Friday, March 27, 2015
I talked to a friend today who had an interaction with a broker who was adamant that a particular transaction be funded TODAY! The broker had recommended the client sell certain investments to purchase new investments. Because of the settlement of the sales, the cash wouldn't be available to make the buys until next week. The client was indifferent as to whether the new investments were purchased today or next week, but the broker tried everything he could think of to make sure the purchases were made today. Ultimately, the broker was unsuccessful, so he won't get credit for the sales until next week, which is likely all included in 2Q even though April doesn't start until Wednesday.
If you ever find yourself on the client side of this type of interaction, you should probably ask yourself "Why is it so important that this happen TODAY?" I would always be wary of acting on a recommendation of a broker, especially towards the end of the year/quarter. The broker is going to get paid commission on a purchase no matter what quarter it happens in. Because there are often quarterly bonuses based on total sales, this sale could have been the difference between getting an additional bonus or not.
Sorry for not warning you earlier. Stay safe out there.
Monday, March 23, 2015
The most common example I would see would be when someone had bought a variable annuity and had no idea how it worked, why they owned it, or what benefit it provided to their overall financial plan. In these scenarios, the penalty for ending the contract early often outweighed the savings they could realize by doing so, so they were effectively stuck with a poor decision for several years. In many cases, had they understood what they were investing in and why, it is unlikely that they would have actually made the investment.
Only investing in things you understand sounds obvious, but the fact that some of the worst financial products continue to be sold is proof that it isn't. Individual investors aren't the only ones guilty of this. In the run up to the financial crisis of 2008, the city of Narvik, Norway, lost $64 million investing in synthetic CDO's, a complex product that essentially was tied to sub-prime US mortgages. A good book that talks about this in greater detail is David Fabers "And Then the Roof Caved In".
Investing in things you don't understand doesn't always end poorly, but should be avoided nonetheless. Back in early 2008, I bought shares of Visa (V) right when they first began trading. I paid around $59 per share and held them for about 6 ½ years, selling for around $260 per share, earning an average annual return of 24%. Sounds good right? The problem with this investment was that when I bought the shares, I didn't know how Visa made money! I figured it would be a good investment just because of the ubiquity of the brand name, but didn't really know what would have made the stock go up or down. Did you know that credit card companies make money every time you use your card, but aren't actually loaning you any money? This has become more common knowledge now that products like Square are allowing anyone to accept credit cards and pay swipe fees, but back in 2008, it was something I didn't yet know. This investment worked out well for me that time, but I attribute all of that to luck and not to my own understanding of the investment.
One thing I'd like to make clear though, is that although you should never invest in something you don't understand, not investing in things you don't understand is not an excuse to avoid learning about investments. Just like starting to save early will have compounding benefits in the values of your investments, the sooner and more you can learn about ways you can invest your money the better. The benefits will compound as many different investment types are interrelated and you can understand how several work by learning the basics.
To help avoid investing in something you don't fully understand, here are few questions you can ask yourself before taking the plunge.
- What factors will contribute to your investment going up or down in value?
- Are there any risks unique to this investment that wouldn't affect the overall economy?
- What are some comparable alternatives and how have they done? Why is this investment better than the alternatives?
- Who is recommending the investment and what are their incentives?
- What are the costs, upfront and/or recurring?
- How do you get money out and how long does it need to be kept in?
- Are there any guarantees? If so, who provides the guarantee and what exactly is guaranteed?
- If there is a guarantee, how often in the past XX (100?) years would I have needed the guarantee? (hint – the answer is likely close to 0, and if so, you probably don't need to pay for that guarantee).
If you'd like to get a good handle of the basics, one of my favorite books for that purpose is Learn to
Earn, by Peter Lynch. It's a book I've given to recent high school graduates or college graduates and it explains very simply how mutual funds work.
Friday, March 20, 2015
Remember when I spent a short stint working as a financial advisor getting paid 100% commission? This experience helped me learn how important it is to know the different types of financial advisors. Even if you don't want to BE a financial advisor, you will likely interact with a financial advisor at some point, so it's a good idea to know which type of advisor is best for you. The easiest way to differentiate between advisors is the way that they are paid. How an advisor is paid will determine what they are able to offer you, and can also be a sign of potential conflicts of interest. For simplicity, I'll combine these into three groups, commission based, fee-only, and salary based advisors.
