We wrote about portfolio diversification a while ago - we related how a 15 - 25 stock portfolio can give you 90% of the benefits of diversification and how a 40 stock portfolio can give you 99% of the benefits. (Diversifying away non-systemic - company specific - risk is important in achieving the highest possible return for the amount of risk taken). We work hard educating our clients on the importance of building properly diversified and appropriate portfolios consisting of stocks and bonds. Properly diversified to us means eliminating all unnecessary risk while appropriate means putting our clients at a risk (and return) level that works for their financial situation and temperament.
But what about individual stock selection? If strategic asset allocation (the percentage of a portfolio allocated to stocks, bonds, real estate, commodities, and cash) accounts for most of the variation in returns over the long run (and it does), why even bother with individual security selection?
A very good question indeed!
Because we can add to returns with careful security selection and reduce taxes through tax loss harvesting. The empirical evidence overwhelmingly shows that we can outperform the market using a common sense approach to investing - buying businesses when they are trading for less than a knowledgeable buyer would pay for the entire company in an arms length transaction. In other words, buying companies when they are trading cheaply. It only makes sense! An investor should outperform the market over the long run by purchasing undervalued businesses and avoiding overvalued businesses - and the academic data supports that view.
How is it possible that the market is inefficient enough to give value investors a known edge over other types of investors? Economics 101 teaches us that excess profits in a capitalistic system are eventually competed away. Why don't the majority of investors recognize that value investing brings superior returns and join the gravy train?
The answer lies with some well-known investor biases that endure, despite wide recognition that they exist. People will be people! It is estimated that only about 10% of investors are value investors while the other 90% chase growth and momentum. Value investors are able to take advantage of investor biases which create excess profit opportunities for them. For instance, investors routinely associate good companies with good investments and are willing to pay a premium for them in the stock market. The Behavioral Finance term is "representativeness". Good companies are usually widely recognized as such and are highly priced as a result - and on average they under perform the market going forward. Likewise, investors routinely associate low growth (bad) companies with poor investments and shun them, creating a profit opportunity for the savvy value investor.
As well, a majority of investors expect stocks with poor liquidity (thinly traded) to have lower returns, yet the empirical evidence shows otherwise. Also, investors expect lower returns from stocks that are not widely followed by the financial analyst community, yet the evidence contradicts that expectation. Less widely followed stocks actually tend to outperform.
It really isn't rocket science. Rather, it is having the patience and discipline to buy a good company at a great price (or a great company at a good price) and waiting for the herd to recognize that it was overly pessimistic. It is also about having the discipline NOT to buy a stock just because the entire stock market it rising. We will not pay up for an investment - ever! Price discipline makes for successful investing and we never forget it at Biechele Royce Advisors. Although we aren't willing to market time per se, we are willing to let cash build up in our client accounts if we can not find good businesses at great prices or great businesses at good prices. Price discipline is risk management and risk management is a must during a secular bear market.
Thursday, August 6, 2009
Friday, July 10, 2009
Mutual Funds and Benchmarks
Many people are invested in mutual funds. Most people have no clue how to tell if their mutual funds are better or worse than average. Many people allow their financial advisor, planner, accountant, or fee-based advisor (broker) to put them into mutual funds but must take their advisors word for the "best-in-breed" claim. Unfortunately the reality is that actively managed mutual funds do not out perform their unmanaged benchmarks on a risk-adjusted basis after taking fees into account. Furthermore, the mutual funds that do outperform their benchmarks on a risk-adjusted basis over trailing five and ten year periods are unlikely to outperform going forward. In other words, the top ten performing mutual funds in a market segment - say large cap - over the trailing ten year period are unlikely to be the same funds that out perform over the following ten year period. Bottom Line? There is no way to know in advance which funds will outperform their benchmarks on a risk-adjusted basis, net of fees, over five and ten year periods.
Now stop and think through what I just wrote. Most financial advisors tout their mutual fund picking ability as a primary reason to hire them (never mind the fact that their advice is often skewed by which funds pay the best commission!). Yet the brainiacs ensconced in the ivory towers of Wharton, the University of Chicago, and Harvard will tell you in excruciating detail why it is impossible to know a priori which mutual funds will out perform their benchmarks. John Bogle of Vanguard has it right! Index funds will beat the majority of actively managed mutual funds over long periods of time and, therefore, are above average!
Now stop and think about THAT for a moment. You can actually outperform the majority of mutual funds over the long run simply by indexing. Furthermore, since an index fund merely matches its benchmark's risk (average risk) yet outperforms the majority of peer group funds, you are able to know in advance that you are investing in a fund with a favorable risk/reward relationship (average risk and above average reward). And you didn't even need a Morningstar report to figure it out!
But since many of you are determined to speculate on mutual funds much in the same way that many of you speculate on individual stocks, here's the appropriate way to measure your actively managed fund's performance. You must compare your fund to the asset subclass in which it invests. A large cap growth fund should be bench marked against the Russell 1000 growth index and a large cap value fund should be bench marked against the Russell 1000 value index. In both cases, you should adjust for risk. Unfortunately, even then it isn't quite so simple since most fund managers cheat. Large cap fund managers will add small and mid cap stocks, or foreign stocks to their portfolio in an effort to beat their benchmark by going outside the appropriate universe of stocks. Of course they will sell those stocks before the required reporting period so that no one is the wiser - the practice of cleaning up the portfolio prior to reporting holdings is known as window dressing and is a common Wall Street practice.
To recap: Investors who use mutual funds should index. The academic case is overwhelming. Index funds outperform the majority of their actively managed peer group with only average risk. You don't need a fee-based financial advisor (aka broker) to pick actively managed mutual funds for you, since he's whistling in the dark anyway, while collecting commissions on those A, B, and C shares. What you need is someone to help you arrive at an appropriate strategic asset allocation and then implement that allocation with index funds. Better still, seek out a financial advisor that employs Chartered Financial Analysts capable of building low-cost stock portfolios chock full of businesses purchased at less than their fair market value, because the same academic research that categorically shows it is better to index than attempt to pick mutual fund outperformers, also shows that value investing outperforms the market over the long run!
