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by Dan Solin

Here are two stories that appeared in the financial media one day apart.

The first story was very good news for UBS, AG, Switzerland’s biggest bank. It attracted $12 billion in new assets from wealthy clients in the first quarter of 2012.  This impressive influx of funds beat analysts’ estimates and sent the stock soaring.  It was up 5.5% on May 2, 2012 when the news hit the business wire.  UBS is understandably optimistic about its future.  Its CEO and Chairman said “… we believe our wealth management businesses as a whole will continue to attract net new money, as our clients recognize our efforts and continue to entrust us with their assets.”

The reference to “entrust us with their assets” is significant.  It seems obvious that trusting the integrity of the firm managing your wealth is the most important criterion governing your selection of a financial advisor.

But is it?  That brings us to the second story. On May 1, 2012, the SEC reported that UBS AG will pay $26.6 million to resolve claims its Puerto Rico-based brokerage unit sold shares in its closed end  mutual funds without disclosing that it was propping up the price of the funds in the secondary market.  UBS had allegedly solicited thousands of investors to invest in these funds by representing there was a liquid and competitive secondary market for the funds.

UBS allegedly bought shares into its own inventory from customers who wanted to exit the market and then sold 75 percent of its closed-end fund inventory to unsuspecting investors.

According to SEC Enforcement Director Robert Khuzami, this conduct deprived these investors of “accurate price and liquidity information” and “UBS Puerto Rico denied its closed-end fund customers what they were entitled to under the law — accurate price and liquidity information, and “a trading desk that did not advantage UBS’s trades over those of its customers.” The $26.6 million will be placed into a fund for investors harmed by this conduct. Although UBS consented to this settlement, it did not admit that it engaged in any wrongdoing.

In October 25, 2011, UBS agreed to pay a fine of $12 million to settle accusations it failed to oversee millions of short sale trades over a five year period. Allegedly, it permitted its employees and some of its clients to sell short without verifying that its traders could actually produce the underlying shares.  UBS also denied any wrongdoing in this matter.

On April 11, 2011, UBS was ordered to pay nearly $11 million in connection with charges it misled its customers about the safety of principal-protected notes issued by Lehman Brothers in the months prior to its bankruptcy.  It is alleged to have failed to emphasize to its customers that these notes were unsecured and payment of principal was not guaranteed.  Without admitting to any wrongdoing (sound familiar?), UBS agreed to pay a $2.5 million fine and to reimburse customers an additional $8.5 million.  FINRA’s enforcement chief commented that UBS brokers “did not even understand the complex products they were selling.”

While UBS’ regulatory woes are probably no greater than those of its competitors, its conduct  should be a source of concern to investors.  Yet, this is clearly not the case.  You have to wonder whether the confidence investors are placing in UBS is misplaced.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of “The Smartest Investment Book You’ll Ever Read,” “The Smartest 401(k) Book You’ll Ever Read,” “The Smartest Retirement Book You’ll Ever Read” and “The Smartest Portfolio You’ll Ever Own.” His new book is “The Smartest Money Book You’ll Ever Read.” The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

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I used to play a lot of golf, probably far too much. When my friends would ask for advice, the number one question I would get is, “What kind of driver should I buy?” I suppose this was my introduction to the efficient mal-location, excuse me, allocation of capital. Like investing, throwing money at the non-issue doesn’t solve any problems, nor should it. The unfortunate truth is that allocation of both money and time is mostly wasted in golf and investing. From my personal experiences:

Golfer’s optimal allocation of capital

Golf Lessons > Golf Balls > every club except the driver > driver

Golfer’s actual allocation of capital

Driver > another driver if that one doesn’t work > every club except the driver > golf balls > golf lessons

It comes as no surprise to me that the actual allocation of resources is the opposite of the optimal allocation, mostly because the optimal allocation requires the most discipline and the willingness to do something you don’t want to do. The assumption that drives this behavior is that money spent on something tangible has an explicit yield. In reality, while services such as financial advice and golf lessons don’t have any tangible utility, they provide an invaluable albeit intangible benefit–they prevent YOU from making mistakes. Why someone would opt to forgo the chance to solve the real problem, which offers the most potential for improvement, to waste money on the most substitutable piece of the puzzle, is beyond me.

As Benjamin Graham said, “The investor’s chief problem- and even his worst enemy- is likely to be himself.”¹ The behavioral component of investing is just as likely to negatively impact investor returns, if not more so, than the actual investments themselves. Even investors who own funds with good performance can find their actual returns to be severely lagging the investment’s return due to behavioral mistakes. A recent Dalbar study  and IFA.tv episode compares the average investor’s return compared to that of market indexes; the former woefully lags the latter, unfortunately. Education is the antidote to the destructive behavioral tendencies experienced by most investors.

