Four Things Every Investor and Fiduciary Should Remember-2016

The abundance of investment products and investment information available today can be intimidating and confusing to many investors, both novice and professional. Without question, the most common questions I get from people are how to properly manage their investment portfolios and/or how to evaluate financial advisers.

Over my twenty-plus years as an attorney and investment adviser, I have tried to help others focus on some of the critical information in order to avoid unnecessary investment losses, to help level the playing field against some of the ne’er-do-well that continue to defraud the public and plague the financial services industry.

I started thinking about some of the “inside” information I have shared with my clients that produced the most reaction and appreciation.  In hindsight, I think four core facts/numbers/principles have stood out the most to me and my clients.

1. “75″ – The number “75″ is actually important for two reasons.  First, a study by Schwab Institutional found that approximately 75% of investor portfolios were poorly structured and unsuitable for their investors given the investors’ financial needs and goals.  I believe that this is primarily a result of the fact that (1) stockbrokers are not required to act in a client’s best interests, and (2) investors are often mislead by portfolios that appear to be diversified because they hold a number of different types of investments, but such portfolios are often not truly, effectively diversified.

The second reason that the number “75″ is important is because research and history have shown that approximately three out of four , or 75%, of stocks follow the general trend of the market.  So, bottom line, it is hard not to make in a bull market. This simply supports the popular Wall Street adage, “[don’t] confuse brains with a bull market.”

2. “94″ – While there are many firms and individuals in the financial services industry calling themselves wealth managers, a study by CEG Worldwide, a well-respected financial services consulting firm, concluded that 94% of those calling themselves wealth managers or claiming to provide wealth management services failed to meet the criteria used to qualify as wealth managers.  The criteria that CEG used in their study to determine true wealth management was based primarily on advisers who practiced wealth management as a process as compared to those who simply used “wealth management” as a marketing ploy to push product.  This is the same criteria that investors and fiduciaries should use in choosing a financial advisor to work with.

Secondly, one expert has suggested that this number (OK, actually 93.6, which rounded off is 94), and the study that produced it may have caused more damage to investors than any other number/study.  The number comes from the famous 1986 Brinson, Hood and Beebower (BHB) study that stated that 93.6% of the variation of a portfolio’s returns could be explained by the portfolio’s asset allocation.

The study did not say that asset allocation explained 93.6% of the portfolio’s actual returns, but rather the variation of the portfolio’s returns.  Nevertheless, dishonest brokers and advisers misrepresented, and still do misrepresent,  the BHB study’s findings to convince investors to choose an asset allocation and rigidly adhere to it, despite the proven cyclical nature of the markets.  This is the mantra of the” buy and hold” approach to investing, an approach that some have suggested is better described as the “buy, hold and regret” approach to investing.  Just ask investors how well that worked during the 2000-2002 and 2008 bear markets.

3. Zero – This number represents the number of variable annuities (VA) and equity indexed annuities (EIA) an investor should own.  As a former compliance officer and a current securities attorney I have heard all the convoluted and conniving justifications for these atrocities.  I have written posts and articles warning investors about these products.  While there may be a few limited instances where they may make sense, such as wealth preservation for high net worth investors, the way they are marketed to the masses is extremely questionable.

One Wall Street Journal article reported that variable annuity salesmen were told to treat potential annuity clients as “blind twelve-year-old,” and to “put a pitchfork in their chests,” and provide questionable responses to potential client’s questions.  VA salesmen and VA advertisements often tout that by purchasing a VA the investor will never run out of money.

What is often not made clear that in order to guarantee that lifetime stream of money, you give up all rights to the money invested in the VA.  Once you annuitize your VA, the balance goes to the insurance company once you die, not to your heirs.  In most cases the insurance company offers various choices for payout, such as joint survivor and a guaranteed period, but these options generally result in lower periodic payouts and, in  some cases, additional fees.

One of the most onerous aspects of VAs is the excessive fees that most VAs charge, especially with regard to the so-called death benefit.  VAs typically guarantee that in the event the VA owner dies without having annuitized the VA, the owner’s heirs will receive either the accumulated value of the VA at the time of the owner’s death or the amount of the owner’s actual investment in the VA, whichever is greater.  So the VA issuer is only insuring the amount that the VA owner actually puts in the VA.

Meanwhile, the insurance company assesses the VA’s annual death benefit fee not on the basis of their actual legal obligation, which is the amount of the VA owner’s actual investment, but rather on the accumulated value of the VA.  One study estimated that the actual expense of the annual was approximately 0.10-0.12, but that the insurance companies often charged approximately 1.50%, or approximately fifteen times the estimated value, resulting in a nice windfall for the insurance company.  The additional fee also cost a VA investor by reducing this investment return.

EIAs are also problematic.  EIAs are generally sold with the pitch that investors can earn the same return that the stock market does, with the guarantee that even if the market is down, the EIA investor is guaranteed a minimum return.  What many investors are told is that the potential return is usually capped at a relatively low number, say 10%, and then  is reduced even more by a “participation rate,” usually an additional 2-3% reduction.  In short, the EIA investor is looking at annual rate of between 2-7%.  If the market is up 20% or more for the year, just who is getting the benefit of the excess over the investor’s return?

