5 Bad Investment Ideas

How do you tell a good idea from a bad one? In my experience, there are a few indicators that may suggest a particular course of action is ill-advised.  A few examples would be:

1. Anytime a friend dares you to do something, especially if it is a "Double Dog" dare.
2. When someone says, “Hold my beer and watch this!”
3. When something sounds too good to be true.

Other times, especially with investing decisions, it can be less obvious. While I could make this list much longer (and probably will in a future blog entry) the following five bad investment ideas are some of the most frequent I encounter. The good news is that while many have paid the price that these mistakes cost, many more of us can profit from the knowledge.

#5 – Buying a deferred annuity in a tax deferred account. One of the chief selling points for deferred annuities, both fixed and variable, is that the earnings are tax deferred. Through sucker (bonus) rates, riders, and even claims of protection from creditors, these confusing products are often sold in lieu of less expensive, less complicated, and equally creditor sheltered alternatives.

With retirement money, like in an IRA or 401(k), the tax deferral and creditor protection benefits already exists, with or without putting the money into an insurance product. It's like wearing a belt and suspenders. All of those other features, like death benefits and guaranteed withdrawal rates, virtually never justify the extra expense.

Some recent evidence that the insurance industry understands they are selling bad products are recent projections of fixed annuity sales dropping 30% after the Department of Labor’s new fiduciary rules governing retirement accounts go into effect. That's a pretty strong indicator that deferred annuities in retirement accounts benefit the insurance company more than the customer.

#4 – Chasing returns. “Past performance is no guarantee of future results”. So reads the disclaimer on virtually every piece of investment literature published today. It’s not just a cliché. Not only does last year’s top performer rarely repeat, the pattern of performance is unpredictable. Picking last year's winner with investments is only marginally more effective than picking last year's lottery winner. As the following illustration of returns from various asset classes over the last 15 years demonstrates, last year's winner rarely repeats and often fails miserably.

#3 – Trying to beat the market. There is a simple truth when it comes to investing, it is very hard to beat the market. When less that 1 out of 5 equity mutual funds (and less than 1 out of 10 bond funds) survived and beat their indexes for the 15 years ending in 2015, it’s pretty obvious that most of the people making money from active stock and bond pickers are the pickers.

#2 – Not investing. Saving and investing are not the same. According to a recent Fidelity Investments study, Millennials are saving more. The bad news, according to another study by T. Rowe Price, is that 25% of them are invested 100% in cash. Investing means taking some risk, but not investing is also risky. Take a look at the price of milk to see how not taking risk can virtually guarantee losing.

#1 – Not paying yourself first. The reasons for not saving and investing can be plentiful. Paying off debt, saving for college, or “got to have necessities” like cell phones and cable TV can all seem like reasonable priorities over saving for long term goals. But the reality is that interest rates are at all-time lows, college expenses can be managed in other ways, and many of today’s necessities are really just pretty expensive luxuries.

Paying yourself first is best accomplished with that first job by setting enough aside to maximize all of your retirement contributions before you become accustomed to spending it. If you haven’t already made that commitment, start today by setting something, anything, aside in a retirement account. Then, any increases in pay you receive going forward, put that into the retirement account until you are maxing it out.

With interest rates at all-time lows, long term investments in growth assets can provide the opportunity to earn more than the interest you are paying. The power of compound growth over time is truly one of life’s wonders, as demonstrated in this Accountable Update last April. It all starts by paying yourself first!

Flingin' It - 8/19/16

Flingin' It is an occasional version of the Accountable Update where I throw out a variety of topics that may potentially impact ATX Portolio Advisors' clients and friends. I will also share articles from other sources that I enjoyed or found interesting. I hope some of it sticks!

In this edition, I have a quick update on a proposal from the Treasury Department that could significantly impact estate plans for some readers. I also share a piece from DFA where the relationship between GDP growth and stock market returns is explored. Finally, I included an always entertaining article by Jim Parker from his Outside the Flag series. Enjoy!

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Popular Estate Planning Technique Curtailed By Proposed Treasury Regulation

Family Limited Partnerships (FLPs) have been a popular estate planning tool for high net worth families' over the past 15 years or so as a series of Tax Court rulings favored their use. On August 2, the Treasury Department proposed new regulations that will remove or severely restrict the primary tax benefit of FLPs, discounted valuations for lack of control and marketability of family controlled entities.

