Industry "Professionals"

[moda0306]

I met with a friend of mine last night who works for a wealth advisory firm (a relatively good one, not just a product pusher), and I was completely underwhelmed by his knowledge of macroeconomic ties to investing (our currency, interest rate movements, the debt ceiling vote and S&P downgrade).  This isn't to say he disagreed with me and I'm simply letting him have it, but moreso that he didn't seem to understand things on the level of many people here.  Simply, he's betting on individual horses, while we know how to run the race track.... or at least we are trying to learn.  These guys are probably trying to get inside-info on a given horse's injuries or whether the betters have under/over-bet a certain horse, putting tons of man hours in and sweating bullets while they wait for their strategy to pay off.  We are looking at the future of the gambling industry, and deciding how much to invest in the race track vs other things that we feel may perform better given how much we can afford to lose... (since in this example, gambling is the "sure-bet" industry (PP).

This was obviously a good comparison of the world my friend lives in vs the world I/we live in.

He's worked there for three years in the investment analysis department, no less... he's not just a client shmoozer or financial planner.

When discussing these issues of macroeconomic weight, I got the feeling that he didn't really know the broader issues, and probably understood the investing business well within a certain box, or mindset, and that nothing in the past few years has challenged him to look outside that box, but simple keep trying to bounce off walls within it, confused and dizzy.

I feel like I never liked investing (before 2008/2009) because it wasn't based on macroeconomics, but the greater fool theory and a bunch of hot-heads trying to out-cheat each other... I saw Wall Street and Trading Places and didn't like what I saw.  I liked my finance classes, but despised the "investment club" for some reason... I couldn't put my finger on why.  I feel, now, like understanding bonds should come well-before putting a bunch of highschoolers into a stock-picking operation... like the latter is supposed to instill some kind of responsibility or investing savvy within the saving-public... we don't teach our kids personal finance nearly well enough in schools, but when we try to, it's throwing a bunch of kids in a room asking them to pick their favorite pop or sports car or video game console whose stock they want to invest in because the don't know any better... what a sham!

I think I realize now that without a solid grasp of history, domestic/world politics, macroeconomics, currency types and how they behave, federal reserve accounting (even if we disagree on some of the details of the implications), demographics and social science, the tax code, both present and possible future, etc, that you can't really truly know that much about the market and how to advise clients, and even then you're just scratching the surface of what might happen, and have to hedge against being wrong anyway.  In fact, it takes a study of all those things to truly realize how unpredictable the market is.  In the past 4 years we've seen a housing bubble collapse, wars continue, middle-east revolts, a flash crash, a financial collapse, 10%+ unemployment, a sharp rebound of the stock market, a Euro quasi-failure, riots in Europe, US debt downgrade & debt-ceiling stare-down, and a Japanese Tsunami.  I think there are WAY bigger wheels turning than technical indicators can do much to assist us in... at least with money we can't afford to loose.

I feel so lucky that my interest in macroeconomics and career in accounting/taxes came first, and brought me into the investing world, because backing into it the other way leads to some serious group-think and in-the-box analysis that is hard to break out of.  My career in accounting/taxes has also given me the ability to see things in terms of balance sheets and cash flows, liquidity vs tax-efficiency, compliance considerations, and overall planning strategy to the degree that another career wouldn't have.

I guess this is just a post of random thoughts and examples of where I think most people on this board are, mentally, psychologically and analytically, vs the retail investors and even the investment "professionals."  Rest assured, we aren't a bunch of lemmings subject to group-think who are about to lose our shirts.  We are ahead of the curve.  We understand things they don't even seem to care about, or are at least intellectually curious about them, and honest with ourselves when it comes to information contradicting our beliefs.

[melveyr]

The state of finance really bothers me. I am 20 currently studying finance, and finding myself underwhelmed by what is being taught.

My finance class (not my teacher's fault) was breeding a bunch of risky speculators. DCF cash flow analysis assumes that we know way more than we do about the future. Tools like this give us a false sense security and "intrinsic value."

What tools we do have for measuring risk are fatally flawed. Using standard deviations assumes that financial returns are normally distributed. They definitely are not. When is the last time you saw a market return something close to its "average return." It rarely happens! However, I see "average height" people all of the time. Height may follow the normal distribution, but finance certainly does not. It is a world dominate by extremes, not the mean. I am trying to dive into Mandelbrot's work. I think he is onto something with his work involving fractals in finance.