4. “Portfolio management is-and always should be-a defensive process.” – Charles Ellis

As people who follow me know, I am a devoted fan of Charles D. Ellis. In my opinion, his book, “Wining the Loser’s Game,” is the best book on investing and should be required reading for every investor.

Far too many investors and financial advisers spend their time chasing investment returns. As we discussed earlier, three out of four stocks follow the general trend of the market. So the market will take care of the upside. Investors, fiduciaries and investment professional should spend more time implementing strategies to that will provide downside when the inevitable market corrections and bear markets occur. Yet few do.

When I speak to groups of investors I always reinforce the value of defensive investing by ask pose the standard 50% loss/50% gain question to them – if my $10,000 portfolio loses 50% in year 1, followed by a 50% gain in year 2, what is the value of my portfolio at the end of year 2? Invariably, there will be those that say the value of the portfolio is zero (50-50). The correct is answer is obviously $7,500, since the 50% return in year 2 was only the $5,000 value as a result of the 50% loss in year 1. (Note: For those interested , the formula for calculating the amount of return needed to recover from a loss is [(1/1-percentage of loss)-1] times 100.)

Many stockbrokers and other financial advisers try to discount such losses by blaming the markets and claiming that everyone is also losing money, that simply is not, and should not be true, at least not to the same extent as those who failed to implement effective defensive strategies in constructing and managing their investment portfolios. Whether the chosen strategy is as simple as proper diversification and/or rebalancing, or a little more advanced strategy such as the use of protective puts and/or inverse index funds, there are effective wealth preservation strategies that can help provide the downside protection that all investors need to reduce potential investment losses.

Investment losses are not only costly in terms of the actual loss sustained, but they also constitute an opportunity cost since once the market does recover, the capital lost during the downturn in the market cannot fully participate in the new gains in the market since it must help recover from the previous loss. As I tell [people, “you’ll never get ahead if you have to spend all of your time catching up.”

In my practice, I believe that adopting a defensive approach to wealth management includes preventing losses due to unnecessary fees and costs since they also reduce an investor’s end return . By focusing on investments that are cost-efficient, an investor can attempt to maximize the benefits of compound returns on their portfolio.

I created the Active Management Value Ratio™ 2.0 (AMVR) to provide investors, attorneys, financial advisers and other financial professional with a simple means of evaluating the prudence of actively managed mutual funds. Despite their poor historical performance records against passively managed, or index, funds and the facts their fees and other costs are often 300-400 higher than index funds, approximately 80 percent of all money invested in U.S. mutual funds is invested in actively managed mutual funds.

The AMVR is based on studies by investment icons Charles Ellis and Burton Malkiel. As Ellis points out in “Winning the Loser’s Game,”

Index funds reliably produce a “commodity product” that reliably delivers the market rate of return with no more than market risk….When a commodity product is widely available, the real cost of any alternative is the incremental cost as a percentage of the incremental value. 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 the risk-adjusted incremental returns above the market index.1

[T]he incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fee for a comparable index fund relative to its returns. When you do this, you’ll quickly see that the incremental fees for active management are really, really high – on average, over 100 percent incremental returns!2

That’s right: All the value added – plus more – goes to the manager, and there’s nothing left over for the investors who put up all the money and took all the risks.

In computing a fund’s incremental costs, the AMVR uses both a fund’s stated expense ratio and a calculation of the fund’s trading costs. While many investment formulas factor in a mutual fund’s expense ratio, I have never seen a formula that includes a fund’s trading costs in the evaluations process.

One of the reasons for this oversight may be the fact that mutual funds are not legally required to report their actual trading costs. However, trading costs are a legitimate issue, as they do reduce a fund’s bottom line and, consequently an investor’s end return. Furthermore, as noted by investment icon Burton Malkiel in his classic, “A Random Walk Down Wall Street,”

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting the future performance [of mutual funds] are expense ratios and turnover.

The process for calculating the AMVR for an actively managed mutual fund is straightforward and only requires the ability to add, subtract and divide.The data needed to perform the calculation is available online for free at such site as,,and

A fund’s AMVR score is calculated by dividing a fund’s incremental, or additional, costs by the fund’s incremental, or additional, returns. If a fund fails to provide any positive incremental returns above and beyond those of a less costly index fund, then the fund is obviously not a prudent investment option. Likewise, if a fund does provide a positive incremental return, but the fund’s incremental costs exceed such incremental return, then the fund is obviously not a prudent investment since an investor would actually lose money on the investment. A more detailed description of the AMVR and the calculation process is available here.

The AMVR also provides a means for investors to evaluate the quality of advice that they are receiving from their financial advisers. Investors should perform their own AMVR calculations on the investments being recommended to them or that are actually in their investment portfolios and immediately question any recommendations that fail to produce an acceptable AMVR score. Investors in 401(k), 403(b) or similar pension plans should calculate the AMVR score for each investment option in their plan and question any investment option with an unacceptable AMVR result.

So that’s my approach to successful wealth management in a nutshell. I do use some additional screens in analyzing investment portfolios, but the AMVR has proven to be very effective as a first step in eliminating imprudent investments. Investors and fiduciaries that use the AMVR and remember the principles and numbers discussed in this article should be in a better position to protect both their financial security and/or their clients’ financial  security.

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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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