Currently, FLPs allow for the value of property placed into the partnership to be discounted, which can reduce the size of an estate, and ultimately estate taxes. General Partners, usually the older generation, can further reduce their holdings (and estate taxes) by gifting partnership interest to limited partners, typically the heirs, while retaining control of the property. 

Unable to get anything done in Congress, an increasingly assertive Obama administration is essentially taking authority through Executive action from the vacuum created by gridlock to further their agenda, in this case, estate tax reform. Since multi-millionaires are the only impacted group, don't expect much outcry from either side of the aisle as what essentially is a "1%" loophole, is closed. 

What should you do? The regulations must go through a 90 day comment period and wouldn't be enacted until 30 days after that. If you have an estate valued greater than $5.45 million as an individual or $10.9 million as a married couple, there is still time to call up your estate planning attorney to see if there is any need or opportunity to review or update your estate plan. 

If you would like to be introduced to a qualified estate planning attorney, feel free to get in touch to discuss your situation.

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Economic Growth and Equity Returns

A relevant question for many investors is whether their view of economic growth should impact how they invest.

Opinions about future economic growth often differ across market participants. For example, in a survey of more than 60 economists conducted by the Wall Street Journal in June 2016, estimates of US GDP growth in 2017 ranged from 0.2% to 3.7%.[1] A relevant question for many investors is whether their view of economic growth should impact how they invest. In this regard, they may be surprised to find that the historical link between annual GDP growth and equity returns has been quite weak.

Exhibit 1 shows annual GDP growth vs. annual returns for developed and emerging markets. These plots indicate that there has not been a strong relation between GDP growth and equity returns in the same year. For example, in developed markets country/year combinations[2] when GDP growth was positive, the spread in returns was substantial: 323 country/year combinations had returns above 10% while 192 country/year combinations had returns below −10%. We see a similar pattern in realized returns for developed markets country/year combinations when GDP growth was negative. Emerging markets show a similar pattern.

Exhibit 1.       Annual GDP Growth and Equity Market Excess Returns

Sources: World Bank, MSCI, Morningstar. Shorter time periods shown for some countries due to data availability. Past performance is no guarantee of future results. See Data Appendix for details.

Despite this weak relation between GDP growth and stock returns in the historical data, investors often ask whether shorter-term fluctuations in economic cycles impact stock returns in the near term. Stated differently, while on the surface Exhibit 1 presents a weak picture of GDP growth and stock returns in the same year, is there a relationship between the two that is not obvious from this exhibit? 

To address this question, we examine 23 developed markets from 1975 to 2014 and 19 emerging markets from 1995 to 2014.[3]  Each year, countries are classified as either high or low growth depending on whether their GDP growth was above or below that year’s median GDP growth, defined separately for developed and emerging markets. We then look at stock market returns of high and low growth countries over the following year. The return for each group of countries is the average stock market return of all countries in the group weighted by countries’ market capitalization weights.

Exhibit 2 shows that, historically, differences in GDP growth over the past year contained little information about differences in equity returns this year. In both developed and emerging markets, average annual returns were similar for high and low growth countries. In fact, low growth countries had slightly higher average returns than high growth countries, although this return difference was not reliably different from zero. In other words, there is no evidence that this return difference occurred by anything other than random chance.

Exhibit 2.       Equity Returns and Economic Growth in High and Low Growth Countries [4]

Sources: World Bank, MSCI, International Finance Corporation (World Bank). Past performance is no guarantee of future results. Filters were applied to data retroactively and with the benefit of hindsight. Returns are not representative of indices or actual strategies and do not reflect costs and fees associated with an actual investment. Actual returns may be lower. Please see Data Appendix for more information.