Now stop and think through what I just wrote. Most financial advisors tout their mutual fund picking ability as a primary reason to hire them (never mind the fact that their advice is often skewed by which funds pay the best commission!). Yet the brainiacs ensconced in the ivory towers of Wharton, the University of Chicago, and Harvard will tell you in excruciating detail why it is impossible to know a priori which mutual funds will out perform their benchmarks. John Bogle of Vanguard has it right! Index funds will beat the majority of actively managed mutual funds over long periods of time and, therefore, are above average!
Now stop and think about THAT for a moment. You can actually outperform the majority of mutual funds over the long run simply by indexing. Furthermore, since an index fund merely matches its benchmark's risk (average risk) yet outperforms the majority of peer group funds, you are able to know in advance that you are investing in a fund with a favorable risk/reward relationship (average risk and above average reward). And you didn't even need a Morningstar report to figure it out!
But since many of you are determined to speculate on mutual funds much in the same way that many of you speculate on individual stocks, here's the appropriate way to measure your actively managed fund's performance. You must compare your fund to the asset subclass in which it invests. A large cap growth fund should be bench marked against the Russell 1000 growth index and a large cap value fund should be bench marked against the Russell 1000 value index. In both cases, you should adjust for risk. Unfortunately, even then it isn't quite so simple since most fund managers cheat. Large cap fund managers will add small and mid cap stocks, or foreign stocks to their portfolio in an effort to beat their benchmark by going outside the appropriate universe of stocks. Of course they will sell those stocks before the required reporting period so that no one is the wiser - the practice of cleaning up the portfolio prior to reporting holdings is known as window dressing and is a common Wall Street practice.
To recap: Investors who use mutual funds should index. The academic case is overwhelming. Index funds outperform the majority of their actively managed peer group with only average risk. You don't need a fee-based financial advisor (aka broker) to pick actively managed mutual funds for you, since he's whistling in the dark anyway, while collecting commissions on those A, B, and C shares. What you need is someone to help you arrive at an appropriate strategic asset allocation and then implement that allocation with index funds. Better still, seek out a financial advisor that employs Chartered Financial Analysts capable of building low-cost stock portfolios chock full of businesses purchased at less than their fair market value, because the same academic research that categorically shows it is better to index than attempt to pick mutual fund outperformers, also shows that value investing outperforms the market over the long run!
Monday, June 29, 2009
Diversified Portfolios
Many people believe they have too little money in their investment portfolio to own individual stocks. They feel that mutual funds give them the "safety" of diversification. I often review portfolios for prospects and find that they are invested in five, six, ten different mutual funds. The prospects believe they are adequately diversified; after all, they own multiple mutual funds which hold one hundred plus stocks each on average. They are often surprised when I tell them that they are not very well diversified at all. They are down right disbelieving when I tell them they could get almost the same diversification with a portfolio of 25 carefully chosen stocks. The reality is that 15 to 25 well chosen stocks provide 90% of the benefits of diversification and that a 40 stock portfolio can provide 99% of the benefits of diversification. The hundreds of additional stocks owned by the mutual funds in which our prospects are invested provide almost no additional diversification benefits. Have $100,000 allocated to equities? More than enough to build a 25 stock portfolio that will adequately diversify away your non-systemic (company-specific) risk. However, you aren't properly diversified just because you own a properly diversified stock portfolio.
A properly diversified stock portfolio provides nowhere near the diversification benefits of investing among different asset classes. Small, large, domestic, and international stocks are sub-asset classes, not truly separate asset classes. After all, stocks tend to move together because companies tend to prosper or suffer together as economies expand or contract. Rather than limiting oneself to a single asset class, investors should build a properly diversified portfolio containing all four major asset classes (the historical data indicates that a four asset class portfolio composed of stocks - domestic and international, bonds, real estate, and commodities provides high levels of return per unit of risk).
The famous Brinson, Hood, and Beebower (BHB) study done in 1986 indicated that approximately 92% of a portfolios' variation of returns is due to the mix of asset classes chosen. BHB used stocks, bonds, real estate, and cash in their study. Simply put, the percentage of each asset included in your portfolio will go a long way in determining your returns and the volatility of your returns over the long run. Individual security selection and market timing are not major determinants of long run returns and variation of returns relative to the asset classes in which you choose to invest. (Importantly, the value style of investing does outperform so-called growth and momentum styles over the long run and therefore does add to an investor's returns).
Consider that approximately 80% of actively managed stock mutual funds don't beat their benchmarks. Most large cap funds don't beat the S&P 500 index (large cap). Most small cap funds don't beat the Russell 2000. Furthermore, the funds that do beat their benchmarks vary from year to year and there is no evidence whatsoever that a savvy financial advisor can pick a priori (in advance) which funds will outperform (Connecting the dots - your financial advisor or planner is blowing smoke when he confidently informs you that he'll only put you into the best mutual funds, since he can't possibly know which ones those will be. Unfortunately, too many financial advisors put their clients in mostly, or only, stock mutual funds and they tend to use the ones with the highest commissions!)
Okay, to review: a 25 stock portfolio will get you 90% of the benefits of diversification and a 40 stock portfolio will get you 99% of the benefits (assuming diversification is your goal). But is that a properly diversified portfolio? Stock portfolio - yes, investment portfolio - NO!
Multiple-Asset-Class investing offers demonstrably superior results to investors, providing high rates of return with less volatility than one, two, and three asset class portfolios. For instance, an equally weighted four asset class portfolio (composed of domestic stocks, international stocks, bonds, and commodities) returned 11.24% per annum from 1972 through 2008 with a standard deviation of only 14.11%, resulting in a Sharpe ratio of 0.46 (high). What that means for us individual investors is that we want to create portfolios containing stocks (domestic and international), bonds, real estate and commodities for the long-term. Importantly, we can adjust volatility by adjusting the mix. Also importantly, we can add additional return by using value investing (paying less for a business than its worth) rather than growth investing (paying a premium for a business) or momentum investing (buying a stock simply because it is going up).
