The US economy continues to give mixed signals.  As some sectors weaken, others rebound, and the housing market continues to boom.  The Index of Leading Economic Indicators fell for the fourth consecutive month in April, yet consumer confidence and factory orders jumped sharply.  The bottom line is that overall economic growth has slowed somewhat from the 2004 pace, but growth should still be near 3% for all of 2005.  No recession is in sight.

Most analysts continue to believe that the Fed will raise interest rates once again later this month and probably in early August as well.  But as I discussed last month, there is a good chance the Fed will end its rate hiking cycle in August when the Fed Funds rate is likely to reach 3½%.

If the Fed stops raising rates, this should present another excellent buying opportunity in stocks later this summer.  Actually, stocks have held up amazingly well this year in light of the modest slowdown in the economy, rising short-term interest rates, soaring oil prices and declining consumer confidence earlier this year.  Given that stocks have held up better than expected this year, we may not get the sell-off many investors are hoping for to get back in the market. 

The uncertain stock market outlook we are now in argues more than ever for professional management for a significant part of your equity portfolio.  The same goes for your fixed income portfolio now that long rates have fallen more than just about anyone predicted.  BCA continues to recommend market timing and sector rotation strategies for the current market environment (see page 8). 

This month we look at a recent study which investigated the investment habits of Nobel Prize winners in economics.  The most surprising finding was that even Nobel Laureates in economics have a hard time with their investments.  Many, including Harry Markowitz, who is generally credited as being the father of “Modern Portfolio Theory,” did not diversify their portfolios as they preached.  I think you’ll find this story very interesting and insightful as it pertains to your own investing habits.

Introduction

What do Nobel Prize winners in economics know about investments that you don’t know?  You would think a lot.  You would also think their investment portfolios would greatly outperform those of the average investor, wouldn’t you?  As it turns out, not necessarily.  A recent article from the LA Times cited a growing body of research showing some of those who claim to know the most about investing don’t capitalize on this knowledge.

The obvious intent of this article was to speak to the issue of Social Security private accounts, and the public’s inability to manage them.  After all, if a Nobel Prize winner can’t manage his own funds well, then how is John Q. Public supposed to be able to do so?

In this issue of F&T, I’m going to discuss the LA Times article, as well as others that discuss that workers are generally unprepared to manage their own financial destinies.  I will talk about why some Nobel Laureates as well as average workers don’t fare well when they invest their own money, and then relate this information to the Social Security private account debate.  My conclusion may surprise you, so read on.

Some Nobel Laureates Are Lousy Investors

On May 15th, the Los Angeles Times ran an article discussing the investment practices of past winners of the Nobel Prize for economics.  During their investigation for the article, they found that a number of Nobel Laureates did not follow even basic financial planning concepts when investing their own nest eggs.

Perhaps most surprising was their discussion of Nobel Prize winner Harry Markowitz, who is generally credited as being the father of “Modern Portfolio Theory” (MPT).  MPT is an investment discipline that stresses diversification among various asset classes to reduce portfolio risk.  In 1952, Mr. Markowitz scientifically proved the old adage, “You shouldn’t put all your eggs in one basket.”   He won a Nobel Prize in 1990 for his efforts.

The LA Times article pointed out, however, that in reality, Mr. Markowitz was less than diligent in practicing what he preached.  While MPT advocates wide diversification, Markowitz split all of his money right down the middle, with half in a stock fund and the other half in a conservative, low-yield investment.  He now admits that he should have allocated more of his assets to stocks when he was younger, but the fact remains that he wasn’t very good at following his own advice.  Unfortunately, he’s not alone among Nobel Prize winners.

George Akerlof, a 2001 winner of the Nobel Prize in economics currently has a significant percentage of his investments in money market accounts, which have very low returns.  He confesses, “I know it’s utterly stupid.”   Nevertheless, his personal investment strategy seems to fly in the face of discoveries by prior Nobel Prize winners.

In all, the LA Times surveyed 11 Nobel Prize winners in economics from this decade and several others from the 1990s, and many admit that they fail to manage their retirement savings properly.  The most often-found faux-pas was that they had too much of their money invested in low-yielding, conservative investments rather than in stocks that have historically provided better returns.

