7 Hidden Fees to Watch Out for in Retirement

While I usually only provide original content on this blog, I thought this article from the Motley Fool’s web site was very well done and worth sharing.

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Toxic or Terrific: Evidence Based Investing with the Active Management Value Ratio 2.0

As an attorney, I put a great deal of emphasis on the value of evidence. Two of the most persuasive pieces of evidence regarding investing have to do with the consistent underperformance of actively managed mutual funds. For instance:

  • The most recent SPIVA (Standard & Poor’s Indices Versus Active) report, for the year ending December 31, 2014, reported that 87.23 percent of domestic equity funds as a whole underperformed their respective index.  The long term performance of all domestic equity funds was equally dismal, with said funds underperforming over both a five and ten year period, 80.82 percent and 76.54 percent respectively.
  • A study by Schwab Institutional concluded that 75 percent of new customer accounts being transferred to Schwab were unsuitable as being inconsistent with either an investor’s financial goals or financial needs.

And yet, despite this overwhelming evidence, according to the Investment Company Institute 2014 Fact Book, only 20 percent of the estimated $16 billion invested in domestic equity mutual funds as of the end of 2014 was invested in indexed equity mutual funds. One positive sign is that the Fact Book reports that sine 2007, there has been an outflow of approximately $659 billion, hopefully due to an increased education and awareness among investors. Hopefully this trend will continue, as the evidence clearly shows that the investment numbers should be completely opposite to what they are now.

The Active Management Value Ratio 2.0™

Investing can be very intimidating to investors, as many are hesitant to question investment “professionals.” Studies have shown that this is especially true of women and the elderly.

Which brings us to the role of the Active Management Value Ratio 2.0™ (AMVR). My purpose in creating the AMVR was to provide a simple and effective means of quantifying suitability and best interests for investors to help them protect their financial security against some of the questionable sales tactics practiced in the investment/financial services industries.

The AMVR is a simple cost/benefit analysis that is a basic concept in every introductory economics class. What makes the AMVR different is that the metric uses a fund’s incremental costs and returns as the analysis’ input data. The use of a fund’s incremental cost and return data is based on the concept that since index funds provide a means of reliably achieving essentially the market return with no additional market risk, the value added benefit provided by actively managed mutual fund, if any, is reflected in the incremental, or additional, return provided by the fund and the relative incremental, or additional, cost incurred to achieve such return.

The AMVR calculation simple and straightforward, requiring only the basic math skills of addition and subtraction. Incremental costs are calculated on the basis of a fund’s annual expense ratio and its turnover/trading costs, since studies have consistently shown that

The two variables that do the best job in predicting future [of mutual funds] are expense ratios and turnover. High expenses and high turnover depress returns….– Burton Malkiel “A Random Walk Down Wall Street”

AMVR calculations will result in one of three scenarios:

  1. the actively managed fund will fail to produce any incremental return for an investor, therefore providing no benefit to an investor;
  2. the actively managed fund will produce an incremental return for an investor, however the incremental costs incurred by the fund in producing the incremental return will exceed the incremental return, therefore providing no benefit to an investor; or
  3. the actively managed fund will produce an incremental return greater than the fund’s incremental cost, therefore producing a benefit for an investor.

Scenarios 1 and 2 create obvious liability concerns for a financial advisor, as both scenarios result in increased costs for an investor without providing any benefit in return for an investor. Both scenarios would obviously not be neither suitable, prudent  nor in the best interests of any investor, resulting in liability exposure for their provider who provided such recommendations.

Scenario 3 does result in a financial benefit for an investor, justifying further evaluation based on a fund’s comparative value to other qualifying mutual funds using qualitative issues such as risk, stress testing and consistency of performance.


Most of my career in financial planning and investments has  been centered on quality of investment advice issues, first as a compliance director/officer and then a the director of quality advice for the financial planning division of a major international insurance company. All along I recognized the need for the public to have a simple, yet effective means to evaluate the financial advice they receive from investment “professionals.”

