Monday, October 26, 2009

Financial advice or snake oil, sometimes it's hard to tell

What is the value provided by a financial advisor? Indeed, what kind of bang does the consumer of financial advice get for their buck? Some question the value consumers gain in doing business with financial professionals, while others ponder the nature of the commissions and fees withheld by these professionals for their services provided and how these commissions and fees are connected to the underlying motivation financial advisors have in offering the sales of various securities and insurance products to trusting consumers. Exactly what does the consumer gain in the long run from using the services of a financial advisor? Overall, a financial advisor functions within an industry that is regulated by the federal government via the Securities and Exchange Commission (SEC), and by the individual states regarding insurance products and services. Anyone offering advice, sales of securities or financial or insurance related products needs to possess a valid license from each authority to legally transact business within the industry. The purpose of these licensure requirements rises from the many and varied past abuses of the public trust by charlatans and rapscallions posing as ‘advisors,’ offering nebulous products that on the surface sounded good as described by these slick hucksters, but in reality provided little if any actual value in exchange for the hapless consumer’s hard earned cash. Have things changed all that much from those days to what we see within the financial services industry now, given that the industry is reigned in to some extent by extensive regulation? Not really. Regarding the credibility of each advisor, what exactly do they know about the future and how this will affect your financial position? The answer: absolutely nothing. Nobody has a crystal ball, and the fact that they predict likely performance based on what happened in the past with each instrument they hawk is always disclosed by their catch all (and mandatory) phrase: ‘past performance is not a guarantee of future results.’ In other words, they are guessing about how your portfolio will look going forward given the general history of the products and services they sell you, when in reality they have no more information about what will happen in the future to the value of the products they shill than anybody else. What exactly do financial advisors know that you don’t know when it comes to how a security will perform in the future? Again, nothing. One advisor (a Certified Financial Planner, or CFP) recently emailed me the following: ‘…you may want to increase your international exposure. Inflation is coming and the value of our dollar will fall, which is good for international. The government printed up so much money to stimulate our economy that inflation is bound to happen. Also, I know you don’t want bonds, but you may be able to get stock like returns from I bonds in the future. Do this in your IRA or annuity though. I bonds spin off phantom income which accountants don’t like.’ Sounds like this guy knows his economic theory, doesn’t it? Is this CFP a credentialed economist? No. Although there are a few FA’s that have formal educations in finance and economics, most FA’s are not financial experts or economists, and have no real education in economic theory. This guy likely just read some financial journal article in which the esteemed author opines that rampant and out of control inflation is inevitable. Accordingly, this FA positions this opinion as the bogeyman to be defeated by his international bond proposal. In truth, this ‘Certified Financial Planner’ has absolutely no clue whether our dollar will rise or fall or whether rampant inflation will occur in the future, because no one knows for sure. This particular CFP based his sales pitch on a singular economic opinion. Unfortunately, the field of economics is not called the ‘dismal science’ for nothing: much of the science of economics is dedicated to economic theory which is far more subjective than objective. Because the real world application of these economic theories by politicians currently in power rarely produce exact results on any nation’s actual economic activity, the old saying certainly rings true: ‘if you lay all of the economists in the world end to end, they would never reach a conclusion.’ Or this one: ‘economists have accurately predicted nine of the last five recessions.’ And certainly one of my favorite economist jokes goes something like this: Q: What's the difference between an economist and a befuddled old man with Alzheimer's Disease? A: The economist is the one with the calculator. If you ask me, I have an opinion of the future that is no less valid than any other economist’s out there: if one looks around, clearly we are seeing with our own eyes a deflationary period, which is completely contradictory to this CFP’s alarmist cries. Unemployment is nearly 10% (9.8% as reported on October 1, 2009), home values are down 25% or more over the last two years, and retailers are slashing prices to lure scarce customers (along with their scarcer dollars) into their stores. According to economic theory (for what it’s worth), for inflation to occur the money supply