There’s been a certain movement in financial circles to re-examine compensation models of investment advisors.  One of the central proposals to such reform includes moving from a commission based model, with connotations of the hard sale, to a hourly and fee based model, which has a more advisory undertones. Yet, the legal industry, built on foundation of the billable hour, is in naval gazing mode about a broken business model which includes clients revolting over high billable hours and the perception of inefficiencies related to this billing model.

How can one industry suggest partially moving to a compensation model that another industry notoriously associated with it is thinking of abandoning?

The ultimate issue is not the compensation scheme but the value given by the consumer to advice.

…and therein lies the problem.  Value is ultimately a subjective concept. For example, imagine two investors who pay the same advisor the same compensation annually. The “active client” calls the investor every other month for an hour, has meetings several times a year and goes to all the free seminars (and eats all the free food). The “passive client” perhaps meets the advisor once a year partially due to benign neglect and partially because the active investor is monopolizing all the advisor’s time.   Assume the same return annually.

If I am the active client, I may actually be mad. The advisor gave me all this time and energy and I got the same performance as the passive client! But the passive client thinks he got conned because the advisor never gave him any time but got compensated anyways. In other words, the advisor is in a no-win situation because value is ultimately in the eye of the beholder.

This example also magnifies the problem in the financial industry since advice is often equated with performance. Ultimately, this is a misguided barometer of the value of advice since performance has a contextual and individualized risk/reward factor. A desired performance may require a greater than required risk tolerance.

If we presume there is a certain class of investors who will never be happy with the value of the advice they receive and eliminate them from the equation, and we can somehow make the value of advice something to be judged objectively, the question becomes two-fold: (i) what is good advice? and (ii) to paraphrase Dale Rathberger, where can different classes of investors get good advice?

To answer the second question first, and let’s not worry about the plight of the high net worth individual, advice is ultimately best appreciated when the recipient understands the larger context of the advice. Speaking from legal experience, you can set out all the options to a client but if the client does not even appreciate the larger “game”, the advice ultimately falls on deaf ears.  Thus, for those younger investors or investors with modest portfolios, I would flip the question around to “before seeking good advice, what do you need to know about finances?”

Fundamentally, know yourself. Managing money is like majoring in psychology and minoring in finance. Emotional control is more important than product selection.

I would also suggest learning simple book-keeping. Balancing books is key to household management. Revenue recognition skills (simply put, revenue must match an expense) is crucial to analyzing a stock or a real estate investment property.  There is a reason why entrepreneurs are more likely to be millionaires: by running a business, they understand how money works.  Going to any advisor with a blank slate is a sign of an easy mark for an unscrupulous advisor.

As to what should constitute good advice objectively (if this standard even exists), the focus should be on advice focused on the strategy and not the product. Some average investors believe good advice should constitute an advisor finding them a magic bullet product to cure all their financial woes. The problem is it fails to consider larger strategic considerations as to a proper strategy, sticking to that strategy and adjusting the strategy accordingly. The basis of a good strategy gets back to my initial point above- know yourself well (which is the most important question you have to ask about money- what do you want?)

If you doubt yourself or constantly seek unrealistic solutions, can you blame any industry of taking advantage of you?

The hard reality is that the investment industry is like anything else in life- 80% of good advice comes from 20% of advisors. To somehow believe that the entire financial industry would be fair and virtuous to its clients, when life is neither of those, is to suspend one’s notion of reality. However, a focus on knowing yourself, being educated and always keeping an eye on the larger picture will most likely help you weed out the 80% of bad advice givers and lead one to appropriate advice being given.

I am off until September on a mini-blogging vacation. Enjoy the rest of the summer. Keep safe and have fun.

Fortune Magazine recently pointed out that the new normal of our economic lives includes a return to renting rather than owing. A 2010 Harvard study showed between 2004-2009, the number of renters has increased 10%. With real estate values continuing to show no steady acceleration trend in the U.S. and the theory that those with negative equity in their homes will have to convert to renters, it bears watching whether this will become a longer term trend.

