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Sunday, November 11, 2007

You cannot outsource financial work part II

A few days ago, I was talking to someone at work, and he said, "I'm going to have to fire my financial adviser. I started working with them 3 months ago, and they're providing negative returns."

There are a few issues with this statement. First of all, financial planning is a multi-decade process. Judging the results of an adviser after 3 months is a lot like judging the results of a marathon after the first 300 meters. Secondly, it is very important not to confuse process with outcome. The decisions and the reasons behind the decisions are more important than the immediate outcome. Let's say you decided, based on your analysis of certain macro-economic factors, that an unusually large bet on say, Vanguard Energy Fund was desirable. If someone suddenly invented a cold fusion reactor the size of a car's engine thereby eliminating the need for gasoline, the result would be bad for your portfolio, but there was no way to have anticipated that outcome without knowing the future.

Finally, it is very easy to get carried away with making short term decisions. For instance, in one of his rare errors, the man behind pfblog writes about switching away from Vanguard's Value Fund to the Fidelity Contra Fund because of the poor recent performance of the former. The two funds are so different that he was comparing apples with oranges! The ContraFund is at its heart a Growth fund, and this has been a great year for Growth. Value funds have recently taken a hit over the last few months. When Bill Bernstein made that observation, he followed up with a comment: "this reflects the additional risk of the value strategy. And that's a good thing, because if there was no risk, there would be no reward."

That is why you won't get me posting my portfolio performance numbers here on this blog (and wouldn't you like to know!). Even a five year performance number wouldn't be really representative, since we've been fortunate this last five years to have a great bull market. As the old saying goes, "When the tide goes out, that's when you find out who's been swimming without shorts."

Despite my statements about how you cannot outsource financial work, some people keep insisting on asking me for recommendations on financial advisers. When they do that, I point them at the Vanguard Financial Advisers page. These are the only guys I've talked to who don't come across as sleaze balls. They're conservative (which is a good thing --- you want your financial adviser to be more conservative than you are), and they know what they are doing. That said, in the middle of my interview with one of them about 3 years ago I realized that I knew more than the guy who was talking to, and that was that.

There is one guy I am using to get access to DFA funds. But we don't have an advisory relationship. He does seem like quite a reasonable fellow, but you won't get me recommending people unless I've interviewed them extensively, and so far, no one who's asked me for a recommendation for a financial adviser has been willing to pay my hourly rate to interview someone extensively enough for me to provide an evaluation.


lahosken said...

"If someone suddenly invented a cold fusion reactor the size of a car's engine... the result would be bad for your portfolio"

If that happens, then I expect the managers of the Vanguard Energy Fund to whack the inventor before said inventor can let the world know about the invention. See, that allows you to spread some of the risk around, taking it away from the portfolio and putting it on the shoulders of meddlesome inventors. That's why you bring in professionals.

md said...

I am not bashing the Vanguard reps, but... when I talked to one, I asked him about hedging for inflation risk, and his response was basically that we can rely on the government to keep inflation moderate. I wasn't thrilled that he didn't have a more extensive response. But I agree with you that he struck me as honest and not sleazy. I just was hoping for more expertise. I felt like I had hit the limit of his knowledge on that one.

Piaw Na said...

I'm not at all surprised. You very quickly hit the limits of what a Vanguard-trained adviser can provide, hence my statement that you can't really outsource financial work.

That said, Vanguard does have a pretty wonderful inflation protected bond fund.

md said...

Vanguard does have a pretty wonderful inflation protected bond fund

That does look kind of tempting, since I still haven't convinced myself to get into TIPS. I looked at the prospectus for VIPSX. It looks to me like it's at least 80% TIPS and at most 20% non-inflation indexed other stuff. Would it not be more economical to just purchase TIPS oneself? Or do you think that the management of this fund will more than make up for the (small) fund expenses?

Piaw Na said...

You can definitely buy TIPS through Treasury Direct. In fact, when Burton Malkiel first visited Google for his pre-IPO financial talk to employees, I asked him if your intention was to just hold the bond to maturity, why would you buy a bond fund, and he agreed. With the exception of TIPS. According to him, when they wrote the tax rules for TIPS they screwed up --- the tax implications of the inflation adjusted part of the TIPS return comes due before the TIPS themselves pay out the inflation adjustment, ensuring that the only place where buying individual TIPS makes sense is in your IRA. Now things might have changed since then (this was 2004), but I would check with someone who knows for sure before doing this.

For now, I make sure I hold my inflation adjusted securities in the fond of I-bonds (which are tax-deferred) or in my IRA.

md said...

Now things might have changed since then (this was 2004), but I would check with someone who knows for sure before doing this.

From the horse's mouth - TreasuryDirect says:

Generally, the interest payments are taxable when received, which is consistent with the tax treatment of other Treasury securities. The inflation adjustments to the principal are taxable in the year in which such adjustments occur even though the inflation adjustments will not be paid until maturity.

Hm, strange and unappealing. What were they thinking?