Eugene Fama's Contribution to the 2013 Nobel Prize in Economics

What does the Eugene Fama part of the 2013 Nobel Prize in Economics tell us?

This years prize went to Eugene Fama, Lars Hansen and Robert Shiller. All have done work on asset prices - think stock prices.

Fama is the father of the efficient market hypothesis - which states that without consistent inside information it is difficult to determine a better price for a stock other than the current price of that stock.

The argument is that stock prices incorporate all known information into the price of the stock at any given time. Which means that prices will react to new news as it becomes available. That is why they appear to bounce around in a random pattern. Thus the  term "random walk" of stock prices. There are so many people analyzing so much data that it is hard to find an edge. A 7/11/2013 Business Week story on hedge funds says it all:

" In pure dollar terms, there are more resources, advanced degrees, and computing firepower devoted to chasing this elusive goal than almost any other endeavor, and that may include fighting wars. Yet traders face the immutable fact that every second, each megabyte of information, blog post, one-line rumor, revenue estimate, or new product order from China has already been taken into account by the efficient market and reflected in a security’s price. This means that trying to gain what traders call an “edge,” at least legitimately, is almost impossible. As the financial incentives on Wall Street have become enormous, so have the competition and pressure to gain an advantage at any cost."

This means that it is hard to pick stocks that will give you market beating returns. When an investor purchases a stock that he thinks is a good buy, there is a seller who is selling for some reason. What do they know that you dont?

After 2008 many liked to say that the efficient market was dead. Those that said that didnt understand the nuances of Fama's argument:

Fama says that markets dont always get prices correct, sometimes they get prices terribly wrong, but in a random, unpredictable manner, and therefore investors cannot develop systems to consistently outperform the market.

What should an investor do? The answer has been: dont try to time the market or outsmart the market, rather simply own the whole market. By doing so an investor owns the return on capital markets over time. The US stock market has returned around 10% since 1926. Not too bad.

This insight has lead to the growth of index funds over the last 40 years. Index funds allow investors to own the whole market at a very low cost. The lesson for the average investor is to just own the market and stop trying to outsmart all the other smart people. There is not a system to date that has figured out how to outperform the market over the long run (net of fees and taxes).

Note: the stock market fluctuates wildly at times, investors in the market need to understand that point and plan accordingly.

An Example Of Why Many In The Industry Opposing The Fiduciary Standard?

Many in the financial industry are opposing the DOL's push to require financial advisers of retirement plans (401K, IRAs) to act as a fiduciary when advising their clients. Recently, the CEO of Raymond James issued a call to arms:

http://wealthmanagement.com/raymond-james-national-conference/opposition-dol-fiduciary-gains-ground

A fiduciary standard would require the adviser to put the clients needs above their own. How is this a bad thing? Why would those who earn commissions or annual fees on investment products oppose this.

The answer is made clear in a prior blog post of mine reproduced below:

How was an adviser, who placed their client in the Highland Small-Cap investment shown above, acting in their clients best interest?

Recently, I have taken on 3 new clients. All 3 were with commission or fee based advisers prior to asking me for advice.

The chart above, produced by Morningstar, is representative of at least 10 of the funds that the new clients owned.

In this case, the client's adviser invested the clients money in the Highland Small Cap Equity fund in 2011. Highland invests in small company growth stocks.

The chart shows the following;

1. Highland's performance over the last 10 years in blue.
2. The performance of all small cap growth funds in orange.
3. The performance of the Vanguard small cap index in yellow.

The Vanguard Index is simply a fund that holds all stocks that meet the definition of small cap growth - this is known as an index fund. The fee for this particular index fund is .08%

The other funds are known as actively managed funds - which means the funds employ managers who pick stocks in an effort to outperform a benchmark (or index). In this case the managers are trying to outperform the small cap growth sector.

A review of the chart shows that the Vanguard index fund clearly was a better choice in 2011 based on a visual look at the performance.

So why would an adviser NOT place their client in the Vanguard?

A look at the the top of the chart shows that there is a 4% load on the fund and an annual expense of 2.75%. This means that for every $1,000 initially invested the adviser gets an initial fee of $40. In addition, the fund takes 2.75% off of the balance every year. In fact, of that 2.75%, 1% goes to the adviser on an annual basis.

The adviser had a choice, he could have recommended the no load, .08% annual fee Vanguard fund, yet they placed their client in the Highland fund which rewarded him a 4% initial fee + 1% of the balance annually.
How was that good for the client. It seems it was good for the adviser.

In my opinion, this is what is wrong with this industry. It is based on a system where brokers and fee based advisers earn income off of recommended investments.

One way to combat this is too work with a fee-only adviser who doesnt accept commissions or fees from products they recommend. Dont confuse fee-only with fee based. fee based can receive fees from products they recommend to you. A fee-only adviser will generally charge an hourly rate or base the fee on the dollar amount of assets managed.

Note: Michael Angelucci MBA, CFP is a fee-only adviser.