Having said that, there is now an open pro-renter policy lobby.  Specifically, Richard Florida, while not the first to suggest it but certainly the most famous given he is the “it” boy of economics, argues that a distorted home ownership rate slows an economy’s ability to recover from downturns given many people are rooted to location rather than being able to pick up and pursue opportunity. The more practical consideration is whether debt-strapped governments can continue to allocate resources to support home ownership.

What seems to be happening is the recognition that certain people do not have to economic means to own a home and the market should be allowed to correct itself.

There has been some musing lately that much battered insurance company Manulife Financial may be becoming a value play. Manulife’s declining share price may partially have to do with self-created issues caused by the selling of variable annuities which were not hedged to drops in the stock market. However, one of its larger competitors, Sun Life Financial, is also experiencing 52 week lows along with most of the the life and health insurance sector. It appears then that Manulife’s woes are part of a larger downward trend for the entire industry.

Why are life and health insurance companies struggling in general?

Insurance have just as complicated balance sheets as banks and suffer from the same interest rate sensitivities. An insurer’s largest liability are payout of insurance policies or annuities which tend to have much longer payout dates than the primary assets they hold, typically fixed income instruments. Thus, you end up with a fundamental issue of balancing a fixed long term liability versus a short-term asset which changes in value according to the interest rates.  When interest rates decline, the value of the assets decline so more money has to be set aside to rebalance assets and liabilities.

(as an aside, Larry MacDonald pointed out how the mark-to-market rules hurt insurance companies, and most financial institutions, and has basically resulted in Manulife reporting a loss. Mark-to-market is an accounting rule requiring certain companies to report the value of an asset based on its current value and not the purchase price/book value. The issue with mark-to-market is that it works best in a stable market where the price of an asset is knowable. In unstable markets, it produces unintended consequences and can cause jittery investors to over-react. It is something to be aware of if you invest in financial stocks)

The second shoe to drop for insurance companies in low interest rate environments is that demand for annuities and most life insurance policies generally tends to decline. No one wants to lock into an annuity for a relatively low rate of return and yield chasing takes many consumers away from insurance products (here is a short primer on how annuities work).

A bank can continue to make the spread between what it lends out and what it pays its deposit base even in a low interest rate environment. Its spread may be smaller but it is still ahead of the game. An insurance company has the dual issue of propping up balance sheets while sales slow in the same environment. This problem frames the bank stock vs. insurance stock choice in favor of the former in certain economic conditions.

The medium to long term implication is that an extended period of low interest rates will continue to put financial pressure on insurance companies, reducing the chances of dividend hikes and healthy return on equity. The solution to this problem is, funnily enough, to transform insurance companies into large financial empires with banking,  mutual fund and any financial service subsidiaries; in other words, create more too big to fail institutions which are interest rate immune.

In the short term, it may be unrealistic to assume a life insurance company will power your portfolio’s return.

Economist Moshe Milevsky’s book, Your Money Milestones, addresses the interaction between your employment income and your portfolio investment. Among other things, our employment income has equity like or bond like returns and our investment decisions should account for the characteristics of our employment income. In essence, human capital- the ability to generate economic value through our labor- is an often overlooked factor in how we view our financial lives.

Apropos to this point, a lot of the money chatter in my immediate circle is finding a product with yields greater than the meager returns of a money market fund. None of the suggestions I have heard involve investing or upgrading education or skill-set as a means of generating greater human capital. Yet, this is a means of improving one’s financial picture.

The much cited 2007 U.S. Census Bureau survey finds a person with a Bacholar’s degree has a means earning of greater than $25,000 over a person with a high school dipolma. An individual with a professional degree earns over twice as much with a counterpart holding a Bachelor’s degree.

What is interesting to note is that a person going from a Bachelor’s to a professional degree gets the most bang for the buck between the ages of 35-44 and 55 to 64 which tends to affirm the opinion of some that obtaining a MBA or a legal degree at a young age will not bear fruit until later in life when life/professional experience catches up with book learning.

Given that some people began to accumulate enough disposable income to invest in these two age ranges, perhaps the dialogue should not be equity or bonds, active or passive but to invest in the market or to invest in oneself?