Many of these investors will throw good money after bad by purchasing expensive actively-managed mutual funds that they hope will capture all of the upside while protecting them from a down market. Others will make the same mistakes time after time. It’s analogous to purchasing driver after driver thinking that it is going to make you a better golfer. Tiger Woods takes golf lessons and pays a handsome sum of money to have his caddie give him advice on the course. In fact, Tiger Woods’ caddie (earning 10% of tournament winnings) would have made over $1 million in 2005, enough money to finish 70^th on the PGA Tour ® money list by himself. That would have been enough to earn his own PGA tour card for the 2006 season had he been swinging the club. Is it more likely that Woods paid his caddie big bucks because $1 million is the going rate for raking bunkers and replacing divots, or that even for the best in the world, great advice can be extremely valuable, especially when you need it the most?

A golfer who can minimize his mistakes during the round is most likely to post the lowest score. While he may not make as many birdies, he knows that his score at the end of the day will be the envy of his fellow players. This is directly analogous to taking a guided passive approach to investing. While a well-advised passive investor may forgo the possibility of owning the single investment with the highest return, the returns that she will receive over the long term are likely to be superior to the returns received by the vast majority of investors.

¹Benjamin Graham, The Intelligent Investor, A Book of Practical Counsel, 1949

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About a month ago, I wrote about Nicolas Darvas, a world famous dancer who claimed that he made $2 million in the stock market. This claim was vigorously disputed by the New York State Attorney General, Louis Lefkowitz. A write-up of the allegations against Darvas can be found here. While Darvas avoided prosecution, he did agree to never work in the U.S. securities industry. However, this did not stop him from writing a second book, Wall Street: the other Las Vegas. Although much of it is simply a recapitulation of the same drivel that fills his first book (e.g., “The only sound reason for my buying a stock is that it is rising in price.”), the extended analogy drawn between Wall Street and Las Vegas is both entertaining and informative.

Darvas portrays Wall Street as a giant casino populated by dealers (stock-brokers), croupiers (the administrators of the stock exchanges which could include the floor traders and specialists), touts (the brokerage firm analysts making their recommendations), and of course the winners and losers (the minority and majority of investors, respectively). Although his approach to investing could not be more different than Darvas’, John Bogle draws the same analogy when he depicts active investors playing a zero sum game which becomes a negative sum game after costs where the only sure winners are the “croupiers” (the financial services industry) whose annual take Bogle estimates at a staggering $600 billion.

In the eyes of Darvas, the dealers of Wall Street (i.e., the stock brokers) are a contemptible lot, indeed. Writing in 1964, well before the advent of discount brokers, Darvas illustrates the corrosive impact of trading costs on profits, and he repeatedly reminds us that regardless of whether a trade is profitable, the broker always makes his commission. Next up in the food chain are the people who run the Wall Street casino, the croupiers. As a prime example, Darvas brings forth Richard Whitney who was very much the Bernie Madoff of his day. A former president of the New York Stock Exchange during the time immediately after the 1929 crash, Whitney was discovered to have misappropriated over $5 million (a kingly sum in those days) of client money. Unlike Madoff, Whitney served only 3 years in Sing-Sing. Darvas holds the croupiers culpable for the “rigged game” that leads to the fleecing of the majority of its participants.

While Darvas recognizes many of the problems that plagued Wall Street a half century ago (and continue to the present day), his prescription is simply not helpful to investors, to put it as nicely as possible. Rather than playing a game they cannot win by trying to become superstar traders, most investors would do much better with the advice of John Bogle: Avoid the casino altogether by buying, holding, and rebalancing a risk-appropriate portfolio of index funds.

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While we at Index Funds Advisors, Inc. do not dismiss the bleak scenario envisioned by the authors of books such as Aftershock or The Day after the Dollar Crashes as completely implausible, there are a number of problems with books of this doomsday genre that deserve consideration:

1. Economic forecasting is a fool’s errand at best. We know that the “experts” do no better than we would expect from chance alone. The reason for this is that the economy is infinitely complex and subject to myriads of unknown future events. There simply is no model that can adequately capture it, and it is unlikely we will see one anytime soon. It is important to understand that the market itself has some economic forecasts embedded in financial instruments such as interest rate futures contracts and in combinations of securities such as the yield difference between nominal and inflation-protected Treasury bonds. None of these market-based forecasts (where real money is at stake) currently indicate future high inflation. Furthermore, the currency futures and forwards markets do not predict a future large devaluation of the dollar. For most investors, it is probably not a good idea to bet against any of these markets.
2. Even when an economic forecast is accurate (or perhaps lucky), it tells you little if anything about how you should position yourself. We have several examples of people (like Peter Schiff) who correctly called the real estate bubble yet still lost money because their predictions about which asset classes would thrive were simply wrong. Even if the predictor is right about what positions to take, getting the right timing on these positions is critical. For example, we know that those hedge fund managers who arrived too early to the long position on the credit default swap trade were unable to hold their positions in the face of mounting losses. The market stayed irrational longer than they could stay solvent. A more recent example is Bill Gross who predicted at the beginning of 2011 that the Treasury bond bubble was ready to pop. The bearish bets that he made against long-term T-bonds turned against him and he was forced to do a “mea culpa” after falling 3.7% short of his benchmark. Our point is that if Bill Gross who has access to a staff of PhD economists that could put most university faculties to shame couldn’t get the timing right, then what possible hope do you or the authors of the doomsday books have? Perhaps someday Bill Gross’s bet will work beautifully and whoever does get the timing right will be the subject of all manner of media adulation, but Bill Gross’s experience proves to our satisfaction that luck will be the more likely explanation than skill.
3. Most of these books are thinly veiled attempts to get you to purchase additional services offered by the authors (e.g., subscription newsletters, expert consulting by the hour, etc.).

Getting down to the question of the predictions made in these books, the central theme is that the US government has taken on too much debt and has vastly increased the money supply (quantitative easing) in an effort to keep the financial markets afloat, both of which will eventually lead to an economic calamity characterized by high inflation and a collapse of the dollar. We certainly will not say that any of this is untrue, and we do agree that the actions of the Fed and our political leadership have increased the probability of this bleak scenario coming true, but it does not have to unfold the way the doomsday purveyors predict. The Fed does have the ability to soak up the extra liquidity it has created by selling the bonds it has purchased. The timing of course, is critical. Regarding the massive increase in public debt, yes this is a terribly difficult problem to solve because debt never goes away. However, we like to think of Winston Churchill characterizing America as a country that will do the right thing when all other options have been exhausted. The only way it will be solved is a combination of economic growth and entitlement reform (Medicare, Medicaid, Social Security, government pensions, etc). Even if we taxed millionaires and billionaires at 100% of their wealth, it would not raise enough revenue to solve the underlying spending problem.

It is important to bear in mind that there is no feasible way for the market to be surprised by the debt. Everybody knows about it. One question worth asking is whether the cost of capital of publicly traded companies (which is what drives the return on equities) is truly dependent on the amount of government debt outstanding. Historically, there is no clear-cut relationship; there have been times when the market has done quite well when there was a vast increase in the public debt (e.g., World War II). Likewise, there have been times when the market did poorly as the debt-to-GDP ratio was reduced (e.g., the late 1940’s).

In closing, we would caution investors against making any investment decisions based on what they read in any of these books regardless of the accuracy of the authors’ past predictions.

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Wellington
Dimensional Fund Advisors

The surge in stock prices around the world in the first quarter serves as a reminder that predicting market trends can be a frustrating business. Six months ago, the outlook for stock prices appeared to be fading from grim to grimmer: Congressional leaders were wrangling unsuccessfully to craft a deficit reduction plan, Standard & Poor’s had removed its AAA rating on US Treasury obligations, and Greece appeared one step away from defaulting on its debt. Yet just when many investors least expected it, stocks staged a powerful rally: From the low for the year on October 3, the S&P 500 Index rebounded 28.1% through March 30 while the Russell 2000 Index jumped 36.2%. As the news excerpts below suggest, it is worth recalling the Wall Street adage that “bull markets climb a wall of worry.”