The AMVR metric finally provides the public with a means to evaluate both the investment advice they receive and the person providing such advice. The AMVR can be used to evaluate investments options in both personal retail investment accounts and company retirement plans such as 401(k), 403(b) and 457 plans. The cost of calculating the AMVR is free, as the calculation process in the “white paper” section of this blog, and the information is freely available online at sites such as morningstar.com under the “Funds” tab.

Are your investments toxic or terrific? How valuable is your financial security to you and your family? Investors now have the means to privately evaluate both their investments and their financial advisers to determine if their investments and/or their advisers are truly serving the investor’s best interests.






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God Bless Charles Ellis

I am often asked what I feel is the best investment book for investors and what one piece of advice I would give investors. Fortunately, the answer to both is the same – read “Winning the Loser’s Game” by Charles Ellis. The book is written in a style that anyone can understand and offers sound, practical advice for every level of investor, newbie or veteran.

When people come into my office, I think they expect to see volumes of investment related books. Instead they see just three investment books on my credenza – “Winning,” “The Intelligent Investor” by Benjamin Graham, and “A Random Walk Down Wall Street” by Burton Malkiel. In my opinion, those are the only three investment books an investor needs to be a successful investor.

I first read “Winning” back in its first edition in 1987, when it was titled as “Investment Policy.” The reason I chose “Winning” as my favorite investment book is that it introduced me to the concept of investment analysis using an investment’s incremental cost and incremental return, when Ellis advised investors that they

“should consider the true cost of fees charged by active managers not as a percentage of total returns but as the incremental fee as a percentage of risk-adjusted incremental returns above the market index.”

Ellis pointed out that since investors could essentially obtain the market return through an inexpensive index fund, using incremental fees and returns allowed investors to get a better picture of what value, if any that an active manager provided

That concept has been the core element of my entire practice, as it allows investors to avoid unnecessary costs, which reduce an investor’s end return. Remember, each additional 1 percent of fees and other costs reduce an investor’s end return by approximately 17 percent over a 20 year period.


Using an actively managed mutual fund’s incremental costs and returns reinforces what study after study has shown, namely that the majority of actively  managed funds fail to outperform passively managed index funds. The SPIVA report (S&P Indices Versus Active) provides a biannual analysis comparing the performance of actively managed funds versus passive indices.

For the year ending on December 31, 2014, the actively managed funds once again posted consistent under-performance versus the indices. The 5 and 10 year under-performance percentage for all domestic mutual funds was 80.82 and 76.54 respectively. For domestic large cap funds, the 5 and 10 year under-performance percentage was 88.65 and 82.07 respectively. For domestic mid cap funds, the 5 and 10 year underperformance percentage was 88.65 and 82.07 respectively. For domestic small cap funds, the 5 and 10 year underperformance percentage was 86.55 and 87.75 respectively. Despite these facts, the investment options offered by most 401(k)/404(c) plans continue to be dominated by actively managed mutual funds.

Incremental analysis also allows an investor to see that in most cases, actively managed mutual funds either fail to provide any benefit at all, or that the fund’s incremental costs exceed any incremental return produced. In both cases, an investor loses money.

My metric, the Active Management Value Ratio 2.0™, uses a fund’s incremental return and incremental costs to evaluate the intrinsic value, if any of an actively managed mutual fund. The information needed to perform the calculations are available for free on various web sites. The calculation process only requires simple subtraction and division.

There is a saying in the investment industry – the public focuses on investment returns, investment professional focus on investment risk. while most modern investment books focus on returns since that is what interests the public, Ellis focuses on the importance of the effective management of investment risk in successful investing.

The great secret of success in long-term investing is avoiding serious, permanent loss….[M]anaging market risk is the primary objective of investment management….We now know to focus not on rate of return but on the informed management of risk.

