Monday, February 07, 2005

Franklin, Dilbert, and Blodget, Part I

No, the above title is not the name of a law firm, an investment banking establishment, or a stock brokerage. Each refers to an individual (one fictitious), that relates in some fashion to each other. The first is Benjamin Franklin, who, amongst a host of other notable activities, created and published the earliest political cartoon in America. (See below). Depicting a snake whose severed parts represent the colonies, this image served Franklin’s political purpose of supporting his plan for an inter-colonial association to deal with the Iroquois Indians at the Albany Congress. Virtually every other newspaper on the continent republished this image. Ironically, despite its popularity, and its success in establishing a connection between drawing and a specific political idea, the Albany Congress was a failure.

While the art of political cartooning expanded greatly throughout the 19th century, not until the end of that century did the cartoon give birth to the comic strip. Evidence of comic strips appeared in American newspapers as early as 1892 as a means of boosting circulation. However, Rudolph Dirks’ Katzenjammer Kids is generally acknowledged as the first true comic strip making consistent use of a series of panels to tell a story. Bud Fisher created the first successful daily strip, Mutt and Jeff, in 1907. If you would like to go down memory lane (assuming you are old enough to remember), some of the earliest examples of this new genre were Tim Tyler’s Luck (1928), Tarzan, (1929), and Buck Rogers (1929). These led to such classics as Dick Tracy (1931), Terry and the Pirates (1934), Flash Gordon (1934), And one that continues through today, Prince Valiant (1937). Versions that are more current are Peanuts, Garfield, Doonesbury, and Dilbert.

The latter two happen to be my favorites, but for purposes of this article, Dilbert, or at least Scott Adams, its creator and cartoonist, is more relevant. In his recent book, Dilbert and the Way of the Weasel, Adams writes:

“I once tried to write a book about personal investing. It was supposed to be geared toward younger people who were investing for the first time. After extensive research on all topics related to personal investing, I realized I had a problem. I could describe everything that a young first time investor needs to know on one page. No one wants to buy a one-page book even if that page is well written. As a consumer you’d feel you were paying mostly for the binding.”

Adams then goes on to describe what he terms “Everything You Need to Know About Personal Investing”:

  • Make a will
  • Pay off your credit card balance.
  • Get term life insurance if you have a family to support.
  • Fund your company 401K to the maximum.
  • Fund your IRA to the maximum.
  • Buy a house if you want to live in a house and can afford it.
  • Put six month’ expenses in a money market account.
  • Take whatever money is left over and invest 70 percent in a stock index fund and 30 percent in a bond fund through any discount brokerage company and never touch it until retirement. (Editor’s note: Use Vanguard, not any company.)
  • If any of this confuses you, or you have something special going on, (retirement, college planning, tax issue), hire a fee-based financial planner, not one who charges a percentage of your portfolio.

Adams’s advice seems to be as significant and enlightening in his investing advice as he is in his cartooning endeavors. For example, in one of his strips, he shows Dogbert, the evil dog character, speaking to Dilbert. Dogbert says, “I’d be a good stock market expert.” In the next panel he explains, “I’d buy stocks and then go on TV and recommend them so they go up.” Dilbert inquires, “What about the fundamentals?” To which Dogbert replies, “It doesn’t get more fundamental than that.” While that was said in jest in a cartoon, interestingly, that describes exactly what our next named individual did in real life.

In 1999, in the middle of the high tech stock bubble, Henry Blodget was a small time, relatively unknown stock analyst. Amazon was hitting record highs, selling for over $200 a share. Despite the fact that Amazon had yet to produce a profit, Blodget predicted that the stock would go to $400—and it did. At that point, Blodget looked like a genius and Merrill Lynch immediately hired him as their Internet analyst. As it turned out, his actual function was to act as a shill for the stocks of Internet companies whose investment banking business Merrill Lynch coveted. He touted stocks to the public at the same time he disparaged them in emails to associates within Merrill Lynch. One example related to a company Excite@Home. He wrote, “It is such a piece of crap.” Another dealt with Life minder stating, “I can’t believe what a POS [piece of sh-t) that thing is.”

His success was evidenced by an estimate that Merrill Lynch earned $150 million in investment banking/commissions from Blodget’s team. An indication of his stature was the ranking credited to him in an annual survey by the industry magazine Institutional Investor as the highest ranked analyst in the country. As evidence of its appreciation, Merrill Lynch paid Blodget a total of $18 million over his relatively short period of employment dating from 1999 through 2001, plus another $2 million after he resigned. When exposed, he was also banned from the securities industry for life. The theoretical “Chinese Wall” that supposedly existed between banking and research at Merrill Lynch was belied by New York Attorney General Spitzer’s investigation, and the huge fine of $1.4 billion imposed upon Merrill Lynch (resulting from Blodget’s activities).