Also, at one point I did want to be a financial advisor. I think I would do an honest job, but it would have to be on my own. I now realize that I would not be comfortable working at most firms. The compensation structure really encourages pushing products. I did a short internship for Axa Advisors and the culture seemed to view  the client as a pinada, and the game was to blast the pinada with annuities until all of the candy fell out.

I am hoping corporate finance will be a better fit for more. Time will tell.

[MediumTex]

It's better to be a philosopher first, and an investor second.

That's the way Harry Browne approached it.

[moda0306]

melveyr,

I'd love to be a financial planner... it really combines my tax knowledge and planning with all the things we've discussed here.

I am equally disheartened at the state of financial advising today... the "good guys" are few and far between.

[Storm]

Moda, I wouldn't get too discouraged about it.  He probably has way more specific knowledge about the details of his specialty than any of us do.  You don't need to understand physics to be an airplane mechanic.  Likewise, you might be Einstein and understand all of the physics that allow an airplane to fly, but that doesn't mean you understand how to rebuild a jet engine.

It's all about specialists and generalists.  There are a lot of brilliant minds on this forum and I have learned great amounts from them.  Some of us are generalists and know a little bit about everything, while others are specialists and might have learned an incredible amount of detail about one tiny thing.  Both approaches work in your career and life.

[Storm]

I am trying to dive into Mandelbrot's work. I think he is onto something with his work involving fractals in finance.

Ryan,

I really enjoyed reading your website.  It's amazing that a 20 year old has such a firm grasp of finance as well as great writing skills.  I have a friend who is a professional risk analyst for energy trading companies, and I was surprised to find that he is much more of a computer geek than I would have imagined.  They use a program called MatLab to model risk.  http://www.mathworks.com/products/matlab/

This gets way beyond my abilities, but I believe they use MatLab because of it's matrix algebra capabilities.  Using MatLab, they can model a whole matrix of possibilities.  I think this type of approach could be very successful at modeling risk.  In a world of millions of possibilities, you can just model "what happens at Dow 10K, or what happens at Dow 15K?"  You need to model "what happens at every point along the Dow 10K -15K when 10 year Treasury yield is a range of 2.0-3.0% and gold price is a range of $1K-2K per ounce."

I think fractals and matrix algebra is probably the best way to model our world that has infinite possibilities.

[stone]

Moda,  I guess widespread inept investing is what our political system chooses as a sort of asset tax.

[stone]

Melvin R, mathematical finance is neat but I think it is vital to think way outside the box as well. What does it mean for a bunch of people to have savings compounding by >5% real (or whatever) over decades and decades? Are they gaining control of something from someone else? What if such claims increase overall for all of humanity without there being anything more to share around? Isn't the classic example that a single gold coin compounded at 2% since the time of Christ would now be a sphere of gold larger than the solar system? I think if people at large are skilled at mathematical finance but fail to see the bigger picture, then the financial system gets into a destructive warp drive that screws up real life.

[moda0306]

Storm,

I'm sure what these guys are doing is complicated, but the question is does it add value?  I could try to do 500 pushups, and it would be incredibly difficult, but it doesn't add value for anyone (ok, maybe my pecks a bit).

The problem is that these guys are supposed to be adding value to their clients through financial planning and risk management, and them sitting in front of charts and comparisons all day is not seeing the forest through the trees, which is what they're paid to do.  They aren't stupid, but because of their approach they're getting lost in the details when rising above them is extremely important, at least for some perspective on the broader plan.

Many aren't doing this on purpose, as is the case with my friend, and while he may not be a generalist, he designs portfolios for use by families and institutions, and didn't really understand macroeconomics.  This is fatally flawed IMO.

[melveyr]

Thanks for the encouragement Storm I will poke around that site.

moda and stone: Don't get me wrong, I see many dangers in an over-reliance on mathematics. For investing, I turn to philosophy before any other academic field. However, the big guys running the shots do use mathematics. And if you read Mandelbrot's work you will see that many of their models are fatally flawed. BTW, I am talking about the mathematics that help manage risk, not beat the market. I think there is a serious value in a financial system that knows how to manage risk.