A properly diversified stock portfolio provides nowhere near the diversification benefits of investing among different asset classes. Small, large, domestic, and international stocks are sub-asset classes, not truly separate asset classes. After all, stocks tend to move together because companies tend to prosper or suffer together as economies expand or contract. Rather than limiting oneself to a single asset class, investors should build a properly diversified portfolio containing all four major asset classes (the historical data indicates that a four asset class portfolio composed of stocks - domestic and international, bonds, real estate, and commodities provides high levels of return per unit of risk).
The famous Brinson, Hood, and Beebower (BHB) study done in 1986 indicated that approximately 92% of a portfolios' variation of returns is due to the mix of asset classes chosen. BHB used stocks, bonds, real estate, and cash in their study. Simply put, the percentage of each asset included in your portfolio will go a long way in determining your returns and the volatility of your returns over the long run. Individual security selection and market timing are not major determinants of long run returns and variation of returns relative to the asset classes in which you choose to invest. (Importantly, the value style of investing does outperform so-called growth and momentum styles over the long run and therefore does add to an investor's returns).
Consider that approximately 80% of actively managed stock mutual funds don't beat their benchmarks. Most large cap funds don't beat the S&P 500 index (large cap). Most small cap funds don't beat the Russell 2000. Furthermore, the funds that do beat their benchmarks vary from year to year and there is no evidence whatsoever that a savvy financial advisor can pick a priori (in advance) which funds will outperform (Connecting the dots - your financial advisor or planner is blowing smoke when he confidently informs you that he'll only put you into the best mutual funds, since he can't possibly know which ones those will be. Unfortunately, too many financial advisors put their clients in mostly, or only, stock mutual funds and they tend to use the ones with the highest commissions!)
Okay, to review: a 25 stock portfolio will get you 90% of the benefits of diversification and a 40 stock portfolio will get you 99% of the benefits (assuming diversification is your goal). But is that a properly diversified portfolio? Stock portfolio - yes, investment portfolio - NO!
Multiple-Asset-Class investing offers demonstrably superior results to investors, providing high rates of return with less volatility than one, two, and three asset class portfolios. For instance, an equally weighted four asset class portfolio (composed of domestic stocks, international stocks, bonds, and commodities) returned 11.24% per annum from 1972 through 2008 with a standard deviation of only 14.11%, resulting in a Sharpe ratio of 0.46 (high). What that means for us individual investors is that we want to create portfolios containing stocks (domestic and international), bonds, real estate and commodities for the long-term. Importantly, we can adjust volatility by adjusting the mix. Also importantly, we can add additional return by using value investing (paying less for a business than its worth) rather than growth investing (paying a premium for a business) or momentum investing (buying a stock simply because it is going up).
Monday, May 18, 2009
The Really Big Picture
I had a prospective client ask me the other day how we were handling the current stock market rally. He wanted to know if we planned on raising cash as the rally progressed or whether we thought this was the start of a new bull market. My prospect's question certainly isn't unusual. In fact, CNBC and the other popular media outlets spend hours debating those same questions. Speculating on where the stock market is going, what interest rates will do, whether commodity prices will rise once again this year - these are the questions to which people want answers. And, Wall Street provides those answers in abundance, although many of the answers contradict one another and most of the answers turn out to be wrong - predictable once you realize that it is all just speculation about an unknowable future.
Yet most individuals are so indoctrinated into the Wall Street mindset of prediction that they view it as a normal part of investing. Buy a stock because it may go up in the next six to twelve months - that's what the typical mutual fund manager tries to do. Look at ways to predict that a stock will rise in the short term - for surely six to twelve months is the short term. Upside earnings surprises, stock price momentum, rising earnings estimates, beating revenue forecasts - all designed to capture a short term stock price move. The problem? Not much in the way of business valuation gets done by the majority of investors, which is the core of any true investment methodology. Successful investors buy businesses for less than they are worth and sell them for more than they are worth. Business valuation is the core and price paid is the THE key.
I did answer my prospects questions. After all, I have just as much fun as the next guy trying to predict what the economy and the stock market will do next. It's fun, fascinating and endlessly entertaining, but I don't forget for one instant that it is still speculation and I make very sure to use my forecasts only as a backdrop for our core investing discipline in order to help us with risk management. For the record, I don't think this is the start of a new bull market; the economy is not yet on the mend, despite all of the cheer leading now emanating from the government and the talking heads on the Street. As well, any expansion is likely to be short lived once the economy does begin to respond to the massive fiscal and monetary stimulus that has been applied. The United States has simply taken on too much debt and has an insufficient ability to earn enough to pay it off. In short, the economy will continue to founder for years (perhaps decades) under the weight of the ever growing mountain of debt our government and corporate America have assumed.
Enough of the macroeconomics though. Now I want to answer my prospects question on how we are handling the current rally in the hope of passing along something useful to you.
We buy businesses when they are selling for substantially less than what we think a knowledgeable third party would pay for the entire business in an arm's length transaction. Bear markets create plenty of opportunities to buy good companies for great prices and great companies for good prices. We are currently buying hand over fist because we are finding plenty of bargains. Conversely, bull markets make for far fewer opportunities to make great investments, which means we will often end up holding cash toward the end of a bull market because we can't find a worthwhile investment.
We do adjust our buy discipline for macroeconomic factors. It was obvious to us in late 2007 and early 2008 that the financial sector was toast. The red flags were everywhere. We will not buy a business at any price if we don't think the business is viable, which means the balance sheet must be strong enough to allow a company to survive. The banking system is currently insolvent as a whole and the rules of the game change daily as the government attempts to salvage it - we will not buy into the banks at any price right now.
Likewise, we adjust our sell discipline for macroeconomic factors. During the great secular bull market of the 1990s it was reasonable to hold businesses longer than we normally would as the bull market pushed valuations further than justified. Rather than selling a business as it returned to fair value, we commonly held them a bit longer if the chart indicated that the uptrend was intact. However, price risk is not something you want to take during a secular bear market, which means we are currently much more aggressive selling investments as the market pushes them back near fair value.
