Thornton Wealth Management

A Forecast By Any Other Name . . .

2009-07-09T21:17:38Z

… is, you guessed it, still a forecast.

Recently, I watched a recorded presentation by Dave Loeper of Wealthcare Capital, and he made a comment that really got under my skin. I might be misquoting him, but he said something along the lines of “mean reversion is really just a fancy term for a market forecast”.

Think about that for a minute. Really let it sink in.

For those not familiar with the term “mean reversion” it essentially means that the farther and longer something (anything) diverges from its long-term average, the more likely it is that it will move back (or revert) to that average (or mean). If someone has a clearer or more concise explanation, I welcome you to leave it in the comments below.

Back to the topic … is mean reversion a forecast? I would have to agree that it is. Whether discussing the market or the weather, we might have a hunch of what will happen in the future, but we really don’t know. And just because something has diverged from an average, doesn’t mean that it will return to that average in any expected or rational manner.

Let’s expand this concept … for people out there that subscribe to the Fama-French model espoused by Dimensional Fund Advisors (this includes me, by the way), you would generally agree that there is additional expected return, albeit with additional expected risk, to be achieved by overweighting or tilting toward value and small companies. But isn’t this just another forecast?

Sure, Fama & French have applied exhaustive academic research to demonstrating this value and small cap “premium” in the past, but to hold any expectations for it to continue into the future is still subscribing to a market forecast.

I realize that I might draw some heat for sharing these thoughts, but isn’t it my job as a financial advisor and fiduciary to my clients to ask these questions and challenge the status quo? Then again, maybe I’m just stating the obvious.

Do I have a better solution or alternative to offer? No, I do not and don’t know that I ever will.

However, I think it’s misleading to ourselves and our clients to demonize market forecasting in any color, shape or form, while at the same time implementing a forecast ourselves. Investing, by its very nature, involves making some forecast, whether explicit or implicit. If we didn’t think stocks were going to go up over time, which is yet another manner of forecast, why are we investing at all?

I hope this will spark some discussion and I welcome your comments, questions and critiques in the comments section below.

What do you think?

Is the Market Rational?

2009-06-18T11:00:00Z

Thanks to a colleague, who wishes to remain anonymous, for the following:

Over six years ago, Fortune writer Justin Fox wrote an article titled, “Is the Market Rational?” Much of the article focused on the intellectual rivalry between two Chicago professors—Eugene Fama and Richard Thaler—and Fox made no secret which of the two he found more persuasive. The next generation of finance professors, he said, were “ripping Fama’s teachings to shreds,” and market efficiency as an organizing principle was being shouldered aside by something called “behavioral finance.” In this view, irrational investors make systematic judgment errors that produce predictable patterns in stock prices. Fox noted approvingly that the Nobel Prize in economics had been awarded the previous month to a Princeton psychology professor in recognition of his work on behavioral biases and suggested it was possible for investors with sufficient “contrarian gumption” to outperform the market by exploiting such biases. But he doubted most of his readers would be successful in this effort, due to their own propensity to make mistakes. His conclusion for investors? “That’s easy,” he wrote. “Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control—costs—and keep them as low as possible.”

Fox has been hard at work since that time; the article has mushroomed into a 328-page book and the title is no longer a question but an assertion: The Myth of the Rational Market. The book has much to recommend it—a wide-ranging survey of the battle of ideas among financial economists over the last century, with an enormous cast of characters. Readers of Peter Bernstein’s Capital Ideas will find themselves covering familiar ground, but there is enough new material to make it worthwhile. Fox’s breezy style is effective in distilling complicated ideas into digestible portions, and his colorful sketches help maintain our interest in a dry, statistics-laden topic. Social critic Thorstein Veblen, for example, is a “crotchety philanderer.” Yale economist Irving Fisher is a prohibitionist and health-food advocate. Milton Friedman finds the early research on efficient portfolio design similar to his work during World War II on the statistical properties of artillery shell fragmentation.

There is so much ground to cover that some intriguing questions are left barely explored. After pointing out the flaws of the efficient market hypothesis using the CAPM model of expected returns, Fox quickly dismisses the alternative Fama/French multifactor approach as “clunky” and moves on. The value premium, in his view, is attributable primarily to investor irrationality. This is certainly one interpretation, but a more nuanced view deserves attention as well. Chicago Ph.D. and hedge fund manager Cliff Asness has pointed out that despite the extensive literature on the issue, an explanation for the value premium remains a “gigantic, subtle, and still unsettled academic debate.”