Can superior forecasts of short-term future economic growth help improve investment decisions? To address this question, we extend the analysis and assume perfect foresight about GDP growth over the next year. We now study the returns of high and low growth countries over the same year we measure GDP growth. This is not an implementable strategy because investors do not have the advantage of knowing economic growth in advance. They must rely on GDP forecasts, adding additional uncertainty. Exhibit 2 shows that even under the assumption of perfect foresight, using GDP data would not have generated reliable excess returns for investors. In developed markets, low growth countries had higher average annual returns than high growth countries, whereas in emerging markets, high growth countries had higher average annual returns than low growth countries. Neither difference in returns was reliably different from zero. This suggests that markets quickly incorporate expectations about future economic growth, making it difficult for investors to benefit from growth forecasts even with the advantage of perfect foresight. Differences in equity returns across countries seem to be driven more by differences in discount rates than by differences in GDP growth, even under a perfect forecasting scenario.

conclusion

Many investors look to economic growth as an indicator of future equity returns. However, the relation between economic growth and returns in the historical data has been shown to be weak. This should not come as a surprise given that returns are determined by discount rates and investors’ aggregate expectations of future growth. Surprises relative to those expectations, whether positive or negative, may cause realized returns to differ from expectations. The evidence presented here suggests that differences in GDP growth contain little information about differences in stock returns in the same year and over the subsequent year. This means that it is difficult for investors to earn excess returns by relying on estimates of current or future GDP growth—even estimates that perfectly forecast GDP growth over the next 12 months.

[1].   “Economic Forecasting Survey,” Wall Street Journal, http://projects.wsj.com/econforecast.
[2].   Each observation in Exhibit 1 represents, for one country in one calendar year, the equity market excess return over one-month US Treasury bills as well as the rate of GDP growth. For example, one of the observations shows that in the US in 2014, the equity market excess return was 12.7% and GDP growth was 2.4%.
[3].   See Data Appendix for details. 2015 GDP growth data was not available for most countries at the time of writing.
[4].   A t-statistic is a measure for the reliability of an average return difference. Normally, a t-statistic of at least 2 in absolute value is necessary to reliably say that the result is different from zero.

Data Appendix

Developed markets since 1975 (unless stated differently):
MSCI Australia Index (net div.), MSCI Austria Index (net div.) (from 1980), MSCI Belgium Index (net div.), MSCI Canada Index (net div.), MSCI Denmark Index (net div.) (1980), MSCI Finland Index (net div.) (1988), MSCI France Index (net div.), MSCI Germany Index (net div.), MSCI Hong Kong Index (net div.), MSCI Ireland Index (net div.) (1988), MSCI Israel Index (net div.) (1999), MSCI Italy Index (net div.), MSCI Japan Index (net div.), MSCI Netherlands Index (net div.), MSCI New Zealand Index (net div.) (1988), MSCI Norway Index (net div.), MSCI Portugal Index (net div.) (1990), MSCI Singapore Index (net div.), MSCI Spain Index (net div.), MSCI Sweden Index (net div.), MSCI Switzerland Index (net div.) (1981), MSCI United Kingdom Index (net div.), and the MSCI USA Index (net div.).

All of the following emerging markets are included since 1995 for Exhibit 1.

For Exhibit 2, since 1995 (unless stated differently):
MSCI Brazil Index (gross div.), MSCI Chile Index (gross div.), MSCI China Index (gross div.) (from 1996), MSCI Colombia Index (gross div.), MSCI Egypt Index (gross div.) (1998), MSCI Greece Index (gross div.), MSCI Hungary Index (gross div.), MSCI India Index (gross div.), MSCI Indonesia Index (gross div.), MSCI Korea Index (gross div.), MSCI Malaysia Index (gross div.), MSCI Mexico Index (gross div.), MSCI Peru Index (gross div.), MSCI Philippines Index (gross div.), MSCI Poland Index (gross div.), MSCI Russia Index (gross div.) (1998), MSCI South Africa Index (gross div.) (1996), MSCI Thailand Index (gross div.), MSCI Turkey Index (gross div.).

A country is included in the analysis for Exhibit 1 in a given year if MSCI index return and GDP growth data are available and in the analysis for Exhibit 2 if MSCI index return, country weight, and GDP growth data are available. Returns are in USD. GDP growth is real GDP growth in local currency, converted to USD using constant 2005 USD as provided by the World Bank.

Source: Dimensional Fund Advisors LP.

All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Past performance is no guarantee of future results. There is no guarantee an investing strategy will be successful.

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Outside the Flags

History on the Run

When news breaks and markets move, content-starved media often invite talking heads to muse on the repercussions. Knowing the difference between this speculative opinion and actual facts can help investors stay disciplined during purported “crises.”