must increase. One only has to look around, and your own eyes will tell you that the money supply is shrinking, not increasing currently. True, the government has trillions of spending projects budgeted but in reality has printed only a fraction of that currency, contrary to the CFP’s alarming statement above. And even those dollars are not getting circulated, as the banks glom onto any cash that comes their way just like the rest of us, and accordingly credit markets are exceptionally tight, and banks are not loaning nearly as much as they were in the past to small businesses which are the core of the U.S. economy. As many as 15 million Americans that had jobs only two years ago now are unemployed and an additional 9 million are underemployed. It is possible that these figures may actually be understated. In fact, deflation is the situation now because there is just not enough money circulating in the economy as people hunker down and tighten their belts during this recessionary period. This CFP quoted above has arguably got it completely wrong, and yet he wants to encourage the purchase of international bonds to counter the evil effects of pending rampant inflation, which hasn’t yet occurred and may not occur to the extent of which he direly warns us all. Strangely, we as a nation still buy financial products and services from these ‘expert’ financial advisors who rarely know what they are talking about most of the time, but consumers continue to pump billions and billions of dollars annually into their brokerage house coffers. Why do Americans continue to funnel dough into the clutches of these guys? The answer to that question is simple; fear. The financial services and insurance industries are basically built on fear. Fear of the unknown, fear of uncertainty and essentially the fear of poverty and death that we might face should things go badly for us in the future. And FA’s and insurance salesmen know this. This is the basis for every sales pitch that you hear come out of their mouths. The insurance guy will always start with something that goes like this: ‘Have you taken steps to provide for your loved ones in the event that something happens to you?’ They may dwell on this for a time, drawing a mental picture of your loved ones getting kicked out of their warm, safe homes and into the cold, mean streets to starve, languish in misery and die in the gutter because you failed to adequately provide for them earlier. Then, the pitch for insurance against this eventuality will be served up, depicting your loved ones living on in a worry-free paradise after you are dead and gone as a result of you doing the right thing in happier times with your immediate purchase of their life insurance policy, variable or fixed annuity, etc. Let’s assume that you fall for their slick pitch and buy a whole life policy. Exactly how do you gain from this transaction? How do you profit from the deal? You have to die to get a positive outcome from this deal, but ironically that would be a negative outcome, if you ask me. If you don’t die, you have to pay your annual premiums to the insurance company. That is also basically a negative outcome for you. On the positive side (if you call dying a ‘positive outcome’), your family gains from the proceeds issued from your policy after your death, assuming that you meet all the criteria stated in the 2 inch thick policy you signed, and that will be determined by the insurance company. This verification will be done at the insurance company’s pace, and on their schedule, which I guarantee is nothing even close to the pace and schedule you would like. And what are the odds that everything will come out alright, after the insurance company looks into every nook and cranny of the policy? Flip a coin, because their job is to deny, deny, deny. And when in doubt, deny the claim. Likewise, the financial advisor might ask you ‘what have you done so far to provide for your retirement?’ Whatever your answer, they will seek to poke holes into your existing security plans in any way they can, disparaging your ‘cash is king’ plan by bringing up the specter of inflation, and how this will destroy your buying power. Or, if you have bonds they will bring up reasons why you should be more diversified into stocks, or if you have stocks why you should have more bonds, etc. etc. etc. Whatever your position, the FA will invariably find fault with it, and discuss possible future occurrences that will diminish your existing flawed portfolio, unless you buy into their suggestions as to how to insulate yourself from a sub par future and ‘diversify’ and ‘allocate’ your assets into this fund and that instrument (which generates them a commission, fee, etc.). Regardless of the future, in which your portfolio will gain or lose principal, the FA’s wallet will only gain the dollars that you give them for their expert ‘advice’, regardless of whether you win or lose going forward into an unknown future. Under the auspices of the SEC, the independent Financial Industry Regulatory Authority (FINRA) attempts to project an image of the industry to financial services consumers as that of a highly regulated and honest segment of the business community. Unfortunately, there are several less than flattering sides of