Few investors seems to realize the true impact of investment losses. When I do presentations, I often ask the audience a sample question to impress upon them the impact of investment losses. The question poses a situation where an investor suffers a 50 percent loss in year 1, followed by a 50 percent gain in year 2. The audience is then asked where the investor stands versus his beginning position.

Most of the audience will say that the two 50 percent numbers cancel each other out, so the investor is back where he began, with no loss. However, the correct answer is that the investor is still down 25 percent. If we assume that the investor started off with $1,000, lost 50 percent to $500, then gained 50 percent, or $250, on the $500, the investor only has $750, or $250 (25%) less than what he started with.

To calculate the gain needed to offset investment losses, an investor can use the following equation: [(1/(1-amount of loss))-1] times 100. For example, it takes a return of 100 percent to offset a loss of 50 percent. (1/(1-.50)) x 100 or (2 x 100) equals 00 percent.

The bear market of 2008 saw investor losses of 40 percent or more. To recover from a loss of 40 percent, an investor needed to achieve a return of  approximately 67%.

Ellis discusses several risk management options, including effective asset allocation/diversification. Many investors mistakenly believe that they are effectively diversified by holding various classes of mutual fund, e.g., large class growth, small cap value. However, since most domestic equity-based mutual funds share a high correlation of returns, owning various classes of domestic equity-based mutual funds does not provide an investor with the downside protection against losses that true diversification provides.

If you truly care about investing to protect you and your family’s financial security, do yourself a favor by finding “Winning the Loser’s Game” and investing a couple of hours in reading it. By doing so you will discover the truth of our blog’s tagline, “the power of the informed investor.”

Posted in Asset Protection, ERISA, Fiduciary, Investment Advice, Investment Portfolios, Investor Protection, pension plans, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Retirement Plan Participants, Retirement Planning, Uncategorized, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , ,

Wealth Preservation – Avoiding Common Financial “Games”

When people ask me what kind of law I practice, I tell them that I am a wealth preservation attorney. To me, wealth preservation consists of three separate areas of wealth management – accumulation, protection and preservation. Wealth preservation involves estate planning, asset protection, retirement distribution planning and other related areas of wealth management.

There is a popular saying that “knowledge is power.” Nowhere is that truer than in the world of investing. Knowledge allows an investor to be proactive and protect their financial security.

In my experience as a securities compliance director and a securities and wealth preservation attorney, I have seen a lot of “games” often used by the financial services industry. In most cases, the “games” are employed to provide more compensation to the financial adviser at the investor’s expense.

Five of the most common “games,” or deceptive practices, used in the industry are:

1. Inverse pricing by variable annuities – This refers to the practice by the variable annuity industry to base their annual fees on the total value of the variable annuity rather than the cost of their legal obligation to the annuity owner, commonly referred to inverse pricing since the fee is not based on the actual potential cost to the variable annuity issuer. Most variable annuities obligate the variable annuity issuer to pay the annuity owner’s heirs the greater of the value of the variable annuity or the owner’s actual contributions.

Given the historical trends of the stock market, it is unlikely that the value of the variable annuity will be less than the owner’s contributions. Consequently, inverse pricing essentially guarantees the variable annuity issuer a substantial windfall at the owner’s expense. Most variable issuers charge an annual fee of 2 percent or more, despite the fact the fact that one well-known study estimated that the actual value of the protection for which the fee is charged is approximately 0.10 percent.

The annual fee charges is even more egregious when one considers that each 1 percent of additional 1 percent of investment fees reduces an investor’s return by approximately 17 percent over a twenty year. When you add the additional fees for a variable annuity’s sub-accounts, the total fees on variable annuities often exceed 3 percent or more, effectively reducing an investor’s end return by over 50 percent or more. For more issues with variable annuities, read our white paper, “Variable Annuities: Reading Between the Marketing Lines,” and “Stuart Berkowitz’s article, “5 Reasons you Should Be Wary of Variable Annuities.

