Archives for January 2009

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My Issue with “Risk”

In case you haven’t noticed from earlier posts, I have some complaints about the common use of the word “risk.”

I think I’ve finally figured out what it is that bothers me so much: We use the word “risk” to encompass several distinct concepts that should really be kept separate. For example:

  • We call investing in a stock “risky” because the company might go out of business.
  • We call investing in stocks via a mutual fund “risky” because the stock market is volatile.
  • Long-term bonds are “risky” because they’re subject to price volatility resulting from changes in market interest rates.
  • Foreign investments are “risky” due to fluctuations in exchange rates.
  • Savings accounts and CDs are “risky” because inflation can consume your entire return.

In my opinion, trying to have an intelligent conversation using the word “risk” (as opposed to indicating what kind of risk) is comparable to having a conversation using the word “investments” without ever distinguishing between stocks, bonds, CDs, or real estate. In a few instances it will work, but most of the time it’s just going to cause problems.

We’re Causing Confusion

Imprecise definitions certainly make writing difficult, but more importantly they cause confusion. I think the fact that we refer to so many different concepts using the same word causes severe misunderstandings among the investing public.

[Actually, I suppose this is worse than causing confusion. When you’re confused, you know it. When you misunderstand something, you’re not even aware that you don’t understand it properly.]

Let’s use an example. Imagine that we tell somebody “Investing in the stock market can be risky. Every few years we have a bear market, and share prices drop.”

What we mean: “The stock market is volatile. If you’re going to need your money soon, investing in the market isn’t a great idea, because you could lose your money.”

What (I suspect) people hear: “The stock market is risky. Every few years, you lose a bunch of money.”

See the difference?

We’ve made it easy for people to come to the conclusion that a decline in the market is the same thing as a loss of money, when in reality, that’s only true if you’re going to be selling soon.

And–now that we’ve convinced investors that market decline = loss of money–can we really blame them when they get out of the market after a big drop? After all, if you were thinking “Oh my god! Everyday I stay in the market, I’m losing more and more money!” …you’d want to get out of the market too, right?

Too bad we didn’t explain what we meant when we said the market was risky.

I think we could all benefit from being more precise with our wording when we call something risky.

Earn 15% annually in the stock market.

Given that I’m currently working on a narrative-style investment book, I figured it would be a good idea to read some of the others in the field. A couple weeks ago I read (and thoroughly enjoyed) The Richest Man in Babylon, and over the last couple days, I read David Chilton’s The Wealthy Barber.

The most recent version of the book has a copyright date of 1998. And boy does it show! (And I’m not even talking about the references to saving up for a VCR, which must have been left in from a version even earlier than ’98.) I’m talking about the assumed rate of returns in all the investment examples.

Over and over, Chilton uses an assumed annual rate of return of 15% for investments in equity mutual funds. 15%! He also states that an “ultraconservative allocation” should easily be able to earn an 8% rate of return. Funny: Just the other day I was predicting an 8% long-term return in the stock market–and I was saying that we should be excited about it!

I find it fascinating that Chilton–an author who expounds the virtues of conservative investing (i.e., suggesting CDs in IRAs for people in their late 20’s)–was caught up in the absurdly optimistic expectations of the era. I guess it’s hard to escape.

Maybe, just maybe, we’re seeing the exact opposite going on right now. 😉

By the way, for anybody who’s curious: From January 1, 1998 to December 31, 2008, the market’s actual annual return was a mere 1.03%. Looks like he was a little off! Hehe.

Are Stocks Dangerous?

Kalinda (my wife) recently started a cooking blog. What this means for me–aside from an abundance of delicious, homemade meals–is that I end up dicing/chopping vegetables most nights. A recent close call with a chef knife got me thinking.

Asian Orange Tofu Stir Fry

A few observations about chef knives:

  • If used improperly, they’re dangerous.
  • If used for the wrong job, they’re dangerous.
  • When used correctly, and for the right purpose, they get the job done in a (fairly) safe manner.