The LA Times article went further and asked Harvard University about the investment habits of its faculty.  They found that an estimated 50% put all or most of their retirement savings into low-yield money market accounts.  In many cases, contributions were left in money market funds simply because the Harvard faculty and staff didn’t bother to provide any investment direction (advice) for their accounts.  If this is happening with Nobel Prize winners and Harvard professors, then just imagine how widespread this phenomenon is among the general public!

The obvious implication of the story is to say if “smart” people like college professors and Nobel Prize winners can’t manage their own money, then how does President Bush expect the average American to do so in a Social Security private account?  The Internet “blog” website “Say Anything” put it a little differently, concluding that the premise of the LA Times article is to “…convince you that if Nobel Prize winners can’t figure out investing, then you’re obviously too stupid to do it…”

The problem that I see with the LA Times article begins with its title, “Experts Are at a Loss on Investing.”  Since when are all Nobel Prize winners in economics experts about investing?  OK, I’ll admit that Markowitz should have done a better job investing his retirement savings, but all economists are not necessarily also investment experts. 

Economists are supposedly experts at observing economic data, trying to make sense out of it, and then providing some sort of prediction about future economic conditions.  But given how often economic predictions are wrong, this may explain why these people don’t follow their own advice.    An economist observing economic events is no more guaranteed investment success than a meteorologist observing weather patterns is guaranteed sunny skies.

The same goes for the faculty and staff of Harvard University.  Since when are they all investment experts?  How many of the estimated 50% in money market accounts were “smart” faculty versus lesser-educated staff members?  Or, are you automatically deemed to be smart just because you work for a lofty university?

Again, if this is happening to Nobel Prize winners and Harvard professors, then just imagine how widespread this phenomenon is among the general public!   No doubt, millions of average investors are doing the same things.

401(k) Participants Also Miss The Boat

Unfortunately, recent information regarding 401(k) participant investment practices adds fuel to the “too stupid to invest” argument made by the LA Times article.  Since most 401(k) plans are set up to allow workers to call their own investment shots, employees must decide for themselves which investment alternatives are most appropriate for them.

Unfortunately, many 401(k) participants are not very effective in managing their retirement plan accounts.  Various studies have been performed over the years regarding the investment habits of 401(k) participants.  The most frequent problems encountered are:

1.  Various studies and industry surveys show that over 25% of employees elect not to participate in their employer’s 401(k) plan.   This is true even though most employer plans offer some level of “matching contributions” by the employer, meaning that employees are leaving free money on the table.  These matching contributions amount to an immediate return on employee contributions, so not participating is clearly not prudent.

2.  Many employees who do participate contribute only a small percentage of their compensation, well below the maximum allowed.

3.  A number of participants fail to manage their 401(k) contributions at all, leaving their money in cash accounts or invested according to “default” allocations provided by the plan.

4.  Many participants who do manage their accounts do so too conservatively, much like the Nobel Prize winners discussed above.   They put most of their money in safe, conservative investments that provide little growth over and above inflation.

5.  Still other participants invest far too aggressively, especially when stock in the employer’s company is an investment option.   Some employees feel disloyal if they do not allocate a large portion of their 401(k) account to employer stock, but this can be a very aggressive strategy and lead to huge losses.

6.  Many workers tap into their 401(k) balance via participant loans without recognizing the consequences.  For example, if the worker changes jobs and rolls over his or her balance into a Rollover IRA, the loan cannot be rolled over, and becomes an immediate taxable distribution, and may be subject to an additional 10% penalty tax if the worker is under age 59½.

In some cases, the lack of participation in an employer’s 401(k) plan is because certain workers feel they do not earn enough to be able to afford to participate.  Yet for those who do participate, it is stunning how many are not managing their contributions effectively.  Even though Department of Labor rules require employers to provide general financial and investment information to 401(k) plan participants, many still experience dreadful returns.  

Even though government regulations attempt to educate 401(k) plan participants, they appear to have the same problem as “smart” Nobel Prize winners and college professors: they often fail to make needed decisions about how to invest their retirement money, and when they do make decisions, they are often bad ones. 

Obviously, these problems don’t just pertain to Nobel Prize winners and 401(k) participants.  These problems are evident throughout the investment public.