A recent addition to the annuity product line is the so-called fixed-income or equity-based index annuity. While these products have a number of negative issues, the leading issue if that fact that such products come with various features that seriously limit the real return that investors can achieve. A more comprehensive analysis of these products is available here.

Wealth preservation “best practice”: Variable annuities and indexed annuities…just say no!

2. “Pseudo” or false diversification – This refers to the practice of providing investors with investment recommendations among various types of investments, e.g., large cap growth funds, small cap value funds, international funds and leading an investor to believe that the recommendations will provide the investor with with a diversified investment portfolio and protection against downside risk. But looks can be misleading.

True diversification provides investors with both upside potential and downside protection against substantial losses.  However, given the high correlation of returns among most equity-based investments, both domestic and international equity-based investments, the recommendations often do not provide the protection supposedly provided by diversification at all.

Looking at the five-year (2009-2014) correlation data for five equity-based categories often used in asset allocation recommendations, (large cap growth, large cap value, small cap growth, small cap value, and a popular international index, MSCI’s EAFE), the pattern of high correlation is obvious:

94% correlation between LCG-LCV
91% correlation between LCG-SCG
90% correlation between LCG-SCV
87% correlation between LCG-EAFE
90% correlation between LCV-SCG
94% correlation between LCV-SCV
86% correlation between LCV-EAFE
97% correlation between SCG-SCV
75% correlation between SCG-EAFE
76% correlation between SCV-EAFE

Looking at the ten-year (2005-2014) correlation data for the same categories further demonstrated the high correlation pattern for equity-based investments:

92% correlation between LCG-LCV
92% correlation between LCG-SCG
87% correlation between LCG-SCV
87% correlation between LCG-EAFE
88% correlation between LCV-SCG
93% correlation between LCV-SCV
87% correlation between LCV-EAFE
95% correlation between SCG-SCV
79% correlation between SCG-EAFE
77% correlation between SCV-EAFE

Bottom line, in most case, “pseudo” or false diversification simply provides an investor with nothing more than a false sense of security and an unnecessarily expensive index fund, with reduced returns due to the excessive fees.

Wealth preservation “best practice”: Investors should always ask their financial adviser to prepare a correlation of return analysis for both their existing investment portfolio and the investment portfolio being recommended by their financial adviser. After all, without a correlation of returns analysis, how can a financial adviser know whether his/her recommendations are in the best interests of the investor?

3. Closet index funds – Mutual funds with high R-Squared ratings are often referred to
“closet index” funds, as their high R-Squared rating indicates that investors may be able to achieve similar or better returns at a significantly lower cost by using index-based investments.

Morningstar defines R-squared as a measure of the correlation of the portfolio’s returns to the benchmark’s returns. An R-squared of 100 indicates that all movements of a portfolio can be explained by movements in the benchmark. Conversely, a low R-squared indicates that very few of the portfolio’s movements can be explained by movements in its benchmark index. Effective diversification involves combining investments with low correlations of return so that the investments provide downside protection against large losses, regardless of economic or market conditions.

There is no universally accepted R-squared rating level for classification of a fund as a closet index fund. Some use a rating of 95 as the threshold rating, while some us 80-85 as a threshold R-squared rating.

InvestSense classifies any mutual fund with an R-squared rating of 90 or above as a “closet index” fund.  This position is based upon our belief that the ability to achieve the same or similar returns of a benchmark index fund without the higher fees generally associated with actively managed mutual funds, often 3-4 times higher than a comparable index fund, is more more conducive to effective wealth management and preservation.

Wealth preservation “best practice”: Do not invest in “closet index” funds, funds with R-squared ratings of 90 or higher.

4. Cost inefficient actively managed mutual funds – One of my specialities is fiduciary law. One of the primary duties of a fiduciary is to manage any money entrusted to them in a prudent manner, always putting the best interests of the client first. One of the primary aspects of prudence is to avoid unnecessary fees and expenses.