And that is how we're handling the current rally. We are aggressively buying good businesses at great prices and great businesses at good prices but with the expectation of selling them as they approach fair value because we do not think that the next great bull market is anywhere close at hand.
Yet most individuals are so indoctrinated into the Wall Street mindset of prediction that they view it as a normal part of investing. Buy a stock because it may go up in the next six to twelve months - that's what the typical mutual fund manager tries to do. Look at ways to predict that a stock will rise in the short term - for surely six to twelve months is the short term. Upside earnings surprises, stock price momentum, rising earnings estimates, beating revenue forecasts - all designed to capture a short term stock price move. The problem? Not much in the way of business valuation gets done by the majority of investors, which is the core of any true investment methodology. Successful investors buy businesses for less than they are worth and sell them for more than they are worth. Business valuation is the core and price paid is the THE key.
I did answer my prospects questions. After all, I have just as much fun as the next guy trying to predict what the economy and the stock market will do next. It's fun, fascinating and endlessly entertaining, but I don't forget for one instant that it is still speculation and I make very sure to use my forecasts only as a backdrop for our core investing discipline in order to help us with risk management. For the record, I don't think this is the start of a new bull market; the economy is not yet on the mend, despite all of the cheer leading now emanating from the government and the talking heads on the Street. As well, any expansion is likely to be short lived once the economy does begin to respond to the massive fiscal and monetary stimulus that has been applied. The United States has simply taken on too much debt and has an insufficient ability to earn enough to pay it off. In short, the economy will continue to founder for years (perhaps decades) under the weight of the ever growing mountain of debt our government and corporate America have assumed.
Enough of the macroeconomics though. Now I want to answer my prospects question on how we are handling the current rally in the hope of passing along something useful to you.
We buy businesses when they are selling for substantially less than what we think a knowledgeable third party would pay for the entire business in an arm's length transaction. Bear markets create plenty of opportunities to buy good companies for great prices and great companies for good prices. We are currently buying hand over fist because we are finding plenty of bargains. Conversely, bull markets make for far fewer opportunities to make great investments, which means we will often end up holding cash toward the end of a bull market because we can't find a worthwhile investment.
We do adjust our buy discipline for macroeconomic factors. It was obvious to us in late 2007 and early 2008 that the financial sector was toast. The red flags were everywhere. We will not buy a business at any price if we don't think the business is viable, which means the balance sheet must be strong enough to allow a company to survive. The banking system is currently insolvent as a whole and the rules of the game change daily as the government attempts to salvage it - we will not buy into the banks at any price right now.
Likewise, we adjust our sell discipline for macroeconomic factors. During the great secular bull market of the 1990s it was reasonable to hold businesses longer than we normally would as the bull market pushed valuations further than justified. Rather than selling a business as it returned to fair value, we commonly held them a bit longer if the chart indicated that the uptrend was intact. However, price risk is not something you want to take during a secular bear market, which means we are currently much more aggressive selling investments as the market pushes them back near fair value.
And that is how we're handling the current rally. We are aggressively buying good businesses at great prices and great businesses at good prices but with the expectation of selling them as they approach fair value because we do not think that the next great bull market is anywhere close at hand.
Tuesday, May 5, 2009
Medicare Supplements
Medicare isn't the end all and be all of medical care for seniors. The truth is that most seniors need supplemental insurance if they can't afford to reach into their pockets repeatedly as they grow older and require increasing amounts of medical attention. In fact, practically everyone needs a Medigap or Medicare Supplement policy. The only folks who probably don’t need a supplement are those who qualify for Medicaid or another government assistance program. It is important to sign up during the 6-month window provided by law after turning 65 to avoid having to qualify medically. The six month window allows you to enroll in any plan you like; you may lose that freedom of choice if you miss the window and your health is questionable.
You need to understand what Medicare is and isn't to understand the value of a supplemental policy. Medicare is a federally funded health insurance plan for citizens of the US who are age 65 and above. Medicare Part A is an automatic enrollment and costs nothing. This is the “Hospital” coverage portion of Medicare. Individuals must enroll in Medicare Part B which covers out of hospital charges; doctor’s visits, lab work, outpatient surgeries and the like. Part B coverage is paid out of your social security benefit and currently costs $98.00 per month.
One of the most misunderstood things about Medicare is how it pays benefits. Many seniors think that it will pay for all their medical expenses and that can be a costly error. The reality is that Medicare comes in two parts. The 2009 Part A Deductible is $1068.00 annually and is for hospital stays. The 2009 Part B Deductible is $ 135.00 annually and is for non hospital expenses. Now here is the IMPORTANT part. Medicare does not pay 100% after the deductible is met, instead paying only 80% of the costs. And that is very important to understand because if an individual with Medicare parts A & B goes into the hospital and generates a $100,000.00 bill from their stay, then that individual would owe approximately $20,000.00 to the provider. Yikes!
But that is where Medigap policies enter the picture as they are designed to pay one or both deductibles and the 20% remaining balance that Medicare does not pay. Remember that $20,000 bill we generated with our single hospital stay, even after Medicare had paid its portion? Your bill would drop to $0.00 with a Medigap policy.
Now you do have choices to make regarding which plan is right for you. There are 10 STANDARD Medicare supplement plans (standardized by the federal government a few years back). Pricing and the actual plan details are the key as every insurance company must provide an identical standardized plan by law. Of course, the financial strength of the insurance company is also a front and center issue. One important attribute of the standardized plans is that they allow policyholders to go to any doctor/hospital that accepts Medicare assignment. It is critical that prospective buyers understand that Medicare Select policies and some of the newer policies such as the "Advantage Plans" severely restrict your access to doctors and hospitals and also require you to make co-payments for services, as well as limit some benefits. Non-standardized plans are not necessarily wrong for you, but you do need to make sure you understand what you are and aren't getting for your money.
