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Archive for November 2010

The Difference Between Individual and Institutional Investors

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

Many investment entities (banks, money managers, consultants, etc.) make the mistake of treating all investors alike.  But, corporate investors are far different from individual investors.  While a pool of money make look the same, there’s a huge difference when it comes to focus.  Here are six notable differences:

  1. Most individual investors will, at some point in time, discontinue adding additional cash to the portfolio.  An institution (pension plan, foundation, etc.) can usually count on continuing cash contributions in the future, which can provide a cushion against inflation or market reversals.  Retired individuals don’t normally have that luxury and can’t count on additional inflows to help protect against the loss of their purchasing power.
  2. Individual investors do not benefit from the tax-exempt status that qualified plans and most foundations and endowments enjoy.  The individual investor must deal with capital gains and income taxes that must ultimately be paid.  It’s important, therefore, that individual investors have access to advisors and money managers experienced in working with taxable portfolios.
  3. Individual investors buy – or `should be’ buying – services, not products.  The advisory relationship is generally more important to individuals than to most institutions.  Relative performance is not as critical as absolute performance.
  4. Individual investors are less likely than their corporate peers – even when corporate portfolio size is comparable – to hire professional advisors or consultants.  Most individual investors prefer to make their own investment decisions, utilizing outside advisors only when a significant life event occurs (sale of a business, retirement, etc) or turn to the brokerage community for Wall Street ideas.
  5. Individual investors pay more for the same investment services as institutional investors of comparable size.  This can often be due to `bundling’ of fees, which seldom provide a sufficient level of transparency. 
  6. Unless the family wealth is tied to trusts or private foundations, the individual investor is not encumbered with regulatory oversight; which is often why `prudent practices’ seldom enters into the individual investor’s process who believes `It’s my money and I’ll do with it as I please.”

Individual investors and institutions do differ – in their needs and in their practices.  Most individuals would not allow anyone they know to manage their life savings with the process they themselves use, which is why licensing qualifications, practice standards, and a regulatory environment exists for those who provide those services professionally.

Jim

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™  and in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained herein should be regarded as tax or legal advice and the reader is urged to seek competent counsel to address those issues.   The above represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a formal financial and investment plan.   For questions or comments, you can reach Jim at 805.265.5416 or through the IFG website, http://www.indfin.com.

A Tax-Reduction Strategy For Your Investments

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

The Problem:  Lack of customization and efficiency.[i]

Here’s a hypothetical example of a situation worth reviewing.  A client was investing in a separate account program offered by a well-known large wire-house brokerage firm.

As with most traditional separate account programs, each money manager ran a portfolio of securities in a separate and distinct account.  The result was little-to-no coordination between and across accounts, which can result in a certain amount of overlap among holdings.

The client then moved to another major firm, which offered multi-disciplinary accounts (MDAs); but, soon realized the accounts offered primarily proprietary (in-house) or affiliated managers and cookie-cutter asset allocation models.  In addition, the accounts weren’t as `tax efficient’ as was thought since the lack of manager coordination resulted in wash-sale issues that should have been avoided.

The client wanted to move beyond this environment to an independent platform where  non-proprietary, unaffiliated managers could be used and portfolios could be completely customized for stock restriction, tax management, asset allocation, and manager selection.

The Solution:  An Overlay Separate Account Platform (OSAP)[ii]

Here’s how the typical separate account platform to an OSAP solution:

Suppose you have two managers who each hold the same stock now valued at $80 per share.

  • Manager A’s Position:   100 shares with a cost-basis of $30                                                     
  • Manager B’s Position:    200 shares with a cost-basis of  $75

At $80 per share, the price just hit Manager A’s sell target.       The result:  At $50 per share, a $5,000 realized gain.   Meanwhile, Manager B is holding 200 shares with far less gain built-in!