Stocks are rather like a sharp chef knife:

  • If used improperly (buying and selling with great frequency, or owning a portfolio that’s not sufficiently diversified), they’re dangerous.
  • If used for the wrong job (short-term savings, for instance) they’re dangerous.
  • When used correctly, they get the job done in a fairly safe way.

How to use stocks properly and safely?

  1. Own a diversified portfolio via a low-cost fund.
  2. Hold them forever (or as close to forever as you can manage).

My 30 Year Market Prediction

As we’ve previously discussed, over (very) extended periods, the market’s return is made up almost entirely of dividend yield and earnings growth. In other words, one of the best methods for predicting the long-term rate of return for the entire market is to simply add the current market dividend yield (3% at the moment) to our economy’s average rate of earnings growth (5-6%).

This tells us that for every dollar we put into the market right now, we can expect a long-term rate of return in the 8-9% range. Many people may see that number and get disappointed. After all, you don’t get rich quick(ly) with an 8% rate of return. That said, I look at this number and see two great reasons for investing in the market.

It hasn’t looked this good for quite a while.

When was the last time that the market was offering a dividend yield of 3%? Almost two decades ago: 1991. If you’re feeling scared to invest in the market right now, take a moment to ponder that. The market’s expected rate of return hasn’t looked this good since before Clinton was in office.

It’s a heck of a lot better than what we can expect from bonds.

Right now, 10-year treasury bonds are yielding roughly 2.5%. In other words, the stock market’s dividend yield alone is enough to make it more attractive than the alternative. Once we add in the future earnings growth, we get a very substantial difference in long-term expected rates of return. We haven’t seen this kind of discrepency between bond yields and expected market return in a long while either.

Just for comparison, if we look back a few years ago to 2006, the market’s dividend yield was about 1.77%, giving a projected market return of roughly 7%. That’s barely any higher than the bond rate (about 6% at the time). And yet, people were confident investing in the market.

What to do?

  • The numbers tell us that now is a great time to invest–better than it’s been in over a decade.
  • The media tells us that the stock market is dangerous and we need to “wait until things settle down.”

Who do you believe? 🙂

Edward Jones IRA Review

Let’s start with the obvious: If you don’t feel that you need a financial advisor, there is absolutely no reason to have an account at Edward Jones. You can go elsewhere and find less expensive funds, less expensive stock trades, and lower account fees.

If, however, you do need a financial advisor, should Ed Jones be one of the places to consider?

Let’s take a look.

Advantages of Edward Jones

The primary selling point of Edward Jones is their broad network of local offices. In most parts of the U.S., there will be a Jones office not too far from where you live. If face-to-face interaction with your brokerage firm is important to you, Jones is hard to beat in terms of convenience.

The second primary advantage of Edward Jones is that you’ll have no difficulty understanding your advisor’s recommendations. Jones’ investment philosophy is straightforward. They suggest that you buy and hold a portfolio of comprised of:

  1. blue chip stocks,
  2. bonds, and
  3. actively managed mutual funds (i.e., funds that seek to earn above-market returns).

Edward Jones Commissions and Costs

Per a phone call to Edward Jones’ customer service line, their commissions per stock trade are based on the size of the trade and break down as follows:

  • 2.5% for trades less than $6,000
  • 2% + $30 for trades between $6,000 and $10,000
  • 1.5% + $80 for trades between $10,000 and $25,000
  • 1% + $205 for trades between $25,000 and $100,000

That’s likely hundreds of dollars more per trade than you’d pay with a typical discount brokerage firm. Between that and their $40 annual IRA fee, Edward Jones isn’t exactly on the list of cost-effective places to invest.