Banker's need numbers. They want a quantitative way to look at things, even if its wrong. It helps them feel precise in a chaotic world. Mandelbrot started poking holes in the use of the bell curve in the 1960s. The problem is, he created an academic vacuum. An entire new field would have to be developed in order for people to have a quantitative way of managing risk. The vacuum has left to be filled with anything substantial, and so we are hobbling around with tweaked versions of a bell curve based analysis of finance. The desire for using precision is so strong, that a banker would rather use a flawed model than no model at all. This desire for a model is compounded because of the size of our institutions. Workers don't want to stick their neck out, for fear of getting chopped off. Models allow a homogenous environment, so it is easier for employees to dodge blame when the SHTF.

I don't like that finance is dominated by models, but I don't think it is going to change anytime soon. Wouldn't it be nice if we at least had models that were more realistic?

[stone]

melveyr, I just think the problem is that risk HAS to build up and cause the financial system to implode every time financial returns out pace the real economy. The more sophisticated the financial system gets at managing risk, the further it will be able to stretch out the bungy cord before the snap back that always has to come. I think financial sophistication is ultimately counter-productive when seen from a global perspective. To my mind  financial mathematics would best serve the real economy if it pointed out that reality and then we could have a very rudimentary, self limiting, financial system. Basically the top financial mathematics gurus should ideally advise on how to make the system less exposed to being exploited by those with a knowledge of financial mathematics much like software is made virus resistant.

[moda0306]

Well put stone.... I guess there's another good way to illustrate what I'm saying... What if you had the following conversation with your financial advisor...

You: "So what do you think the implications are in terms of interest-rate changes in light of our sovereign fiat currency, deleveraging, and demographic decline in the context of whether we could go the route of Greece vs Japan vs something else?"

Advisor:  ???

You: "What do you see on the horizon as far as middle-east or European unrest as a result of economic and demographic shifts?"

Advisor:  ???

You: "What role do you see precious metals playing if stocks & bonds start to correlate negatively?  Do you see monetary metals vs industrial metals playing a different role?"

Advisor: We use TIPS and REITs

You: Do you maximize my tax-efficiency by choosing tax-efficient, low-turnover funds, use loss-harvesting and individual security recognition basis method, and strategic placement of different asset classes in taxable, tax-deferred, and nontaxable accounts?

Advisor: Look, we have guys that spend a lot of time looking at complicated technical indicators and different portfolio models based on time horizons and goals.  These guys work very hard to find a portfolio that works for you, though unexpected events that haven't been tested before may throw them into a bit of a loop.  They are very smart, and though they may not know about this "fiat currency" you speak of or what demographics have to do with anything, they know how to compare stock funds for maximum probable return, if things go as planned.


Back to me speaking: I'm sorry, but you can't design portfolios inside a box.  Financial planning needs generalists, with specialists handling special cases and situations, not creating canned allocations based on past-fund performance and technical indicators to sell to the masses.

[Storm]

Banker's need numbers. They want a quantitative way to look at things, even if its wrong. It helps them feel precise in a chaotic world. Mandelbrot started poking holes in the use of the bell curve in the 1960s. The problem is, he created an academic vacuum. An entire new field would have to be developed in order for people to have a quantitative way of managing risk. The vacuum has left to be filled with anything substantial, and so we are hobbling around with tweaked versions of a bell curve based analysis of finance. The desire for using precision is so strong, that a banker would rather use a flawed model than no model at all. This desire for a model is compounded because of the size of our institutions. Workers don't want to stick their neck out, for fear of getting chopped off. Models allow a homogenous environment, so it is easier for employees to dodge blame when the SHTF.

I don't like that finance is dominated by models, but I don't think it is going to change anytime soon. Wouldn't it be nice if we at least had models that were more realistic?

You're exactly right, Ryan.  Fundamentally, we could say the entire finance industry adds little value to the economy.  But, when you've decided to invest money into a financial opportunity, a good risk analyst could tell you what was the best possible entry and exit point, and back up their theory with sound math.  They could also attempt to build mathematical models around a number of possibilities and tell you how the risk of each impacts the original model.

I can only imagine what my friend that is a risk analyst for energy trading companies does, but I can imagine a lot of his day to day work revolves around modeling the risk of extracting energy at various oil price points.  If oil is worth $80 a barrel the risk of investing into X might be totally different than if oil is worth $100 a barrel.

What I really need is a serious risk analyst to tell me the optimal entry and exit points for my PP options trading strategy!  I'm going to get a couple beers in him and see what he thinks...  ;D

[Storm]

Advisor:  ???