At the end of June this year, UK citizens voted in a referendum for the nation to withdraw from the European Union. The result, which defied the expectations of many, led to market volatility as participants weighed possible consequences.

Journalists responded by using the results to craft dramatic headlines and stories. The Washington Post said the vote had “escalated the risk of global recession, plunged financial markets into free fall, and tested the strength of safeguards since the last downturn seven years ago.”[1]

The Financial Times said “Brexit” had the makings of a global crisis. “[This] represents a wider threat to the global economy and the broader international political system,” the paper said. “The consequences will be felt across the world.”[2]

It is true there have been political repercussions from the Brexit vote. Theresa May replaced David Cameron as Britain’s prime minister and overhauled the cabinet. There are debates in Europe about how the withdrawal will be managed and the possible consequences for other EU members.

But within a few weeks of the UK vote, Britain’s top share index, the FTSE 100, hit 11-month highs. By mid-July, the US S&P 500 and Dow Jones Industrial Average had risen to record highs. Shares in Europe and Asia also strengthened after dipping initially following the vote.

Yes, the Brexit vote did lead to initial volatility in markets, but this has not been exceptional or out of the ordinary. One widely viewed barometer is the Chicago Board Options Exchange Volatility Index (VIX). Using S&P 500 stock index options, this index measures market expectations of near-term volatility.

You can see by the chart above that while there was a slight rise in volatility around the Brexit result, it was insignificant relative to other major events of recent years, including the collapse of Lehman Brothers, the eurozone crisis of 2011, and the severe volatility in the Chinese domestic equity market in 2015.

None of this is intended to downplay the political and economic difficulties of Britain leaving the European Union, but it does illustrate the dangers of trying to second-guess markets and base an investment strategy on speculation.

Now the focus of speculation has turned to how markets might respond to the US presidential election. CNBC recently reported that surveys from Wall Street investment firms showed “growing concern” over how the race might play out.[3]

Given the examples above, would you be willing to make investment decisions based on this sort of speculation, particularly when it comes from the same people who pronounced on Brexit? And remember, not only must you correctly forecast the outcome of the vote, you have to correctly guess how the market will react.

What we do know is that markets incorporate news instantaneously and that your best protection against volatility is to diversify both across and within asset classes, while remaining focused on your long-term investment goals.

The danger of investing based on recent events is that the situation can change by the time you act. A “crisis” can morph into something far less dramatic, and you end up responding to news that is already in the price.

Journalism is often described as writing history on the run. Don’t get caught investing the same way.

[1]. “Brexit Raises Risk of Global Recession as Financial Markets Plunge,” Washington Post, June 24, 2016. 
[2]. “Brexit and the Making of a Global Crisis,” Financial Times, June 25, 2016. 
[3]. “Investors are Finally Getting Nervous about the Election,” CNBC, July 13, 2016.

About Jim Parker
Jim Parker is a Vice President for DFA Australia Limited, a subsidiary of Dimensional Fund Advisors. As head of the communications and marketing team in Australia, Jim helps create strategies to communicate Dimensional's philosophy and process in ways that engage clients, prospects, regulators, and the media. He does so through presentations, books, papers, and articles, including his "Outside the Flags" column and, more recently, his weekly "Coffee Break" links to interesting articles. 

Jim joined Dimensional in 2006 after 25 years working as a journalist in newspapers, television, radio, and online media. His specialty was financial journalism, particularly in relation to economics and financial markets. Jim holds a bachelor of arts in social and economic history from Deakin University and a journalism certificate from Auckland Technical Institute.

Dimensional Fund Advisors LP ("Dimensional") is an investment advisor registered with the Securities and Exchange Commission. 

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This content is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services. 

A Picture is Worth Thousands ($)

What do you think about when you walk into a place that puts the “Employee of the Month” picture on the wall? We've all seen them at auto dealerships, retail stores, and even some restaurants. I don’t know about most folks, but for me, that is generally the last person I want to speak to at a business.

“Why? Wouldn’t you want to work with the best employee,” you may ask?

Absolutely, but the “best” employee for the employer isn’t necessarily the best for the customer. That is why it may serve you well to avoid those with the glamour shots hanging on the wall.