Some Of The Reasons For Failure

So far, I have highlighted articles and studies that illustrate how many people have a hard time managing their investments.  By combining these sources, I have tried to point out that a person’s level of education does not always mean that their investment management will be any more successful.    There are many workers with a broad range of financial education and sophistication that do effectively manage their 401(k) and IRA investments.  So what’s the difference between those who can and those who can’t?

I think the answer lies in the emotional aspects of investing.   In other words, there are some people who are emotionally capable of handling the ups and downs of the markets, while others would rather do nothing (money market accounts) than have to worry about the possibility of losses.  There are those who can select a broad range of investments and leave them alone, while many others feel they have to chase after the hottest returns and frequently switch their money from one place to another.

I have often written about this latter group, the ones who are always chasing hot returns.  Various studies over the years have shown how they actually end up hurting their long-term returns by “buying high and selling low.”  Boston-based Dalbar, Inc. just recently released the latest update of its “Qualitative Analysis of Investor Behavior” study.   It shows that over the past twenty years, the average investor’s returns are 9 percentage points LESS than the S&P 500 Index return, primarily because of frequent switching to chase the highest performance.

While education may help you explain why your emotions react in a certain way, it doesn’t necessarily override these emotional responses.  I think that’s one reason why various Nobel Prize winners did not act upon the knowledge they had.  Knowing something is one thing; being emotionally prepared for the consequences is quite another.

We see this often at ProFutures.  We always gauge the “risk tolerance” of a prospective client before we present an investment recommendation.  On a questionnaire, investors will frequently indicate that they have a great amount of tolerance for investment losses, since they have been educated that you have to take some risk to achieve potentially higher returns.

However, true risk tolerance comes into play when losses stop being theoretical and start to affect the actual value of their investments.  I have had investors who indicated on their questionnaires that they were aggressive investors and could tolerate significant losses from time to time, only to discover that they were ready to run for the exits at the first sign of losses.

That’s why I have designed our questionnaire to attempt to address the emotional issues related to investing.  For example, our questionnaire asks how large a loss could you tolerate, but it also addresses the issue a different way, by asking you specifically how you would react if a 15% loss actually occurred in your account. 

To learn more about your own risk tolerance, and what type of investor you are, you can go to our website and download our  Confidential Investor Profile.  Fill it out, and fax or mail it to us, and we will give you a free analysis of your responses. Many readers of my weekly E-Letter have already done this, and some were very surprised at the results.

Procrastination Kills

The employee benefits industry has become concerned about the lack of participation and investment direction now evident in 401(k) plans.  As a result, they have engaged behavioral scientists to help explain why employees fail to act upon issues that are very important to their long-term retirement needs.  Some of the results are surprising, while others are not.

First, the researchers found that having too many investment choices in the plan will actually work against participation.  Even when provided general financial and investment education, most employees do not feel competent enough to make their own investment decisions.  When you couple that uncertainty with having to choose from among 20 or 30 mutual funds, it only gets worse.  Employees are so afraid of making a wrong decision, that they often make no decision.

A second finding is that many employees do not participate or do not manage their accounts just because of plain old procrastination.   They know they should do it; they have been given the education and tools to do it; but they just haven’t quite gotten around to it yet.  For these individuals, no amount of generic financial education will goad them into action. 

My take on procrastination is not that it is only a lack of will to take action, but is indicative of a deeper problem.  Most people procrastinate on doing things that they dislike, or do not feel comfortable doing.  Since most employees are not experienced in investing, they put off making decisions regarding their retirement.  They do not want to commit the time and study necessary to do a good job, so their retirement needs remain unmet.

Employers and the investment industry are taking steps to help relieve these problems.  First, many employers allow for automatic enrollment into the 401(k).  This works by automatically enrolling the employee into the plan at a minimal level of contribution, unless the employee specifically opts out.  This gets more employees in the plan, even if at minimal levels of participation, by using procrastination to their benefit.

Another solution is to provide “default” investment alternatives for employees who cannot or do not make their own investment elections.  Some employers provide pre-set default portfolios that range from conservative to more aggressive, and the employees can choose among them.  While this subjects employers to some higher degree of liability, most feel it is not as great as the liability that may come later on when the employee has accumulated too little for retirement by having too much invested in cash accounts.