Here’s where the overlay strategy comes in.  The overlay manager works this way:

  • 200 shares held by Mgrs A and B
  • Cost basis A = $30
  • Cost basis B = $75
  • Stock MV = $80
  • Mgr A initiates a `Sell’ ticket on 100 shares
  • Overlay manager sells $75 cost basis shares from Mgr B
  • Result: $5 gain 100 shares = $500 realized gain
  • Realized Gain reduced by $4,500! 

That’s a hypothetical example based on a single transaction.   Do you know how much duplication exists in your holdings?  You might be surprised!

Enjoy your Thanksgiving weekend!

Jim

 

[i] Hypothetical, but a very realistic problem many investors face.

[ii] This solution is appropriate only  for individual accounts valued in excess of $500,000.

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™  now in his 19th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained herein should be regarded as tax or legal advice and the reader is urged to seek competent counsel to address those issues.   The above represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a formal financial and investment plan.   For questions or comments, you can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com.

A Portfolio Review Isn’t An Investment Plan

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

You’ve seen it a thousand times:  Financial advisors use `free’ portfolio reviews as a way of introducing themselves and their services, as well as to demonstrate their competence and capabilities.   Nothing wrong with that; I’ve done it myself! 

The usual process is that the client furnishes his or her most recent tax return and a copy of all their investment statements.  This gives the financial advisor a clear picture of the client’s current financial situation.  The advisor is then able to run a sophisticated analysis revealing individual, as well as total portfolio, annualized raw and risk-adjusted return figures, tax efficiency, and expenses, as well as visually depict how ‘optimized’ the asset allocation is against an ‘efficient frontier’ – which is financial `geek-speak’ for seeing if you’re taking too much risk for the return you’re achieving.

All of this will give you some indication regarding the characteristics of your portfolio; but it won’t tell you if you have the right portfolio for YOU! 

Example:  There was a time when a basket full of high-tech stocks were outperforming all other investments.  One might think that’s a good portfolio; but, would it be appropriate for someone with a family, a mortgage, trying to fund college educations, and supporting an elderly parent who needs constant care?   All of a sudden, that basket looks more like a gamble than a good investment strategy. 

Ya’ think?

It would be easy to construct three different portfolios, all of which would look good; but, would they be appropriate for you?   It could be that only one is truly in your best interest.

Like most things in life, it all starts with a plan.

Try to imagine someone deciding to build a house without a blueprint.    What would the house look like if they ordered materials and tools and began construction?  — all without any plans on paper.

That’s exactly how millions of American’s approach their financial futures today – any also why so few are adequately prepared.   Even if their portfolio review looked good, which it rarely does since everything was usually selected in an ad-hoc fashion, they’re still in virtually all cases not meeting their goals.

Food for thought.

Jim

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™  now in his 19th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained herein should be regarded as tax or legal advice and the reader is urged to seek competent counsel to address those issues.   The above represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a formal financial and investment plan.   For questions or comments, you can reach Jim at 805.265.5416 or through the IFG website, http://www.indfin.com.

Hyperinflation May Be Coming!

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

No, my crystal ball isn’t back from the shop yet; but, you may not need it for this one. 

The government has been spending at unprecedented levels for the past eighteen months, by some accounts adding more debt than all previous administrations combined – from George Washington to George W. Bush.   I was surprised, though not shocked,  to hear George Will on ABC’s This Week announce that the interest payments alone on our national debt now equal the entire budget for the Defense Department.   How will all that debt be redeemed?  If history is a teacher, it’s probably a safe bet that the government will simply print the money needed.  Translation:  Inflation.  And, given the size of the debt, you might want to inject the word ‘hyper’.

How can investors position themselves for this?  Portfolio modifications might include the addition of a couple of instruments designed for an inflation environment.[i]

Two such inflation sensitive investments are Inflation-Linked Bonds, like US TIPS (Treasury Inflation-Protected Securities) and commodities.  Most investors are familiar with TIPS.  They are specifically constructed so that the principal value of the bond is adjusted according to the rate of inflation.  If inflation (CPI) rises, the principal value of the bond is adjusted upward accordingly.  Of course that is not the case with traditional fixed income bonds, as inflation rises, the fixed income stream generated just loses purchasing power and thus there is downward pressure on the principal value of the bond as well. 