- Commission based – This is perhaps the most common way that an advisor is paid. This is also known as a broker. Whenever you make an investment through a broker, you are charged a commission (whether or not you realize it), which goes to pay the broker. Seems pretty straightforward, right? Unfortunately, it's a lot more complicated than it sounds. You may or may not be aware of how much you are paying in commissions, and even if you think you do know, there are likely other behind the scenes payments that occur that you aren't aware of. Another problem is that different investment products pay different rates of commission, with those that pay the highest commission often being the investments that are the worst things an investor could buy. When I worked under this pay structure, I saw this conflict of interest daily and usually saw co-workers leading with the highest commission paying products first. For example, if a broker sells a variable annuity or a private placement, they could earn as much as a 10% commission, quite a bit higher than if they were to sell you loaded mutual funds that pay a 5% commission up front. I don't care who you are, earn twice the money for recommending one thing over another and you're going to see the higher commission investment recommended more often.
Unlike other critics of the commission model, I'm not 100% opposed to working with an advisor that earns a commission, where I do have a problem is when commission represents the vast majority of pay.
- Fee Only – A fee only advisor is just like it sounds, they only are paid in fees, and those fees can only come from you and there are no behind the scenes financial arrangements. A fee based advisor works for you, and when you enter into a relationship with one, you should have a clear picture of what to expect from them and how they are paid. Currently, a fee-only advisor is held to the fiduciary standard, meaning their recommendations must be in your best interest. This type of advisor could charge you in the $150-300 per hour range for things like financial planning, but the most common way a fee-based advisor is paid is on a percentage of assets. This means that they are actively managing your investments and charging you a set percentage based on how much they are managing. As your account balance goes up or down, so does the amount they can collect in fees. This is typically as high as 1%, but generally decreases the more you have invested.
The challenge with this model is that most of these advisors will have high minimum account balances, usually requiring at least $500,000 to $1,000,000, making it nearly impossible for the average investor to work with a fee-only advisor until they are well on their way towards wealth accumulation. Lately there have been 'robo-advisors' popping up that attempt to offer the same service in a web-based, automated solution with minimal contact with an actual person, but I believe that these are still untested. The true test of the robo-advisors will be how they perform in a market downturn. I spent a lot of time in down markets trying to convince clients not to sell everything, and a lot of time in up markets trying to convince (in some cases the same) clients to not invest too aggressively. I'm not sure how well an automated system can reason with a human.
- Salary based –A salary based advisor generally can act as a broker or as a fee based advisor. Because they are licensed as both types of advisors, they can earn commissions when acting as a broker, but if they are acting as a fee-based advisor, cannot earn commissions. This can be confusing, so keep in mind that if you aren't clear how you are being charged, the advisor is acting as a broker. To my knowledge, it is mainly large discount brokers (E*Trade, Fidelity, Schwab, TD Ameritrade, etc.) who will have this structure, and my belief is that it is done this way not to be schizophrenic in their business model, but rather to be able to offer as many different services as possible. These companies are generally in the business of having as many assets under administration (AUA) as possible, whether managed on a fee-only basis or on a commission model. An advantage of this is also that you can typically meet with a representative from this type of company when you are just getting started and don't have to wait until you have accumulated the large minimums most fee based advisors require. They will also often have much lower minimums for fee-based relationships (between $50,000 and $200,000).
When I worked under this model, my pay was roughly 25% salary, 25% commission and 50% bonuses that were based on customer retention, referrals, and customer satisfaction survey results. Yes, I was earning commissions, and yes, the commission rates were different depending on the product sold, but the difference in commission between products was very small. If a client invested $1,000,000, the difference between the highest and lowest commission I could earn was only $400. My real incentive was not to sell the highest commission generating product, but rather to develop strong relationships with my clients and to retain their business, whether that be fee based business or commission based business.
Should you find yourself needing a financial advisor, my recommendation would be to steer clear of the 100% commission based broker. Not only will you be paying fees and commissions, but they will likely be much higher than you are aware, and much higher than if you were to work with one of the other types of advisors.
If you're curious how a financial advisor is paid, it should be as simple as asking the person you are meeting with. If you'd rather research on your own or before going in for a meeting, dig around on the company website and you'll likely find what you're looking for. Fidelity and Schwab have actually published their compensation details on their websites.
Monday, March 16, 2015
I had enjoyed working with clients in my former job, and would have stayed at the job if there was a way that I could have made a decent living while also offering only investment products that I was comfortable with ethically. This would have also been easier if I had clients with a lot of money to invest, but generally speaking, anyone with a lot of money is going to want a financial advisor who has experience and isn't just a recent college graduate with little to no real experience. I had seen something that I liked doing, but needed experience to be able to do it well. How then, was I to get the experience?