the business that truly need to be addressed by the SEC, FINRA, and the professionals within the industry itself. There are obvious and blatant bad apples such as Bernard Madoff whose shameless fraudulent activities paint with a broad brush a negative side to the industry. These highly publicized but rare incidents of massive Ponzi schemes perpetrated by criminals such as Madoff , Allen Stanford and a few other high profile financial advisors/scoundrels that make the news these days do not in truth reflect the general nature of the business for the most part. What can accurately be pointed out, however, regarding the structure of this industry is that it closely resembles a pseudo pyramid scheme itself, not unlike the business model developed by Richard DeVos and Jay Van Andel in the late 1950’s when they established what would eventually become Amway, in which network marketing is the primary means of generating business. Network marketing basically entails selling products to those you know, or to those whom the FA has some manner of relationship, to include blood relatives, friends, associates and most importantly the referrals obtained from these relationships. In other words, for network marketing to work, the FA must ‘pimp’ their family and friends and foist their products and services on the people they are closest to, and then subsequently twist their family member’s and friend’s arms for referrals. Of course, it differs from a true pyramid scheme; while a genuine pyramid scam generates revenues from new investors into the structure to subsequently line previous entrants’ pockets, the nature of commissions and fees from the financial services industry are indeed generated by consumers who are more or less satisfied with the product they purchase, which is advice. This advice can be good, bad or mediocre, and after a period of time, perhaps nonexistent. Amway has been dogged over many decades by accusations of being a pyramid scheme, but the technical structure they have put in place does not cross that line, however close to the line that legal call may lay. From 1959 until the late 1990’s, Amway used network marketing to advance Amway’s reach into virtually every corner of America. Once nearly total saturation of their network marketing plan was obtained in North America by around 2000, Amway focused on new markets internationally, as nearly every family in North America had an Amway connection, and no new network marketing was possible going forward in a nearly total saturation of the North American market place. While the comparison between the business model of Amway and that of most if not all financial services companies is inexact, the basics of both models remain the same: to survive in either environment (Amway or the financial services industry), the sales professional must spread the word of the ‘value’ of their services throughout their own social network rather than more traditional approaches used by businesses in the past such as media advertising. The larger the circle of friends, family and associates (or what is referred to within the industry as a ‘warm market’), the more likely that individual will succeed in gathering assets. In time, a similar saturation as happened with Amway will ultimately occur within the U.S. financial services market, with nearly every American family having a social connection to one financial advisor or another, and expansion using network marketing will no longer be a viable business model within the financial services industry. As to the assets that FA’s seek from their family, friends and associates, these assets will then be transferred by the FA to his/her licensing sponsor (the brokerage firm) and held in stewardship on behalf of the client by the firm and the FA as ‘assets under management.’ Subsequently, under the FA’s ‘professional management,’ this arrangement supposedly justifies the accompanying fees, commissions, trails, transaction costs, etc. Parts of those fees, commissions, etc. are kicked back to the individual financial advisor. Give or take, the FA will receive 50% of the fees, commissions, etc., and often much less. One of the less obvious and yet disturbing facts mentioned previously about working with an FA to manage one’s assets is this: in any downturn in the market, equities, commodities and certain income funds lose value and decrease the amount of principal within a client’s portfolio. This unfortunate event, however, never goes into negative territory as far as the brokerage house’s income statement or the FA’s wallet is concerned. Commissions paid to the FA by the client may decline in a downturn, but they never, ever go into the red as do the portfolio returns of the client. In good times and bad, the brokerage house and the FA gets paid regardless of the performance (or lack thereof) that their ‘professional management’ yields within their client’s portfolios; much like the brokerage partners of ‘Duke and Duke’ in the 1983 film ‘Trading Places,’ starring Eddie Murphy and Dan Ackroyd. When Randolph and Mortimer Duke (played by Ralph Bellamy and Don Ameche respectively) were explaining how the commodities brokerage business worked to neophyte Billy Ray Valentine (portrayed by Eddie Murphy in this film), Billy Ray replied ‘sounds like you guys are a couple of bookies to me.” This observance by Billy Ray is not entirely inaccurate. By merely holding the FA’s license, the brokerage house in effect cashes in on the FA’s relationships which he or she has developed, nurtured and maintained during the course of their lives. Any relationship developed by the FA going forward is expected (mandated, to be more accurate) to be mined and exploited for investment assets by the brokerage firm management, and this arrangement continues on in perpetuity: the brokerage house mandates that the FA ‘pimp’ all of their family, friends and associations in exchange for a partial return on the fees and commissions generated as well as the privilege of remaining FINRA and insurance licensed to continue on in this ‘pimp-like’ arrangement. The basic tenet of marketing in the financial services industry is not advertising their products and services to the ultimate consumer, but rather recruiting financial advisors who will act as pimps to exploit all of their past, present and future relationships for investment assets. The brokerage house needs to do nothing else after signing up the financial advisor but sit back and watch the money flow in as they shamelessly milk their FA’s relationships. There are of course exceptions to this generalization, namely that some of the larger brokerage firms such as Edward Jones and Pacific Life among others advertise the services of their financial advisors on a national scale, but still expect the same network marketing from their FA’s. Many of the larger firms insist that their ethics are beyond question, and that their only goal is doing what is in the best interests of the client. This is in reality only so much lip service, stating that the clients’ interests are paramount, as this is clearly not the case since each financial services company seeks to maximize their own cash flow at times to the detriment of their clients. Edward Jones, for example, has what it calls ‘preferred vendor’ arrangements that allow for certain mutual fund companies to kick back rewards to the FA for promoting their funds over others. This practice encourages the FA to offer more of the preferred products over other products that are outside of the preferred vendor list, regardless of financial performance of any product. Clearly this is not in the best financial interest of the client, but rather benefits the preferred vendor and the FA. Edward Jones does indeed issue a disclaimer indicating this arrangement, and that seems to satisfy FINRA but it does not address the ethical problem of a clear conflict of interest on the part of the FA towards their clients. Another conflict of interest at Edward Jones is the issue of no-load mutual funds: they are strictly forbidden. Not only does Edward Jones refuse to sell or support individual no-load funds, they will not allow in-kind transfer of no-load funds into the company books under any circumstances. The Edward Jones advisor will tell you that this is because they cannot get the same level of vendor support from no-loads that they can from their loaded fund vendors. This excuse is patently untrue: the sole reason they do not sell or support no-load funds is that there is no commission associated with these funds, regardless of how the fund performs financially. Accordingly, refusing to support no-load funds is a conflict of interest; if managing a portfolio to include no-load funds is in the best interest of the client, then Edward Jones should allow this. The bottom line is that Edward Jones will have nothing to do with them UNLESS: they are included in an internally managed product such as the Edward Jones proprietary ‘Advisory Solutions’ product, which includes no-load funds within its portfolio. In including no-load funds within a bundled product such as this, they have no problems in using no-load funds since there are commissions built elsewhere into the product. This reality refutes their explanation that they can’t get support from no-load vendors – obviously the Advisory Solutions account manager has access to unlimited support at the wholesale level of these funds. John Hancock Financial Network works in a similar manner in preferring some products over others regardless of the suitability issues the client faces. If a John Hancock financial advisor pushes insurance products over securities regardless of the needs of a client, the client is ill-served. If, for example, a client feels they are overly invested in their portfolio of insurance products and wants to increase their risk and return ratio by buying equities, the FA at John Hancock is discouraged from adding stock or mutual funds to this particular portfolio in a solicited fashion. Only unsolicited equity transactions are authorized by John Hancock to the FA, thus discouraging clients from increasing their risk/return profile and gently nudging them towards John Hancock’s bread and butter products: insurance. This disregards the need to determine suitability of products for individual clients required by FINRA, and diminishes the FA’s inclinations for risk tolerance profiling. The incorrect assumption by John Hancock management is that most (if not all) people prefer ‘protection’ from the downside of the market