A Convicted Criminal Speaks of Ethics

I just attended the local chapter meeting for the Financial Planning Association. I do not often attend these meetings. But this luncheon offered 3 hours of Ethics credits which I need to maintain my professional credentials.

Over the years I have found most of these ethics-related sessions rather tedious. It has long amazed me that financial services representatives do such stupid things and cause such harm to their clients. While I acknowledge my own professional failings, I have never engaged in fraud, cheating, embezzlement, etc.

The speaker today was Patrick Kuhse. You have probably never heard of him. I had not until today. I won’t forget him.

Here’s what Patrick says about himself on his web site, www.speakingofethics.com, “I'd like to take you on my own personal journey, from successful stockbroker with a loving family and home in the suburbs of San Diego, to the jungles of Costa Rica as an international fugitive, to incarceration in two countries and back again. After spending four years in prison, I now devote myself to speaking to audiences worldwide about the importance of ethical behavior.”

This presentation was riveting. It had a message that was far more than how to be “ethical” in the financial services industry. It was about how any of us can lose perspective, commit critical thinking errors and slide into an ethical morass. I found it humbling.

Patrick opened his presentation with a reference to Socrates. The famous Greek philosopher would evaluate an issue, an opportunity or a situation by asking three simple questions:

1. Is this truthful?
2. Is this good?
3. Is this useful?

If Socrates could not answer each of these questions positively, he would simply move on.

How simple. We should ask ourselves these questions whenever we are uncertain about how to react to a set of circumstances.

Successful DIY Investors

I recently read William Bernstein’s The Investor’s Manifesto. He wrote this in the aftermath of the recent stock market crash. Bernstein seeks to help investors regroup and reminds them of the strategies that lead to long term investing success.

In the foreword to the book, Bernstein identifies the characteristics of successful investors:

1. They possess an interest in the process of investing.
2. They have a basic knowledge of probability and statistics.
3. They have a firm grasp of financial history.
4. They have the emotional discipline to execute successful investing strategies.

How many self-directed investors truly possess these qualities? Indeed, how many investment advisors can make this claim?

The Responsibility of the Media

An article from The New York Times News service ran in yesterday’s (July 6, 2010) Oregonian. The article was titled, “Get out now, stock theorist warns.” The article described how one stock market forecaster, Robert Prechter, is predicting that the Dow “is likely to fall below 1,000 over perhaps five or six years …”

Apparently, Mr. Prechter is a forecaster and social theorist who basis his work on something called the Elliott Wave Theory. I will admit that despite having been an avid student of investing for a decade and I have never heard of this theory. So, I went on the web and did some research.

As I suspected, Elliot Wave Theory is a form of technical analysis (source: Wikipedia.org). It is used to forecast trends in financial markets by identifying extremes in investor psychology, highs and lows in prices and other collective activities. The concept was developed by Ralph Nelson Elliott (1871-1948) who was a professional accountant.

I have studied technical analysis. It uses price and volume data in an effort to predict the direction of a security or the market in general. It has been widely discredited in the academic community. Burton Malkiel’s book, A Random Walk Down Wall Street, is probably the most well known work that refutes the notion that security prices follow any pattern. The Efficient Market Hypothesis, even in its weakest form, dismisses the usefulness of pricing data in market forecasts.

I find it disturbing that the media would pick up the shocking predictions of one prognosticator and suggest the investors should “get out” of the market. This to me is completely irresponsible journalism. I could easily find several equally credible market forecasters who predict that the market will reach some glorious new level in the next five years.

The truth is that no one knows where the market is going. A read of the most credible work on investing consistently warns readers to be wary of anyone who claims to know where the stock market is headed. There are two kinds of people. Those who know they do not know and those who don’t know they don’t know.

Shame on The Oregonian for printing an article that was clearly intended to incite the reader. Just what we need. Millions of investors panic and sell their investments. Then Mr. Prechter’s predictions just might come true.

SEC to “Study” Fiduciary Issue

As I suspected all along, the House and Senate punted on the imposition of a fiduciary standard for all financial advisors. The financial reform bill has been renamed the Frank-Dodd Wall Street Reform and Consumer Protection Act of 2010 after House Financial Services Committee Chair Barney Frank (D-Mass.) and Senate Banking Committee Chair Christopher Dodd (D-Conn.). It calls on the Securities and Exchange Commission (SEC) to conduct a six month study of the issues surrounding the standards of care under which various financial advisors operate. Currently, stock brokers, insurance agents and other advisors operate under a “suitability” standard. Registered investment advisors must adhere to a “fiduciary” standard. [See my previous blog posts for an explanation of the differences in these two standards.]

The SEC must develop regulations that reflect the findings from this study. The bill’s provisions empower the SEC to impose the same “fiduciary” standard on broker-dealers that applies to registered investment advisers. Indeed, Representative Frank has indicated that he expects the SEC to do so. “We gave the SEC the power to do it,” said Mr. Frank from the House floor, “and they’re going to do it.”

We shall see. The bill must still pass in the Senate. With the recent passing of Senator Robert Byrd (D-West VA), that won’t happy until after the July 4th recess. There continues to be significant opposition to the bill in the Senate and it is not clear that the bill will pass as written.

Fiduciary Issue Still Unresolved

The House and Senate continue to wrangle over the fiduciary issue as they reconcile their respective versions of the financial regulatory reform bill.

In case you have not been following this story, here’s the problem. Currently, investment advisors must provide advice and service that is in the client’s best interest. In addition, investment advisors must disclose conflicts of interest. Broker-dealers and insurance agents are required to offer products and services that are “suitable” for the client.

As you might imagine, the brokerage industry, the banking industry and the insurance industry all opposed to a fiduciary standard. They believe a study of the matter is necessary. They also claim a fiduciary standard would change their “business model.” … Yes, and this would clearly be in the best interest of their clients.