• August 5, 2011—S&P downgrades US Treasury debt to AA from AAA; stocks plunge in the biggest selloff since 2008.
• September 3, 2011—Journalist: “The US economy slammed into a wall in August, failing to add new jobs for the first time in nearly a year.”
• September 5, 2011—Gold reaches a record high of $1,895 per oz. (London Fix).
• September 19, 2011—Wall Street chief equity strategist: “I don’t think we’ve seen the lows for the year by any stretch. Things have to get much worse before they get better.”
• September 23, 2011—Journalist: “The world economy once again stands on a precipice.”
• September 26, 2011—Investor: “I don’t see anything changing in the next two or three years.”
• October 1, 2011—Economist cover story: “Unless politicians act more boldly, the world economy will keep heading towards a black hole.”
• October 3, 2011—US stock prices slump to their lows of the year: 1099.23 for the S&P 500 and 609.49 for the Russell 2000 Index.
• October 13, 2011—Census Bureau reports the weakest income growth over a ten-year period since records began in 1967.
• October 20, 2011—Col. Muammar el-Qaddafi killed by Libyan rebel forces.
• November 20, 2011—Consumer goods CEO: “Consumers everywhere continue to be cautious and hesitant to spend.”
• November 21, 2011—US Congressional “supercommittee” fails to reach deficit reduction agreement.
• November 24, 2011—Market strategist: “Earnings growth is very quickly decelerating.”
• November 28, 2011—Moody’s Investors Service warns that multiple countries could default on their debt.
• November 29, 2011—AMR Corp., parent of American Airlines, files for bankruptcy.
• December 10, 2011—Detroit’s mayor predicts the city will run out of cash by April 2012.
• January 6, 2012—Gasoline prices are at the highest point ever for a new year.
• January 18, 2012—World Bank: “Developed and developing-country growth rates could fall by as much or more than in 2008–09.”
• January 18, 2012—Eastman Kodak files for bankruptcy.
• January 25, 2012—Report from Davos World Economic Forum: “Global elite fears renewed downturn.”
• February 13, 2012—Journalist: “There is still plenty that could go wrong in Europe, while U.S. economic growth remains slow and corporate earnings are looking less and less robust.”
• February 27, 2012—Money manager: “This is a business-as-usual overpriced market and you’ll get a zero return for seven years.”
• March 2, 2012—Eurostat reports that Eurozone unemployment in January reached 10.7%, the highest in fifteen years.
• March 12, 2012—Strategist: “The stock market has effectively doubled since the March ‘09 low, and we’re still in redemption territory for equity funds.”
• March 19, 2012—Journalist: “Expectations for earnings have been steadily scaled back this year, as the mood among companies has worsened.”

References

E.S. Browning, “Downgrade Ignites a Global Selloff,” Wall Street Journal, August 9, 2011.

Sudeep Reddy, “Job Growth Grinds to a Halt,” Wall Street Journal, September 3, 2011.

Quotation from Adam Parker, chief US equity strategist Morgan Stanley. Jonathan Cheng, “Wall Street’s Optimism Fades,” Wall Street Journal, September 19, 2011.

Chris Giles, “Financial Institutions Stare into the Abyss,” Financial Times, September 22, 2011.

Tom Lauricella, “Pivot Point: Investors Lose Faith in Stocks,” Wall Street Journal, September 26, 2011.

“Be Afraid,” Economist, October 1, 2011.

Phil Izzo, “Bleak News for Americans’ Income,” Wall Street Journal, October 13, 2011.

Kareem Fahim, “Qaddafi, Seized by Foes, Meets a Violent End,” New York Times, October 21, 2011.

Quotation from Jim Skinner, chief executive of McDonald’s. Jeff Sommer, “From the Mouths of Executives, Little Comfort,” New York Times, November 20, 2011.

Jonathan Cheng and Brendan Conway, “Panel’s Failure Sinks Stocks,” Wall Street Journal, November 21, 2011.

Quotation from David Rosenberg, chief market strategist, Gluskin Sheff & Associates. Tom Petruno, “Wall Street Gets Cautious on Earnings,” Los Angeles Times, November 24, 2011.

Brendan Conway and Steven Russolillo, “No Year-End Stock Surge in Sight,” Wall Street Journal, November 26, 2011.

Liz Alderman and Stephen Castle, “Dire Warnings Are Building on European Debt Crisis,” New York Times, November 29, 2011.

“Nowhere to Run—The Motor City Flirts with Fiscal Disaster,” Economist, December 10, 2011.

Ronald D. White, “Gas Prices Ring in 2012 at a High,” Los Angeles Times, January 6, 2012.

Chris Giles, “World Bank Warns on the Risk of Global Economic Meltdown,” Financial Times, January 18, 2012.

Chris Giles, “Pessimism Hangs in Mountain Air,” Financial Times, January 25, 2012.

Tom Lauricella and Jonathan Cheng, “Too Late to Jump Aboard?” Wall Street Journal, February 13, 2012.

Ajay Makan, “S&P 500 at Post-Crisis Peak but Investors Remain Wary,” Financial Times, February 25, 2012.

Quotation from Jeremy Grantham, chief investment strategist, GMO. Leslie P. Norton, “Not So fast: Coping with Slow Growth,” Barron’s, February 27, 2012.

Brian Blackstone, “Poor Economic Data Slam Europe,” Wall Street Journal, March 2, 2012.

Quotation from Liz Ann Sonders, chief investment strategist, Charles Schwab. Nikolaj Gammeltoft, Inyoun Hwang, and Whitney Kisling, “The Bull Turns Three. Where’s the Party?” BusinessWeek, March 12, 2012.

Ajay Makan, “Wall Street Braces For Hit to Soaring Markets,” Financial Times, March 19, 2012.