Thursday, January 29, 2009

Financial Lessons from the Wealthy

We often hear that the rich keep getting richer, and that’s a common refrain in America. I usually enter this fray by noting that the educated keep getting richer, and that the best economic solution seems to be further education.

This is particularly true of financial education. I’ve been managing money since 1983, and I’ve noticed some important gaps in the typical family’s financial knowledge. Simply put, wealthy people behave differently, and we can learn some important lessons from them.

The stock market isn’t a casino. Many middle-class people think it is. It’s true, buying a single stock is risky. Buying many stocks, though, is prudent.

Millionaires own stocks, but they aren’t frequent traders. When Dr. Tom Stanley and Dr. Phil Danko wrote The Millionaire Next Door (Longstreet Press, 1996), they discovered that fewer than one percent of interviewed millionaires traded stocks on a daily basis. Another one percent traded on a weekly basis. In fact, more than 40 percent hadn’t traded a single stock in the year prior to interview. Clearly, millionaires are investors, not gamblers.

The heart of wealth management is the idea of thoughtful diversification. This scientific basis for portfolio theory won a 1990 Nobel Prize in Economics (several, actually). In essence, risk is reduced and performance enhanced by owning a wide variety of investments. There’s a lot more to it, but that’s the basic concept.

Many so-called safe options collapse to genuine evaluation. Low interest rates, inflation, and taxes eat much of the gain from bank deposits or government bonds. Comfort comes at a very high price, and a bit of education about stocks and diversification can put a mind at ease.

Not all debt is bad. “Neither a borrower or lender be,” Ben Franklin advised. It’s become a sort of holy middle-class mantra. Despite Ben’s advice, there are different kinds of debt, and not all debt is bad. Borrowing for consumer goods such as furniture is almost always bad. Borrowing to buy a nice house in a nice neighborhood is almost always good, so long as the terms of the loan are reasonable. We all know by now that sub-prime mortgages, interest only loans and 50-year mortgages are bad debts.

Many quality advisors recommend against paying off a mortgage early, and there is solid evidence supporting this approach. Nevertheless, many middle class folks want to pay off their residence as quickly as possible.

They think they’re doing the right thing, but money for paying down a mortgage comes from somewhere, and it’s no longer available to invest. That can be counterproductive. Our wealthy friends understand the difference between good and bad debt and aren’t always in a big hurry to pay off their mortgage.

Do-it-yourself isn’t the best choice. Wealthy people know where they excel. Many own a business that relates to their strongest skill.

They also know their weaknesses. They probably don’t try to save money by fixing their own cars because they know a mechanic can do it better, and in the end, they’ll save money by hiring an expert the first time around, rather than to repair mistakes.

When it comes time for a new roof on their home, they pay someone to do it for them, so that they won’t spend their time cleaning up leaks.

And you’d better believe when it comes time for surgery, these are not folks picking up instructions off of the Internet to replace their own knees.

The point is, hiring professionals is often the best path. Consider this the next time you’re looking over your retirement fund or other investments.

Friday, January 23, 2009

A common but deadly mistake

Sometimes people apply mental mathematics in evaluating professional fees. Do you have a friend like this? “Let’s see,” they’ll muse. “If I can get five percent by myself, and you charge one percent a year, then you’ll have to get six percent or more for me to beat the market and come out ahead. Right?” This common logic is not only counterproductive, it’s dead wrong.

First, performance isn’t the only measure that counts. If performance were all that matters (and money was not an issue, of course), we’d all drive Porsches or Ferraris. Truthfully, we also care about safety, reliability, comfort, and cost. When taking all factors into account, we almost universally choose something different than the highest performance available.

So mentally charging a professional fee against just one variable – performance – is a distortion of what your family really needs, and also of what you should expect from a quality advisor.
Look at it another way. Looking back, two separate portfolios earned eight percent one year. One was invested completely in the common stock of a single local company, the other in a diverse mix of blue chip stocks. As an investor, does it matter which one you owned? From a pure performance standpoint alone, the answer is probably no (that year, anyway). But any solid professional would tell you that the comfort, safety, and reasonable expectations from these two portfolios are dramatically different.

If a professional makes your family situation or portfolio safer, more reliable, more comfortable, and or less expensive, they’ve provided something you didn’t have before. They’ve added value even if they didn’t add “net” performance. Millions of very smart families understand that’s worth paying for.

Sure, it’s an added cost, but those are added benefits, too. And the value of each benefit isn’t directly tied to portfolio performance. So, mentally, it’s a terrible mistake to use performance as the only evaluation criterion.

And there are other points, too. It’s entirely possible that a good advisor will create additional performance. Not by being smarter or by “figuring out” the market (a fool’s game) but by suggesting newer products, lower fees, or ideas beyond your personal experience. They may broaden your portfolio in ways you’ve never even considered. There’s no guarantee, but most observers believe that – over reasonable time horizons – expertise adds performance.

Another important factor is not so obvious. Risk is a key component of investing, and many individual investors don’t have a clue. An advisor brings experience, knowledge, and risk measurement tools to each situation. This expertise may not seem important, but it’s critically important during market turmoil. Again, it’s added value apart from performance.

Last, there are other financial issues. Our general rule is that we help clients understand all issues as part of our total service package. Maybe you need a plan for college expenses, or help allocating your 401(k). It’s unlikely that either of these will pay us a cent, but we’ll usually help anyway. The fee you pay – and the service you get – is, once again, unrelated to performance.