The solution I found was to get a job at a large financial services company working in one of their call centers. It wasn't what I initially had thought I would be doing, but it ended up being ideal for what I needed to learn. Starting out servicing accounts and talking to clients without initially having any ownership stake in their financial plans, I was able to see firsthand the consequences of many different decisions, both good and bad. This experience proved invaluable a couple of years later when I was placed in a position where I was again a financial advisor and had a responsibility for the financial success of my various clients. One of the main things I was able to take away from this experience was the understanding that even though a portfolio may look ideal on paper, the plan is useless if an investor isn't going to stick with it. Keeping this in mind, I was able to build more customized solutions for clients, which resulted in happier clients, more referrals, as well as more income for me.
Over the course of seven years with that employer, I had a total of 6 different job titles (one for only 2 months), and was able to see my pay increase from a $35,000 to over $150,000 just a few years later.
While I truly enjoyed many aspects of my work in financial services, I chose to leave the industry for a career in corporate finance to further develop additional skills. Below, I have detailed my annual income over the years to further illustrate this point.
You'll notice that my total income has come down a bit in recent years. One of the things I was looking for in a career move was more stable income. Although my income in 2012 was over $160,000, only $45,000 of that was guaranteed base salary with the rest being highly variable, whereas now my salary is over $100,000 with a much smaller portion of my income coming in the form of variable bonuses. I also have higher growth potential with my current job whereas I was nearly at my peak earning potential in my previous role. Also, because the majority of my pay in 2011-2013 was paid in semi-annual bonuses, I had to live on a much smaller income during the year until those paychecks arrived. I knew that I wasn't going to spend the rest of my career in that job and chose to save and invest the majority of those bonuses while living on little more than the base salary.
One other thing worth pointing out is that my income didn't decrease from 2008 to 2009, rather my 2008 income included a relocation bonus for when I moved across the country. My income was relatively flat from 2008 to 2009 because overtime and bonuses were slashed amidst the financial crisis.
Saturday, March 14, 2015
My first foray into the financial services industry was during my senior year of college, and was where I learned an important lesson that has helped me significantly since then. I was hired as a financial advisor by a company that resonated with me in the way they talked about doing the right thing for the customer and helping people reach their dreams, and was told that once I was licensed, I would be given clients to work with that the office didn't have the bandwidth to properly support. I would be working 100% on commission, but the average rep made $40,000 in the first year, and to not let the 100% commission part worry me. Over the course of a month or two, I got all of my study materials and studied my brains out and passed all the necessary exams. The next day I went to the office, excited to get started helping people reach their goals. I still remember my heart sink when my boss said something like "All right! Now that you're licensed and ready to sell, let's make a list of all your friends and family and start calling them and selling them crap you wouldn't buy if you actually had any money of your own!" At least, that's what I heard. Wait a second, what about all the clients they had told me about who simply needed a rep assigned to their account that I could call to set up an annual review? Anything besides trying to pitch a variable annuity to my grandma! Sadly, my experience isn't all that uncommon but could have been avoided had I done better research on the industry or had someone I trusted teach me what to look for.
The next carrot that was dangled in front of me was that I would be given some existing clients to work with once I had generated $3,000 in gross commissions, and I was given 90 days to do so or be let go. On the surface this didn't sound very difficult since I had been told that 'average' new hires made $40,000 in their first year. When I started to dig into what I would have to do to get to that number, I wasn't quite as optimistic. The products that paid the most commission were the ones that I didn't want to be selling to ANYONE (whole life insurance, variable annuities, etc). In the end, I did meet with several people that I was able to help get started investing for retirement, and I didn't sell any investments that I felt betrayed what was right. I ended up working for about a month and had a mutual parting of the ways with the company.
I learned a lot of things while working for this company, but the main takeaway for me was that I will never feel comfortable with anyone I know investing through a company where the reps are paid solely on a commission basis. I have yet to hear an argument for the commission model that makes any sense and isn't from someone who has some type of vested interest in the model. The vast majority of people who join this type of company don't make it through their first year, and because of this, these companies will often have low entry requirements to be hired (which perpetuates the turnover problem).
This may not be the best example of 'growing your income', but was a very helpful step in getting me to my next job that I'll be talking about in my next post. It also was useful down the road when I actively helped people to avoid investing in companies like the one I was with for a short time.
Monday, March 9, 2015
I like to refer to things like budgeting and frugal living as financial defense. Spending money can be very easy, and have good financial defense ensures that you aren't spending everything you earn and are saving and investing for the future.
Financial offense is your income. Growing your income and career are some of the best investments you can make to enable financial success.
