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Financial advice and investment decisions



Financial Advice
and Investment
Decisions


The Frank J. Fabozzi Series
Fixed Income Securities, Second Edition by Frank J. Fabozzi
Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. Abate
Handbook of Global Fixed Income Calculations by Dragomir Krgin
Managing a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. Fabozzi
Real Options and Option-Embedded Securities by William T. Moore
Capital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. Fabozzi
The Exchange-Traded Funds Manual by Gary L. Gastineau
Professional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank J. Fabozzi
Investing in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia Pilarinu
Handbook of Alternative Assets by Mark J. P. Anson
The Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry
The Handbook of Financial Instruments edited by Frank J. Fabozzi
Collateralized Debt Obligations: Structures and Analysis by Laurie S. Goodman and Frank J. Fabozzi

Interest Rate, Term Structure, and Valuation Modeling edited by Frank J. Fabozzi
Investment Performance Measurement by Bruce J. Feibel
The Handbook of Equity Style Management edited by T. Daniel Coggin and Frank J. Fabozzi
The Theory and Practice of Investment Management edited by Frank J. Fabozzi and Harry M. Markowitz
Foundations of Economic Value Added, Second Edition by James L. Grant
Financial Management and Analysis, Second Edition by Frank J. Fabozzi and Pamela P. Peterson
Measuring and Controlling Interest Rate and Credit Risk, Second Edition by Frank J. Fabozzi,
Steven V. Mann, and Moorad Choudhry
Professional Perspectives on Fixed Income Portfolio Management, Volume 4 edited by Frank J. Fabozzi
The Handbook of European Fixed Income Securities edited by Frank J. Fabozzi and Moorad Choudhry
The Handbook of European Structured Financial Products edited by Frank J. Fabozzi and Moorad Choudhry
The Mathematics of Financial Modeling and Investment Management by Sergio M. Focardi and Frank J. Fabozzi
Short Selling: Strategies, Risks, and Rewards edited by Frank J. Fabozzi
The Real Estate Investment Handbook by G. Timothy Haight and Daniel Singer
Market Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. Levy
Securities Finance: Securities Lending and Repurchase Agreements edited by Frank J. Fabozzi and Steven
V. Mann
Fat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev, Christian Menn, and
Frank J. Fabozzi
Financial Modeling of the Equity Market: From CAPM to Cointegration by Frank J. Fabozzi, Sergio M.
Focardi, and Petter N. Kolm
Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by
Frank J. Fabozzi, Lionel Martellini, and Philippe Priaulet
Analysis of Financial Statements, Second Edition by Pamela P. Peterson and Frank J. Fabozzi
Collateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J. Lucas, Laurie S.
Goodman, and Frank J. Fabozzi
Handbook of Alternative Assets, Second Edition by Mark J. P. Anson
Introduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad Choudhry
Financial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi, Sergio M. Focardi, and
Teo Jasic
Developments in Collateralized Debt Obligations: New Products and Insights by Douglas J. Lucas,
Laurie S. Goodman, Frank J. Fabozzi, and Rebecca J. Manning
Robust Portfolio Optimization and Management by Frank J. Fabozzi, Peter N. Kolm,
Dessislava A. Pachamanova, and Sergio M. Focardi
Advanced Stochastic Models, Risk Assessment, and Portfolio Optimizations by Svetlozar T. Rachev,
Stogan V. Stoyanov, and Frank J. Fabozzi
How to Select Investment Managers and Evaluate Performance by G. Timothy Haight,
Stephen O. Morrell, and Glenn E. Ross
Bayesian Methods in Finance by Svetlozar T. Rachev, John S. J. Hsu, Biliana S. Bagasheva, and
Frank J. Fabozzi


Structured Products and Related Credit Derivatives by Brian P. Lancaster, Glenn M. Schultz, and Frank J. Fabozzi
Quantitative Equity Investing: Techniques and Strategies by Frank J. Fabozzi, CFA, Sergio M. Focardi,
Petter N. Kolm
Mathematical Methods for Finance: Tools for Asset and Risk Management by Sergio M. Focardi, Frank J.
Fabozzi, and Turan G. Bali