I have a confession to make. I didn’t come to this realization by being suckered into an expensive undercoating on a car that never sees road salt in temperate Texas winters. Nor have I been swayed by one too many pretty waitresses stooping down to eye level to see if I need another margarita. (Actually, that one may not be entirely true.)

No, I came to this point of view after years of striving to be the employee of the month/quarter/year, or later as a manager, being the person who choose said employee. The honorees always had one thing in common, besides the photos, plaques, and trophies.

They sold the most stuff.

The titles varied over time. “Investment Representative”, “Financial Planning Consultant”, and “Account Executive” were just a few of the business card descriptions used at my old company. What they all had in common were that they were primarily measured, ranked, and promoted because of their success in “development”, aka, sales.

Wonder if regulators understand how it works? See FINRA’s descriptions on their website:

 “A broker-dealer is a person or company that is in the business of buying and selling securities—stocks, bonds, mutual funds, and certain other investment products—on behalf of its customers (as broker), for its own account (as dealer), or both. Individuals who work for broker-dealers—the sales personnel whom most people call brokers—are technically known as registered representatives. [emphasis added]

Registered representatives are primarily securities salespeople [emphasis added] and may also go by such generic titles as financial consultant, financial advisor, or investment consultant. The products they can sell you depend on the licenses they hold. For example, a representative who has passed the Series 6 exam can sell only mutual funds, variable annuities, and similar products, while the holder of a Series 7 license can sell a broader array of securities. When a registered representative suggests that you buy or sell a particular security, he or she must have reason to believe that the recommendation is suitable for you based on a host of factors, including your income, portfolio, and overall financial situation, your tolerance for risk, and your stated investment objectives.”[i]

Notice that nowhere in the description does it suggest that it is the RR’s job to put the customer’s interest first. Their job is to sell.

As a young employee, I was taught that success was meeting sales goals. The more goals I hit, the more recognition and money I received. When I was new to the sales role, the top performing RR in my office once advised me that if you weren’t generating an occasional customer complaint, you weren’t selling hard enough.

As a manager, I had a long-time top performing salesperson (who had had several brushes with customer complaints) say to me that as long as he exceeded his annuity goals that no one at the company had ever given him grief. He still works there today, in spite of my best efforts.

Over time, as you are recognized for meeting and exceeding sales goals, you accumulate mementos of the “achievements”. Little trophies, certificates, and photos commemorating the award trips and honors clutter the desks and walls of the top achieving RRs at every brokerage firm.

It can be addicting. Once you’ve tasted the nectar, you want more of it. To get more, you MAY work harder. At least that’s what senior management likes to tell themselves and Compliance departments hope to insure. But the reality is that corners get cut, half-truths are told to expedite sales, and the illusion of “expert” advice is presented in the most scalable (cookie cutter) way.

The realization that profits were prioritized over client portfolios didn’t happen overnight for me. It started with annual mandatory meetings to discuss why client accounts that we managed didn’t perform as well as they seemingly should have. Even as academic evidence[ii] began to mount that explained that the fees were the main drag on returns, no one ever suggested that the 1.75% combination of advisory fees + underlying mutual fund costs virtually guaranteed under-performance.

The bullet points provided by the company were designed as much to reassure the RRs to keep selling the high fee accounts as much as they were to provide talking points for wary clients. To underscore these conversations, managers were regularly treated to “Finance Updates” that clearly showed how important these highest fee “solutions” were to the bottom line.

The message was simple, if you wanted to get ahead, the path to success was to sell the most profitable (to the firm) products.

To be clear, I think the vast majority of brokers want to do the right thing for their clients. Like I said, many of my old company’s training efforts were designed as much to convince RRs that they were selling the best product as much as they were to handle customer objections. In fact, they were all just working within a system that is built to take advantage of the average investor that just doesn’t know any better.

How can you protect yourself from a system that some may describe as rigged? Start by looking at the pictures on the wall.

Another approach, of course, would be to seek out an independent advisor that puts your interests ahead of their own. One that is completely transparent about fees, portfolio construction, and performance. If that appeals to you, get in touch.

[i] http://www.finra.org/investors/brokers

[ii]EUGENE F. FAMA and KENNETH R. FRENCH, Luck versus Skill in the Cross-Section of Mutual Fund Returns, THE JOURNAL OF FINANCE • VOL. LXV, NO. 5 • OCTOBER 2010