Category Archives: Investing

Look for Hidden Investment Costs

Annuities are popular investments; almost every new client I see has one. Part of any investment adviser’s due diligence is to understand the history and intentions of the investments in a portfolio. When I ask why someone purchased an annuity, the most common responses are: “We didn’t have to pay any fees or commissions.” “There are no ongoing expenses.” “All my money is working for me.” “The principal is guaranteed.”

Any time you read or hear “no fees,” “no commissions,” “no expenses,” “free,” or “guaranteed” used in conjunction with an investment, it’s a red flag. All investments, including annuities, have costs associated with them. You need to ask some probing questions about those costs before proceeding.

Let’s look at the costs for one popular type of annuity, the fixed annuity. This simply gives you a stated rate of return that often can change annually, similar to a bank certificate of deposit.

Suppose Investor A is sold a fixed annuity with a guaranteed return of 3.5%. Investor B invests her money in a plain vanilla portfolio of mutual funds holding 60% stocks and 40% bonds, which has a long-term projected return of 6%.

The insurance company selling the annuity must earn enough of a return on Investor A’s money to cover their expenses, pay commissions, and return something to Investor A. There is no magic formula on how that’s done. The insurance company invests the money in the same asset classes available to anyone. For the sake of this example, it’s reasonable to assume the insurance company would hold the same 60/40 portfolio as Investor B.

The annuity incurs internal costs for administration, managing the money, insuring the return of principal, and commissions paid to salespeople. While these vary somewhat from company to company, a cost of 2.5% isn’t unreasonable.

If the company earns 6% and deducts 1% to recoup the upfront commission paid to the salesperson, 1.0% for management costs, and 0.5% for administrative fees, they pay out the remainder as a “fixed” return of 3.5%. Investor A only sees that 3.5% fixed return. If Investor A wants out of the policy before the cost of the up-front commission is fully recovered (usually 4 to 15 years), he will also incur a “surrender penalty” that is approximately equal to the remaining amount of commission paid to the broker selling the policy.

Investor B’s 60/40 portfolio will have the same 6% gross return as the insurance company’s portfolio. If Investor B purchases index funds from a company like Vanguard, her costs could be as low as 0.10%, leaving her a return of 5.9%.

Suppose Investors A and B each accumulate $1 million in retirement funds. The difference between Investor A’s guaranteed 3.5% return and Investor B’s average and unguaranteed 5.9% return is potentially an extra $2,000 a month in retirement income. Guarantees come with a cost.

Given these numbers, you may wonder why anyone would purchase a fixed annuity. One reason is that many buyers don’t have the confidence that they can invest the money wisely or the stomach to watch the portfolio’s inevitable peaks and valleys. Another reason is that most buyers don’t fully understand the costs.

Unlike stocks, bonds, and mutual funds, most annuities are sold, not bought. I have never had a new client who independently purchased a no-load annuity. The annuities I typically see were sold by someone who received a commission. Commissions are not inherently bad, but in most cases they do inherently create a conflict of interest.

There are always fees associated with any investment. In my experience, the less transparent those fees are, the higher they are.

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Dangers of Comparing Diversified Portfolio to US Stock Market Returns

It may be entertaining to watch Donald Trump point his finger and curtly say, “You’re fired!” When a client says the same thing to me, it isn’t so funny.

I’m especially not amused if a client fires me because their diversified portfolio is underperforming the US stock market and they abandon the strategy. The result is often a financial travesty.

The February issue of “Inside Information,” Bob Veres’ financial newsletter, puts a name to this phenomenon: “frame-of-reference risk.” The term is used by Roger Gibson, Chief Investment Officer, and Christopher Sidoni, Director of Investment Research, of Gibson Capital in Wexford, PA. Veres reported on a presentation they gave at the American Institute of CPAs (AICPA) Personal Financial Planning conference in Las Vegas in January.

Gibson describes “frame-of-reference risk” as clients’ tendency to compare the performance of their diversified portfolios with current returns in the US stock market. He points out, “If the discrepancy gets too painful, they will fire you and abandon a diversified approach at the wrong time.”

Based on the emphasis the media gives the US stock market, one could easily conclude US stocks must be the largest, most important asset class in the world. Not at all. US stocks represent less than 10% of the world’s wealth and make up 10% to 20% of most diversified portfolios.

Neither do US stocks consistently produce the best returns. In the 1970’s, commodities dwarfed US stock returns. In the 1980’s, international stocks led the way. In the 1990’s, US stocks were the stars. In the 2000’s, the leader was real estate.

Yet most investors judge the performance of their portfolios by US stocks. They may compare the returns of a diversified portfolio with news reports about the S&P 500 and the Dow, which together include only 530 companies.

Between 1994 and 1999, Gibson’s multi-asset class strategy delivered a 13.05% return, which paled in comparison to the US market’s 23.55% return. He lost one-third of the assets he managed in 1999, as clients fired him. They abandoned their diversified investment strategy at just the wrong time to save themselves from the 2000-2002 US stock market downturn, when real estate and commodities soared. Gibson’s multi-asset class portfolios did 9.96% from 2000 to 2005, when US stocks rang up losses.

