a high dividend and good price appreciation every year.

Understand that this is not asset allocation. Asset allocation is a method of balancing a portfolio with multiple market sectors hoping that the good ones will outweigh the bad.

Dogs of the Dow is a specific stock selection strategy.  You are attempting to select stocks that will appreciate in price faster than the other stocks in the Dow Jones Index.  A fair number of people use this strategy because it is very easy and because it works most of the time.

If you research Dogs of the Dow, you are likely to come across the Hennessey Funds.  The Hennessy Total Return Fund (HDOGX) invests 75% of its assets in the ten highest dividend-yielding Dow Jones Industrial Average stocks (known as the “Dogs of the Dow”) and 25% in U.S. Treasury securities.

Neil Hennessey was the person who first introduced me to this strategy somewhere around 1985.  He was working with it successfully back then and still does.

This strategy is not hard to master.  It shows that you do not have to be a rocket scientist to be a successful investor and in most years you will beat the index.



Investing for Millennials

There is an ongoing discussion in the investment advisor industry regarding how to attract millennial investors. I have read several articles that suggest that a great many millennials have minimal savings.  And for those who do, investing for retirement may not be a high priority.

Many millennials are drawn to robo-advisor platforms. I find robo investment advisors to be a sick joke foisted on millennials and others by an industry that makes its money gathering assets.  If for no other reason than robo platforms will never advise investors to sell, the portfolios of many robo investors will suffer losses when the market comes down.

There is nothing wrong with the idea of asset allocation if you have a portfolio of size, are investing for the long term and allocate and re-balance your portfolio correctly.  But most robo platforms do not allocate portfolios correctly. There is a wide variance of portfolio allocations from platform to platform so investors really cannot know with any certainty how the platform they select will perform.

I have seen more than one study that suggested that millennials are attracted to robo investment platforms not just for their convenience and affinity for technology but because a great many millennials distrust the human financial advisors who their parents used.  Trust is important when you select any professional to work for you.

But the wholesale lack of trust in financial advisors is misplaced. I say that as a representative of the generation that coined the phrase: “don’t trust anyone over 30.” The truth is that the best investment advisors are older, having been seasoned by a market cycle or two. There was a lot to be learned when the market crashed in 1987, 2001 and 2008.  Advisors who were around and learned those lessons should be less likely to let their clients take losses in the next crash when it comes.

There is an annoying debate based upon studies that suggest that the average financial advisor cannot get even average returns, meaning equal to a broad index, year in and year out. The debate tips toward the idea that passive investing, just buying the index or sectors within the index, is superior.  Passive index and sector investing is what you get with a robo platform.

For the most part, the large institutions, insurance companies, pension plans and endowments, still invest the old fashioned way; using fundamental securities analysis to purchase investments that will either provide a good continual rate of income or which are likely to appreciate in price. Most stocks and bonds are bought and sold on the basis of research. Robo and passive investing is still a small portion of the overall trading volume.

Most asset allocation models counsel that younger investors can accept more risk and allocate a higher percentage of the portfolio to stocks.  The theory is that younger investors can take more risk because they have more time to make up losses if they occur.  Stocks are usually riskier than bonds.  If you invest a significant portion of your portfolio in stocks or a stock index you are guaranteed to experience losses when the stock market comes down.

Investing in an index, riding it up and then down is foolish. A smart investor gets out of the market before the market turns down. A smart investor takes their profits when their stocks move up and then invests in something else.

There is also an idea that millennials can begin investing with a very small amount of money. In some cases, I have seen firms advertising that you can start with as little as $500 or $1000.  I would certainly encourage any young person to begin saving, but a diversified portfolio of securities on a robo platform is not where you should begin.

If you were to take a reputable course in financial planning one of the first lessons that you will learn is about something called the investment pyramid. If you Google “investment pyramid,” you will find that there are many versions of it but that all are variations on the same basic theme; save first, invest later.

An investment pyramid starts with the idea that before you invest your first dollar you should have some cash in savings.  The standard has always been enough to cover 6 months of living expenses in case you find yourself unemployed because the company downsized or you cannot work due to an accident or illness.

The idea behind any investment pyramid is that you build a sound base for your portfolio of safer, income producing investments, usually bonds, before you buy anything else. The interest from the bonds, together with your annual contributions, will help the portfolio grow.  After you have built a sound foundation you can move up to the next layer of the pyramid.

The second tier of the pyramid also contains income producing investments, usually dividend paying stocks and REITs. At this point the idea is to have a steady income stream from everything in which you invest.  In many cases, the companies in which you invest will have dividend re-investment programs that will allow you to accumulate additional shares without paying commissions.

As you move into stocks you should diversify your portfolio into different sectors, some energy stocks; some pharmaceutical companies; some transportation companies.  It matters less if all the companies pay dividends. In years when one company’s share price is down, the dividend re-investment program will purchase more shares at the lower price. Over time, this will have the effect of lowering the average price per share that you paid and increase the overall dividend yield of the portfolio.

Once you have a solid base and a second tier both of which produce income that will continue to add value to your portfolio, you can add a third tier of growth stocks and a smaller top tier of more speculative investments.  Do not take risks with your money unless and until you have taken care of the business of building a portfolio that will take care of you after you retire.

Let us say that you are fortunate enough to put away $50 -$75 thousand by the time that you are 35 years old. Using an investment pyramid you will likely hold only cash and bonds.  If you use a robo investor platform you are likely to hold mostly stocks which may be worth more or less than the money that you actually put into the account.  This is a lot like the story of the tortoise and the hare; the tortoise usually wins over the long term.