Financial Advice
and Investment
Decisions
A Manifesto for Change

JARROD W. WILCOX
FRANK J. FABOZZI


Copyright © 2013 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States
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to the accuracy or completeness of the contents of this book and specifically disclaim any
implied warranties of merchantability or fitness for a particular purpose. No warranty may
be created or extended by sales representatives or written sales materials. The advice and
strategies contained herein may not be suitable for your situation. You should consult with a
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of profit or any other commercial damages, including but not limited to special, incidental,
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ISBN 978-0-470-64712-7 (cloth)
ISBN 978-1-118-41811-6 (ebk)
ISBN 978-1-118-41532-0 (ebk)

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1


JWW
To my lifelong partner, Linda Wilcox

FJF
To my beautiful wife, Donna,
and my children, Francesco, Patricia, and Karly



Contents

Preface
Acknowledgments
About the Authors
CHAPTER 1
Why Do We Need Better Financial Advice?
The Individual
Organizational Influences
The Rest of the Story

CHAPTER 2
The Evidence Is Compelling
Financial Planning
Your Most Important Investment Decision
Option Payoffs are Not Simple
After-Tax Payoffs are Not Simple
Our Primitive Brains and Monkey See, Monkey Do
Others’ Agendas and the Perils of the Ivory Tower

CHAPTER 3
The Extended Balance Sheet Approach to Financial Planning
The Simplest Model
The Stochastic Dynamic Programming Alternative
The Mental Accounting Alternative
The Extended Balance Sheet
A Financial Planning System

CHAPTER 4
Properties of Mostly Efficient Markets
Multi-Agent Emergent Behavior
Why Security Returns are Difficult to Predict
Markets Bubble and Crash
Investment Implications of Market Characteristics

xi
xiii

1
2
4
10

13
13
14
18
20
21
22

25
25
29
30
31
37

43
44
46
48
57

vii


viii

Contents

CHAPTER 5
Growing Discretionary Wealth
The Discretionary Wealth Approach
Elements of the Approach
Appropriate Markowitz Risk Aversion

CHAPTER 6
Coping with Uncertain Knowledge
Interpretation of Probability
Bayesian Probability Fundamentals
Resisting Forecasting Overconfidence
Making Estimates More Robust to Extreme Observations
Taking Context into Account
Making Better Use of Information in Decisions

CHAPTER 7
Controlling Investing Behavioral Biases
Facing Up to Complexity
Promoting Independent Thinking
Controlling Organizational Biases

CHAPTER 8
Tax Efficient Investing
Context
Taxes that Affect Investment Returns
General Principles of After-Tax Investing
Measurement of After-Tax Performance and Benchmarks

CHAPTER 9
Matching Investment Vehicles to Needs
Revisiting Risk Aversion
Taxes Again
Diversification
Higher Moments
Implementation

CHAPTER 10
Active vs. Passive Strategies
Pricing Efficiency and the Active–Passive Debate

59
59
60
73

79
80
81
87
95
99
102

105
106
115
117

121
121
123
131
140

143
144
146
148
150
155

167
169


Contents

CHAPTER 11
Performance Measurement
Relating Measurement to Purpose
Spending Control
Measurement for Individual Passive Investing
Performance Reporting for Active Investors
Delegating Your Investments Based on Measurements
Measuring vs. Evaluating Performance

CHAPTER 12
Organizational Investing
Representative Investing Organizations
Delegating Superior Investing Results
Motivating Organizational Benefits

CHAPTER 13
Financial Advice and Society
Social Ideals and Financial Problem Symptoms
Redesigning Society with Better Financial Advice
And in Conclusion…

APPENDIX A
Traditional Asset Classes and Alternative Assets

ix

185
185
187
190
197
208
213

217
217
232
241

243
245
248
274

275

Asset Class Defined
Common Stock Asset Classes
Real Estate
Alternative Assets

275
276
278
280

APPENDIX B
Bond Features, Yield Measures, and Risks

287

Features of Bonds
Yield Measures and their Limitations
Call and Prepayment Risk
Credit Risk