This pattern, familiar to many financial planners, is the sad consequence of frame-of-reference risk.

Another aspect of that risk is our human tendency to stay in a comfort zone where most of our neighbors are doing pretty much what we’re doing. One client even told Gibson, “I would rather follow an inferior strategy that wins when my friends are winning and loses when my friends are losing, than follow a superior strategy that at times causes me to lose when they’re winning.”

Unfortunately, this tendency can lead us into disasters. Diversified portfolios are once again underperforming the US stock market. Predictably, an increasing number of investors are abandoning diversification, right in time to get nailed.

Gibson and Sidoni’s conclusion seems to be that educating clients to stay the course is a no-win game. In their view, advisors need to craft a less efficient, lower-return long-term strategy that clients will consistently follow rather than a more efficient strategy that clients may abandon in mid-stream.

While that view seems pragmatic, it really misses the mark. Instead of dumbing down portfolios to match client’s dysfunctional money scripts, it would be a better outcome if advisors concentrated on helping their clients uncover and modify the money scripts that are driving their self-sabotaging behaviors. This approach can help keep clients from saying “You’re fired!” at the wrong time for the wrong reasons.

Passive Investing: Lower Costs, Lower Risk, Better Returns

“Buy low and sell high.” That was my simple approach when I was a smart young investment advisor. I poured over a company’s balance sheet, earnings statements, and forecasted returns. Then I bought those companies that were bargains and waited for my gains to roll in. More times than not, they did—eventually.

The problem came with the “not” and “eventually.” A majority of my picks did go up in value, but the minority that were “nots” still lost enough to have a negative impact on my bottom line. Even more frustrating, some of my “nots” turned into gains “eventually” after I sold them.

My investment returns were similar to findings from Dalbar, Inc., a financial services research firm. Dalbar’s studies have shown that average active investors barely beat inflation over the long term. They significantly underperform investors who put their money in an index fund of stocks and leave it alone.

So much for my early investment brilliance. Continue reading

The Risks of Being in Business with Family

Every now and then I get a call from a client wanting my opinion about starting a business with a friend, investing money in a business owned by a family member, or co-signing a loan to help a family member buy a business. Being in business with family is something I know a little bit about, having been in partnership with my father and brother for 40 years. Going into business with family members or close friends can carry a high degree of risk, both financially and emotionally.

In part this is because it is uncomfortable or difficult to ask the necessary dollars-and-cents questions. We don’t want to seem uncaring, unsupportive, or untrusting. We are concerned about damaging the relationship. Yet the relationship is far more likely to suffer if we don’t ask those questions and the venture fails.

The following are some things to consider before you invest or go into business with someone close to you:

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Collecting Treasures–Or Not

Almost everyone has a story about a cousin or an aunt who bought a box of junk at an auction and found in it a diamond ring worth several hundred dollars. Every once in a while a valuable painting by a famous artist turns up in someone’s attic. “Antiques Roadshow” sometimes features odd items that have been sitting around in someone’s house for years and that are appraised for thousands of dollars.

This doesn’t mean buying and selling art or collectibles is a good way to make money.

Buying art, antiques, or collectibles is extremely speculative, in part because values are so subjective. What a given item is worth depends entirely on what a collector might be willing to pay at any given time. A piece of pottery or jewelry might fluctuate considerably in value as trends come and go. Yesterday’s hot collectible (think Beanie Babies or Jim Beam bottles) might be tomorrow’s overpriced embarrassment.

Does this mean you should never buy art or antiques in hopes that they’ll increase in value? Not necessarily. I am suggesting, though, that investment shouldn’t be the primary reason for your purchase.

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Finding the Right Path to Wealth

After three decades as a financial planner, working with successful wealth-builders, you’d think I would have a clear idea of the right path for creating wealth.

Instead, what I’ve learned is that there is no such thing. Here are just a few of the paths that aren’t the sure routes to wealth they might seem to be:

1. Education and career choices. Going into a field like law or medicine might seem to guarantee financial success. Not necessarily. I’ve seen many physicians, for example, who have accumulated significant wealth. I’ve seen just as many who live paycheck to paycheck.

2. High earnings. Again, this isn’t the reliable predictor of wealth it would seem to be. Continue reading

Comparison Shopping for Financial Advice

You can spot comparison shoppers a few aisles away at any retail store. They are the ones carrying articles from Consumer Reports, badgering the salesperson with a million and one questions. People who manage money well are usually big fans of comparison shopping.

If comparison shopping is important before choosing a new refrigerator or lawn mower, it’s even more essential before choosing an investment advisor. Unfortunately, there is no easily available consumer’s report on advisors. Even more frustrating, those selling financial products often have incentives not to be forthcoming with the information that is crucial for comparing advisors.

One aspect of shopping for an investment advisor is knowing what questions to ask. Continue reading