Seniors who currently have a plan can shop for another, cheaper one as long as they qualify by answering a few health questions. There are no lengthy exams and the underwriting decision is usually made within a few hours. Premiums for Standard plans are determined by age, take into account whether you are a smoker, and sometimes are adjusted based on medicines prescribed. You should expect to pay around $100.00 per month for age 65 up to around $240.00 per month for a 90 year old depending on the plan you choose.
It is worth while talking to an agent when shopping around for a plan. Agents are paid a commission from the insurance company so no direct fees to the client are involved. Of course, the insurance company will seek to recoup those commissions with a portion of the premiums paid. A knowledgeable agent should be able to help a senior with the choice of a supplemental plan that makes sense for the senior while also advising on an Rx plan under Medicare Part D (the prescription drug portion of Medicare that currently offers 75 different options). Another service that an agent can provide is accessing a clients qualifications to see if they are eligible for free or discounted medications. Any agent you choose should have some experience in the insurance industry, the ability to review part D for you, have an understanding of low cost Rx plans, and also be able to advise the client on other senior products, such as long term care planning.
In summary: Medicare Standard plans allow the owner the most flexibility and best coverage. They are a commodity product though so shop price. While Select and “Advantage” plans may be less expensive, you are restricted in choice of providers and may have poorly disclosed co-pays for each service. It is important that you understand exactly what you are and aren't getting in these non-standard plans. And don't forget that you may replace your current plan for less benefits, more benefits, or a lower price.
(I'd like to thank Bob Dorman of Dorman Benefit Consultants for providing invaluable help with researching the article.)
You need to understand what Medicare is and isn't to understand the value of a supplemental policy. Medicare is a federally funded health insurance plan for citizens of the US who are age 65 and above. Medicare Part A is an automatic enrollment and costs nothing. This is the “Hospital” coverage portion of Medicare. Individuals must enroll in Medicare Part B which covers out of hospital charges; doctor’s visits, lab work, outpatient surgeries and the like. Part B coverage is paid out of your social security benefit and currently costs $98.00 per month.
One of the most misunderstood things about Medicare is how it pays benefits. Many seniors think that it will pay for all their medical expenses and that can be a costly error. The reality is that Medicare comes in two parts. The 2009 Part A Deductible is $1068.00 annually and is for hospital stays. The 2009 Part B Deductible is $ 135.00 annually and is for non hospital expenses. Now here is the IMPORTANT part. Medicare does not pay 100% after the deductible is met, instead paying only 80% of the costs. And that is very important to understand because if an individual with Medicare parts A & B goes into the hospital and generates a $100,000.00 bill from their stay, then that individual would owe approximately $20,000.00 to the provider. Yikes!
But that is where Medigap policies enter the picture as they are designed to pay one or both deductibles and the 20% remaining balance that Medicare does not pay. Remember that $20,000 bill we generated with our single hospital stay, even after Medicare had paid its portion? Your bill would drop to $0.00 with a Medigap policy.
Now you do have choices to make regarding which plan is right for you. There are 10 STANDARD Medicare supplement plans (standardized by the federal government a few years back). Pricing and the actual plan details are the key as every insurance company must provide an identical standardized plan by law. Of course, the financial strength of the insurance company is also a front and center issue. One important attribute of the standardized plans is that they allow policyholders to go to any doctor/hospital that accepts Medicare assignment. It is critical that prospective buyers understand that Medicare Select policies and some of the newer policies such as the "Advantage Plans" severely restrict your access to doctors and hospitals and also require you to make co-payments for services, as well as limit some benefits. Non-standardized plans are not necessarily wrong for you, but you do need to make sure you understand what you are and aren't getting for your money.
Seniors who currently have a plan can shop for another, cheaper one as long as they qualify by answering a few health questions. There are no lengthy exams and the underwriting decision is usually made within a few hours. Premiums for Standard plans are determined by age, take into account whether you are a smoker, and sometimes are adjusted based on medicines prescribed. You should expect to pay around $100.00 per month for age 65 up to around $240.00 per month for a 90 year old depending on the plan you choose.
It is worth while talking to an agent when shopping around for a plan. Agents are paid a commission from the insurance company so no direct fees to the client are involved. Of course, the insurance company will seek to recoup those commissions with a portion of the premiums paid. A knowledgeable agent should be able to help a senior with the choice of a supplemental plan that makes sense for the senior while also advising on an Rx plan under Medicare Part D (the prescription drug portion of Medicare that currently offers 75 different options). Another service that an agent can provide is accessing a clients qualifications to see if they are eligible for free or discounted medications. Any agent you choose should have some experience in the insurance industry, the ability to review part D for you, have an understanding of low cost Rx plans, and also be able to advise the client on other senior products, such as long term care planning.
In summary: Medicare Standard plans allow the owner the most flexibility and best coverage. They are a commodity product though so shop price. While Select and “Advantage” plans may be less expensive, you are restricted in choice of providers and may have poorly disclosed co-pays for each service. It is important that you understand exactly what you are and aren't getting in these non-standard plans. And don't forget that you may replace your current plan for less benefits, more benefits, or a lower price.
(I'd like to thank Bob Dorman of Dorman Benefit Consultants for providing invaluable help with researching the article.)
Monday, April 27, 2009
Fiduciary Standard
Fee-only is different from fee-based... period, and don't let your fee-based advisor tell you any differently (and they'll try). I recently talked with a stock broker from Raymond James Financial (of course he called himself an advisor) who wanted to split hairs in an effort to get me on board with the idea that someone such as himself was really the same as a fee-only advisor. Baloney!
I politely explained to him that only a firm that gets paid solely by the client, and not by a third-party, can legally claim to be a fee-only advisor. He looked a bit puzzled and asked me what I meant. I said it was really quite simple. A fee-only advisor doesn't accept money from anyone other than their client. A fee-only advisor works for their client and their client only. When I asked him if the many mutual funds he sells his clients pay him a sales commission (a loaded fund) he reluctantly admitted that they did. Bingo! Major conflict of interest since the advisor now has a vested interest in selling you products that will make him money, paid to him by a third-party, rather than products that are in your best interest.