Considering his misdeeds, it is puzzling as to how and why Mr. Blodget avoided criminal prosecution and jail time. Nevertheless, because of his expulsion from the securities business, instead of merely sitting at home counting his remaining millions, he has found employment as a writer. Slate magazine initially hired him to report on the Martha Stewart trial. (Was this a case of “It takes a thief to know a thief?”)

If you are not familiar with Slate (, it is an on-line journal originally owned by Microsoft, but sold to The Washington Post on the day this article was submitted for publication. It happens to be an excellent periodical with features galore, one of which coincidentally, is a segment devoted to Doonesbury. If that were not enough to endear it to me, another section highlights current cartoons from publications worldwide. Blodget is featured in its “Business” section with a series of articles titled, “The Complete Guide to Wall Street Self Defense.”

While Blodget may be an unsavory character without principle, based on his articles, he does know the investment business, and provides insightful concepts for avoiding the same type of dishonest and underhanded tricks practiced by so many of the supposedly reliable Wall Street firms. His articles convey the importance of sticking to investment fundamentals and ignoring the overly optimistic hype of most investment professionals.

In one series, he personalizes his experiences by recounting his visit to a financial advisor while seeking advice for his own portfolio. If you have ever consulted with a financial professional, or if you should ever consider doing so, Blodget’s description of his experience will be instructive. He notes what he perceives as important and valuable fundamentals that should precede the actual investment process. However, he also critiques a number of factors that might relate to your own portfolio.

Blodget emphasizes (and rightly so) that the preliminaries are considerably more important than the selection of individual securities. He meets with a financial advisor from a full service brokerage firm (unnamed) after having submitted financial details—assets, risk tolerance, time horizon, objectives, etc. Based on these factors, the advisor presented a “proposed investment program.” Related to his objectives, Blodget reveals, “Having vaporized a chunk of my portfolio [some $700.000] by loading up on Internet funds in February 2000 (great insider timing!), my primary objective was to avoid losing money.”

Blodget was favorably impressed with the proposed program, in that “the advice was responsible and sane emphasizing asset allocation (instead of stock picking), diversification (instead of swinging for the fences), and patience (instead of trying to predict short term performance). His further reaction, at least initially, was hopeful, in that the program projected that “with careful asset allocation, manager selection, and portfolio rebalancing, it should generate average returns of about 10 percent a year.” In fact, Blodget thought it sounded great, especially if, as the advisor suggested, it came with low risk and volatility. He was also impressed with the fact that it didn’t tout the advisor as a stock -picking wizard.

Most investors, presented with that type of program (usually in a thick, beautifully bound, personalized, graph and chart laden book) would be so overwhelmed and impressed by what might be termed the “staging,” would gratefully accept all that came thereafter. Blodget, however, knew better. Having participated in (putting it mildly) misleading investors, he delved into the program and discovered (surprise, surprise!) the numbers that followed did not quite add up.

While Blodget does not specifically accuse the financial advisor or the brokerage house of deliberate deceptive practices, there is unquestionably a tendency to overstate potential performance and understate risk when portfolio programs are submitted to clients. Here again we turn to Scott Adams’s characters. In the first panel, we see Dogbert declaring to Dilbert, “I’m starting a mutual fund for investors who aren’t bright enough to know their alternatives.” In the next panel Dogbert continues, “It must be a huge market. Otherwise most people would invest in index funds.” In the final panel Dilbert inquires, “What’s an index fund?” Dogbert exclaims, “Ouch, Ouch! You’re making me wag [my tail] too hard.”

In another, Dogbert is shown on television declaring, “Studies have shown that monkeys can pick stocks better than most professionals.” In the next panel Dilbert is watching the TV as Dogbert continues, “That’s why the Dogbert Mutual Fund employs only monkeys.” Then, Dogbert, surrounded by several monkeys states, “Yes, our fees are high, but I don’t apologize for hiring the best.” More to the point, we have Dilbert sitting at his kitchen table with a financial advisor who says, “I recommend our Churn N’ Burn family of mutual funds.” He continues, “We’ll turn your worthless equity into valuable brokerage fees in just three days.” Dilbert inquires, “Is it risky?” The advisor explains, “Are you kidding?! We have actual brochures.”

Part II will explore more of Blodget’s observations, and perhaps Dogbert’s too.

Franklin, Dilbert, and Blodget, Part II

Scott Adams, the creator of the comic strip, Dilbert has developed a rather cynical view of investing, and his suspicions are reflected in his strips. In an interview, Adams describes his investment misfortunes:

Question: “What about your personal experience with big business? We understand you made a couple of unfortunate investments.”