Since commodities are a meaningful component of inflation, investments in that asset class also provide a high degree of sensitivity to inflation rates.  Key to the relationship between inflation and commodities is their apparent correlation, remembering that commodity prices have historically been much more volatile, with moves that are magnified by several multiples the movement in inflation. 

These two asset classes can help in the creation of an inflation-focused portfolio intended to act as buffer for the effects of inflation on other assets like fixed income bond investments.

A quick comment on stocks and inflation.  Equities can provide a reasonable return relative to inflation in periods of moderate inflation.  But when inflation accelerates beyond the moderate level, stock prices have struggled.  Ned Davis Research has quantified that in periods where inflation is rising more than 1% above the previous five year average, stock prices have averaged –2.2% per year.*

*Ned Davis Research, S&P 500 vs. Consumer Price Index, 01/31/10

 ——-

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™  now in his 19th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained herein should be regarded as tax or legal advice and the reader is urged to seek competent counsel to address those issues.   The above represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a formal financial and investment plan.   For questions or comments, you can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com.

[i] Before instituting any investment strategy, you should talk with your financial advisor first be sure your financial and investment plan is up-to-date.    

Understanding Management’s Value

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

You would like to evaluate a potential portfolio manager.  Is s/he any good?  How do you know?  

Most people would look at the manager’s performance and compare it to other managers and an index.  Many would look at some rating service to see how many ‘stars’ the manager had (too bad they don’t know how those calculations are weighted and their complete lack of predictability, but that’s another article).

Does ANY of that really tell you how good the manager actually is?

The real question is whether the manager actually added value to the underlying portfolio holdings.   After all, a manager is being paid to manage!  What if the portfolio holdings would have done just as well – or better – if left unmanaged completely?

Knowing whether the manager actually adds value is an important part of the management selection process.

Do you have your green eye-shades ready?   A little warning:  There’s math involved.

Before a manager’s value can be understood, a portfolio’s expected return must be identified.  For this, we use the Capital Asset Pricing Model (CAPM):

__                  __

RP = RF + (RM-RF) βp

Translation:  The Expected Return of the portfolio =  risk-free rate of return* + (expected return of the market minus the risk-free rate of return**) times the portfolio’s beta.    

*   the short-term treasury is the typical proxy.

** this is the market’s return `spread’ in excess of the risk-free rate

Is it time for a break yet?

Okay, once we know what a portfolio’s expected return is.  We can compute the management’s alpha – a measure of added value –  by analyzing actual performance.

The Jensen Alpha calculation is accomplished by simply using the original ‘expected return’ we found previously and subtracting CAPM.  If an investment portfolio or fund generates a return that is exactly what would be expected of a portfolio or fund with its beta, the alpha would be zero.  There’s no added value.

        __                __

aP = RP – [RF + (RM-RF) βp]

Once a manager’s alpha is identified, the next question generally turns to risk, i.e., how much return is achieved per unit of risk assumed?    That’s an important question!   Why would you want to assume two units of risk for one unit of return?

For this answer, one of two ratios can be used, depending on the character of the portfolio: 

  • The Sharpe Ratio, sometimes called the reward to variability ratio, calculates this for undiversified portfolios using total risk.  The
  • Traynor ratio, sometimes called the reward to volatility ratio, calculates this for diversified portfolios using market risk. 

Each is calculated subtracting the risk-free rate of return from the portfolio’s expected return.  Sharp divides the answer by the portfolio’s standard deviation.  Traynor divides the answer by the portfolio’s beta.

If you’ve even read this far it shows you are either very good at mathematical analysis  or you really have nothing else to read.    Either way, this is probably a good place to end this before we have to call 911.

