OK, but what kind of advice?

My impression is that when you boil it all down investors hire financial ‘advisors’ (I include financial planners, CFPs, money managers, hedge fund managers, mutual funds managers, etc. in this category) for Timing and Selection advice. That is to say, investors rely on their financial guy or gal to find the best stocks that will outperform all others and/or get them in and out of the market at the right times.  Unfortunately, every single piece of research and evidence suggest that this cannot be done. Yet, financial ‘advisors’ perform this Sisyphean task day in and day out.

The other problem I’ve experienced with some financial ‘advisors’ is they enable their clients’ destructive behavior.  But then again, why wouldn’t they? The timing and selection advisors have the duty of mollifying their clients in volatile markets and so if panic-stricken clients call to sell their position, why not agree with them and facilitate the trade? The justification is that this will ‘help the client sleep better at night’ and heck, if it generates a commission for them, it’s a classic ‘win-win’ in their book.

Think about it. Why would any advisor risk losing a client by telling them, “No, I will not allow you to panic-sell here when the Dow is at 7,500.”  Can you imagine the backlash he would get when the Dow drops to 6,600?  That’s because the advisor’s value proposition is Timing and Selection.

In my view, once an appropriate portfolio is selected for the client, financial advisors’ highest and most valuable duty is being there as a fail-safe against emotional selling or buying.  Dalbar, Inc. produces research that shows how individuals investing in equities (with their timing and selection) fare versus the S&P 500 index (no timing, no selection). Each year it’s the same song, different verse. For the 20-year period through 2010, the equity investor averaged 3.83% per year while the S&P 500 index averaged 9.14% per year during the same period.  Translation: research shows that investors, left to their own devices, take ALL of the market risk and get less than half of the return.

The single most validation of the destructive nature of timing and selection can be found upon closer examination of last decade’s most successful fund.  According to Morningstar, the CGM Focus Fund–careful with the pronunciation–delivered a whopping 18.2% a year from 2000 through the end of 2009. (Note that this was done during a period when the S&P 500 index was largely flat.) The same source, however, reveals that the average shareholder in the fund LOST 11% a year! Not only did the Focus Fund investors underperform the market, they underperformed the very fund they were in! How is this possible?

Let me attempt to explain.  In 2007, when the markets reached all-time highs and the CGM Focus Fund delivered an 80% return that year, investors dumped more the $2.6 billion into the fund the following year.  Then in 2008, when the fund dropped 48%, shareholders panicked and pulled out $750 million by the end of November. Succinctly put, they were victims of Timing and Selection. (Technically, investor coaches would call it a combination of fatal investing errors such as hind-sight investing, track record investing, and the flawed notion of Persistence of Performance).

Dalbar’s annual research and this real-life tragedy of last decade’s best performing fund proves that long-term investment performance is very largely determined by investor behavior. Behavioral investment counseling–or investment coaching–then should be the top priority of investment advisors and what you really should be paying them for.

Any questions? Please comment below.

John Choi

Since 1946 through 2010, I can tell you that declines of 10% happen about once a year. You can bet on it.

I can also tell you that you should expect an average intra-year decline of 14.1%.  This means that there is a 50/50 chance that the markets will go down MORE THAN 14.1%.

Furthermore, I can tell you that there is a 1 in 3 chance that the markets will retreat 15% or more this year.

And lastly, I can tell you that there is a 1 in 5 chance that the markets will experience a drop of 20% or more this year.

But also know this. During those 65 years the S&P 500 index rose in 46 of the 65 periods, or 71% of the time.  Over this entire period the index went from 18 to 1257! The S&P 500 index return with dividends reinvested averaged 10.55% per year.

But you wouldn’t know that watching the news. They’ll only tell you the first half of the story.

So what can you take away from this?

Don’t be surprised when the markets drop.  Surprise is the Mother of all Panic. When you are surprised, you panic. And when you panic, you sell at or near the bottom.

Keep these facts in your back pocket.  You’ll need them later this year.

To Your Peace of Mind,

John Choi

Investors (and brokers alike) need to understand that there are two and only two investment philosophies. You need to choose between these two competing and diametrically opposed philosophies.  The first philosophy espouses that timing and selection is the way to go; the second is that structured funds and coaching will ultimately be better for you.