Great post, moda, and I love the use of smileys! 

I had a conversation like that with a CPA that I was interviewing to see if he could handle my tax returns.  He told me he was also a certified financial planner, so I asked him what he thought I should be investing in.  Immediately he told me I should be all in stocks at my age (37) because the returns are so great.  I told him "I'm very comfortable with my portfolio allocation," then asked him if he had heard of the Permanent Portfolio.  He said he had, but after asking a few more questions I could tell he was clueless.  I told him the portfolio had 25% gold and 25% 30 year treasuries and he said "gold is worthless and treasuries are way too conservative for someone your age."  I told him the gold portion of my portfolio had seen 50% gains since I purchased it, and the long term bonds are there for deflation protection, not for yield.  He didn't understand, and immediately had the exact same reaction you've probably heard at many dinner parties/friendly conversations, something like "Treasuries? you're happy with just a couple % yield?" or "gold? it's a barbarous relic that drops faster than a rock in value when the market is going up."

Anyway, I was hoping he could give me ideas for how to tax optimize my portfolio but in the end I decided not to let him do my taxes (his rates were way too high), or plan my finances.  He might be a successful accountant but he knew nothing about financial planning.

[moda0306]

That's part of my problem with the whole thing, Storm.

I think tax-planning and financial planning are crucially attached at the hip... in fact I think the term "tax planning" is kind of a BS term, in some ways, because the overarching importance lies with financial planning, with several tax implications helping form the strategy... to start from the tax code and back into someone's financial plan is ridiculous.  The client's life situation, wealth placement, goals, and future cash needs are the meat and potatoes, with the tax-code providing a path to maximizing return and liquidity simultaneously.

The goal is not to go through life having paid the fewest taxes, but having gone through life having your hard-earned cash work hard for you and be there when you need it to... part of that is avoiding taxes, both year-by-year and through long-term planning.

I think for 85% of people, their tax professional and financial planner can and should be the same person, in an ideal world, because for the vast majority of the population, neither the most complicated parts of the tax code nor real complicated areas of investing or estate planning are necessary.  This isn't the case, though, as accountants spend all their time on minescule yearly details instead of broad planning, and financial planners spend all their time trying to make their job look harder than it is and sell products.

[MediumTex]

...the long term bonds are there for deflation protection, not for yield.  He didn't understand, and immediately had the exact same reaction you've probably heard at many dinner parties/friendly conversations, something like "Treasuries? you're happy with just a couple % yield?"

I am consistently surprised by how few people really seem to understand how the bond market works (both treasuries and corporates).

This includes people who you would think WOULD understand the bond market, including investment advisors who sell hedging strategies that INCLUDE bonds.

I have put people on the spot in presentations with bond strategy questions and I didn't even mean to.  I just assumed they were aware of the nuances of the concept they were selling.  One guy told me he would have to have someone analyze my question and get back to me.  I told him not to bother and tried to give him a quick tutorial on the differences in volatility between coupon and zero treasuries and how you could get the same amount of volatility in a smaller package by going farther out on the yield curve.

He just acted annoyed, and still didn't seem to understand the point I was trying to make.  He did remind me that interest rates have nowhere to go but up, and suggested that moving farther out on the yield curve isn't something I would want to do anyway.

[moda0306]

MT,

Your post gives me a headache... stop it.

I think the financial services industry has to be, hands-down, one of the most self-enriching, parasitic, non-value adding industries there is.

[cabronjames]

I think the financial services industry has to be, hands-down, one of the most self-enriching, parasitic, non-value adding industries there is.

Word to Elizabeth Warren, John Bogle, Harry Browne, Clark Howard, & Kevin Phillips ("Bad Money" author notes the expansion of FIRE industries in last 30 yrs)

Amen, brotha!

[Storm]

Moda, that quote may come back to haunt you... 

MT, I think it really takes a lot of brain matter to understand how bonds work.  To be honest, it took me several months to understand how the bond value is inversely affected by yield (or vice versa), and why the duration until the maturity date affected the yield, as well as how the yield curve functioned.

I'm not surprised that the average investor can't wrap their brain around it.  I'm even not surprised that most financial planners can't wrap their brain around it.  There are several psychological barriers:

1.  They must first of all avoid all brainwashing from real estate brokers, mainstream media, and other types that say "interest rates have nowhere to go but up!"