Fee-only, independent advisors registered with the SEC can claim fiduciary status; the manufacturers and sellers of financial products (mutual funds, variable annuities etc.) can not. In the words of Evan Cooper of InvestmentNews, "the providers of products and advice (whether known as brokers, representatives, financial consultants, financial advisors or any other title that connotes investment advice-giving) must recommend only those products that are suitable for a client," (a much looser standard that does not require the client's best interests to be placed first.) Mr. Cooper goes on to write that, "Wall Street wants to keep the suitability standard as long as it can, because it permits principal trades. If a brokerage firm can sell a bond from its inventory when a client comes in to buy, it's a lot more profitable for the firm than having to shop the order among other dealers to get the best price. There's a lot of money to be made by the brokerage business by putting the broker-dealer ahead of the investor."
Not a problem you say to yourself? You don't buy bonds from your fee-based advisor? How about stocks? Your boy gets a commission every time you buy one of his recommendations, incentivizing him to sell you stocks, whether it is in your best interest or not. And how about those front-loaded, high operating cost, 12b-1 mutual funds that are still so prevalent in the industry? Your boy gets paid every time you pony up your hard earned money to make an investment in an average performing fund that almost certainly has a no-load, lower operating cost alternative. I mean for crying out loud! There are something like 10,000 mutual funds out there now, more funds even than stocks.
Want to know the saddest part? The academic evidence overwhelming shows that no one can pick a mutual fund that will outperform its peer group a priori (in advance), which means that everyone should be focusing on costs and tax efficiency when it comes to mutual fund selection. That's right, all of those so-called advisors out there who tout their ability to put you into the best performing mutuals funds are full of you know what. The fact is (and it is a fact) that the top twenty performing mutual funds from the prior five-year investing period will not be the same top twenty who outperform over the coming five-year period. In fact, few if any names will repeat.
Oh, and one last pearl of wisdom from Mr Cooper of InvestmentNews that I couldn't agree with more, "The rules should be crystal clear. If you are licensed to give financial advice in any way, shape or form, you must put clients' interest first. If brokerage firms (and fee-based advisors) can't comply, let them reorganize themselves, or label their advice as sales promotion."
Amen!
I politely explained to him that only a firm that gets paid solely by the client, and not by a third-party, can legally claim to be a fee-only advisor. He looked a bit puzzled and asked me what I meant. I said it was really quite simple. A fee-only advisor doesn't accept money from anyone other than their client. A fee-only advisor works for their client and their client only. When I asked him if the many mutual funds he sells his clients pay him a sales commission (a loaded fund) he reluctantly admitted that they did. Bingo! Major conflict of interest since the advisor now has a vested interest in selling you products that will make him money, paid to him by a third-party, rather than products that are in your best interest.
Fee-only, independent advisors registered with the SEC can claim fiduciary status; the manufacturers and sellers of financial products (mutual funds, variable annuities etc.) can not. In the words of Evan Cooper of InvestmentNews, "the providers of products and advice (whether known as brokers, representatives, financial consultants, financial advisors or any other title that connotes investment advice-giving) must recommend only those products that are suitable for a client," (a much looser standard that does not require the client's best interests to be placed first.) Mr. Cooper goes on to write that, "Wall Street wants to keep the suitability standard as long as it can, because it permits principal trades. If a brokerage firm can sell a bond from its inventory when a client comes in to buy, it's a lot more profitable for the firm than having to shop the order among other dealers to get the best price. There's a lot of money to be made by the brokerage business by putting the broker-dealer ahead of the investor."
Not a problem you say to yourself? You don't buy bonds from your fee-based advisor? How about stocks? Your boy gets a commission every time you buy one of his recommendations, incentivizing him to sell you stocks, whether it is in your best interest or not. And how about those front-loaded, high operating cost, 12b-1 mutual funds that are still so prevalent in the industry? Your boy gets paid every time you pony up your hard earned money to make an investment in an average performing fund that almost certainly has a no-load, lower operating cost alternative. I mean for crying out loud! There are something like 10,000 mutual funds out there now, more funds even than stocks.
Want to know the saddest part? The academic evidence overwhelming shows that no one can pick a mutual fund that will outperform its peer group a priori (in advance), which means that everyone should be focusing on costs and tax efficiency when it comes to mutual fund selection. That's right, all of those so-called advisors out there who tout their ability to put you into the best performing mutuals funds are full of you know what. The fact is (and it is a fact) that the top twenty performing mutual funds from the prior five-year investing period will not be the same top twenty who outperform over the coming five-year period. In fact, few if any names will repeat.
Oh, and one last pearl of wisdom from Mr Cooper of InvestmentNews that I couldn't agree with more, "The rules should be crystal clear. If you are licensed to give financial advice in any way, shape or form, you must put clients' interest first. If brokerage firms (and fee-based advisors) can't comply, let them reorganize themselves, or label their advice as sales promotion."
Amen!
Monday, April 13, 2009
Retirement Planning Requires Goals And Balance
The talking heads on TV spend a majority of their time agonizing over the question of stock market direction. When they aren't talking stock market direction, they're talking economic trends - hoping that will help them predict stock market direction. Less often they will focus on individual stocks and try to predict their near-term direction. It is well understood within the industry that most "marks" (read individual investors) don't have the patience to actually buy a stock for the long-term (three to five years) and instead want their investments to start appreciating right away. Stock brokers get that, which is why they tout growth and momentum strategies, despite the mountain of evidence showing that those strategies under perform over the long run. Brokers know that most investors are all too happy to buy a sexy growth story, rather than buy a company selling for less than its intrinsic value.