There are two ways of evaluating the fees charged by actively managed mutual funds. The first involves calculating the effective cost of such fees based up on the actual active management component of a fund. The higher the R-squared rating of a fund, the lower the actual active management component of such fund.

Since closet index funds have a small active management component, their effective fees will be significantly higher than their stated annual fees. A study by Professor Ross Miller found that the effective cost of active management generally exceeded a fund’s stated annual expense, often by as much as 300-400 percent.

A second way of evaluating the fees of actively managed mutual funds is to use our proprietary metric, the Active Management Value Ratio 2.0™ (AMVR) to evaluate the cost efficiency of a mutual fund. The AMVR is a powerful, yet simple, cost/benefit analysis that requires nothing more than the ability to perform simple subtraction and division. And yet, the AMVR often indicates that actively managed mutual funds are cost inefficient, as the incremental, or extra, return provided by actively managed mutual funds, if any, is exceeded by the fund’s incremental , or extra, costs.

Wealth preservation “best practice”: Avoid “closet index” mutual funds and take the time to calculate the AMVR 2.0 rating for mutual funds currently owned and/or being considered as potential investments. 

5. Relative returns – aka the “we’re number 1” scam. Investment ads and advisers like to tout that their product has had the best performance compared to their competitors. This comparative, or “relative,” performance allows an investment company or financial adviser to make such a claim, even though the actual return was lackluster or even negative.

This is a common practice after a down year for the stock market, such as the bear markets of 2000-2002 and 2008, when many mutual funds suffered losses of 30 percent or more. The fact that one’s mutual fund suffered a 30 percent return while another fund suffered a 32 percent is hardly cause for celebration.

Investors need to focus on funds that have provided consistent absolute returns. Absolute returns are simply the actual returns that an investment has provided over time. An investment with a consistent history of positive absolute returns means that an investor has not benefited from the returns themselves, but also from the benefit from the compounding of such returns over time.

Wealth preservation “best practice”: Ignore mutual fund advertisements touting their relative returns and focus purely on a fund’s ability to provide consistent and positive annual absolute returns.

Posted in Asset Protection, Investment Advice, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, IRA, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement Distribution Planning, Retirement Planning, Variable Annuities, Variable Annuity Abuse, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , ,

Conflicts of Interest and Full Disclosure

Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits and our salespersons’ compensation may vary by product and over time.

The referenced disclosure, commonly known as the Merrill Lynch Rule after one of the leading broker-dealers in the U.S., was proposed by the Securities and Exchange Commission (SEC) as an alternative to enforcing the law requiring that those who provide investment advice for a fee must register as an investment adviser. The Financial Planning Association (FPA) eventually sued the SEC to force them to enforce the Investment Adviser’s Act of 1904 and to require the broker-dealers providing investment advice for a fee to register. The FPA eventually won their case and the SEC withdrew the conflict of interest disclosure requirement.

The conflict of interest problem still exists today. Both the Department of Labor (DOL) and the SEC are involved in heated disputes regarding the need for a universal fiduciary standard that would require that anyone providing investment to the public would have to always put a customer’s or a client’s financial interests first.

While it would seem that such a requirement is simply common sense and fair, the financial services industry claims that such a requirement would result in financial advisers refusing to provide advice to certain segments of the public and that such a requirement would result in disaster for investors. To date, the financial services industry has failed to produce any hard evidence of such claims, basing their claims on pure speculation.

The conflicts of interest issue has recently been addressed in an excellent article, “Is Your Financial Advisor Really Putting You Before Profits.”  As the article states, studies have consistently shown that the public mistakenly believe that anyone proving investment advice is required to put the customer’s best interests first. As the conflicts of interest disclosure points out, that is not true. Fiduciaries, such as investment advisers, are required to always put a customer’s best interests first. Stockbrokers and other financial adviser are generally not considered to be fiduciaries and there are allowed to, and often do, put their financial interests ahead of their customers’ best interests.