Undoubtedly, we live in a timing and selection culture. The vast majority of Wall Street and its marketing message is designed to convince you that somehow they can time the market–either by getting you out of the market before a precipitous drop or get you in the market before a huge run up–or they can pick the winning stocks in advance.  Unfortunately, the vast majority of investors have been duped into using timing and selection as their basis for investing. Let’s think about this for a moment.

If proper timing and selection was the panacea of investing then it would be difficult to explain why millions of investors lost trillions of dollars between March 2000 to the end of 2002.  If would be equally difficult to explain why so many suffered massive losses in 2008 and 2009.  Even if you doubt these facts, the hardest concept investment firms would need to defend is the idea of diversification.

Mutual fund companies have hundreds of funds with thousands of different individual equities.  IF THEY REALLY KNEW WHEN TO GET IN OR OUT OF THE MARKET OR WHICH STOCKS TO PICK, WHY WOULDN’T THEY HAVE JUST ONE STOCK THEY “KNEW” WAS GOING TO BE HOME RUN?  WHY WOULD THEY NEED TO DIVERSIFY ANYTHING? This is intellectual dishonesty at its finest.  The very practice of diversifying a portfolio is their admission that they cannot time the markets or select winners.

We subscribe to the investment philosophy that returns come from markets, not managers. We diversify because there is no statistical evidence that you can time the markets or pick winners on a consistent basis. We invest in markets (asset classes), diversify according to investors’ risk tolerance, rebalance, and enjoy returns that markets have given to us over the long-term.  We do this by using structured funds and coaching our investors.

You should NEVER diversify your portfolio…unless, of course, you don’t believe in timing and selection.

John Choi

Here are some interesting facts about Greece:

Mid-January 2010: The media begins its barrage on the Greece and their debt situation. S&P 500 hovers around 1150.

April 23, 2010: Greek government requests IMF bailout package. S&P500 closes at 1217.

April 27, 2010: S&P cuts Greece’s debt rating to Junk status. S&P500 closes at 1184.

July 22, 2011: Greece’s economy is collapsing and their default on their debt is almost a certainty. S&P500 is sitting around 1340.

Hopefully what you’ll take away from this is that the market, which is smarter than everyone in the world (because it IS everyone in the world) has decided that despite Greece’s troubles–along with the EU’s–that businesses will continue forward and that the end of the world as we know it has been put on hold…again.

Oh I almost forgot to mention–Greece has been in sovereign default during 105 of the last 200 years.  Spread that “news” around at your next cocktail party.

To your clarity, direction, and confidence,

John Choi

Unfortunately Mr. Johnson’s comment echoes the sentiments of the typical broker or financial advisor. They believe that because passive investing accepts market rates of returns, they produce average rates of return. In a minute, we’ll see why nothing could be further from the truth. But first, let’s examine why this message is being spread to investors.

To truly understand the industry mentality, we need to realize how mutual fund firms, brokerage houses, and financial advisors make their money. The entire premise of the brokerage industry is that brokers add value by being able to pick stocks or forecasting the future direction of the market. In fact, they spend millions each year in advertising to convince you that they have this skill. However, one needs to look no further than the firms themselves to shatter that myth. If they could time the market or pick stocks, it would be difficult to explain why millions of investors lost trillions of dollars during the tech bubble and even more during the downturn of 2008.  When asked about indexing, the typical broker’s response is,”Indcxing is for investors who want average returns. You want to do better than average, don’t you?”

Here’s the truth. A simple unmanaged index fund consistently beats the majority of active mutual fund managers year after year. There are those lucky managers to do beat the indexes at times but their future success in doing so is a crapshoot. The rub is, you cannot rely on past performance of managers to predict their future performance (there are numerous studies about it)–and that’s why I call them ‘lucky’.

Remember the performance of mutual funds during 2000-2009, often mislabeled the “Lost Decade”? Most actively managed funds were lucky to eek out a positive return. Our globally diversified, all-equity portfolio returned over 70%. I’m not trying to brag because those returns weren’t due to some genius stock picking or crafty market timing. I’m just trying to point out that you don’t need to engage in destructive behavior like stock picking and market timing (i.e. active management) to get positive returns.

Bottom line is that passive investing produces market returns, not average returns–which are far lower–and it does so in a low-cost and relatively tax-efficient manner. The average active mutual fund produces below market results (maybe you could even call them ‘average’ returns?) and does so with great consistency and in a tax-INefficent manner.