Speaking of stock brokers, I want to be very clear what they actually do for a living. Stock brokers are out on point, selling whatever new hot products Wall Street wants sold. Oh, they've taken to calling themselves financial advisors, financial planners and "financial health coaches" (no kidding, I actually had a broker tell me recently that he tells his meal-tickets he's a financial health coach. I guess he's hoping the meal-ticket will view him like a personal trainer instead of as the commissioned based salesman that he actually is). But at the end of the day, stock brokers are exactly what they've always been, Wall Streets hit men, compensated handsomely for pushing product through the pipeline and into the hands of the unsuspecting public. John Bogle, founder of Vanguard, is on record as stating that most of Wall Street's innovations are designed to benefit Wall Street, not investors. Ya think! Legendary value investor Jean-Marie Eveillard told Consuelo Mack recently in an interview that, "When I’m in a good mood, I say Wall Street is a vast promotional machine,” Eveillard said. “When I’m in a bad mood, they are a den of thieves.” Amen! And don't forget that the "financial health coaches" aka stockbrokers, are the den-of-thieves' agents (think Mr. Smith from the Matrix)!
Okay, enough of the broker bashing (for now). Let's get to the retirement planning.
You can't know how to get there if you don't know where you're going. Sounds straight forward enough right? But you'd be surprised how many individuals really haven't sat down to figure out where they are going. For example, most individuals I talk with have actually spent very little time thinking about how big their investment portfolio should be in order to throw off enough cash in retirement to meet their desired lifestyle. One million? Two million? Three million?
How's 4 percent grab you?
William Bengen developed the 4% rule in 1994, arguing that investors could safely withdraw 4% from their balanced stock/bond portfolio in the first year, and then adjust that dollar amount upward for inflation each year. Bengen recommended an allocation as close to 75% stocks as possible, with the remainder in bonds. Subsequent research suggested a mix closer to 60/40 stocks and bonds was better. The consensus now seems to be somewhere in the 40% to 75% stock range. Cooley, Hubbard, and Waltz quantified Bengen's rule in 1998, determining that "safe" represented a 95% success rate with a 50/50 portfolio.
And success is defined as making your retirement portfolio last 30 years without running down to zero. Bengen's original findings were that the 4% rule allowed a retiree to live off his investment portfolio in every 30-year period on record from 1926 through 1994, some periods with only a few bucks to spare and some periods with millions left over. The 4% rule has maintained its success rate since 1994, despite the last eight years of horrible stock market returns.
Investors who are sophisticated enough to correctly gauge market valuations can fine tune the 4% rule based on current market valuations when they retire. It turns out (as common sense would suggest) that investors can increase their withdrawal rate when market valuations are depressed at the start of their retirement. Michael Kitces, publisher of The Kitces Report, showed in a 2008 study that safe withdrawal rates in a balanced portfolio depend on market levels. Withdrawal rates in excess of 4% are possible when valuations are depressed, based on Shiller's P/E (a 10-year trailing average). Conversely, of course, withdrawal rates should be reduced when market levels are high, as they were in 2000 and again in 2007. In fact, the greatest risk to a retiree's portfolio is severe market under performance at the beginning of the retirement period, a risk that many recent retirees are unfortunately experiencing first hand right now. The problem with stock exposure is that severe under performance at the beginning of the retirement period will leave the retiree with a depleted portfolio balance that will result in a smaller annual distribution, at least until the portfolio recovers - which can be a very long time depending on the investing period.
There are some retirement experts who believe that stocks should be avoided entirely, precisely because of the risk of early-year under performance. Robert Huebscher has written (Advisor Perspectives, March 24, 2009) that an all bond portfolio is preferable to a stock/bond portfolio. His main contention is that an all-bond portfolio offers far more certainty of success because cash flows are much more certain and total real return depends only on correctly forecasting inflation rates. He further maintains that "inflation is far more predictable than equity market returns and can be efficiently hedged using TIPS." His last main point is that, "the all-bond portfolio is insulated from the risk of historically unprecedented adverse-market conditions near the beginning of the retirement period." Although he admits that there is a risk to the all-bond portfolio - underestimating inflation.
I think Mr Huebscher makes some interesting points, but his over-all argument for an all-bond portfolio is dependent on not underestimating inflation, and that is, in my humble opinion, exactly where we stand today. I also take issue with his contention that TIPS provide an efficient means of hedging inflation. The U.S. government has a huge vested interest in under reporting inflation, since all of the cost of living adjustments for social security and federal employees and retirees are tied to the CPI. It is extremely naive to believe that our government is accurately reporting inflation. In fact, economist Dr. John Williams, of Shadowstats fame, estimates that inflation is currently running about 8% higher than the official number.
More importantly, we are at the cusp of a long period of rising inflation and rising interest rates, brought on intentionally by a government determined to debase our currency in order to make it easier to meet the $65 trillion in unfunded liabilities it has taken on over the last twenty years of unprecedented spending. Governments everywhere and always have chosen the least politically painful option of currency debasement, once they've recognized their inability to make debt payments. The process has just begun in the United States and is likely to culminate, as in the 70's, in double digit inflation rates and double digit interest rates. Now, I am making no guarantees. It is barely possible that our elected officials will do the right thing, sharply curtail spending, raise short-term rates to encourage savings, and defend the dollar at every turn in an effort to keep it front and center as the world's reserve currency. But I doubt it.
The main point, however, is that an all bond portfolio will leave retirees eating dog food in 10-years or so if my inflation scenario comes to pass (and I give it better than a 50% chance of doing so). A prudent investor would do well to maintain a balanced portfolio of stocks and bonds in order to balance the risk of a near term short fall in stocks at the beginning of retirement against a longer-term risk of loss of purchasing power with an all-bond portfolio. It is exactly the uncertainty surrounding both stock market returns AND inflation rates that demands using both asset classes to increase the likelihood of a successful retirement using the 4% rule. (And no I do not think that stocks are cheap enough yet to raise the withdrawal rate to 5%, but that is for a different blog).
Oh, and the average inflation rate since 1966 has been 4.6%, yet many financial advisors use the 2.5% to 3.0% default rates prevalent in the investment planning software used by many of them when projecting real, long-term portfolio returns for their clients. You might want to ask them why next time you speak with them...