The counter argument, and you will find it everywhere, is that stocks will potentially give you more bang for your buck. Smart people will tell you that you will be sorry if you fail to invest in the next Amazon when it comes along. If you can spot the next Amazon and the one after that and so on, you do not need advice from me.

The importance is that you realize that if you use a robo platform they are more likely than not going to steer you into stocks. If you use the investment pyramid model, you are going to start out with bonds and stay with bonds for a while. Its apples and oranges.


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.










7 Reasons Why Robo-Investing Will Not Work. Millennials – Wake Up

Robo-investing is the next really big, really dumb thing. Millennials are expected to pour enormous amounts of money into these programs in the next few years. That would be an enormous mistake.

Robo-investment programs promise to help users to set up investment portfolios now and then to help manage those portfolios for the next 25 or 30 years. The portfolio with which you will end up, all those years down the road, is likely to be a disappointment.

I looked at a number of the websites and advertisements for these programs as I was writing this article. One proposes that a”moderate risk” portfolio would have 90% held in stocks. Another has a member of their investment team who takes a “holistic” approach to financial planning. That may be fine for some people but is not a serious approach to managing your money as far as I am concerned.

These computer programs do not have what it takes to intelligently construct a portfolio for you now or to manage it over a period of many years. Years from now, you will wish that you had a portfolio put together and monitored by a well trained and intelligent flesh and blood investment adviser. By then it will be too late.

Robo-investment advisers tout the fact that they cost less than a human investment adviser would cost. It does not really matter. Robo-investment advisers are inexpensive because they provide investors with little or no value.

If you have any doubt that these robo-investment adviser programs are less than worthless, here are seven obvious reasons why the actual portfolio that you will get from a robo-investment adviser program is likely to perform poorly.

Number One: It is not about your age.
One of the few personal questions that a robo-investment adviser program will ask is your age. If you are thirty the program will assume that you can afford to take on more risk than a person who is sixty. If it is suitable for you to take on more risk then your recommended portfolio will get more stock funds or ETFs and fewer bond funds and bond ETFs.

Investing based upon your age assumes that your age and the markets are somehow related. What you should or should not buy today is dependent upon the market, not upon your age. If you start down this path, what you will have bought or sold over the years that you stay with the program will have had nothing to do with what might have been a good investment at any time.

Number Two: Today might not be a good day to invest in either stocks or bonds.
Let us say that the program suggests that you create a portfolio that is 35% bond funds or bond ETFs and 60% stock funds or stock ETFs with 5% held in cash. In truth, it does not seem that most of these programs ever hold a lot of your funds in cash which always increases the portfolio risk.

If you begin investing this year when the stock market averages are making new highs it is reasonable to expect that next year or the year after the market might correct. It is very possible that five years down the road 60% of your portfolio will be worth less than it is today.

After seven years of forced low interest rates is this a good time to put 35% of your money into bond funds or ETFs? Savvy investors know that bond funds do not do well when interest rates rise. The computer will not adjust for the hike in interest rates that everyone knows is coming until after it happens and the portfolio has taken the loss.

Number Three: It is about the right math, the right data and more.
Robo-investment advisers claim to have sophisticated algorithms that will crunch the numbers and produce good results. The algorithms may be good but these programs look at the wrong numbers. A robo-investment adviser never gets past a limited set of gross market data. A robo-investment adviser never actually looks at any company’s balance sheet. They are an example of the GIGO principle of statistical analysis; garbage in, garbage out.

It is not only about the numbers. Before I would invest in any company I would want to know about products that the company might have in the pipeline, what its competitors were up to and what the CEO is thinking about. I am not alone. A robo-investment adviser is never interested in these things that most other investors would want to know.

Number Four: Investing cannot be done in a vacuum.
The computer program does not get a live news feed and would not know if Germany had invaded Poland so events leading up to any crisis that might affect the markets and the portfolio would necessarily be ignored. The program does not concern itself with current commodity prices, currency rates or international politics. Intelligent investors do.

To my mind, using a robo-investment adviser to construct and manage your long-term portfolio is the same as making all of your investment decisions from inside a small closet with the lights off and the door closed.

Number Five: The markets will not be static for the next 25 years.
The noted theorists upon whose works Modern Portfolio Theory and asset allocation are based were examining data from the markets prior to 1990. The financial markets have evolved significantly in the last 25 years. It is not just the speed or the technology. The markets are now global, there are a lot more participants and there is a lot more money in play. How the markets will continue to evolve and operate in the next 25 years is anyone’s guess and is certainly not built into any robo-investment program.

Number Six: The data that the program uses to select portfolios is based upon the past performance of the markets and past performance only. I should not have to tell you that past performance is an unreliable indicator of future results. If you invest with any one of these programs future results are exactly what you are trying to achieve. Why use data that is unlikely to get you there?

Number Seven: Human beings are actually necessary.
The sales pitch for these robo-investment advisers suggests that can do better than any human financial adviser. One company even touts that its program alleviates the risk of human error.

Using a robo-investment adviser will inevitably lead to portfolio losses every time the stock market goes down or interest rates go up. It will never tell you to avoid downturns or to get out of the markets all together before a crash. Likewise, the program never looks for new companies that might do very well or for any other investment opportunities that might make you money.

Severe market downturns can be scary. Investors are prone to panic. When your account value is dropping you are going to want someone to call. The robo-investment adviser will offer neither solace nor advice. That will only come from a knowledgeable human being. For that you have to pay a little more.