287
289
296
297

APPENDIX C
Probability Distributions Commonly Used in Investment Management

301

Normal Distribution
Student’s t-Distribution
Stable Distributions and Stable Paretian Distributions

301
303
303


x

Contents

APPENDIX D
Useful Financial Planning Formulas
Working with Present Values
Determining the Required Savings-to-Income Ratio
Taking Initial Investments and
Needed Retirement Income Reduction into Account
Investment Return Mean and Variance
Deriving an Estimate of Discretionary Wealth Growth Rate
Estimating Appropriate Expected Return for Compounding

References
Index

305
305
305
306
307
307
308

311
321


Preface

verywhere we look, we see opportunities for better financial decision
making. They begin with the saving and investment decisions of individual investors. It is for their benefit that we undertook this book. However, we also see attractive possibilities for profitable innovation focused
on customer needs in the business models and practices of many financial
organizations. Paradise may be just around the corner if we can also help
governments to further encourage better quality financial services, more precautionary saving, and reduce the frequency and impact of financial crises.
Well, maybe not. But we do believe each improvement in financial advice
helps build a foundation for further progress.
We know we are nowhere near what can be accomplished.
Late in 2008, Bernie Madoff was arrested for operating a purported
$50 billion dollar Ponzi scheme. It was big news in the United States and
worldwide. Victims were swindled because they were not able to evaluate
the credibility of steady monthly returns amounting to a reported 10% to
12% a year. That ability to evaluate could have been a requirement for
graduating from college, if not high school.
Extensive research has established that most investors would be better
off financially if they invested in passive index mutual funds or exchangetraded funds (ETFs) rather than actively managed funds, leaving attempts
to beat the averages to exceptional professionals. Yet hundreds, if not
thousands, of low-quality funds persist, reducing the ability of investors to
properly save for retirement. Even large pension funds, banks, and insurance companies are not exempt from serious flaws in investment policies.
We think that quality is likely to improve, but progress has been slow, and
should be sped up.
At the same time as the collapse of the Madoff scheme, a vastly larger
group of investors and businesses was undergoing the pain of a worldwide
financial crash. It revealed too much debt, poor lending criteria inflamed
by conflicts of interest, misunderstood financial derivative products, lack of
transparency, and too much reliance on third parties for credit evaluation.
These symptoms shared the same underlying diagnosis—a curable inability
to evaluate the quality of financial advice.

E

xi


xii

Preface

We even see hope for better government legislation and regulation if
more people in government take to heart some useful facts about the investment world—things like the impact of leverage on systemic risk. It is really
not rocket science.
Bad financial advice is not usually intentionally deceptive. In many
instances, we are merely subjected to poorly informed, overconfident or
unconsciously biased advice givers. It is not limited to us as individual
investors. It plagues brokers, pension fund trustees, bank managers, hedge
fund managers, government regulators, and most everyone involved with
financial products and services. We see considerable hope, however, in the
increasing service opportunities created through the evolution of the Internet. Most people will still want the help of a trusted adviser, but improving
the ability of customers to evaluate the quality of what they are getting can
free advisers to do what they do best. Good advice is available, but it needs
an audience educated to appreciate it.
We recognize that our book will not appeal to everyone. It takes considerable effort to form new habits—whether in saving, investment, business,
teaching, or governing. All we offer are some key facts, some small conceptual models to help you think about financial problems, and a little advice
from our experience. It is up to you to do the rest.
Jarrod W. Wilcox
Frank J. Fabozzi


Acknowledgments

We would like to acknowledge Mark Rubinstein, Professor Emeritus
of Finance at the Haas School of Business at the University of California–
Berkeley, who provided helpful confirmation that the discretionary wealth
model introduced in Chapter 5 was derivable from his much earlier work on
generalized logarithmic utility.
We are grateful to the following individuals for their insightful comments on Chapter 13, namely, Russell Fogler, Sergio M. Focardi, Martin
Fridson, and M. Barton Waring.