Financial success is NOT guaranteed with a higher income, but it certainly helps.
To illustrate this point, let me share an interaction with a prospective client several years ago that I will never forget. He called my office and asked to set up an appointment with a financial advisor. Our office had 8-10 different financial advisors, and like many financial service companies, we generally determined what advisor a client was paired with based on the amount of money they had to invest. This segmentation of clients is common since different strategies and complexities exist for larger portfolios than smaller portfolios that may not have as many alternatives. The prospect wasn't very forthcoming about his investments, but assured the scheduler that he probably should meet with the most experienced advisor in the office. When he came in, it wasn't long before we realized that he was the poster child for the phrase "all hat, no cattle".
This prospect bragged that for the preceding 8 years, his income had been between $500,000 and $800,000 per year as an attorney, and felt he had reasonable expectations for that income level to continue. Clearly he had done well growing his income and playing financial offense. The problem though was that he was not very good at financial defense. His total investable assets (checking/savings accounts, investment accounts, retirement accounts) were only about $100,000. Where did it all go? Well, he had a beautiful house and an equally beautiful vacation home, both of which were worth considerably less than he owed on them. He also had multiple very expensive luxury vehicles with very large car payments. If that wasn't enough, he also felt that his income justified picking up aviation as a hobby, so he had bought a small airplane for $300,000 or so. In total, his debts were approaching $2 million and he had a negative net worth. It was hard to believe that someone with that high of income could be living paycheck to paycheck.
Sadly (or maybe not so sadly), this person never ended up becoming a client of ours. He didn't have enough investable assets to meet my minimums, and our philosophies differed so much that it wasn't worth making an exception.
On the flip side, I have met several people who have become millionaires while earning average $40-50,000 incomes, but mastering financial defense.
The point of this is that YES, growing your income is useful in building wealth, but doing so can be meaningless if financial defense isn't also practiced.
In the next post I'll continue discussing financial offense, including my income history and what I've done to grow my income.
Saturday, March 7, 2015
In the hopes of removing some of the social taboo associated with talking about personal finances, I wanted to share some details of my household net worth over time. I will periodically provide updates to these figures in order to enhance my own accountability and hopefully to motivate or inspire any readers.
Deciding to pay off debt, and doing so aggressively, was critical to the success that I have seen thus far. Not having any non-mortgage debt freed up several hundred dollars per month to save and invest, and living on a budget has helped to develop spending habits that have ensured that saving and investing remain a priority.
Friday, March 6, 2015
Take a peek at the chart below. What it shows is what would have happened over the past 5 years to $1,000 invested in 5 different companies. The bold orange line, however, is what would have happened had you taken $1,000 and invested it evenly between the same 5 companies.
There are a few things to notice here.
First – over 5 years, the values ended up roughly around the same whether you chose to invest in a single stock, or in a diversified portfolio of the 5.
I purposefully picked stocks with similar performance over this time frame to make the main point, which is that even though you end up in roughly the same spot after 5 years, the diversified portfolio got there with less dramatic ups and downs than the individual components.
Lastly – notice that these 5 companies come from 3 different industries (Industrials, Energy, and Information Technology), so the fact they had very similar performance over the past 5 years isn't because they were in similar businesses.
Wednesday, March 4, 2015
I once met with an investor who had $2M in investable assets, with $1.5M of that in the stock of his former employer. In order to help this person understand the absurdity of having so much in one company I simply asked "If you had $1.5M in cash and no stock in 'XYZ', would you buy $1.5M worth of 'XYZ'?" The response was priceless, the person said "Of course not, what do you think I am, an idiot?" I didn't have to respond, as the person immediately realized the error of their way of thinking. My rule of thumb when advising clients was that if they insisted on having a lot of a particular stock, I never advised having more than 5-10% of investable assets in that particular company. Personally, I don't allow any individual stock to be more than about 1% of our assets.
One other former client was head of Investor Relations for a multi-billion dollar company. This client shared with me that although he probably knows the details of the company better than most people in the organization, he would not own any individual company stock, including that of his employer (as part of his compensation, he was given stock grants that he would immediately sell and invest in a more diversified portfolio). His reasoning for this was because in his line of work, his job was to talk to and answer questions from analysts from Wall Street banks and Hedge funds all day. He was always amazed at how they seemed to be able to read between the lines of many of the footnotes and details in their annual reports. He noticed that they would usually be asking questions about details that, although already publicly available, were several weeks or months away from getting any attention in the mainstream media. Because of all the brainpower being dedicated to this type of research, it became apparent to this former client that there was no way he, as an individual investor, could ever know a single company well enough to have any type of advantage when buying their stock.