Edward Jones Conflicts of Interest

The biggest drawback to having an account at Edward Jones (and the other “full-service” brokerage firms like Merrill Lynch and Wachovia) is that your financial advisor is paid on commission. Specifically, Edward Jones financial advisors earn money when you:

  • Buy or sell a stock,
  • Buy a bond, or
  • Buy a mutual fund that charges a sales load.

This payment system leads to Edward Jones clients receiving advice that’s biased in a few ways. For example, an Edward Jones financial advisor will never recommend a no-load mutual fund (even when that’s the best option for the client) because he/she won’t receive a commission if you purchase such a fund.

An additional conflict of interest is created by the fact that Edward Jones receives “revenue sharing” payments from a handful of fund companies.

In other words, certain fund companies pay Edward Jones in order to receive preferential treatment. So if you’re a Jones client, you can expect your advisor’s recommendations to consist almost exclusively of the following fund families:

  • American Funds
  • Franklin Templeton
  • Hartford Investments
  • Invesco
  • Lord Abbett
  • MFS Investment Management
  • Oppenheimer Funds

No Online Trading

While it’s easy to check your holdings and account balances on Edward Jones’ website, they don’t actually provide any online trading capability whatsoever. If you want to execute any transactions, you’ll have to call your broker.

The official Jones position is that the lack of online trading is intended to prevent rash investment decisions. To some extent, that makes sense. Personally, however, I find it frustrating. I want to be able to do what I please with my money without having to talk it over with somebody.

Summary

Pros:

  • Local offices,
  • Personal customer service,
  • Easy-to-understand investment philosophy.

Cons:

  • Significant conflicts of interest between you and your advisor,
  • High costs.

In most cases, if you feel that you need a financial advisor, I’d suggest going with one who charges a simple hourly or annual fee rather than one who is paid via commission. By using a fee-only advisor, you’ll get unbiased advice, and you’ll likely reduce the overall costs on your investment portfolio.

If you’d like to compare Edward Jones to other brokerage firms, here’s a comparison of IRAs at various discount brokerage firms.


Can Risk Tolerance Change?

In an interview (which has since been taken offline) with Money Magazine editor Eric Schurenberg, author/associate professor/retirement expert Moshe Milevsky made the following statement that I particularly enjoyed:

I think advisers tend to take the mental aspect a little too far. People’s risk tolerance changes every day. Yesterday the market is up: People are risk tolerant. Today the market plummets: They’re no longer risk tolerant. You should build your retirement portfolios on something more stable than just your mood this morning.

I think Milevsky makes a great point that it’s all to easy for an investor to let 5 consecutive years of positive returns lure him into thinking that he’s more risk tolerant than he really is.

What I really like though is that he brings up the idea that risk tolerance isn’t a static thing. This is something I’ve been pondering myself as I’m working my way through The Four Pillars of Investing.

The author (William Bernstein) suggests in a few places that you should guess conservatively when estimating your risk tolerance. That is, if you think you’re a pretty risk tolerant person, who could handle the volatility that comes with a 90% stock portfolio, it’s likely better to try an 80% stock portfolio just to ensure that you don’t panic when things go wrong.

That’s the conventional wisdom. And it makes sense. But you already know how I feel about it.

Also, this type of suggestion assumes that a person’s risk tolerance is set in stone.

Doesn’t knowledge increase risk tolerance?

To me, the more a person knows about markets (and, more specifically, their cyclical nature), the greater her risk tolerance. After all, if you’ve researched enough about market history, you know that downturns are followed by upturns. That’s just how things work.

And if you’re perfectly calm during a market crash because you’re aware that the market will come back up at some point, isn’t that the very definition of risk tolerance?

So if knowledge leads to confidence (and confidence is the same as risk tolerance), doesn’t that mean that a person can increase his risk tolerance simply by taking the time to educate himself about market history?

And finally, if a person can increase his risk tolerance via learning, wouldn’t this be a worthwhile thing to do (as opposed to simply being content with a more conservative/lower returning asset allocation your whole life)?

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