One final note:  Managers are generally evaluated using time-weighted returns which gives each period in time the same weight, regardless of the dollars invested.   Individual investors should compute their own returns using dollar-weighted returns if they are making additions or taking withdrawals from a portfolio.  In those cases, investor performance will likely differ from the manager’s.  I knew that would cheer you up.

Some Fiduciary Links You Might Like

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

This post will be short.  Since first writing about the fiduciary vs. suitability issue last August, several people have asked me more about this – some may have even wondered if I made it up(!); so, I thought I’d provide a little more insight on this issue which has been covered by MSN,  PBS, and Forbes, among many others both inside and outside the financial industry.

The issue is being addressed by the Department of Labor now and the outcome could change how IRA advice is given in the future.   

For investors who often choose advisors on subjective criteria, it’s important to understand these distinctions and the differences they might entail.  A reading of the linked articles above might offer some help in that department.

Jim

Jim Lorenzen is a Certified Financial Planner™  now in his 19th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained herein should be regarded as tax or legal advice and the reader is urged to seek competent counsel to address those issues.   The above represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a formal financial and investment plan.   For questions or comments, you can reach Jim at 805.265.5416 or through the IFG website.

Is All Your Money in Company Stock?

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

If all your money is in your company’s stock, you’re committing a major – make that MAJOR – ‘no-no’.  And, common sense should tell you it’s true, no matter how great you think your company’s stock is – and no matter how much you believe you know something others don’t because you work there.

Remember when General Electric (GE) was regarded as ‘blue chip’ and a ‘safe’ stock investment?  How about the people who worked for Lucent Technologies in senior management who still suffered huge losses when that stock went south.

“But Jim”, the argument goes, “my company will think I’m disloyal if I sell any of my stock!” 

Really?  Ask them to put that in writing.  Ask them to recommend – in writing – that having the majority of your money in company stock is your best financial option.  

  • If they don’t do it, it’s because they know that making this type of recommendation places them in the position of acting as a fiduciary.  That’s a legal status which means they MUST put your interests ahead of the company’s and this advice just doesn’t fit the bill.  In addition, it constitutes providing investment advice, which automatically classifies the individual giving it as a fiduciary.[1] 
  • If they DO put it in writing, the person who signed it should probably be dismissed for accepting fiduciary status which subjects both the signer and the plan sponsor – your company – to liability under the Employment Retirement Investment & Securities Act (ERISA).  A person’s fiduciary status is determined by actions, not title.  A person becomes a fiduciary by their actions even if they acted without proper authority.   In other words, if a company representative – even a clerk in the H.R. department – gives you investment advice regarding company stock, that individual has acted as, and has become, a fiduciary under ERISA.[2]

Best practice:  Remember your first loyalty should be to your spouse and your children.   If you didn’t work for your company but some other highly-regarded one, say Coca-Cola for example, would you have ALL your money in that stock?   If the answer is yes, then why don’t you do it now?  If the answer is ‘no’, then it should tell you something about your own situation.

If you have a huge portion of your assets in your company’s stock, the chances are excellent you do not have a professionally-prepared financial plan for your future.  By `professionally prepared’, I mean a plan hammered-out between you and an advisor that is not only qualified, but will accept fiduciary status for the plan and the investments chosen.  That will separate the planners and advisors from the salespeople for you.

If you’d like to learn more, you can request a copy of my paper, Why Investors Fail by simply using the `Request Info’ button on our website.  You can also learn more by subscribing to this blog on the right side of this page.

Jim

The Independent Financial Group is a fee-only registered investment advisor and does not sell products earn commissions, or accept any third-party compensation or incentives of any description.  IFG also does not provide tax or legal advice.  The reader should seek competent counsel to address those issues.  This post represents the author’s opinion and should not be regarde as investment advice which is provided only to IFG clients.  You can reach Jim at 805.265.5416 or through his website, http://www.indfin.com


[1] Retirement Success, 2nd edition, Dr. Gregory W. Kasten, United Trust, 2005, p296

[2] Ibid.