Another former client was the President of a different multi-billion dollar company. He was very highly compensated, and a large portion of his compensation came in the form of company stock. By my rule of thumb of not having more than 5-10% of your portfolio in a single stock, he definitely had too much in one stock. His situation was somewhat unique, however, in that part of his job is to be optimistic about the company stock, and since all of his purchases and sales of stock are public record, significant sales could reflect negatively on the company. I never pressed him too hard to sell his company stock though, because even if he lost it all, he still had several million dollars of other assets that would be more than enough to support his lifestyle for the rest of his life.
Monday, March 2, 2015
Of course, the counter argument is that if you just put all your money into something like Apple that has gone up a lot lately, you could have grown your portfolio by >20x in the past 10 years. True, but good luck figuring out what stock is going to do that over the next 10 years. In order to diversify a portfolio, you should have several different stocks. By doing so, you reduce the risk that a catastrophic event for one of your stocks wipes you out, but you also give up the opportunity for significant gains that can occur with individual stocks. The most successful investors I have met didn't grow their assets to significant levels by being heavily invested in a single stock, nor did they put their wealth at risk by investing it heavily in an individual stock.
Other than simply not knowing any better, there are a few reasons that I have seen investors hold what I would consider 'too much' in one stock. Here's what I have to say about them:
- "I work at 'XYZ company', I know what we've got coming down the line, you won't believe how great it's going to be" (often accompanied by a wink, wink). Or "I'm ok having half my nest egg in this stock because I work there every day and I can keep an eye on what's going on with the company."
- You very well may know what's coming down the line from your division, but unless you are one of the top 5 or so people in the company, there is no way you know everything that is going on in the company and what your competition is doing before that information is already priced into the company stock.
- There are probably several stock analysts out there that know your companies financials way better than you do. These analysts are just as familiar with the financials of all your competitors and have a much better idea than you of how your company stock will perform relative to the competition.
- If you have a lot of stock in the company you work for, it is actually riskier for you than it would be for someone else who doesn't work for the company. If things went south for your employer, not only is your nest egg at risk, but so is your job. Double whammy!
- If you really have enough time at work to 'keep an eye on' every facet of the company to know what is going to impact the stock price, and you're not the CEO, eventually someone will figure out that you don't actually do anything at work and probably aren't really needed.
- Similar to the Apple counterargument to diversification, I have seen people fall in love with companies, either for their products, or simply because the stock has gone up a lot recently. Somehow this love for the company translates to an investor believing that they should dump most of their money into that companies stock. Apple is one example of this, but I have also seen investors get attached to automotive stocks (Ford, GM, etc), consumer staples stocks (P&G, Johnson & Johnson, etc), entertainment stocks (Disney), and Biotech/Pharmaceutical companies (Pfizer, Genentech, etc).
- It was once said that "what was good for our country was good for General Motors, and vice versa". Putting all of your money into GM may have sounded like a good idea at that time to some people. My how things have changed. I'm not predicting anything bad for any particular companies, but just remember that there is no stock that has consistently been the best performer.
- When you develop this sort of obsession with any company stock, it makes it difficult for you to view it objectively and you can find yourself making excuses for poor management decisions and saying things remarkably similar to things you could hear from a gambling addict ("I'll sell when it gets up to X", then after it reaches 'X' you move your target sell price up, or "I'll sell it if it drops to Y", then when it does, you make excuses for why it shouldn't have dropped in price, it's a short term correction, it will be back, etc…).
- What exactly is your strategy? Faith and hope are great attributes, but they are not an investment strategy.
- "I can't sell now, I've made so much the taxes are going to kill me".
- You only pay taxes on your gains, not the entire sale amount. Even if you invested $1,000 and now it has grown to $100,000, it's not like you won't have the cash to pay the taxes, since you will get the full $100,000 when you sell.
- The downside risk you take by holding a stock is always significantly more than the taxes you may have to pay if you sell. Mathematically, this doesn't make sense. If you invested $20,000 and your investment is now valued at $50,000, you are risking $50,000 to save $4,500 (50,000 – 20,000 * 15%) by not selling and locking in your gains.
I have read books that claim that diversification is a bad idea and that you'd be better off making big bets with big payoffs. The only problem with that strategy is that even with the risks being calculated, it is still a bet. For every investor who has made a fortune with this approach, there are hundreds of investors whose stories you won't hear because they lost everything trying the same thing. Diversification certainly isn't as exciting or sexy as some of the other approaches, but IT WORKS.