Maybe it would help to consider professional fees apart from the portfolio itself. Is it worth a few dollars per year to hear advice on how to allocate investments? Might an advisor suggest cost-saving strategies or a better approach to taxes? Could they recommend a manager or fund that would mitigate risks in down markets? Depending on the size and complexity of your investments, $1,000 might be a bargain!

It amuses me that some people think they can manage their own portfolio just as well as a full-time, properly trained professional – all in the name of saving money. Millions of successful people gladly pay advisors for assistance. They don’t have money to burn; simply, they perceive value that overrides the fees paid. The smartest families see that value and let professionals improve their situations. If you have a friend who’s fallen into this common mistake in thinking about professional advice, hand them this column and let them know there’s a better way.

Thursday, January 15, 2009

Act now for family financial success

Investment fear is everywhere. There’s no question that we’ve lived through some pretty awful investment times. These past ten years have been as volatile and depressing as any on record. Families are still frightened, with plenty of good reason.

The stock market can be a frightening place. Peter Lynch often points out that the stock market – on average – has a twenty-five percent setback every five years. That magnitude, alone, is enough to keep many people investing solely in bank certificates. And the 2000-2002 Bear Market was recorded as one of the worst ever. Then, when things seemed all better again, along came 2008 to remind us again about harrowing markets. We’ve lived through both recent Bears (so far), but it is no wonder that some people are terrified.

Perhaps the worst manifestation of fear is paralysis. This is the “deer in the headlights” syndrome that is so well-documented in nature (in fact, using bright lights to hunt is so predictably easy that it’s illegal). Sometimes, like with wild deer, things just seem so frightening to us that we choose not to do anything. Paralyzed by our own fear, we can become statue-like spectators to our own destruction.

Now is the time to take positive action. True, restructuring a portfolio now might involve acknowledging some earlier mistakes. It might require changing how you do business or how you research investment decisions. It may mean that it’s time to dump a broker or other adviser who contributed to those disasters. These aren’t easy decisions, but they are necessary considerations for future success.

For families, now is a perfect time for review. What worked? What didn’t? How are you progressing towards family goals? Emergency reserves. College savings. Retirement investments. A genuine review should offer new insight into the necessary steps for success.

Now is a unique point of investment opportunity. Let an old proverb work for you. Shifting “all your eggs out of one basket” works even better when you can buy both eggs and baskets at bargain prices! Almost every investment sector is down right now and this could be a terrific time, maybe the best in our lifetimes, to build a superbly diversified portfolio.

Now is the perfect time to hook up with a quality investment advisor. Marginal professionals have already left the investment business, and others will soon join them. The truth is that easy investment times attract lots of friendly faces. Tougher times require professional diligence, skill, persistence, and – above all – a genuine desire to help clients. Good people survive, and now’s a great time to find one.

Above all else, remember this: Unlike the deer, we have the power to learn from our mistakes. Many mistakes are correctable, but to correct them, we must act. The sooner the better. Now is the perfect time to get started.

Wednesday, January 7, 2009

Create a Purpose-Driven Investment Plan for Your Family

Many people look at investing and finance as a big mystery. It’s a convenient myth, because that allows for failure without responsibility. Good news, though. Some very simple steps can put almost anyone on the path to financial success. In this age of information, there are no secrets and mysteries are rare.

To succeed financially, follow these steps.

Create a purpose-driven investment plan. Each investment dollar should be tied to a specific family purpose. Emergency reserve? Retirement? College? Purpose and time frame determines the best course of action for saving and investing.

Research “best practice” investing for each purpose. You’d never know it from the general media, but this isn’t rocket science. Financial planning is a profession with incredible depth and resources. Seek out books, articles, and websites devoted to each purpose, and gather some solid material to guide your way.

Choose strategies offering promise of success with reasonable comfort. There are a lot of roads leading to success, but some are more efficient and comfortable than others. Some folks enjoy the scenic routes, but your best chance of arriving comfortably and on time are mainstream routes. (Remember: more comfort comes from more education.)

Implement each strategy, with an eye towards cost and convenience. Diversity in the marketplace creates a broad spectrum of choice and fees. Laypeople often suffer because costs and fees are confusing and obscure. A little digging can shed a lot of light on the subject. It’s a zero sum game, though. The higher the fees are, the less that is left for investors.

Monitor key data. Professionals focus on certain things. In our practice, we carefully watch portfolio composition, fees, and performance against peer managers. You may choose other factors, but create a simple dashboard for periodic review. Delve deeper only if the dashboard reveals problems. What prompts your engine light to flicker on?

Conduct an annual review. Compare against each purpose and meaningful investment benchmarks. Compare stock performance to the S&P 500 index and bonds against the Lehman Brothers Aggregate Bond index. How are your portfolios progressing towards each stated purpose? As long as things look reasonable against those standards, stay the course!

Ignore market and finance noise. The morning traffic report only matters when it affects your route to work or school. Similarly, much of the media’s (endless) market discussion is about things beyond your neighborhood or town. Tune to a station with inspiring music or challenging discussions. Maintain focus.

Delegate financial tasks that are too burdensome or too boring. Investing is such a small part of financial success, and it’s easier (and cheaper) than ever to hire professional help. Use the time you free up for education or increased productivity. If you can’t or won’t follow these steps, find a professional who will.

Dan Danford is founder and CEO of Family Investment Center in St. Joseph, Mis­souri. The firm is a commission-free investment advisor registered with the SEC. Danford and other advisors at the firm specialize in managing large portfolios of traditional investments. They do, however, advise investors on a broad range of wealth management services. More about Danford and this unique firm can be found at