The investment industry is getting in on the act by developing mutual funds that take the guesswork out of asset allocation.  This is accomplished through what are known as “lifestyle funds,” which seek to provide automatically diversified asset allocations based on the participant’s age, risk tolerance and expected retirement date.  These funds are designed to be appropriate as a single investment, so the participant need only make one decision.

The problem with these funds is that they do not take into consideration the unique financial situation of each 401(k) participant.  Rather, it’s a “one-size-fits-all” investment technique.  Even so, if availability of these funds helps an employee participate who would otherwise not do so, then I think they are appropriate.

Another recent study by CIGNA Retirement & Investment Services indicated that 89% of employees in 401(k) plans would like to have personal financial planning advice for their 401(k) plan investments.  This CIGNA finding mirrors an earlier survey conducted by Vanguard that indicated 80% of 401(k) participants wanted professional advice in managing their accounts.   Perhaps these studies show that employees are not as interested in a one-size-fits-all mutual fund investment as they are in having someone make sense of all of the information and options they have been given. 

How This Applies To
Social Security Private Accounts

As I discussed above, the overall purpose of the LA Times article was to extrapolate the experiences of Nobel Prize winners and college professors to illustrate how Social Security private accounts will not work.  Other articles I have read say the problems with 401(k) participants proves that private accounts won’t work.

It may surprise you, but I happen to agree with these articles, at least to the degree that they apply to workers who can’t (or don’t) make needed decisions or those who invest imprudently.  The question is whether to discard the whole idea of private accounts just because some people will not make the most of their opportunity.  To that, my answer is “No.”

America abounds with opportunities for its citizens.  I disagree with those who say that Social Security private accounts should not be allowed simply because some of the workers who choose to participate will not manage them effectively.  You don’t hear these same critics saying we should abolish 401(k) plans that have similar problems; instead, these people use 401(k) statistics as ammunition against private accounts.

The bottom line is that any proposal for private accounts should include some pre-set “default” investment portfolios for those who cannot or simply don’t get around to making an investment selection.  Perhaps this default investment would be a blend of Treasury securities as recently outlined by President Bush.  However, such an investment would continue to make Social Security tax revenue available for Congress to spend.  A better choice may be several default portfolios, including various mixes of stocks and bonds, ranging from conservative to more aggressive, as noted above for 401(k)s.  The age and income level of the worker would determine to which portfolio his or her contributions would be allocated.

The best alternative would be to require indecisive workers to seek the counsel of a Certified Financial Planner (CFP) or other qualified financial professional.  In this way, the Social Security private account could be coordinated with any other investments the person may have, and therefore be incorporated into an overall financial plan.  I discussed above that studies have shown that 80% or more of 401(k) plan participants would like to have professional investment assistance, so it’s no stretch to believe that over 80% of workers in Social Security private accounts might want the same advice.

It’s no secret that I think investors are best served by seeking advice from qualified financial planners and turning over many of their investment decisions to professional money managers.  I have no different opinion in regard to Social Security private accounts.

In my own case, even after 28 years in the investment business, all of my investment portfolio is managed by professionals.  They make all of the specific investment decisions.  And just so you know, over 90% of my investment portfolio is managed by the professionals we recommend at ProFutures.

Conclusion

What all of the studies and articles that I have mentioned in this newsletter show is that many people have a hard time actually managing their own money.   In my own company, we get hundreds of calls every year from people who are either paralyzed and can’t make a decision, or who tried to manage their own investments and lost money.

To be sure, there are a lot of people who can effectively manage their own money, but I would venture to say that they are not in the majority of workers.  For 401(k) plans or Social Security private accounts to work, it will take a comprehensive approach to address the needs of both those who can, and those who can’t, manage their own investments.

Unfortunately, President Bush’s proposals on private accounts are long on concept but short on detail.  In a “Clintonian” tactic, I think Bush has thrown out a few general proposals to see how they fare in the polls, and is now trying to figure out the details based on comments and criticism from the press and public.

I think there is a way for Social Security private accounts to be made available to all workers, and done in such a way as to make them viable for both those who are sophisticated in investment matters as well as those who are not.  Of course, this doesn’t address the issue of where to get the money to pay for the redirection of Social Security Taxes into a private account, but that’s a subject for another newsletter.

