Monday, February 07, 2005

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.


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