Adams: “That’s an understatement. It’s true. I invested in Enron, World Com, and at various times Rite-Aid and Tyco. I got them all. Every one. And that’s just the ones that are outright evil. Forget about the fact that I owned Cisco in ’65. And I bought all those, thanks to professional advice. Now I do my own investing in index funds. That’s where I am now.”

Question: “Have you fired all the advisors and taken on managing your own investments?”

Adams: “You don’t really have to fire investment advisors when the money disappears. It’s a self-liquidating relationship. The beauty of it is that you never have to make that phone call that says, “Give me back my money” because it’s already gone.”

Question: “So, index funds. Is that it? Index funds aren’t likely to grow this into an Enron size fortune. Is writing more books and continuing to work what is going to build your fortune?”

Adams: “Pretty much. I’ve been investing since 1979 or ’80, and during that time, I’ve managed to amass losses. I think my total worldwide investment success is negative at this point. And bear in mind, I followed all the rules. I didn’t do any crazy stuff.”

Index funds, huh? How prosaic.

Actually, Adams has little to be concerned about. Counting syndication in some 2000 newspapers, royalties on Dilbert related items, best selling books (about 10 million copies), and ownership of two restaurants and a vegetarian food business, investments may be the least of Adams’s worries. All he has to do is follow his own one page advice as outlined in Part I of this article. Adams maintains, “no one has yet refuted my one page.” As for his Dilbert characters, he said, “Dogbert is probably the best investor of the bunch. He’s the most distrustful of humanity, and least likely to be taken.” Sad, but probably true.

Adams’s experience is reflected in the investing public’s skepticism and fears that now abound, primarily because of the greed displayed by large numbers of major financial institutions and their executives. There also seems to be a concomitant disdain, to the point of contempt, shown by the financial industry for investors in general. Perhaps this is the result of an increasingly obvious mania on the parts of financial institutions to maximize profits (therefore benefiting executive bonuses and such)—by hook or crook—and that in turn seems to be the driving force embarked upon by the entire financial community. The old and traditional dictum that protecting the investor’s well being was a fiduciary responsibility seems to have disappeared. This was summed up by Alan Greenspan’s observation, “It’s not that humans have become any more greedy than in generations past, it’s just that the avenues to express greed have grown so enormously.”

Be that as it may, the necessary ingredients for greed are low moral standards and unethical—even fraudulent—behavior as practiced by the Henry Blodgets of the world. Now we have Henry himself ‘fessing up in an attempt to redeem his much besmirched reputation. Presently writing for Slate (an on-line magazine), in a series of articles titled The Wall Street Defense Manual, he recounts his experience as he attempts to get portfolio advice from a full-service brokerage. Blodget is savvy enough to recognize that the brokerage’s estimate of future returns for his recommended asset allocation is grossly overstated. Yet, the brokerage predicted (just as most other financial advisors do) that future stock market average returns would mirror historic returns. Blodget warns, “The method the brokerage firm used to generate projected returns for my hypothetical portfolio—extrapolating past performance—is common. It is logical, and in some cases defensible. It is also, unfortunately, dangerous.”

It is true that over the past 200 years, U.S. stocks have, on average, returned approximately 10 percent a year. However, most investors are not aware of, and few financial advisors or institutions will point out facts conveyed by Warren Buffett in a now legendary 2001 Fortune article. He observed, that the 20th century encompassed three major bull markets in which the Dow jumped more than 11,000 points, and three major stagnant markets in which the Dow lost 292 points. If viewed out of context these comparisons look extremely favorable for the market. However, consider this: the three bull markets in aggregate, lasted 44 years; the three bear markets, 56 years. For more than half the century, stock market performance was, to put it mildly, uninspiring. .

You probably remember—with some longing—that the last major bull market lasted 18 years (1982-2000), taking the Dow from just over 800 to just under 12,000. However, most investors have forgotten (or never knew) that the previous bear phase lasted 16 years (1966-1982), going nowhere, or down almost 20 percent. And don’t think bonds did any better during that period—they actually did worse.

The portfolio recommendations developed for Blodget were based on an asset allocation of 3 month T-bills (10 percent), municipal bonds (30 percent), international stocks (7.5 percent), U.S. stocks (37.5 percent), and funds of funds (15 percent). The brokerage assumption was that an average annual return of over 9 percent could be achieved over a ten-year period. It is difficult to understand how, with 40 percent invested in bonds, the brokerage could have come up with a 9 percent overall return. Yet, most investors, impressed and overwhelmed by a beautiful presentation book, customized and personalized, and filled with attractive pie charts, graphs and tables, would accept this calculation without question. Blodget was experienced enough in the often misleading tactics employed by brokerages, to exercise some due diligence.