For those hoping to find some concrete suggestions for improving the investment results, the book is apt to be disappointing. Fox finds little evidence of success among professional money managers in exploiting the inefficiencies he believes are so clearly evident. He has some kind words for academics who have set up money management firms to apply research on behavioral biases to generate superior returns, but he cites no evidence of their success, perhaps because their results are generally well explained by the standard asset pricing models he is so quick to condemn.

Fox appears frustrated that the evidence of market irrationality appears so clear but the evidence of investor success in exploiting these mistakes is so thin. His brief message to investors toward the end of the book carries an air of resignation—all the effort devoted to identifying flaws in the rational market model doesn’t appear to offer hope of a superior approach. Almost as an afterthought, his practical advice to investors includes the following suggestions:

“If you have money to invest, the only sensible place to start is with the assumption that the market is smarter than you are. You don’t have to stop there. But if you do come up with an idea for beating the market, you need a model that explains why everybody else isn’t already doing the same thing you are.”
“If you’re picking somebody else to manage your money, the chances of finding a market-beating path are even harder.”

Bottom line: Ideal way to bone up on financial economics if you want to sound like a know-it-all. But it’s unlikely to change anyone’s mind with regard to the optimal investment strategy.

Asness, Clifford. “The Value of Fundamental Indexing.” Institutional Investor, October 19, 2006.
Bernstein, Peter. Capital Ideas: The Improbable Origins of Modern Wall Street. Hoboken, NJ: Wiley, 2005.
Fox, Justin. “Is the Market Rational?” Fortune, December 3, 2002.
Fox, Justin. The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. New York: HarperBusiness, 2009.

What If You Couldn't Fail . . .

2009-06-17T13:12:58Z

How would you live your life or what would you do differently?

Now, before you think I’ve gone all New Age on you, I consider myself a practical guy and realize you can’t just “wish” your problems away. Further, I don’t subscribe to the notion that if you blindly follow your passions you’ll find an emotionally and financially rich and rewarding life along the way, although it can certainly happen.

At the end of the day (or maybe I should say the end of the month), you still have to pay your bills and put food on the table.

Having said all that, I still think this is a valuable exercise. Seriously, think about it … What if you couldn’t fail?

I know I’m guilty of making decisions and living my life, in part, based on preconceived notions of what’s acceptable and what’s expected of me. I also know that some things are automatically categorized as too risky or not worth taking the chance. These influences, whether conscious or sub-conscious, come from family, friends, co-workers and society at large.

But if you could mentally escape all that for a moment and forget about what’s expected of you or even what you expect of yourself, what would your life look like?

Would you take that trip to Asia you’ve always dreamed about?
Would you quit your job to pursue a long-held passion?
Would you take a kick ass vacation and renew your vows with your spouse on a beach somewhere?
Would you take drawing or dancing classes just because you’ve always thought it would be fun?
Would you volunteer at a local shelter and do your small part to make the world a better place?

I mean, if you think about it, we all carry around a lot of baggage, and most of it has been loaded onto our backs, even if unintentionally, by our closest family and friends.

I challenge you, just for a moment, to put the “baggage” down and dream about what you’d do different if you weren’t so concerned about the consequences or what other might think?

I think most of us, and I include myself, define personal failure based on the thoughts and feelings of others. But that’s not for them to decide, and you shouldn’t empower other people to have such influence over your life.

While this concept certainly has application in my work as a financial planner, I think it’s also a much larger issue with broad ramifications.

So, I ask you again, what would you do if you couldn’t fail?

I hope you’ll leave some thoughts, feedback and comments below.

David Booth Discusses Retirement, Risk And Return

2009-06-09T22:10:58Z

In the following video, David Booth, Chief Executive Officer, Dimensional Fund Advisors, discusses the importance of balancing volatility risk and purchasing power risk when investing for retirement.

He explains that T-bills have not produced the real returns necessary to preserve living standards over the long haul, and illustrates how investors can manage both types of risk through an appropriate commitment to stocks.

Please leave your feedback and comments below.

Fixed Income In A Low Interest Rate Environment

2009-06-08T19:57:30Z

Whether you measure interest rates by looking at mortgage rates, bond yields or your money market fund, they’ve begun to creep up from their recent lows.

Will they steadily climb higher and higher? I don’t know, and neither do you. That’s not the point of this blog post.

However, I’d like to remind you of a often-used quote in the financial advice industry:

More money has been lost chasing yields than at the point of a gun.

The natural tendency is to try to find the most “bang for your buck” that you can right now. And for many who are scared of the equity markets, they have a lot sitting in cash and/or fixed income. The only problem is that you could wind up with all bang and no buck.