Speaking of stock brokers, I want to be very clear what they actually do for a living. Stock brokers are out on point, selling whatever new hot products Wall Street wants sold. Oh, they've taken to calling themselves financial advisors, financial planners and "financial health coaches" (no kidding, I actually had a broker tell me recently that he tells his meal-tickets he's a financial health coach. I guess he's hoping the meal-ticket will view him like a personal trainer instead of as the commissioned based salesman that he actually is). But at the end of the day, stock brokers are exactly what they've always been, Wall Streets hit men, compensated handsomely for pushing product through the pipeline and into the hands of the unsuspecting public. John Bogle, founder of Vanguard, is on record as stating that most of Wall Street's innovations are designed to benefit Wall Street, not investors. Ya think! Legendary value investor Jean-Marie Eveillard told Consuelo Mack recently in an interview that, "When I’m in a good mood, I say Wall Street is a vast promotional machine,” Eveillard said. “When I’m in a bad mood, they are a den of thieves.” Amen! And don't forget that the "financial health coaches" aka stockbrokers, are the den-of-thieves' agents (think Mr. Smith from the Matrix)!
Okay, enough of the broker bashing (for now). Let's get to the retirement planning.
You can't know how to get there if you don't know where you're going. Sounds straight forward enough right? But you'd be surprised how many individuals really haven't sat down to figure out where they are going. For example, most individuals I talk with have actually spent very little time thinking about how big their investment portfolio should be in order to throw off enough cash in retirement to meet their desired lifestyle. One million? Two million? Three million?
How's 4 percent grab you?
William Bengen developed the 4% rule in 1994, arguing that investors could safely withdraw 4% from their balanced stock/bond portfolio in the first year, and then adjust that dollar amount upward for inflation each year. Bengen recommended an allocation as close to 75% stocks as possible, with the remainder in bonds. Subsequent research suggested a mix closer to 60/40 stocks and bonds was better. The consensus now seems to be somewhere in the 40% to 75% stock range. Cooley, Hubbard, and Waltz quantified Bengen's rule in 1998, determining that "safe" represented a 95% success rate with a 50/50 portfolio.
And success is defined as making your retirement portfolio last 30 years without running down to zero. Bengen's original findings were that the 4% rule allowed a retiree to live off his investment portfolio in every 30-year period on record from 1926 through 1994, some periods with only a few bucks to spare and some periods with millions left over. The 4% rule has maintained its success rate since 1994, despite the last eight years of horrible stock market returns.
Investors who are sophisticated enough to correctly gauge market valuations can fine tune the 4% rule based on current market valuations when they retire. It turns out (as common sense would suggest) that investors can increase their withdrawal rate when market valuations are depressed at the start of their retirement. Michael Kitces, publisher of The Kitces Report, showed in a 2008 study that safe withdrawal rates in a balanced portfolio depend on market levels. Withdrawal rates in excess of 4% are possible when valuations are depressed, based on Shiller's P/E (a 10-year trailing average). Conversely, of course, withdrawal rates should be reduced when market levels are high, as they were in 2000 and again in 2007. In fact, the greatest risk to a retiree's portfolio is severe market under performance at the beginning of the retirement period, a risk that many recent retirees are unfortunately experiencing first hand right now. The problem with stock exposure is that severe under performance at the beginning of the retirement period will leave the retiree with a depleted portfolio balance that will result in a smaller annual distribution, at least until the portfolio recovers - which can be a very long time depending on the investing period.
There are some retirement experts who believe that stocks should be avoided entirely, precisely because of the risk of early-year under performance. Robert Huebscher has written (Advisor Perspectives, March 24, 2009) that an all bond portfolio is preferable to a stock/bond portfolio. His main contention is that an all-bond portfolio offers far more certainty of success because cash flows are much more certain and total real return depends only on correctly forecasting inflation rates. He further maintains that "inflation is far more predictable than equity market returns and can be efficiently hedged using TIPS." His last main point is that, "the all-bond portfolio is insulated from the risk of historically unprecedented adverse-market conditions near the beginning of the retirement period." Although he admits that there is a risk to the all-bond portfolio - underestimating inflation.
I think Mr Huebscher makes some interesting points, but his over-all argument for an all-bond portfolio is dependent on not underestimating inflation, and that is, in my humble opinion, exactly where we stand today. I also take issue with his contention that TIPS provide an efficient means of hedging inflation. The U.S. government has a huge vested interest in under reporting inflation, since all of the cost of living adjustments for social security and federal employees and retirees are tied to the CPI. It is extremely naive to believe that our government is accurately reporting inflation. In fact, economist Dr. John Williams, of Shadowstats fame, estimates that inflation is currently running about 8% higher than the official number.
More importantly, we are at the cusp of a long period of rising inflation and rising interest rates, brought on intentionally by a government determined to debase our currency in order to make it easier to meet the $65 trillion in unfunded liabilities it has taken on over the last twenty years of unprecedented spending. Governments everywhere and always have chosen the least politically painful option of currency debasement, once they've recognized their inability to make debt payments. The process has just begun in the United States and is likely to culminate, as in the 70's, in double digit inflation rates and double digit interest rates. Now, I am making no guarantees. It is barely possible that our elected officials will do the right thing, sharply curtail spending, raise short-term rates to encourage savings, and defend the dollar at every turn in an effort to keep it front and center as the world's reserve currency. But I doubt it.
The main point, however, is that an all bond portfolio will leave retirees eating dog food in 10-years or so if my inflation scenario comes to pass (and I give it better than a 50% chance of doing so). A prudent investor would do well to maintain a balanced portfolio of stocks and bonds in order to balance the risk of a near term short fall in stocks at the beginning of retirement against a longer-term risk of loss of purchasing power with an all-bond portfolio. It is exactly the uncertainty surrounding both stock market returns AND inflation rates that demands using both asset classes to increase the likelihood of a successful retirement using the 4% rule. (And no I do not think that stocks are cheap enough yet to raise the withdrawal rate to 5%, but that is for a different blog).
Oh, and the average inflation rate since 1966 has been 4.6%, yet many financial advisors use the 2.5% to 3.0% default rates prevalent in the investment planning software used by many of them when projecting real, long-term portfolio returns for their clients. You might want to ask them why next time you speak with them...
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