So to respond to Mr. Johnson of Fidelity, I would say, “You are correct, sir. My clients and I won’t be satisfied with average returns–which is exactly why I don’t invest in your funds and I invest passively.”

Keep the faith,

John Choi

Harry Dent made a name for himself in the financial industry by becoming a best-selling author with his book, “The Great Boom Ahead.” In the book published in 1993, he predicted–correctly–a bull market for the foreseeable future based on models which forecast consumer spending patterns and the demographics of America. The book propelled him to national recognition but his crowning glory was when AIM Funds gave Mr. Dent his very own mutual fund to manage: the AIM Dent Demographic Trends Fund which swelled to $2 Billion in assets at one point.

And now…the rest of the story. As a follow up to his national best-seller, Harry Dent wrote several other books.  Titles include,” The Roaring 2000′s: Building the Wealth and Lifestyle You Desire in The Greatest Boom in History” and “The Next Great Bubble Boom: How to Profit From the Greatest Boom in History: 2005-2009.” In the latter, Dent predicted a 40,000 Dow and a 20,000 NASDAQ by 2009. Just in case you weren’t paying attention to the markets, let me remind readers that on 12/31/2009, the Dow closed at 10,428 and the NASDAQ closed at 2,269. And how did the AIM Dent Demographic Trends Fund do? It was merged into another (now extinct) mutual fund after 80 percent of its assets were decimated due to extremely poor performance.

Harry Dent claims he has secret proprietary economic and demographic analysis which in turn can make you money.  This reminds me of a scene in the movie Kung Fu Panda (which my kids watch ad nauseam).  In the movie, the antagonist is a leopard who is chasing after the “Dragon Scroll”. Supposedly, the Dragon Scroll contains a very ancient and secret message that gives the owner immeasurable and unstoppable power. After an epic battle with the Panda, the leopard finally get possession of the scroll and opens it. He finds, however, that there is nothing written in it whatsoever. Instead it is made of a very shiny material that reflects the image of the holder of the scroll.  The leopard is beside himself and complains that the Dragon Scroll doesn’t contain any secret message. It is then the Panda reveals that “there is no secret–YOU are the secret”.

I relay this childish fairy tale because this reminds me of some very intelligent folks like Harry Dent (who obtained his MBA degree from Harvard Business School) who devote lifetimes and huge sums of money chasing after an investment “Dragon Scroll” looking for “the secret” when…there is no secret.

The truth is, your degree of investment success is largely dependent on YOU–your conviction to stay in equities when times get tough, your ability to tune out the financial media with all of their predictions and doom and gloom reports, your resolve to follow the 3 investment rules which are own equities, diversify, and rebalance, and your faith in the free markets.  Our highest value proposition is to act as your investment behavioral coach.

Dedicated to your Investment Success,

John Choi

No one can plan for the future–much less invest successful in it–without believing in that future. And this becomes my working definition of optimism: an abiding faith in the future. And I’m not speaking here of starry-eyed optimism or blind faith. I don’t advocate hope for the future in spite of present reality, but because of it. Indeed, I maintain that optimism is the only realism, in that it is the only worldview which squares with the facts, and with the historical record.

Pessimism, on the other hand, is deeply counterintuitive, because no one examining history would arrive at a declinist worldview. Thus, for me, pessimism is a lot like race hatred: no one would ever generate it spontaneously. Someone has to teach it to you.

The man who writes to you is only in his sixty-fifth year, but the geopolitical, technological and economic progress that’s taken place in my lifetime probably exceeds, in quality and quantity, all previous human advances.

In 1918, along with half a million other Americans and 22 million people worldwide, my father’s older sister died of influenza. Today, we joke about whether or not to get a flu shot this year–and if we do get the flu, we merely fret about missing a few days work.

There are a dozen diseases–tuberculosis and polio, to name two–which were common killers and cripplers at the beginning of my life, and which have been all but eradicated. You cannot be my age and not have been ill six times in your life with maladies that would have killed you had you been born even 50 years earlier. No wonder U.S. life expectancy went from 47 in 1900 to 66 in 1950 to 78 in the year 2000.

Geopolitically, the world always looks as if it has insuperable problems–fundamentalist terrorism, genocide in Africa–but the fact is that today’s world is almost immeasurably safer than the one I came into, and in which I grew up. I was born about two-thirds of the way through humankind’s most terrible war. It was, in every sense, a world war, which began on September 1, 1939, when Hitler invaded Poland, and ended six years and one day later, on September 2, 1945, when the Japanese signed the instrument of surrender. And on every single day of those six years, that war killed an average of over 26,000 people.