So what’s the answer?

Everyone wants the most return they can achieve on their liquid or semi-liquid funds, but you must always remember that risk & return are forever linked together. You can’t get above average return without above average risk.

So, be careful of these fancy sounding bond funds or these “too good to be true” CDs or other products. If it sounds too good to be true, it is.

I recommend an allocation to some level of fixed income in all my clients’ portfolios, and regardless of the market or interest rate environment, I always recommend high quality and short maturities. No junk bonds. No convertibles. No preferred stocks.

In my opinion, fixed income is present in a portfolio to offer a diversification benefit relative to equities. They’re certainly not there to increase or compound the your overall portfolio risk level.

What do you think? Is this too conservative or will “slow & steady” win the day regarding fixed income?

I welcome your comments below.

What Should Investors Do Now?

2009-04-09T11:45:12Z

The following is provided by Dimensional Fund Advisors and presented by Weston J. Wellington, Vice President, Dimensional Fund Advisors.

Six months after Dimensional’s first comprehensive survey of the market downturn, Weston Wellington returns to the topic with a multi-part series on what investors should consider as they move forward. The videos include an examination of capital markets, the effects of recession and government policy on stock prices, how the current market stacks up to previous downturns, and the reasons why Dimensional’s core beliefs have not changed in light of these events.

Capitalism Will Return In Force

2009-03-31T14:14:25Z

Translated from the article “Le capitalisme doit revenir en force,” L’Echo Belgian Business, March 13, 2009. Efficient markets survive crashes.

An Interview with Eugene Fama Jr., by Jennifer Nille

Has the current financial crisis KO’d capital markets? Eugene Fama Jr. says no. The son of the author of the theory reminds us that in troubled times, believers in efficient markets need the courage of their convictions and to keep investing.

His firm, Dimensional Fund Advisors, sets a strong example. Founded in 1981 by David Booth and Rex Sinquefield, and counting among its board of directors Nobel laureates such as Robert Merton and Myron Scholes, the firm started out in less-than-perfect conditions. For nine years, it sustained poor relative returns as its primary asset class, small cap stocks, experienced a lengthy downturn while stocks in many other asset classes had stellar performance. The hard times tested, but did not deter, the firm’s investors: Dimensional went on to manage a total of $111 billion of assets around the world [as of early January 2009].

The key to the firm’s success is its philosophy: a belief in markets, diversification, and reduced costs—principles that Fama continues to reinforce. L’Echo sat down for a chat with Fama at a recent seminar for University of Chicago Booth School of Business graduates held in Brussels.

The concept of efficient markets developed by your father sometimes gets criticized for loosening the regulatory screws that might have prevented the current economic crisis. The theory was similarly criticized following the internet bubble (of the nineties) and the more recent subprime crisis. Is the Efficient Markets Hypothesis still alive?

None of those events contradicts market efficiency, which simply means all available information is reflected in prices. This doesn’t mean prices conform to ex-post assumptions about what things should be worth. Prices are the current consensus of all the knowledge, beliefs, and predictions of market participants. So market efficiency seems alive and kicking so long as no investor or group of investors seems to abnormally benefit at the expense of all the other investors. And this is pretty much what the evidence shows. On a risk-adjusted basis it’s extremely difficult to see how active managers are able to pick and choose stocks that beat markets—especially when everything’s performing poorly like right now.

After the fact we always hear that events like the “internet bubble” were irrational; but keep in mind that the market didn’t know which of the stocks would succeed or by how much. Research suggests that all that was really required to justify the increase in stock valuations was the incidence of one or two future successes on the order of a Microsoft. Doesn’t seem so far-fetched or “irrational” an expectation.

It should be noted that markets have always functioned through strong booms and busts. In a steep decline, all you can conclude is that the consensus about future profits is that they’ll be low—not that markets are broken.

The recent markets have had unprecedented volatility. Why? And does this create a daunting challenge for “buy and hold” strategies?

I have a hunch that the period of high volatility over the last several months is due to increased uncertainty over the threat of more regulation. The government sends different signals to the market every day, which so far has only seemed to increase schizophrenia and daily volatility. But we should also remember that by historical standards, the volatility from the early nineties up to around the year 2006 was abnormally low (and returns unusually high). So given that we had it so good for so long, today’s higher volatility might seem especially bad.

Is diversification the key to guarding against increased volatility?