xiii



About the Authors

Jarrod Wilcox is President of Wilcox Investment, Inc., a registered investment advisor since 2002 serving families. His previous investment experience included institutional money management at Panagora Asset Management, Batterymarch Financial Management, and Colonial Management
Associates. Prior to entering the investment field, he was an assistant professor at MIT’s Sloan School and a consultant with the Boston Consulting
Group. Dr. Wilcox is the author or coauthor of several books on investing,
and recently founded Wealthmate, Inc. to provide Internet financial services.
He received his S.B., S.M., and Ph.D. degrees from the Massachusetts Institute of Technology and is a Chartered Financial Analyst.
Frank J. Fabozzi is Professor of Finance at EDHEC Business School and
a member of the EDHEC Risk Institute. Prior to joining EDHEC, he held
various professorial positions in finance at Yale and MIT. In 2013–2014
he held the position of James Wei Visiting Professor in Entrepreneurship
at Princeton University. Since the 2011–2012 academic year, he has been a
Research Fellow in the Department of Operations Research and Financial
Engineering at Princeton University. A trustee for the BlackRock family of
closed-end funds, Professor Fabozzi has authored and edited many books in
asset management and quantitative finance. The CFA Institute’s 2007 recipient of the C. Stewart Sheppard Award given “in recognition of outstanding
contribution to continuing education in the CFA profession,” he earned an
M.A. and a B.A. in economics in June 1970 from the City College of New
York and elected to Phi Beta Kappa in 1969. He earned a Ph.D. in Economics in September 1972 from the City University of New York. Professor
Fabozzi holds two professional designations: Chartered Financial Analyst
(1977) and Certified Public Accountant (1982).

xv



CHAPTER

1

Why Do We Need Better
Financial Advice?

oney and finance are wonderful inventions. But our makeup is not
yet perfectly adapted even to the uses of money. We have inborn
instincts for success within family and small groups, but success within
money-based economies is far less natural. A competitive public marketplace for legal documents such as stocks, bonds, and derivative instruments is even more “unnatural” than trading for goods and services using
money. Many look with disdain on the accumulation of money through
financial markets. This further discourages us from its mastery, especially
from competence in those skills—such as reasoning with probabilities and
treating shared beliefs with skepticism—that we associate with gambling
and speculation. The financial environment seems too complex for real
comprehension, and we fall back on ancient behavioral mechanisms that
economists, who like to think of themselves as scientists battling the forces
of superstition, term “irrational.”
In this short introductory chapter, we meet the financial enemy, and he
is us. All of us need better financial advice—and some of us should share
it. To motivate our book, we need only illustrate financial decisions we see
frequently in practice. We start with the individual investor, move on to
organizational influences, and finally touch on our government, at least as
exemplified in the United States. Opportunities for better financial decision
making, better financial advice, and better financial laws and regulations
will be obvious. In the following chapters, we support our view in depth and
go on to make specific recommendations.
When we refer to the financial decision maker as “you,” we realize,
of course, that you would never make all the mistakes we now describe.
But put yourself into this picture, and you might be surprised to see how
well some of it fits. We illustrate this with an unduly confident investor, but
overly cautious investors make mistakes of their own.