2.  Second, they must avoid all brainwashing regarding the inevitable insolvency of the US treasury, and again the mainstream media pundits talk about how a fiat currency always ends up worthless.  Fiat currency is not equal to bonds...

3.  They must learn to ignore yield completely and realize it is just an arbitrary value assigned at a certain point in time.

4.  They must study historical market moves and look at how bonds reacted during those market cycles.  (This is the key)

Once you have studied how bonds, and specifically long bonds, reacted during different market cycles of inflation, deflation, prosperity, and recession, you can begin to understand when it is appropriate to use them in a portfolio.

I think the average investor and financial planner just assume "when the market is good stocks go up, and when the market is bad, everyone loses."  They look at it as if when the market is bad, nobody can win, so why even bother trying?  We have figured out that not everybody has to lose in a down market...

[Gumby]

I am 20

Wow. I can't even imagine what how much savings I'd have by now if I had started adding to a PP when I was 20. Live long and prosper!

[MediumTex]

I am 20

Wow. I can't even imagine what how much savings I'd have by now if I had started adding to a PP when I was 20. Live long and prosper!

I, too, am very impressed.

I just hope his insights do not leave him in a sort of Flowers for Algernon-style mental re-orientation.

Life is a long road, and, as Daniel Boone (may) have once said: "I can't say I was ever lost, but I was bewildered once for three days".  I have spent more than three days being bewildered numerous times.

[stone]

Long term treasuries are unpopular and misunderstood by retail savers now but isn't that a recent phenomenon? Dickens and Forster novels mention "gilt consols" http://en.wikipedia.org/wiki/Consol_(bond) and the UK WWI cost was funded by selling "war bond" perpetual bonds that were bought by retail savers. I kind of imagine that someone from the 19th century would be astonished that people in 2011 found them confusing. I guess if many people had them and saw the way the price swings, then general awareness would follow. I suppose the same thing could be said about the PP in general.

Does the aversion to LTT date from 1994; with that event just remaining as a dim aura of fear that keeps retail savers away?

http://money.cnn.com/magazines/fortune/ ... /index.htm

[gizmo_rat]

Does the aversion to LTT date from 1994; with that event just remaining as a dim aura of fear that keeps retail savers away?

I did find gilts intimidating to buy;

* not available electronically
* assumption that you know what you are talking about from the telephone dealer (hah)
* lots of muttering and calculator action from them before they give you a price
* price feeds broken since Jan so you have to calculate their current worth by hand

Not exactly a user friendly asset purchase, don't think they would have been able to finance WW1 like this.

[Storm]

Long term treasuries are unpopular and misunderstood by retail savers now but isn't that a recent phenomenon?

Stone, that's a great insight.  Our generation can't understand this, but during World War II, it was considered patriotic to buy government bonds:



I still think this generation deserves to be called "the greatest generation."  They didn't just buy bonds out of a selfish sense of greed - they bought them as their civic duty to help the country win the war.

[moda0306]

I think between the inflation of the 70's and the stock boom of the 80's, bonds just got somewhere between scary and boring.

I think bonds, being the more simple-to-compare & understand instrument (once you "get it" in terms of long-bond behavior, you realize bonds are quite simple and can teach you a lot about the economy and tell a pretty cool story (yield curves and yield spreads... and changes to both over time, indicating certain expectations about the economy in the short-term and long-term), should be the first-understood asset class.  The fixed rate of return and return of principal gives them simplicity with which you can build comparable knowledge on when comparing treasuries to munis and corporates.

Unfortunately, they're seldom understood, which is a shame because in the 90's you could get 7-9% ROI guaranteed for 30-years and people just saw 30-years and ran.... further, they were treasury instruments, so by definition they probably were way too conservative in return but risky in possible volatility (if they even understood that aspect).

One interesting thing to me, though, is that maybe we should look at volatility differently for the average retired income-seeking bond-holder than a PP investor.  To an old lady on fixed income, income volatility (think ST bonds) could be much more of a concern than value-volatility, even if she's at-risk of losing to inflation.  If someone needs a certain guaranteed fixed income, with the rest of her portfolio geared more towards protecting them from inflation, long-term bonds can provide an excellent annuity-like instrument.  This may look to people like us to have volatility, but an old lady might see that 3-year treasury bond ladder as having volatility, because what used to provide her with $10,000 per year in income is now providing her $1,000.