A Matter of Trust and Wealth Preservation

As many people know, I have been a very outspoken advocate for a universal fiduciary standard for the financial services industry. As a securities/wealth preservation attorney and a former compliance director, I am well aware of the questionable practices that some in the financial industry employ. Just this weekend another story has come out about improper conduct on Wall Street which hurt investors, especially pension plans.

One of my fellow deacons died recently. His wife, Mrs. A, has always been a faithful volunteer to help with our weekend sports programs, serving as a co-manager of our concession stand. I had told her to take a week off and relax. She insisted on coming, saying it would help her.

A couple of us had gone to get more soft drinks from the supply room. As we returned, I saw Mrs. A point to me and tell a gentleman at the stand, “that’s Jim Watkins and he handles all my affairs. I only trust him.” I pulled the gentleman aside, confirmed that he was a broker, and informed him that if he attempted to solicit Mrs. A or anyone else on church grounds, I would file a complaint against with FINRA, the securities industry’s regulatory body, and obtain a restraining order if necessary. Being the sports commissioner can be fun.

I may be in the minority, but I believe that there is no greater compliment than to hear someone tell you that they trust you. Unfortunately, we all know that are numerous cases where advisers, even those required by law to always act in the best interests of a client, have taken advantage of a client’s trust. Matthew Hutcheson, a well-known advocate of the fiduciary standard, was recently sentenced to prison for defrauding his clients.

From a client’s perspective, it is hard to decide who to trust and whether an adviser is truly acting in their best interests. A study commissioned by the SEC and conducted by the Rand Corporation found that most investors polled mistakenly believed that stockbrokers were required to always put a client’s interest first, but registered investment advisers were not required to do so. In truth, it is just the opposite. However, this misunderstanding may have allowed many investors to suffer unnecessary investment losses due to misplaced trust.

Congress, the SEC, and the financial services industry have yet to answer my long-standing question – “What is so unfair or onerous about requiring that anyone who provides investment advice to the public must always put the public’s interest first?” I am still waiting for an honest answer.

Unfortunately, the current situation requires that investors take a more proactive stance in managing their financial affairs.  I have provided several article on this blog to help investors toward that goal.  My article on variable annuities, “Variable Annuities: Reading Between the Marketing Lines ,” has been read by thousand of visitors to this blog and was cited by the Financial Planning Coalition in hearings before Congress in connection with the need for a fiduciary standard.

When I speak at conference or talk to the public, I stress the need to become more proactive in managing one’s investment affairs. Sadly, the elderly are often targets for unethical financial salesmen. Financial fraud is the leading crime against those age sixty-five and older. This is an area of the law that has been under-served by elder lawyers.

Financial fraud and abuse come in various forms. However, based on my experience, there are three scenarios that appear frequently and cost investors dearly – unnecessary fees and expenses, pseudo-diversification, and the myth of buy-and-hold portfolio management. A simple understanding of these three issues can help avoid becoming a victim of investment fraud.

Fees and Expenses

We all know that management fees are high. Poor performance does not come cheap. You have to pay dearly for it. – Rex Sinquefield

Fees and expensesobviously reduce one’s investment returns. Each 1 percent of fees and expenses reduces an investor’s end wealth by approximately 17 percent over a period of twenty years. Investment advisors often charge 1 percent annually for their services. If the advisor is recommending mutual funds that also charge an annual fee of 1 percent, the investor is losing over a third of his end return. If the advisor recommends the purchase of a variable annuity, with a typical 2-3 percent annual fee and a typical 1 percent annual fee for the annuity’s subaccounts, you can find situations where an investor will lose almost 70 percent of their end wealth to fees alone.

Investment advisors and other financial fiduciaries are required to only recommend investments that are prudent and in an investor’s best interests. As mentioned earlier, stockbrokers are not necessarily held to this same standard.

While there may be various factors in assessing the prudence of an investment. I developed a metric, the Active Management Value Ratio™ (AMVR), that allows both investors and financial fiduciaries to perform a cost-benefit  analysis and quantify prudence through a calculation that only requires simple subtraction and divisions. An explanation of the AMVR with examples can be found in various posts and white papers on this blog.

My experience with the AMVR has shown that very few actively managed mutual funds are cost efficient and would be not be considered prudent investments for most investors. And yet, most stockbrokers only recommend expensive actively managed mutual funds for their clients. According to the Investment Company Institute, based on 2012 data, approximately 90 percent of the money invested in equity based mutual funds is held by actively managed mutual funds, with only 10 percent in less costly, but equally or more effective, index funds. To quote Voltaire , “common sense is not so common.”

Even more disturbing is that many actively managed funds have high R-squared ratings, indicating that the majority of their performance can be attributed to the performance of their underlying benchmark rather than the skills of the fund’s manager. Funds showing a high R-squared rating are called “closet index” funds since their performance can be attributed to an appropriate stock market index. This is yet another argument for investing in inexpensive, yet effective, index funds.

CommonSense InvestSense: Calculate an actively managed mutual fund’s AMVR rating and compare to an index mutual fund with a similar objective before investing. The ask you financial advisor to calculate the AMVR ratings for you. If they will not do so, take that as a red flag.


To reduce risk it is necessary to avoid a portfolio whose securities are all highly correlated with each other. – Harry Markowitz

Harry Markowitz introduced the concept of Modern Portfolio Theory (MPT) in 1952. Prior to MPT, portfolios were generally constructed based on an investment’s returns and standard deviation. With MPT, Markowitz suggested that an investment’s correlation of returns with other investments should be a factor in constructing an investment portfolio.  While legitimate questions have arisen regarding some of the assumptions behind MPT and MPT’s calculation process, the value of factoring in correlations of returns between investments is indisputable.