M

1


2

FINANCIAL ADVICE & INVESTMENT DECISIONS: A MANIFESTO FOR CHANGE

THE INDIVIDUAL
You are 23 and are just beginning your first serious full-time job. Do you
save part of your paycheck? You may live for another 60 or 70 years, or
more, and will want to have an acceptable income throughout. Yet, the image of those far-off spending needs pales in comparison with today’s desires.
So, do you stop to calculate the very positive effect of an early financial
savings stream on your well-being decades from now? Not likely. You are
ripe for bad financial advice, not from professional advisers, or even from
the financial media, but from consumer advertising: “It is good to spend on
better cars, on better clothes.” In the succeeding years, this message will be
directed toward a more upscale vacation and a bigger house. You may think
spending is even patriotic because it helps the economy. You save very little,
losing the opportunity to benefit from the compounding of returns on savings and investment over long periods.
Now move forward in time. You are 30, have married, and you and your
spouse have a first child. You want to buy a house large enough for a growing
family and in a good school district. Fortunately, the government has a program that requires a very low down payment, which is a great deal because
house prices have increased fairly steadily for many years. Despite your lack
of collateral and savings, your bank is happy to give you a mortgage.
Later, you are 40 years old, have advanced your career, and met some
of your family responsibilities. You want to begin to build retirement savings. You are planning for retirement in another 25 years. How much of
your savings, that is, your investment portfolio, should you put into stocks
as opposed to bonds and other financial assets? How much of your portfolio should you allocate to asset types with different risk characteristics?
Nobody knows the future with certainty, but you see that stocks have done
well in the last 10 years. You want to put most of your funds into things that
have demonstrated good returns.
On the other hand, how much risk can you tolerate? Based on filling out
a broker questionnaire, you decide that you can handle stock market ups
and downs so long as they are not too bad.
Moving forward again, and looking back from age 50, you remember going through a horrendous time when the stock market crashed. You
sold all your stocks at just the wrong time because, subsequently, the stock
market recovered, leaving you safe but with not much to show for the last
decade of investing.
You decide now that you need better financial advice. But to whom
should you listen? Your best friend recommends an adviser. The adviser asks
how much you want to spend in retirement, and you provide that information. Then the adviser evaluates your savings plan and current investments,


Why Do We Need Better Financial Advice?

3

and tells you that you will not have enough to absolutely assure that much
future spending. However, if you invest wisely, and take a little risk, your
returns should be about 8% a year, which is what big pension plans assume,
and that will meet your retirement spending plan.
You and your adviser also agree on an investment plan. You are going
to do your part. You have been successful in business so far, and although
your investing has had its share of disappointments, you believe you have
learned from them. You can certainly do better than an index fund, and you
have a special feel for stocks in your industry.1 But to be conservative, you
have your adviser pick some mutual funds with great records in which to
invest part of your savings. You urge your adviser to pick the best manager
of the available choices in each category.
At age 55, you realize that maybe you were not so great at stock picking. The problem seems to be that the strategies you had read about did not
always work. Your adviser wasn’t so great, either. The high fees on the mutual
funds selected by your adviser would not have been bad if the funds had continued their prior good performance, but you discover the funds did not do
even as well as an index fund. Concerned that you had put your faith in the
wrong person, you find a better adviser who had done much better over the
last five years.
In the years until you reach age 60, the economy does fine and the stock
market moves to new highs. The new adviser does well, too, with selections
that go up even more than the market. Your bonds are a bit of a drag, so
you begin allocating more to stocks.
At 65, you retire. You ask your adviser, “How much can I afford to
spend a year when I retire?” The financial adviser responds, “Each year,
take 4% of what you start with at retirement. That has almost always
worked.” That doesn’t sound too bad, though you were hoping for at least
5%. You are in great health, so you and your spouse are planning to do a
lot of outdoor activities and travel.
At age 70, your conventional investment funds are no longer quite able
to supply you with your planned income on a sustainable basis. There was a
financial crisis, followed by years of near economic depression. You had followed the 4% spending rule, but it was a little too aggressive with the lower
returns, higher taxes, and the inflation that followed the years of economic
trouble as the government found itself under too heavy a debt burden. So you
1

An index fund is a fund that provides broad market exposure to an asset class such
as stocks or bonds. The fund manager does so by investing in a portfolio that is
constructed to match the performance of some market index. The market index in
the case of stocks can be, for example, the Standard & Poor’s 500 Index. Investing
in index funds is referred to as “passive investing” The pros and cons of passive
investing versus “active investing” is the subject of Chapter 10.