The bottom line is that most of us are not especially good at investing our money.  Many people invest too conservatively (knowingly or unknowingly).  Others leave their money parked in money market funds which don’t even earn enough to keep up with inflation.  Still others invest too aggressively and subject themselves to very high risks.  Many continue to chase the “hot” returns, and often end up buying high and selling low.

Even though the financial planning industry has mushroomed over the last decade, still only a relatively small percentage of Americans seek advice from financial planners. And very often those who do seek out a financial planner do so only after they are older and realize they are not going to meet their retirement goals.  Many times, it’s too late to change course and fully meet their goals.

As you know, ProFutures is built on the philosophy that you need professionals to manage most of your investment portfolio.  That is why we spend hundreds of thousands of dollars each year seeking out professional money managers and doing our “due diligence” on them, which includes at least one on-site visit to their offices.  And we continue to monitor and evaluate these managers on a daily basis.

In recent years, we have added financial planning to our host of services.  In addition to bringing a Certified Financial Planner (CFP) onboard, we have invested in expensive software that allows us to create sophisticated, personalized financial plans for investors all across the country.  And we do this at no charge to our clients.

Phil Denney Becomes A Vice President

As noted above, in late 1999 we were fortunate to convince Phil Denney to join us.  Phil is our Certified Financial Planner with years of experience.  Many of you have spoken with Phil and know how knowledgeable and personable he is.  I am happy to announce that Phil has been promoted to a Vice President as of June 1.  Congratulations Phil!

In the preceeding pages, I have talked a lot about how most of us aren’t the best at managing our own money.  But there’s now another problem.   The major stock markets have been sideways for almost two years now.  There is a growing number of analysts who now believe that the equity markets could remain in a generally sideways trading range for another year or longer.  Now that bond yields have plunged to the lowest levels in decades, the same could well be true for the fixed income markets.

Whether this assessment is correct or not, most analysts believe that stocks and bonds are not going to earn lofty returns again for at least several more years.  Here’s what The Bank Credit Analyst concluded in its latest June issue:

“It is important to put recent trends into the context of the longer-term market outlook. A world of low and relatively stable inflation means that financial returns will also be low. Indeed, Treasurys could be a very boring asset with 10-year yields fluctuating in a 3½% to 4½% range.

Meanwhile, stocks would get no further benefit from falling [long-term] interest rates while earnings rise by around 5% a year, in line with nominal GDP growth. In this world, a balanced portfolio may produce average returns of only 5% a year over the next decade.

Investor expectations are probably still too high, which explains the ongoing infatuation with hedge funds. Most financial assets are claims on real assets, and risk-adjusted returns should thus not be expected to rise much faster than nominal GDP over time.

Achieving superior returns will depend heavily on successful market timing and on good stock and sector selection.   [Emphasis added, GH.]

As you know, The Bank Credit Analyst is one of the most respected financial publications in the world.  For the last year, BCA has been predicting that equity returns would be disappointing, and that investors should look to traditional “market timing” and “sector rotation ” strategies.  This is precisely what most of our recommended Advisors do.

This year, Ihave introduced you to two new money managers - Third Day Advisors and Scott Daly’s Asset Enhancement Program - which I believe are especially attractive for a stock market such as we have today.   If you have not looked at these two Advisors, you should call us for more information.  We also have recommended Advisors that invest in the bond markets with time-tested market timing strategies.

I highly recommend that you review your overall investment position and consider increasing your allocations to the market timing programs I recommend.  To do so, I would also encourage you to call one of our Investor Representatives to see how you can combine some of the managers we recommend  in a strategy to reduce overall market risk in this uncertain environment.

Lastly, BCA agrees with me that the next good buying opportunity in stocks and equity mutual funds will come this summer when we expect the Fed to end its rate hiking cycle.  I would anticipate that the equity markets will turn higher before the Fed lets it be known that it will stop raising rates.  That could come in July or early August.  The point is, if you are going to increase your allocation to market timing  strategies, NOW  is the time to get started - before the next good opportunity to buy stocks.  We can help you, but only if you take the first step and give us a call to get started.