The key for investors is to recognize and understand the conflicts of interest issue and to take the time to review and evaluate any and all investment recommendations for the potential impact of same on them. To that end, I have previously published one of my proprietary metrics, the Active Management Value Ratio 2.0™, (AMVR) which allows an investor to perform a simple cost/benefit analysis on actively managed mutual funds to determine the cost efficiency of a mutual fund.

The information needed to calculate a fund’s AMVR score is available for free online. Once an investor becomes acquainted with the AMVR calculation process, it should take no more than a few minutes to calculate a fund’s AMVR score. Surely, one’s financial security is worth their investment in such a minimum amount of time.

Unfortunately, as Mark Twain once noted, the adoption of a law does not guarantee that everyone will follow it.  The power of greed will probably result in some financial advisers continuing to put their own financial interests ahead of the best interests of their customers. Therefore, the need for investors to be able to independently evaluate any investment advice they receive will continue to be a valuable skill.



Posted in Investment Advice, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, portfolio planning, Portfolio Planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , ,

The Often Overlooked Importance of Dividends

I just finished reading an interesting article from Dreyfus regarding the historical impact of dividends on the stock market’s total return. The paper states that since 1926, dividends have accounted for approximately 50 percent of the stock market’s total return. You can read the paper here. https://public.dreyfus.com/documents/manual/perspectives/dry-fsdwp.pdf.

Stocks paying respectable dividends are often considered to be too conservative for many investors, who prefer to search for potential 10-baggers, or stocks that grow in capital appreciation to ten times their initial value. And yet, having grown up in Atlanta, Georgia, the land of Coca-Cola, I am well-aware of the number of millionaires that Coke stock produced simply by investors simply re-investing their dividends.

Since 2000, an increasing number of companies have chosen to reduce or discontinue their dividends in order to avoid taxation of such dividends. Such companies, with shareholder approval, have decided to plow back such money into the company in hopes of creating internal growth and increased capital appreciation within the stock.

While both approaches have merit, it is important to consider the benefits that dividends can provide. One of the most valuable benefits that dividends provide is protection in down markets, as the dividend ensures a certain level of return. As the paper shows, certain dividend paying stocks, known as “dividend aristocrats,” have actually provided a historically greater rate of return with less risk.

I am a proponent of what is known as core-and-satellite investing. Core-and-satellite investing involves creating a sound, fundamental core for one’s investment portfolio. The core usually consists of a sound, well-diversified equity based component and a sound, well-diversified fixed-income based component. To that core we add one or two investments that are chosen in hopes of providing a little extra return the overall portfolio.

The satellites can be chosen based on various factors, including the current or expected condition of the economy and/or the stock market. Depending on the individual investor’s personal goals and other personal investment parameters, we often recommend an investment that provides both growth and income, including investments focusing on dividend paying stocks.

Stockbrokers and other financial advisers often only recommend investments focused on capital appreciation. Investors should stop and consider whether an allocation to growth and income investments and/or dividend paying stocks is a wise choice to help provide a buffer against downturns in the market.

History has shown that the stock market is cyclical, undergoing both bull and bear markets. As the Chinese philosopher Lao Tzu once said, “the best way to manage anything is to make use of its nature.” Dividends help manage the inevitable downturns in the stock market.

Posted in Investment Fraud, Investment Portfolios, Investor Protection, IRA, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , ,

The Best Investment Advice…Period

People that follow me know that “Winning the Loser’s Game” by Charles Ellis is my favorite book on investing. Ellis approaches investing from a different viewpoint that is refreshingly different, and absolutely spot on, than most investment experts. I consider three positions especially significant in promoting successful investing.

We now know to focus not on rate of return but on the informed management of risk.

Simply put, investors cannot control the market. They can control investment expenses and investment risk. Controlling investment risk often focuses on an investment’s volatility and the correlation of one investment’s performance with other investments in one’s portfolio.