4

FINANCIAL ADVICE & INVESTMENT DECISIONS: A MANIFESTO FOR CHANGE

take the advice of your adviser, who suggests a fund that owns stocks and
writes call options to convert option time premiums into additional income.
At age 80, your investment portfolio’s value is reduced to the point
where it is clear it will not support your current moderate spending pattern. Your option income fund went down a lot. Disgusted with stock market crashes and current low interest rates on bonds, you consider buying
an annuity, but the income from it would not come close to meeting your
needs. Your good health is a bit of a mixed blessing, because either you or
your spouse can expect to live for another 15 years.
In the preceding example, every choice you made could have been
greatly improved. Yet every choice was one that many people make. And
many others don’t do even as well as in the example because they save very
little in the first place. In the following chapters, we explain how to do better. But let’s go on, because it is not just individuals who need to improve,
but organizations and government as well.

ORGANIZATIONAL INFLUENCES
Let’s leave government aside for the moment. Looking at our schools, our
employers, and different types of financial service businesses, we can see
some problematic influences on the individual investor that might have occurred in the preceding example.
From a young age, you are subject to the influence of consumer advertising, implicitly opposed to taking advantage of the enormous power of
compound interest over long periods. We cannot blame advertisers for
wanting you to buy their products. But this advertising does not come with
a label: “Warning: this product may be injurious to your financial health.”
Each of us must strike a balance between current and future satisfactions,
and unfortunately, although high school included material on health, there
is too little in the way of financial health.
You were later employed by a firm offering a defined benefit pension
plan. After investment returns were generally positive for some years, pension fund actuaries extrapolated them far into the future. The employers
responsible for assuring the benefits of such plans were generally happy to
agree, because long-term optimism reduced their short-term obligations to
contribute to the pension fund. And so, too little was saved to pay future
pension benefits. If the firm gets in trouble, even if your benefits were vested,
negotiations may be reopened.
The willingness of bankers, and particularly less regulated mortgage
bankers, to help new homeowners assume very high financial leverage was
revealed as a tragedy in the 2008 financial crisis. But why would sensible


Why Do We Need Better Financial Advice?

5

bankers do such a thing? The premise was that mortgages were not in high
risk of default, even with very slight down payments, because housing prices
had been going up fairly steadily for many years. Besides, the lenders were
selling off much of the credit risk. We can’t blame them for wanting to make
a profit, but many of the same organizations lost heavily in the crisis from
their remaining exposure, so it is not clear that the game was worthwhile
except in the very short run.
Financial planning based on asking investors how much they want to
spend on retirement, and goal setting in general, is fine if the decision variable to be adjusted is how much to save. But to the extent it only influences
investment allocations to take on more risky investments so as to stretch
returns to meet the goal, it is not helpful because it does not increase the
ability to take risks. However, it does generally increase fees. We don’t suggest that financial advisers are bad people. Many are very sincere in their
desire to help. But as Karl Marx noted over 150 years ago, ideology often
unconsciously reflects material interests.
Rules, such as spending 4% of initial retirement income, may work reasonably well on average; however, there is nothing magic about that number,
and in some cases it should be lower. Such rules do not incorporate enough
flexibility in consumption spending. In effect, they transfer current consumption risk to future risks that could precipitate a downward wealth spiral. We
have to recognize, however, that it may be very uncomfortable for an adviser
to tell a client that he or she must cut personal consumption, especially after
one has been working with the client for years and will be blamed.
Pension funds deciding on investment managers to retain to manage
a portion of its funds and financial advisers recommending mutual funds
both tend to recommend those funds whose managers have done particularly well over the previous five years. Yet the evidence these managers and
funds do better than average over the succeeding five years is scanty and
sometimes perverse. Why do these professionals make this same mistake
individual investors make? Of course, we know that agents have agendas
different from those of the people who hire them. But many, probably most,
of these professional agents sincerely believe they are adding value.
Broker questionnaires satisfy legal obligations to “know your customer”
and make sure that investments are in some sense suitable. But do they
really forecast how investors will behave if they lose a substantial amount of
money? Even putting emotions aside, they measure a subjective belief today
rather than the more relevant objective financial need tomorrow.
There are rules on how investment return performance must be reported,
but they do not require after-tax, risk-adjusted measurements. If this were
done, and compared with the same measurements on a benchmark passive
index fund, it would be much more difficult to tell even naive investors a