Diversification is definitely a key, but not a magic bullet. If you invest in diversified portfolios of risky assets, you still experience risk. The real goal of diversification is to control the type of risk you take. In a market like this, concentrating on a single stock is an invitation to catastrophe. Diversification reduces the effects of losses that are specific to an individual company or industry. Let’s put it this way: when you invest in a handful of stocks you’re betting that handful of stocks survives. When you invest in every stock in the market and all around the world, you’re betting that commerce itself survives. History shows that individual companies come and go but human enterprise plows onward. But there are those times like the recent period when pretty much all security prices fall together and diversification doesn’t protect us from loss. But usually you’re better off than if you had concentrated in a few financial stocks or something like that.

As a disciple of the Efficient Markets Hypothesis, where do you stand on nationalization and increased market regulations?

Free markets are efficient markets. Liberty and capitalism go hand in hand. Attempts to fix supposed “inefficiencies” through nationalization and regulations have a history of making markets less responsive by hampering and distorting the price mechanism. We should never forget that it was government that took what until then was a run-of-the-mill recession and worsened it, prolonging it into the Great Depression of the thirties. Economic problems become worse when they become political problems. We need to keep this from happening again. A belief that markets work and are efficient—that capitalism is productive and virtuous—is a good place to start.

What Is The Price For Failure

2009-03-31T11:56:07Z

Bill Schultheis is a great writer and author of The Coffeehouse Investor, a book I highly recommend everyone read.

In a recent post called “Decisions, Decisions” on his blog, Bill has a really great line. This is one I encourage you to read and really think about. Here’s what Bill has to say (emphasis mine):

Even though exhaustive research has shown that the vast majority of actively managed funds underperform the market, it is “possible” to beat the stock market average, as stock pickers like Peter Lynch have proven. A more relevant question to ask is, “What is the price I pay if I try to beat the market, and fail?”

I think this really gets to the heart of one of the most fundamental issues in investing. Many try in vain to beat the market and wind up achieving results far below what just owning the entire market would have delivered.

Sure, there are those that have and continue to “beat the market”, but I would argue that many, if not all, of these results can be attributed to luck and not skill.

If you’re trying to beat the market, I wish you the best. But if you’re wrong, what is the cost?

Is it delayed retirement? Lower retirement standard of living? Not educating your children in the manner you’d like? Not being able to support your parents if they were to need assistance? Other hopes & dreams that will have to be altered or eliminated?

Remember, it’s not just money we’re talking about here. It’s the goals, hopes and dreams that the money can be used to fulfill.

FreeCreditReport.com Is Not Free

2009-03-24T16:52:34Z

Unless, of course, you consider $14.95 per month “free”.

I received an email from a client this morning interested in checking her credit report and credit score. She asked if it was “safe” to use FreeCreditReport.com? I told her I couldn’t comment on the safety issue, but I did want to make sure she was aware that she would be signing up for a free 7 day trial, after which she’d be charged $14.95 per month for her “membership”.

Don’t believe me? Here’s information from their website listed under Important Information:

When you order your free report here, you will begin your free trial membership in Triple Advantage^SM Credit Monitoring. If you don’t cancel your membership within the 7-day trial period^**, you will be billed $14.95 for each month that you continue your membership.

ConsumerInfo.com, Inc. and Freecreditreport.com are not affiliated with the annual free credit report program. Under a new Federal law, you have the right to receive a free copy of your credit report once every 12 months from each of the three nationwide consumer reporting companies. To request your free annual report under that law, you must go to www.annualcreditreport.com.

If you think about it, how could FreeCreditReport.com afford to plaster those TV ads all over the place if they were just giving away their service for free? The answer: they couldn’t.

For your free credit report, go to AnnualCreditReport.com. This service is sponsored by the 3 main credit reporting agencies and is indeed free.

Note: You can obtain your credit report for free, but not your credit score. You will have to pay to obtain your credit score and the cost is typically between $10-$15.

Financial Planning - What It Means To Me

2009-03-19T13:25:36Z

“Financial Planning” means different things to different people.

Here are some thoughts about what it means to me:

I help you live the one life you have, the best way you can, based on the goals you value.
I believe “financial planning” is a process and an ongoing decision making framework. It’s not a one-time event or a “book”.
It’s about managing your life goals … uniquely … not just your financial assets.
Your investments and your goals need to be a dynamically matched set.
It involves ongoing dialogue and updates with a trusted advisor
It starts with pulling the right “lever”

Can you have a financial plan without the elements above? Yes, I think you can.

However, I don’t know if it will be the best, most appropriate financial plan for you and your family unless it connects with what’s most important to you.

And what’s most important to most people I know isn’t money.

What do you think? Please post your thoughts in the comments section below.