via insurance products over exposure to increased risk (and subsequent higher return) that are offered by equity products during bear market periods such as stocks and mutual funds over the long run. This reflects a built in conflict of interest as it relates to the relationship between a John Hancock financial advisor and their clients. So just what is the value of the advice we get from these guys who claim to be experts in the financial industry worth? Are they credentialed experts in the fields of finance and economics? No, they certainly are not for the most part. Are they savvy investors themselves who have made millions in the market, and now want to show you how it’s done? Most assuredly this is not the case. No, these guys are just sales people, nothing more and nothing less, and are more often than not motivated to sell you a product that pays them a commission, which ultimately comes off the top of your portfolio returns. They are just like every other ‘consultant’ that infests every other business. They know just enough to create fear and uncertainty on your part, sound just savvy enough to make you think they know way more than you do about money, and most importantly they know every closing line in the book to persuade you to give them your money. The value you receive for this? It’s negative value, if the truth be known. These guys are like all ‘consultants’ as they old saying goes and ‘borrow your watch and then give you the time of day.’ The only thing you notice from the advice you pay for is the commissions and fees that they take from you. They do not create any additional wealth, but more accurately are parasites on your portfolio. To answer the question posed at the beginning is that there is no value in the long run to the advice that you get from a financial advisor. Your guesses as to the future are just as good as theirs and your guesses cost $9.99 per transaction at TD Ameritrade, while a full service broker will charge at times $100.00 or more per transaction based on the amount. Anyone can open a TDAmeritrade or Fidelity account and manage their own assets just as good if not better than a paid professional. A few simple rules and you know as much if not more than a financial ‘expert’: Get out of debt. Pay off the highest interest rate debts first, namely your outstanding credit card balances. Once you have retired these, you can continue to use them if you pay off the entire balance each and every month (no exceptions), or if you cannot do this, cut the credit card up into at least 17 pieces. In other words, live within your means. Pay cash for items you used to purchase with a credit card. If you don’t have the liquid cash for something you want, don’t buy it. Again, live within your means. Your mortgage is usually the lowest interest rate consumer debt, and the interest you pay here is tax deductible, so pay this one off last, in conjunction with putting away the cash you used to pay on your credit card debt into the bank. Once you have saved at least the equivalent of 3 to 6 months of monthly expenses (your ‘rainy day fund’), put any amounts above and beyond your mortgage payment into whatever investment with which you are most comfortable concerning the inherent risk versus return of that investment. Do this each and every month (some call this regular investment schedule ‘dollar cost averaging’). Equities (stock in the form of mutual funds), real estate and corporate bonds are available on the cheap now. As they say, buy low and sell high. Things are low right now. Very low. Just think long term on these investments, perhaps 10 years or more time horizon. Any time period less than that, you are engaging in speculation which is different than investing. Words to the wise: stay away from the following: Commodities. These are highly volatile, and the markets for these investments are subject to wild swings based on politics, weather, corruption and all manner of seemingly irrelevant world events. Popular commodities currently are gold and oil. Avoid these investments as you would your broke 2nd cousin who just got paroled from the Big House. Options. These are only for investors with nerves of steel and ice in their veins. Additionally, these investments are purely speculative as to which way the investor guesses the markets will move, up or down. Guess correctly you win, incorrectly you lose. You may as well go to Las Vegas and put your option investment money on either red or green at the roulette table. Payouts are equivalent. Individual Stock issues. The strength in equities is diversification, or owning many different and varied stocks across all industries in large, medium and small companies. Mutual funds do this quite well. Only invest in an individual stock if and only if you know a great deal about the company, its principals, balance sheet, and are prepared to lose everything if this individual company goes belly up. If a single company in a mutual fund goes south, the rest of the fund will likely remain in good shape because most mutual funds are composed of hundreds of individual company stocks, and it is rare that a mutual fund manager will hold over 3% of the total fund assets in any individual stock.

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