Then one day in October 1962, when I was just 19, I sat in a classroom at Columbia University. my economics professor was lecturing–it was probably a pretty good lecture, too–but I wasn’t listening. I was looking out the window at a heartbreakingly beautiful New York autumn day, and waiting to see if I was going to die.  I didn’t take it personally, because I knew that, if I died, so would just about everyone else on the planet. For this was the Cuban Missile Crisis, and for a few days there was a pretty good chance that the species was going to extinguish itself in a total thermonuclear war.

The world didn’t end that day, but the Cold War balance of terror defined global geopolitics for another quarter of a century, until, on November 9, 1989, the modern world was born. On that day, the Berlin Wall came down, amid the death throes of communism. Liberty won, not least of all because liberty can’t lose.

No one will choose oppression instead of liberty, or poverty instead of plenty, once he’s seen liberty and plenty, and once he’s realized that he and his fellow citizens have–or ought to have–a choice.

Soviet totalitarianism could only survive as long as it was able to convince the inmates of its dungeon that capitalism left people worse off. So if it didn’t let people travel to the West, and if it kept jamming television signals from the free word, it could maintain the fiction.

Once those television signals started bouncing off satellites, and the inmates couldn’t be prevented from seeing them any longer, the game was over. When everyone could see that democratic capitalism produces an immeasurably higher standard of living, the emperor could be seen to be wearing no clothes. (Boris Yeltsin was said to have had his epiphany in the middle of a huge supermarket in Texas.) In the long run, something like this process–powerfully magnified by the Internet–has to happen throughout much of the Middle East, and in Africa.

And speaking of the Internet, let’s not forget that, if the defining geopolitical event of our time happened less than 20 years ago, the greatest technological invention of all time happened well within the lives of the vast majority of people reading this book. It was of course, the microprocessor–the entire computer on a tiny chip.  The microprocessor was invented in 1971, and has doubled in computing power (or halved in cost, whichever way you care to look at it) about every two years since. From ATMs to anti-lock brakes to the personal computer to the Hubble Space Telescope to (most particularly) the Internet, the microprocessor defines modernity.

Indeed, it is already possible to see a huge gulf between all of human technological progress to 1971, and all that’s happened since. If you doubt this, or if you just can’t conceive of it in concrete terms, treat yourself to the movie Apollo 13. And watch as the smartest rocket scientists in the world try to figure out how to get those three astronauts safely home using slide rules. Because this was April 1970, and the microprocessor was still a year away. In 2004, Ken Mattingly–the astronaut who got bumped from the crew for fear he had measles–observed that, if you’re wearing a new digital watch, the chip inside it contains more computing power than was available to NASA for the entirety of the Apollo 13 mission.

The Internet’s great contribution to the furtherance of liberty is that it purely democratizes all the information. All oppressive regimes lie to their people in order to cover up their ineptitude, corruption, and criminality. But if you can get on the Internet–as virtually everyone in the world will be able to do over the next several years–you can find out the truth. And not just by reading about it, but by actually seeing and listening to it. “And you shall know the truth, and the truth shall make you free.” This is the great thing–maybe the greatest thing–we democratic capitalist truth-tellers have going for us. And it’s exactly what will ultimately bring down today’s lying hatemongers, just as it brought down communism.

This is the truth. And one thing of which we can be absolutely sure regarding the truth is that you will never see it on the news. For even as the outlets of news have proliferated wildly (on cable and the web), news coverage seems to me to have shrunk down to one story at a time. And that story is always, always bad.

There is virtually always an apocalypse du jour going on somewhere in our world. And on the rare occasions when there is not, journalism will simply invent one, and present it 24/7 as the incipient end of the world.

Thus, the news is always and everywhere antithetical to the truth. And if history must make optimist of us all, there are days on which the news can make a pessimist out of just about anyone.

So, you must choose: the truth shall make you free. Or the news will drive you crazy. The fuel on which all successful wealth-building in equities runs is optimism.

And optimism is the only realism.

What is the most misunderstood term in the investing world? Without a doubt, it’s a concept called Diversification.

Every time I have a conversation about diversification, whether it’s with clients, prospects, or even other investment “professionals” they each have a different idea on what diversification really means.