He reviewed all of the calculations and assumptions from an ultra-conservative viewpoint, and inquired about yet another key issue. Was that 9 percent number before or after fees and transaction costs? Amazingly, the brokerage’s financial advisor did not know (perhaps because he was never asked before). Not surprisingly, it turned out the number was before those factors were deducted, reducing the figure to only about 7 percent. Since Blodget’s main objective was not to lose money and recognizing the shortcomings of the calculations, he ignored the brokerage’s assumptions and he recalculated the assumed returns of each asset class, reducing them to what he believed to be the more realistic average of only four percent annually over a ten-year period.

Here is how Blodget explains his calculations: “On the brokerage firm’s median returns of 9 percent, this would result in a pre-inflation net return of about 6 percent per year and a net increase in purchasing power of about 3 percent a year—less than the advertised rate but nothing to sniff at. [Blodget allows 3 percent for inflation.] For every $10,000 invested today, I would have about $18,000 in 2014, or $13,000 in today’s dollars. On my assumed median return of 4 percent, however, the pre-inflation return would only be about 2 percent a year, with a net loss of purchasing power of 1 percent a year. For every $10,000 invested, I would have about $12,000 in inflated dollars in 2014, or $9,000 in today’s dollars. (Brokers, investment advisors, and the government meanwhile, would have run off with about $2200.)”

Blodget then observes, “Lest this sounds depressing, it’s worth noting what would happen if I did nothing—if I just buried the $10,000 in the backyard. I wouldn’t pay any costs, fees, or taxes (hallelujah!). Thanks to inflation, however, when I dug the money up again, it would be worth only $7,400.”

Most investors, especially those whose portfolios are dominated by actively managed mutual funds, fail to recognize the enormous impact that fees have on portfolio performance. However, there are other factors that affect returns: unless transaction costs, fees, taxes, and inflation are included in the equation, the most important calculation of all, “real spending power,” is overstated.

Blodget cites John Bogle of Vanguard fame, who observes that assuming 5 percent annual appreciation, over 10 years, a 0.2 percent annual fee (a very low fee usually associated with index or passively managed funds) will consume about 3 percent of the initial investment: about $300 for every $10,000 invested. However, if you invest in the average actively managed mutual fund, you will pay a 1.5 percent fee, and at that rate, you would lose some 18 percent of your initial investment—a startling figure. If you choose to invest in funds incurring the highest fees (2.2 percent), that would destroy 26 percent of your initial investment or $2600 of every $10,000. These numbers do not take into account the possibility that you purchased a front-end load fund that would lower your profit even more. Nor does it address the unmistakable historic fact proving that high cost funds underperform all other funds.

Despite Blodget’s belief that the brokerage significantly overestimated the potential performance of his portfolio, he felt comfortable with their recommendations since “The firm and the financial adviser listened to what I wanted (low risk, income). Then they focused on what they could control (asset allocation and costs), rather than what they couldn’t (performance). They probably set me up for disappointment—9 percent returns!—but I would also probably be better off following their advice than doing nothing.”

By the same token, he also provides some cautionary words regarding the use of professional advisors: “Odds are only a handful of financial advisers can beat the market over the long haul. Unfortunately, the time it will take you to determine whether your adviser is a member of this elite group will probably tender the effort irrelevant. The proof will not be that the adviser often picks stocks that go up. Stocks can only go two ways—up or down—and lots of people seem smart when they have 50/50 odds. The proof will be to compare the performance of the adviser’s picks with the performance of an appropriate market benchmark over a decade or more (the time it takes to eliminate the possibility of the performance being luck). And long before then, of course, if the adviser really is a proto-Buffett, he or she will probably have decamped for a hedge fund.”

So, here we have Henry Blodget as a “poster child” for the generation of members of the financial community who allowed their avaricious nature to trump their responsibility to investors. He now finds himself in the position of trying to make some amends by advising his readers to use caution in dealing with other members of the profession from which he is now banned.

Dogbert’s similarity to Blodget’s past life is inescapable. In one comic strip, we have Dogbert posing as a stock market expert on a TV show. He comments on a particular company by saying, “Everyone should buy stock in that company. Sell your house if necessary.” The interviewer asks, “Should we worry that the P/E is over 900, your track record is terrible, and you only recommend stocks you own?” We then see Dilbert watching the interview as Dogbert replies, “Well Ron, as you can see from the one week chart, this stock only goes up.” Dilbert immediately gets on the phone to his broker and yells. “Buy! Buy! Buy!” Is this fiction imitating life, or life imitating fiction? Unfortunately, it’s both.