Learning to Mistrust Your Financial Instincts

Inefficient, Schminefficient

Why?  It’s all a game.  A charade.  A ploy to sell more magazines and line Wall Street’s pocket with fees.  So, with this year’s stock market guides now hitting stores, we think a review of last year’s predictions might provide investors with the necessary caution:

Fortune Magazine assembled a team of Wall Street pros to share its “Ten Best Stocks for 2011”.  Unfortunately for readers, six of the ten stocks plunged an average of 37%.  (The S&P 500 Index returned 2%).^[1]  Transocean declined 40%, Royal Caribbean fell nearly 50%, and Entropic Communications plummeted 60%.  The average return for all of Fortune’s “Ten Best”?  A total bust—down 20%.

SmartMoney published its own “Where to Invest” guide, in which it shared the stock picks of fund managers from the likes of T. Rowe Price, Legg Mason, and Morgan Stanley.^[2]  These experts, hinted SmartMoney, had a track record of making “the boldest moves in dark times.”  How did these gallant Wall Street pros fare?  Not so well.  Their daring picks turned out to be nothing more than duds. The average return for the 13 stocks listed, from recommendation date through year-end, was a whopping zero percent.   

Barron’s assembled ten of the industry’s most “estimable” investors—the likes of Abby Joseph Cohen, Bill Gross , and Mario Gabelli—to share their insights for the year ahead.^[3]   Most of the pros warned against Treasury bonds (up 13% in 2011), favoring instead commodities (-12%), gold (+14%) and stocks in high-growth emerging markets (-18%).  Eight of these “market mavens” provided stock tips; only two selected stocks which collectively delivered positive returns.  The average return of all eight experts’ picks?   Minus 3%—five percentage points less than the S&P 500 Index. 

The Wall Street Journal proclaimed “the stage is set for stock-pickers to shine”, yet cautioned readers against picking just any active fund manager.^[4]  Most managers, claimed the WSJ, are really “closet indexers”, meaning they claim to pick and choose stocks but in fact seek to closely track their benchmark index, such as the S&P 500.  The WSJ suggested investors try a different approach:  favor only those managers willing to make big active bets and deviate significantly from the index by holding concentrated portfolios of just their best stock ideas.  The WSJ identified four such managers willing to “chart their own course.” And chart their own course they did.  While the S&P 500 Index returned 2%, three of the four funds ran aground—underperforming the S&P 500 Index by at least 5% each.   

Longtime Forbes columnist and money manager Ken Fisher peered into his crystal ball and declared 2011 would be “an easy one for stock pickers”.^[5]  He then recommended five stocks readers must buy.  From the January recommendation date through December 30th, Fisher’s five recommendations tumbled an average of 20%.  Oops.

What’s the takeaway for investors?  Instead of seeking to predict the unpredictable, investors should focus on the things they can control—asset allocation, minimizing costs and taxes, and staying disciplined.  After all, reading an expert’s view of the future is entertaining, but following that advice sure can prove costly.

Switching to Cash May Feel Safe, but Risks Remain

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Absolute return? Absolute nonsense, at least with most alternative investment funds.

Employees cited, as an example, Ameriprise’s diversified bond fund offering—which costs 0.78% per year—as “some 71 basis points more than a comparable offering from Vanguard.”  Plaintiffs say Ameriprise selected such funds as a way to earn more in fees, despite the fact such fees directly eat into investor returns.  Employees allege they collectively lost more than $20 million related to high fund costs.

As long-time champions of low-cost investing, we can empathize with these employees’ frustration.  But we believe there’s another story here which has gone unreported:

A little digging on Ameriprise’s website reveals that of all US taxable bond funds available to customers of the firm, the average cost is 1.08%^[2].  That’s 50% higher than the cost of the fund referenced in the lawsuit, and 15-times higher than the comparable Vanguard fund to which Ameriprise employees presumably wish they themselves had access.

This begs the question: When do customers of Ameriprise get to file their suit?

¹ Mercado, Darla.  “Ameriprise workers sue over company’s own 401(k) funds.”  Investment News.  September 29, 2011.

² Ameriprise Financial Mutual Fund Finder.  Average expense ratio for all no-load, Domestic Taxable bond funds.

For those unfamiliar with the nation’s debt ceiling history, it has almost always been this way—contentious, dramatic, and down-to-the-wire.  Since the aggregate debt limit was created back in 1939, it has been lifted almost 100 times.^[1] Many of these incidents were preceded by similar political posturing and predictions of financial disaster.

On each of these past occasions, however, a deal was reached to raise the debt limit and pull our government from the brink—often at the eleventh hour.  Just as in this instance, The U.S. Treasury has repeatedly been forced to use financial maneuvers to buy time while Congress and the President negotiate a deal.  To illustrate just how close we have cut it in the past, consider 1979 when the resolution of the debt limit issue was so late the payment schedule on a portion of short-dated Treasury Bills was missed.^[2] The incident was quickly resolved, but technically speaking, represented a default.

Despite the historical drama and confronting “this time is different” scenarios numerous times, the U.S. has enjoyed its coveted AAA credit rating for the past 70 years.  Notice from ratings agencies, Standard & Poor’s and Moody’s, on the potential for credit downgrades should provide added incentive for decision makers to reach a deal and make progress towards putting the country’s finances on a stronger footing.  One thing participants in this negotiation seem to agree on is the interest rate increase that would result from a credit rating downgrade would make paying down the debt and solving this problem even harder than it is now.

Use of the term “default” as it relates to Treasury Bonds also deserves a little more explanation than it is receiving in some of the press.  Some people might worry U.S. Treasury Bond holders will be left with nothing if the debt limit isn’t raised right away.  Our inability to issue more debt would not immediately result in existing debt going into default.  Actually, U.S. government revenue is still more than 5 ½ times the amount needed to make interest payments.  To be sure, the Treasury would have to make some excruciating choices about what to cut, but would likely prioritize interest payments, Social Security, Medicare, and “essential defense” payments over other types of spending.

Markets appear to be anticipating yet another last-minute debt limit deal.  Stock and bond prices are actually higher now, as the deadline nears, than they were earlier in the year.  The information conveyed by millions of investors with real money at stake is more reliable than the politically charged statements coming out of Washington.

Of course, no one can say with certainty what the short-term future holds.  We do believe, however, that a prudent investment strategy should be based—in part—on lessons learned from periods of past turmoil and not based on pure speculation about the future.  With that in mind, we continue to believe a diversified portfolio consisting of nearly every publicly-traded stock and real estate investment around the globe, complemented with Treasury bonds issued by the largest and most productive economy in the world, is the most effective protection against uncertainty.  That, and a healthy dose of discipline.

¹ Kirchgaessner, Stephanie, Richard McGregor and James Politi.  “US Debt Crunch: A Nation Taken To The Limit.”  Financial Times, July 14, 2011.

² Ibid.