Far too often, investors are not provided with correlation of returns data for their investments. Yes, correlation of return data does change, but so does an investment’s return and standard deviation.

From an investment perspective, the goal should be to effectively diversify one’s investment portfolio to hopefully minimize the risk of large losses. By combining investments that have different levels of correlation of returns, that behave differently in different market and/or economic conditions, we can reduce the risk of large losses.

Far too many investors are fooled into thinking that effective diversification can be accomplished by simply holding different types of investments within the same asset class. For instance, I reportedly see investors whose portfolio consists of large cap equity mutual funds, small cap equity mutual funds, and perhaps an international equity fund.

What such investors do not understand is that over the past decade or so, all equity funds, both domestic and international, have consistently shown a high correlation of returns, generally in excess of 90 percent correlation. As a result, many investors are holding portfolios that provide little or no protection against downside risk, large losses.

To quote Donald Trump, “focus on the downside, the upside will take care of itself.”

Even though most investors see their work as active, assertive, and on the offensive, the reality is and should be that stock investing and bond investing are primarily defensive processes.

This perspective confuses a lot of people, but it is absolutely true. Money that is lost investing cannot fully participate in the market’s subsequent recovery. As I tell my clients, you cannot get ahead if you have to spend all of your time catching up.

When I speak to groups, I often use the 50/50 example to stress the importance of defensive investing.  The 50/50 example is simple – if I lose 50 percent of my investment in one year and realize a 50 percent return the next year, what is the status of my portfolio? Many people will say I’m back at zero. But if I lose 50 percent, and then realize a 50 percent return the next year, my portfolio has still suffered a 25 percent loss (50 percent + (50 percent of 50 percent)).

The impact of investment losses and the amount of return required to fully recover from such losses can be easily calculated. The formula is [1/1 – amount of investment loss] – 1, then multiply by 100. For instance, a 50 percent loss would require a return of 100 percent to fully recover such loss.  [[(1/.50), or 2,  less 1] x 100]

Keep in mind, however that an investor suffers an opportunity loss by having to use that market return to recover from the loss rather than being able to use that return to increase their portfolio’s worth. Investing defensively requires giving up a little upside potential, however it acknowledges that the market is cyclical and helps reduce downside risk.

Defensive investing simply makes sense from a proactive perspective. As the Chinese philosopher observed, “the best way to manage anything is by making use of its nature.”

So rational investors should consider the true cost of fees charged by active managers not as a percentage of total returns, but as the incremental fee as a percentage of risk adjusted incremental returns above the market index.

This concept is at the heart of my entire practice and is the fundamental concept behind my proprietary fiduciary prudence metric, the Active Management Value Ratio™ (AMVR). The AMVR is a simple cost/benefit metric that effectively allows anyone to quantify the prudence of a mutual fund, using just incremental cost and incremental return as the input data for simple subtraction and division calculations.

The value of using incremental cost and incremental returns is that it allows us to analyze an investment in terms of additional cost and return beyond what an investor can achieve by using a less expensive alternative investment providing similar returns, for example passively managed index funds.

Many investors are surprised to learn that many actively managed mutual funds fail to outperform comparable index funds. Using the AMVR, many investors are surprised to learn that even when an actively managed fund does outperform  an index fund, the incremental costs associated with actively managed mutual funds often exceeds the fund’s incremental return, thus resulting in a net loss.

Bottom line, using incremental costs and incremental returns provides us with information that is often hidden by simply looking at a mutual fund’s stated total return and stated standard deviation data.

Most library systems have a copy of “Winning the Loser’s Game,” or are willing to do an interlibrary loan to get a copy from another library. If you are serious about investing and protecting your financial security, I would strongly take a couple of hours and enjoy Charles Ellis’ excellent advice.

Posted in Asset Protection, Investment Advice, Investment Advisors, Investment Portfolios, Portfolio Construction, portfolio planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , ,