The NorthFork View

Almost like clockwork, the switch flipped a couple of weeks ago, and here in Bozeman we went from spring and scattered snow showers to summer thunderstorms.

A different switch flipped in the markets about the same time. Between Federal Reserve Chairman Bernanke’s definitive comments that the Fed will increase short-term interest rates sometime in the future (although still not until 2014, so they say) and China’s overnight clampdown on its “shadow banking system,” the markets saw a quick shock that brought into question the foundation upon which the stock market’s current rally had been based. To no-one’s surprise, Bernanke’s comments sent bond prices down by as much as 10% or more on longer-term maturities.

In addition, the stock market took a bit of a hit as well, giving credence to the assertion that at least some of the gains in the S & P 500 can be directly attributed to what has been, in effect, a loose monetary policy pursued by the Fed. The driving sentiment supporting asset price increases seems to have been, “what’s the advantage of keeping funds in cash earning zero interest when anything else (whether it’s stocks, bonds, real estate, commodities or even a financed purchase) could provide at least some return against 1.4% inflation.” Since the details behind the various market machinations are complex and ever-changing, and short-term reactions to the market are typically ill-timed, we continue to engage the stock market from a long-term perspective but with a decidedly shorter-term emphasis on fixed income positions to reduce the impacts of rising interest rates.

Regardless, focusing on personal goals rather than stock market returns continues to be the most sound approach to managing one’s investments. Too often, we get caught up in the headlines and the mania of the finance media. You should do this – now. And now this. But now jump through this hoop here. If we were to actually follow their guidance, we’d be joining a waltz with a schizophrenic on speed. The only ones who can keep up are those who are calling the dance in the first place. The rest of us are better off keeping the music in the background while we concentrate on the things we can control.

Sure, hedge fund managers with a few finance degrees and hundred-page algorithms play the game – heck, they get to create their own game (and their own rules in some cases as well). Or individual traders who want to try their hand at some strategy or another will try to work the markets. Some of these folks will have some success. But at what risk and at what cost (not to mention the time and energy spent trying to execute a given strategy).

Further, research suggests that relying on stock picking or market timing to beat the overall market is statistically unreliable over longer periods of time. There certainly have been success stories throughout the years – Peter Lynch who managed the Fidelity Magellan Fund and beat the S & P 500 for 11 of his 13 years is perhaps a shining example. But he retired, and despite an APB to try to find his replacement, it didn’t happen. Even Warren Buffet and Charlie Munger, who have also beat the broader U.S. stock market through their holding company, Berkshire Hathaway, by taking concentrated positions through ownership of individual companies and focusing on specific sectors, are the exception rather than the norm.

Since most of us can’t afford to buy entire companies (or even parts of them), and most of us probably shouldn’t be concentrating our holdings anyway, most of us have to rely, at least in part, on the public securities markets and a strategy of diversification within those markets. There are certainly alternatives to the markets, and I would encourage folks to explore how those opportunities may meet their needs; nevertheless, given the way the current system is structured, most of us find we are dependent upon the stock, bond and perhaps real-estate or commodities markets to help us meet our financial goals.

What that means in practical terms is that we need to spend some time evaluating our risk profile and find the lowest-cost approach to getting the returns the market can provide given our tolerance for risk. But both risks and costs can be difficult to identify and evaluate. What does political risk mean? What should I do to address interest rate risk? What are internal expenses? Am I paying commissions? How much and to whom?

Recently, I had the opportunity to hear the academics Eugene Fama and Kenneth French share the results of their many years of research in the field of finance. The biggest takeaway was that the math of investing is really pretty straightforward – and it doesn’t require multiple degrees and a host of algorithms or nonstop attention to the market to execute. Simply stated, an investor in a well-diversified portfolio, which most everyone should have, will see market returns less the fees and expenses they pay. Therefore, in order to maximize one’s return, one has to minimize fees and expenses.

A recent Frontline documentary, The Retirement Gamble, shared the effects of expenses on one’s long-term financial outcomes. Basically, if we assume a starting balance of $10,000 and earn a 7% annualized rate of return over 20 years while paying a 1% annual investment fee (including internal fund expenses, transaction costs and advisory fees), we would end up with a 6% net return after fees, resulting in an account balance of $32,071.28 after 20 years. If we were to pay a 2% investment fee instead, we would end up with a 5% net return after fees, resulting in a balance of $26,532.89. The difference in percentage terms between the starting balance and the end result of the account that is charged a 1% fee versus the one that is charged a 2% fee is over 55% ($5,538.39 difference in ending account balances divided by $10,000).

Of course, it takes time and attention to get a handle on one’s current financial situation and to evaluate one’s appetite for risk. It takes time and attention to determine the specifics of how best to execute a financial plan and investment strategy. For many of us, that’s why we work with an advisor – we’re willing to pay someone to help us with the implementation and monitoring of our financial plans.

But we should all be thinking about what we’re paying for the investments we own and how those fees may be impacting our planned outcomes. Further, we should be asking questions from those who are helping us with our finances. Why is one strategy preferred over another? What are the total costs of a given approach? How do you, as an advisor, get compensated? How does your compensation model compare to other approaches?

These are not easy questions, and for many of us, even asking them is burdensome and discomfiting. For some insights into what an investor ought to be thinking about to help further their own interests, I would recommend a short book called The Investment Answer by Daniel Goldie and Gordon Murray. Perhaps after this brief read your own switch will flip and you’ll be able to say with confidence that you know you are doing the best you can to help yourself and your family reach your financial goals – or at least you will know what you need to do to move in that direction.

All the best for a fun-filled summer!

Bill Stoddart

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