6

FINANCIAL ADVICE & INVESTMENT DECISIONS: A MANIFESTO FOR CHANGE

plausible story of unusually good return prospects. With very few exceptions, fund managers make no attempt to educate their investors on how to
assess their performance. In general, portfolio managers strive for the best
returns they can achieve on the measurements they have been given. But,
again, ideology unconsciously reflects material interests. What does a wellestablished and profitable business organization do if they have no business
model for profitably serving the educated investor?
By the way, we are not suggesting that professional investors have no
skill in improving returns beyond those of passively managed index funds.
We are saying that on average it is difficult for their clients to capture that
benefit after fees and expenses.
Investors seeking higher retirement income are often tempted by brokers and other financial advisers pointing out opportunities to invest in
complicated products such as option-income funds, master limited partnerships, and other investment approaches that averaged over enough
time essentially provide extra distributions while reducing their capital.
Even professionals who manage such funds may not be fully aware that
this is what they are doing.
Successful boutique investment management organizations often earn
their reputations with a well-defined investment approach. They attract
investors who then feel they have bought that approach, not just the firm
executing it. When the investing environment changes, if the manager
adapts by altering the approach, investment consultants and their own clientele will often complain bitterly of lack of focus and discipline. So most
managers stick to their advertised approach, even when they suspect it is not
the best they could do. This is so ingrained that it constrains their research
into new methods as well. A good example occurs when so-called quantitative managers are flummoxed by discontinuities in statistical relationships
governing return correlations and predictors. They could address this by
blending qualitative and quantitative methods, but refrain from doing so
out of concern for losing existing customers and consultant referrals.
We could go on, but you get the idea. Organizational influences on the
investor suffer from benign neglect in schools, shared ignorance by employers, short-term profit desires in many financial service arrangements, and
from the simple need to retain customers who believe smart people should
be able to make them more money than an index fund. We did not always
see it this way. What has changed?
Empirical research and new technology have transformed the formerly
acceptable to unacceptable. Previously, no one knew how powerful highly
diversified passively managed index funds could be. Some professional investors had found very profitable investment approaches because there was less
information available and the markets were consequently less competitive.


Why Do We Need Better Financial Advice?

7

Now the market is more efficient (except when everyone is thinking alike).
Also, as in other fields of endeavor, what was once good quality has become
perceptible as poor quality. At the same time, advances in knowledge and
technology have also created a world of greater complexity. The general public and the organizations that serve it have only started to catch up. So have
those who represent us in government, to which we now turn.

Government
In a democracy, government cannot get too far ahead of the ideas of the
electorate. And we know that new ideas are often actively resisted, and that
this is a natural consequence of their tendency to divide us into winners and
losers. In the United States, this seems to be true for both Republicans and
Democrats. As technocrats, we believe government nevertheless can and
should be wiser. It is painful to watch our government trying to adapt to the
modern financial world. We illustrate this with several examples.
Saving
Demographers have known for many years that birth rates are declining,
that people are living longer, and that new medical technology is making it
possible to extend life—but at high costs. We have known for many years
that the ratio of actively working people to people past working age is
shrinking and will shrink further. Yet the United States does little to increase
savings and, at the same time, it further increases our collective financial
obligations to the elderly.
It gets worse. Decades ago, there was a decline in the popularity of socialism and a consequent widespread adoption of mixed economies with free
market components throughout much of the economically underdeveloped
world. It became obvious that globalization of high labor productivity would
take place, and that workers in the most developed economies in Europe and
North America would now have to compete with vast numbers of workers
in formerly less-developed economies. Economics 101 said that if the supply
of skilled labor applicable to tradable goods and services doubled or tripled,
this would have an effect on incomes of labor in the developed world.
Those in government had every reason to suspect that this enormous
increase in skilled labor supply would worsen the ability of most people in
developed economy countries, including the United States, to increase or
maintain their living standards. Yet the U.S. government has encouraged us
to spend on consumption so as to keep up employment in the short term
rather than to save and invest funds in infrastructure, capital equipment,
research, and education to provide for longer-term success.


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