Before I define diversification, let’s review the Three Rules of Investing (yes, there’s only three rules to be a successful investor)

1. Own Equities

2. Diversify

3. Rebalance

As you can see diversification is critical to your investment success. In geek speak, diversification can lower the standard deviation of the portfolio by adding non-correlating asset classes. In English, it just means we need to add additional “stuff” to our portfolio to guard against huge price swings.

Almost everyone I speak with agrees that we shouldn’t concentrate our portfolios in a relatively few number of stocks. They almost always agree that we should add “other stuff” to the portfolio in an effort to “diversify”. It’s the “other stuff” that’s the source of confusion.

As investors, we are not taught simple, yet critical concepts of investing. In fact, here’s an industry secret…neither are brokers or financial planners. Actually, we are all constantly fed MIS-information. As investors we have clowns like Jim Cramer of Mad Money on CNBC screaming that it only takes 5 stocks to be properly diversified. The Certified Financial Planning (CFP) course on investing says you need 20-50 stocks to diversify away systematic risk. Sorry guys, you’re dead wrong! Please stop misguiding investors.

The concept of diversification was academically defined by a University of Chicago professor, Harry Markowitz. For his work on Modern Portfolio Theory (MPT), Professor Markowitz was awarded the Nobel Prize in Economics.

In a nutshell, MPT says that diversification is owning different asset classes in your portfolio. Those different asset classes are the “other stuff” I discussed earlier. Note that MPT does not necessarily say that diversification means having more stocks, rather stocks that behave differently from each other.

An example I like to give when talking about diversification is the S&P 500 index. The S&P 500 is composed of 500 individual companies in different sectors of the economy–financial, healthcare, technology, consumer durables, consumer staples– just to name a few.

One would think that owning 500 different stocks in different sectors of the economy would mean that you were  well diversified. Nothing could be further from the truth. In fact, owning the S&P 500 means you really only own ONE asset class–US Large Equities.

Other investors feel they’re diversified because they own different mutual funds. Here are my observations from analyzing many different client portfolios:

1. Portfolios consisting of mutual funds are generally in 2-3 different asset classes. The ones I see mostly are US Large, International Large, and Fixed Income.

2. These portfolios generally have very little, if any, exposure to Value and Small stocks, thus forfeiting the Value and Small premiums.

3. Not only are these different mutual funds in the same asset classes (fishing out of the same pond), they often hold the same stocks! (they’re catching the same species of fish).

4. The worst offender of #3 is American Funds.

To be truly diversified, investors need to own asset classes such as US Large Value, US Small, US Small Value, International (large and small, growth and value), Emerging Markets, and Fixed Income.

Here’s one way you can tell if you are properly diversified…large losses in your portfolio coupled with long recovery times. So, for example, you had money in the market during the dot-com bubble (2000-2002) and you lost more than 20% and didn’t recover those losses within the next couple of years, that’s a sure fire sign that you weren’t diversified.

As an investor, you owe it to yourself to be properly diversified. If you have any doubts, please get a second opinion on your portfolio. We are here to help.

“Fire your broker (financial planner, CFP) and hire a Coach”

Mr. Choi is the President of Epiphany Capital, an investment coaching firm in Vernon Hills, Illinois. He can be reached at john@johnchoi.net

My response is threefold. Yes, they have their facts correct when they say the S&P500 index had not produced a positive return in an eleven year period. However, we do not (and never have nor never will) advocate our clients to be 100% in an S&P500 index fund. Pity the poor fool who plowed all his money into one asset class and thought they were “diversified” because they were holding 500 unique equities.

Secondly, in a simple 70% equity 30% fixed income portfolio, there has NEVER been a 10-year period since 1929 which has produced a negative return.  The worst 10-year period was from 1929-1938 where the average ANNUAL return was 4.33% (this includes the Great Depression). This was followed by 1999-2008 where the average ANNUAL return was 5.09%. Roughly translated, this means a $100,000 investment made in 1999 was worth approximately $164,000 at the end of 2008, which includes a 38.5% drop in the S&P500 index–a far cry from a “lost decade”.

Lastly, the pessimist who like to point out the “lost decade” conveniently omit that fact that the eleven year period prior to the “lost decade” produced nearly a QUADRUPLE on your investment in the market.

Arm yourself with the facts, fire your broker and hire a coach.

John Choi