Under consideration is a watered down proposal that would empower the SEC to conduct a study of the standards of care currently in place in the financial marketplace and then establish a single fiduciary standard, if this would eliminate gaps in oversight of various types of financial advisors.

I am not optimistic about this. The forces acting against the fiduciary standard are incredibly powerful. The stakes are high for them. I predict Congress will fail to implement the fiduciary standard. … We should know the outcome soon, as the negotiators would like to complete the bill tomorrow.

The Risks Associated with Investing in Bonds

Investors have been pouring money into bonds since the stock market swoon that began the end of 2008. In fact, according to the Investment Company Institute, there has not been a single month over the past 17 months in which the net flow into bonds has been negative. This is hardly true for domestic and foreign equities.

So, what can we make of this? Investors have clearly become less willing to risk their funds in the stock market. They would rather invest in bonds even if yields are at historically low levels. The yield on the 10 year Treasury is around 3.5%.

But are bonds as safe as most investors seem to think? What are the risks associated with investing in bonds? Here’s a quick overview:

Interest rate risk: When interest rates rise, the value of bonds goes down. The reason for this is that bonds have fixed payments in the form of coupons and a final maturity value. When interest rates rise, these fixed payments become comparatively less valuable. The only way an investor would be willing to be a bond with a lower coupon payment would be if the price of the bond itself were less. This adjustment maintains the marketability of the bond.

Call risk: Some bonds are callable by the issuer. This means that they can be bought back from the bond holders prior to maturity. Issuers tend to call bonds when interest rates drop, because they can re-issue new debt at lower rates and thereby reduce their financing costs.

Prepayment risk: Some bonds allow the issuer to repay portion of the outstanding principal prior to maturity. If rates have dropped, the bond holder will likely be unable to reinvest these proceeds at the coupon rate of the bond.

Yield curve risk: The yield curve represents the relationship between market interest rates and the time to maturity of bonds. Changes in the yields of bonds with different maturities can change the shape of the yield curve. When yields change, prices change.

Reinvestment risk: Bond holders receive payments for providing (i.e. loaning) the bond issuer a principal sum. Investors are concerned with their ability to invest these payments at attractive rates. If market rates drop, reinvestment risk rises.

Default risk: This is the risk that the issuer of the debt will be unable to make the required payments. Default is the failure to maintain the terms of the debt obligation. Issuers perceived to have greater default risk are required to compensate lenders with higher coupon rates.

Credit spread risk: The spread is the difference between yields on Treasury securities and any non-Treasury securities that are otherwise identical. Treasury securities are risk free. All other securities carry some form of risk. The spread represents the risk that the investor takes on for investing in securities that are risky.

Downgrade risk: This is the risk that a credit rating agency will lower its rating on a particular issue. When this happens, the bond is considered riskier. In order to compensate investors for this additional risk, the price of the bond will fall.

Liquidity risk: Liquidity refers to the ability to quickly sell a security. Bonds that can be readily bought and sold with relatively low transaction costs are considered liquid. Investors tend to prefer bonds that are liquid. Bonds that are relatively illiquid are not as attractive and, as a consequence, will sell at lower prices.

Exchange rate risk: This risk is associated with bonds denominated in currency other than the U.S. dollar. Investors who exchange US$ into other currencies and the purchase bonds in those currencies are faced with additional risk of converting the foreign currency back to US$. If the US$ has gained value during the foreign bond holding period, the investor will lose money converting back to US$.

Volatility risk: Bonds with options (call options, prepayment options, and put options) are subject to volatility risk. Change in the volatility of interest rates affects the value of bonds depending on the type of option that are embedded. Imagine a put option on a bond. If volatility increases, the value of the put increases. . This increases the value of the bond.

Inflation risk: Inflation erodes purchasing power. Bond investors are faced with using fixed coupon payments to purchase goods and services that increase in cost over time. If inflation jumps unexpectedly, bond values will drop.

Event risk: Bonds can drop in value if an adverse event occurs. A natural disaster, a corporate change or a regulatory change could cause credit analysts to downgrade a bond. This will lead to a loss in bond value.

So, while investors seem to be rushing into bonds, one wonders how well they understand the risks of investing in these securities.

Sources: Investment Company Institute, CFA Institute

Deflation Threat Remains

The very tepid economic recovery has economists in developed countries pondering the prospects for deflation. Deflation is a general decline in the price of goods and services. Everything becomes less expensive. So, why the worry?

Deflation is typically caused by a decrease in consumer, government and investment spending. There has not been a period of sustained falling prices in this country since the Depression in the 1930s. In fact it is so rare that economists have not had many opportunities to study it in real time.

In Europe and the US, consumers are paying down debt, cutting their spending and saving more. Many countries in the European Union, afflicted with large national debts and budget deficits, are also being forced to cut back on spending. The result of this belt-tightening is a slow down in price increases. The Wall Street Journal reported this week that “excluding volatile food and energy sectors, consumer prices [in the US] were up just 0.9% in May, the smallest increase since 1966.”

Government policy makers find combating deflation very difficult. Traditional policy tools are designed to fight inflation, not deflation. Central banks can’t lower interest rates, because they are already almost zero. Government spending will only exacerbate budget imbalances and increase sovereign debt levels. Consumers will put off purchases, if they expect prices to be lower in the future. This further compounds the problem, as prices have to drop even further to entice consumption.

Lower prices lead to economic contraction. Wages fall, incomes drop, spending falls further, and on it goes. It is a downward spiral that can result in a reduction in overall economic welfare.

Let’s hope we don’t face a serious prospect of deflation, because the Federal Reserve has a very limited ability to do anything about it.