By effectively diversifying one’s investments among investment with various levels of correlations of returns, an investor can provide their investment portfolio with both upside profit potential and downside protection against substantial loss. Unfortunately, many investors are led to believe that they can effectively diversify their portfolios by just combining various types or categories of investments (e.g., large cap growth, small cap value, international funds).

Assume that an investment portfolio is equally divided among a large cap investment (the Standard & Poor’s 500 Index), a small cap investment (the Russell 2000 Index), an international investment (the MSCI EAFE Index), and a fixed income investment (the Barclays U.S. Aggregate Bond Index). The portfolio is obviously allocated among four different asset categories. However, the portfolio is not effectively diversified in terms of risk management due to the high correlation of returns between the three equity based investments. For the five-years period between 2007-2011, the assets showed the following correlation of returns:

    • S&P 500 and Russell 2000 – 95 percent
    • S&P 500 and MSCI EAFE – 92 percent
    • Russell 2000 and MSCI EAFE – 84 percent
    • EAFE and Barclays Bond – 20 percent
    • S&P 500 and Barclays Bond – 10 percent
    • Russell 2000 and Barclays Bond – 2 percent

Therefore, the portfolio would show a 75 percent allocation to highly correlated equity based investments and 25 percent to fixed income investments, an allocation that may not be suitable for many investors given high degree of potential risk. A review of other five-year period of returns shows similar results.

CommonSense InvestSense: Before deciding on an investment portfolio, have your financial advisor prepare a correlation of returns matrix for all investments being considered. If you already have an investment portfolio, have your financial advisor or another qualified investment professional prepare a matrix for you. If the matrices differ or the advisor refuses to prepare a matrix, take that as a red flag.

The Buy-and Hold Myth

One of my favorite references to a buy-and-hold approach to investing was to re-name it as the buy-forget-and-regret approach to investing. The most common form of buy-and- hold investing calls for allocations to be made to various investments and to strictly adhere to such allocations, save for an occasional re-balancing to restore the original allocation percentages.

The primary problem with a buy-and-hold approach to investing is that it ignores the fact that history shows that the market is cyclical, alternating between up and down periods in the market. Just before the bear market of 2008, the price/equity (P/E) ratio on the S&P 500 stood at 42, well beyond historical norms and clearly unsustainable. Nevertheless, many investors did nothing in terms of wealth preservation and suffered devastating losses.

Proponents of buy-and-hold investing point to a historic study, the BHB study, that stated that approximately 93.6 percent of the variability in a portfolio’s investment returns is due to asset allocation. In many cases the financial services industry has deliberately misrepresented  the study’s findings by stating that the study shows that allocation decisions account for 93.6 percent of a portfolio’s returns. The BHB study never made such a representation, as the study looked at variability of returns, which is significantly different from the returns themselves.

Unethical financial advisors point to BHB in support of not making changes to one’s portfolio. Such advisors dismiss the thought of making changes in one’s portfolio as market timing, which is difficult to execute successfully. However, truth be told, one could argue that the rebalancing advocated by the buy-and-hold approach is market timing.

The truth is that classic market timing is defined as moving one’s investments so as to be 100 percent in a particular investment based upon one’s perception of market conditions. The 100 percent is dangerous, both in terms of returns and costs. Taking a proactive approach to investing and making adjustments in one’s portfolio when market and/or economic conditions merit such strategies is simply good sense.

A dynamic approach to portfolio management is in accord with strategies suggested by investment legends. Benjamin Graham, suggested an allocation of 50 percent stocks and 50 percent bonds, with an allowance for sliding between 25 percent minimum and 75 percent maximum, depending on the market and economic conditions. Nobel laureate Dr. William F. Sharpe has recently proposed the use of adaptive asset allocation policies, with adjustments in asset allocation to reflect as changes in total market values.

Advocates of the buy-and-hold approach to investing point out that making changes in a portfolio may result in a taxable event. This is true, although there should be no tax consequences in making changes within a tax-deferred account.

Even if changes did result in a taxable event, the potential benefits in making such changes should be considered. Professor Javier Estrada of the IESE Business School studied the impact of missing the best and the worst days on the Dow Jones Industrial Average (DJIA) for the period 1990-2006. The study found that missing the best 10, 20  and 100 days on the DJIA would have reduced an investor’s terminal wealth by 38 percent, 56.8 percent and 93.8 percent, respectively. Conversely, avoiding the worst 10, 20, and 100 days on the DJIA over the same period would have improved an investor’s terminal wealth by 70.1 percent, 140.6 percent, and 1,619.1 percent, respectively.

To ignore the cyclical nature of the markets is foolish. As the Chinese philosopher Lao Tzu once said, “the easiest way to control something is to take advantage of its natural tendencies.” Or. as Will Rogers once said, “even if you’re on the right track, you’ll get run over if you just sit there.”

CommonSense InvestSense: Construct an effectively diversified investment portfolio, then monitor changes in the markets and the economy and act proactively to preserve wealth by reallocating your resources properly when market and/or economic conditions indicate such a move is prudent.


Thomas Jefferson once wrote, “knowledge is power, knowledge is protection, knowledge is happiness.”  As the byline on our blog states, the proactive investor has the power to protect his/her financial security. By taking the time to learn the strategies discussed herein, an investor can better protect themselves and avoid unnecessary financial loss due to unethical individuals and practices.

© Copyright 2013 InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

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