From the June 2010 issue of Research Magazine • Subscribe!

June 1, 2010

Get New Clothes

Don't stick with a nakedly wrong strategy.

You probably recall Hans Christian Andersen's delightful story "The Emperor's New Clothes," in which a potentate parades before his subjects while supposedly wearing a garment so refined it's hard to see -- until a child points out that the emperor's naked.

Sometime in the spring of 2009, without fully realizing it, I took on the role of the child in a modern day rendition of the fable. As various seers and prognosticators debated "black swans" and even talked about the progeny of Modern Portfolio Theory, I announced to anyone who would listen to me: "Modern Portfolio theory is naked! Its consort, Buy and Hold, is naked. And for good measure, the third pillar of the state finance religion -- don't manage money -- makes it a shivering threesome."

Perhaps I was able to see this as clearly as I did because I am not a financial advisor. Nor have I done a formal study of MPT. But just as the child saw clearly that the emperor was naked, I saw just as clearly that not only is Modern Portfolio Theory threadbare, but that advisors now need to take back the management of their funds. Twice in this new millennium, highly manipulated markets have handed your clients a 50 percent asset reduction plan. Be prepared for the next one.

Given its influence, the bankruptcy of Modern Portfolio Theory as a comprehensive investment management tool should have been bigger news than it was. It should have been on the front page of the New York Times. About the best one could do was a February 2009 Barron's article titled "Modern Portfolio Theory Ages Badly: The Death of Buy-and-Hold," which noted the 2008 fourth quarter massacre saw ostensibly uncorrelated asset classes -- except Treasury bills -- dive into the shallow end of the pool simultaneously.

The 2010 annual research report from Dalbar, "Quantitative Analysis of Investor Behavior," or QAIB, released mid-April, is a must-read for financial advisors who make their living on being more right than wrong. The report states: "In spite of the catastrophic losses in 2008, the belief in Modern Portfolio Theory (MPT) has inexplicably remained strong." As the report explains, MPT presumes asset classes to be predictably uncorrelated, but investment results in 2008 "showed clearly that correlation of asset classes varied unpredictably and with no warning."

The report goes on to suggest MPT "should be thought of as only one reference point for modeling the behavior of a potential portfolio; it is only one dimension of a more comprehensive investment management process."

I'll put it more bluntly: MPT, RIP.

Real vs. Theoretical

Modern finance theory seems to live in a world not connected to the real world of clients, retirement, educational funding needs, illness, joy, sorrow and ultimately death. It lives in a theoretical world, not a real world.

My first encounter with this world was at the University of Virginia where I was pursuing a Ph.D. in Economics. One of my classes was macroeconomics. The professor, a hotshot just out of Yale, would often cover the blackboard with differential equations. Once when he completed a particularly difficult proof and was dusting the chalk off his hands, I raised my hand and asked what all this had to do with anything.

"Mr. Good," he replied smugly, "You have been doing this long enough to know that in economics we deal with the real world and the theoretical world. This was a theoretical world construct and as such, has nothing to do with anything."

I knew that of course. But for whatever reason, on this day, in that proof, something went click and I replied, "That's what I thought."

Then I picked up my five-pound textbook, put it in my briefcase with several other five-pounders and walked out. While I showed up for a few other classes, I was done with my academic career and its torturous journey into the "theoretical world."

Like my class in macroeconomics, "buy and hold" exists in the theoretical world, not the one you and I and investors inhabit. In the real world, buy and hold does not exist.

It certainly does not exist in the mutual fund universe. According to fund-tracker Lipper, U.S. stock funds average turnover of 105 percent, which means the entire portfolio changes about once every year. Nor does it exist for individual investors. According to the Dalbar report, investors' average retention rate for equity funds was 3.22 years.

But even had mutual fund investors transported themselves into the world of indices divorced from reality for a 20-year period, they would have had a net return after inflation of 5.4 percent. On a 10-year buy and hold period, they are at negative 3.75 percent; over five years, they are negative 2.39 percent and over three years, they pulled down a whopping negative 8.43 percent.

Consider the real-world folks who retired, say, March 2000. They were immediately served a poisonous entr?e of a 47 percent trashing of their portfolio. The S&P took seven years and two months to recover. The NASDAQ is not even close to recovery. This is real life, real pain.

What of those who retired in October 2007? Over the 17 months of this bear market, they were served a 56 percent asset reduction plan. Twice in the first seven years of the new millennium, your clients have seen their equity portfolios cut in half.

You have seen the articles that report some 85 percent of high-net-worth investors would consider a second opinion. But when you look at the new account numbers, which are dismal, you conclude that these investors are not changing advisors. Why?

My theory: the second opinion they are hearing is the same as the first. Such is the result when a state religion dominates.

A staple of conventional wisdom is that investors underperform investments because they are "impatient" and "irrational." The conclusion is that advisors should counsel their clients to stay put, since the alternative seems to be buying high as investments approach their peak, and selling low when the panic sets in.

Perhaps. But I see another conclusion. Perhaps advisors should recognize what investors are trying to do as they jump around, and help them do it rationally.

No More Pies

The question on the table: Is it possible to teach advisors how to get out of harm's way and how to manage a fee-based practice, all in a reasonable period of time? I'm involved in a joint venture called No More Pies, aimed at addressing that question.

Let me tell you about my collaborators. Ric Lager, author of Forget the Pie, is an RIA who has been a Bill Good Marketing System user for over 20 years. He's carved out a niche managing 401(k) assets he does not custody. In some conversations in the summer of 2007, he convinced me a storm was coming. I listened. By following his advice on my personal 401(k) account, I was 80 percent in cash when the market tipped over.

Jack Reutemann is a long-time BGM subscriber and multi-million-dollar producer. For many years, Jack has been in the top ten at LPL Financial. Ric and Jack are adept at using a valuable set of tools: the point-and-figure technical analysis system developed by Dorsey Wright & Associates in Richmond, Va.

Technical analysis skills, plus marketing skills, are crucial for anyone who wants to pick up and dust off from the rubble of MPT. We at No More Pies are interested in showing you how. For more info, go to www.nomorepies.net.

Bill Good is chairman of Bill Good Marketing Systems. Visit www.billgood.com.

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