Student Loan Debt - How $50,000 in loans could cost you over $750,000

Here is how $50,000 in student loan debt could really cost you $753,206.

It is not out of the ordinary for many college graduates to have $50,000 in student loans.
With current student loan rates at 6.8% and with a 10 year payback of the loan, a student could have a monthly payment of $575.40/month. This will amount to $69,048 in payments over 10 years. But that is not where it ends.

If the graduate did not have the loan, that student could theoretically save that amount every month in a in an investment account or their company 401K.

Lets assume the graduate saves the $575.40 every month and the money earns 6.8% on average - not an unlikely scenario if the funds are invested in a 60% stock/40% bond portfolio. After 10 years that money would grow to $98,504. It doesn't end here!

If the Graduate lets the $98,504 continue to grow in the account for the next 30 years, and the money continues to earn an average return of 6.8%, the account will grow to $753,206! That is without adding another penny to the balance.

I call the $753,206 the real cost of borrowing.

This does not mean that college degrees should not be pursued and debt not incurred. This cannot be avoided for many professional programs - medical, law.

But, many attend private and out of state universities to pursue degrees in accounting engineering and liberal arts that may not result in higher life time pay than a local state university.

When it comes down to making a college decision, a young person must ask: "if I have to borrow to attend this school will the degree result in more lifetime income than the real cost of borrowing?"

An Instructive Sunday read as told by Malcom Gladwell: Black Swans and the Difficulty of Beating Markets

Last fall, Niederhoffer sold a large number of options, betting that the markets would be quiet, and they were, until out of nowhere two planes crashed into the World Trade Center. "I was exposed. It was nip and tuck." Niederhoffer shook his head, because there was no way to have anticipated September 11th. "That was a totally unexpected event."

The above is the last paragraph from a great New Yorker piece by Malcom Gladwell. I have read dozens of books, articles, and studies on he difficulty of beating the market. For me, this story is one of the most telling: Since nobody can know the future how can you outperform the market over time - no matter how smart you are. A great lesson, I re-read this often.

Spend less than an hour with this well told, instructive story

http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm

Efficient Markets: Markets are not perfect but neither are really smart guys

Next time you think you, your mutual fund, your broker, your stock picking software can beat the market; scan the graphic below and read this short excerpt from Business Week July 16-21, 2013, "The Hedge Fund Myth"

"Hedge funds are built on the idea that a smarter guy (and they are almost all guys; only 16.8 percent of managers are women) with a better computer can make miracles possible by uncovering inefficiencies in the market or predicting the future. In pure dollar terms, there are more resources, advanced degrees, and computing firepower devoted to chasing this elusive goal than almost any other endeavor, and that may include fighting wars. Yet traders face the immutable fact that every second, each megabyte of information, blog post, one-line rumor, revenue estimate, or new product order from China has already been taken into account by the efficient market and reflected in a security’s price. This means that trying to gain what traders call an “edge,” at least legitimately, is almost impossible. As the financial incentives on Wall Street have become enormous, so have the competition and pressure to gain an advantage at any cost."

Full Article: http://www.businessweek.com/articles/2013-07-11/why-hedge-funds-glory-days-may-be-gone-for-good#p2

What if You Paid Your Doctor Like You Pay Your Financial Adviser?

There would be moral outrage if we lived in a world where doctors didn't directly charge patients, but earned all their income from the pharmacy companies for the prescription drugs they prescribed. We would ask "how can the doctor be objective?"

Reality: We live in a world where the vast majority of financial advisors dont directly charge the client a penny, but receive commissions and fees from the investments and insurance products they sell clients. This is how brokers and many fee based advisors earn their fees. There is no moral outrage, no cry of "how can they be objective?"

This year the UK, Netherlands, and Australia have made commissions in financial products illegal, see Jason Zweig's WSJ blog:

http://blogs.wsj.com/moneybeat/2013/06/21/the-intelligent-investor-going-dutch-could-fee-hurdles-come-down-everywhere/

A fee only advisor charges a client directly. The charge is generally based on time spent or on the amount of money managed. The client receives an invoice and pays directly or may pay directly from the investment portfolio.

Ask your advisor how they get paid and then ask whether they can be objective in their advice.

Full Disclosure: AWM is a fee only advisor.

Advice to those attempting to manage their own stock portfolio.

A short quote from  Satyajit Das's excellent book:  Extreme Money: Masters of the Universe and the Cult of Risk.  Excellent advice for those who attempt to own individual stocks and manage their own stock portfolios.

"Bernard Baruch, the famous financier and investor, once offered the following guide to investment success:
If you are ready and able to give up everything else, to study the whole history and background of the market and all the principal companies whose stocks are on the board as carefully as a medical student studies anatomy, to glue your nose at the tape at the opening of every day of the year and never take it off till night; if you can do all that and in addition you have the cool nerves of a great gambler, the sixth sense of a kind of clairvoyant, and the courage of a lion, you have a chance."

Das, Satyajit (2011-08-04). Extreme Money: Masters of the Universe and the Cult of Risk (p. 98). Pearson Education. Kindle Edition.