To illustrate this point another way, in 1980, the number of female undergraduates slightly outnumbered male undergraduates. By 2007, 57% of all undergrads were female and the number of women enrolled in their first professional programs is now almost equal to men erasing a greater than 2:1 advantage in 1980.  Correspondingly, the gender wage gap, while continuing to be a problem, has narrowed significantly since 1980 whereas from 1960-1980 the wage gap remained basically the same. In other words, women have advanced relatively speaking due to greater investment in themselves.

This is not to suggest the only path to increasing economic output is through obtaining a conventional degree from an educational institution.  Night courses and professional development courses, many of which are subsidized or paid for by government or employers, may also be a means to increase skill set and expand networks (the often hidden benefit of skills-improvement; an old prof referred several legal clients to me over the years).

The point is that we often view our investment choices as merely Product A or Product B when the realm of human capital enhancement is often overlooked. As the educational/training industries start up anew in September, it may be time to consider allocating money to your own professional development.

After several years off, I have been dragged back into playing golf this summer. I am a hacker and, although some of my friends won’t admit it, so are they. If you play golf for any period of time, you probably have noticed the following pattern if your golfing buddies are hackers. Someone in the group with some fundamental flaw in their swing decides the solution is to buy a bigger/better/faster/sexier club that will fix all their problems. Of course, in most instances, this  club makes their slice or pull that much more apparent. The result is that the 50 yard slice right into the rough is now 100 yards slice right into the bush with their new toy and the “obvious” solution is to buy the even bigger/better/faster/sexier club next season.

I feel the active vs. passive investing debt has this similar type of feel. Many people have sliced their portfolio into the rough using active investing methods but, instead of mastering their own emotions, they decide the problem is with the active investing club and go out and buy themselves a passive investing club.

(to be clear, the evidence is pretty over-whelming that high fee active management products make no one rich but the issuer but low fee active management options have existed for many years and the poor returns of many active managers is compounded by many of the errors committed by the investor below)

The passive investment may offer advantages to the active investment BUT ONLY IF IT IS DONE RIGHT. Please remember that the fundamental assumption underlying the advantages of passive investing is to invest broadly in low fee products, allocate among asset class properly, reallocate periodically and to stay invested. Without any of those factors cited above, moving from active to passive investment is equivalent to getting a new golf club without taking any lessons to fix the real flaw in the first place.

Morningstar now estimates slightly over 1 in 5 investors now have some type of passive investment strategy in their portfolio. Where there is money, there’s the financial industry to screw you out of it. Thus, there are now products that are not really passive but claim to be, issuers encouraging investors to purchase a multitude of niche products and products which promote quick-turnover by their very nature (most leveraged exchanged traded funds).

The potential result for an investor pursuing perhaps the right strategy from them (passive) but executing it poorly may look surprising similar to the strategy they previously abandoned: too many products being turned over too quickly with some products not even doing what they are supposed to be doing. To go back to my golfing analogy, the club may be different but still the same old hacker.

There’s an old saying in business: invest in a company with a Grade B idea and Grade A execution over one with a Grade A idea but Grade B execution. The same rule applies to investing. Sticking to a plan, controlling one’s emotions and tuning out the imperative to buy marketing buzz will get you farther, regardless of strategy, than constantly changing approaches, being emotional and relying on the supposed superiority of the plan and not in its execution.

If you live in Ontario, you may have received a mailing recently from your auto insurer announcing new changes to the new standard auto policy commencing September 1. Alternatively, if your auto insurance is up for renewal, you may have noticed that your premiums have dropped- unfortunately, it is not solely due to your stellar driving.

Instead, the Province of Ontario is lowering the basic level auto coverage to levels comparable with most other Provinces. For example, after September 1, non-catastrophic medical and rehabilitation benefits are being reduced from $100,000 to $50,000. The income replacement benefit will also be reduced from 80% of gross income up to $400 per week to 70% of gross income up to $400 per week.

While the lowering of the basic auto coverage is being spun as giving the consumer more choice and reducing insurance costs, the underlying rationale may be much more depressing. Simply put, the cost of injury claims are out of control and reducing the amount of money available for assessment and treatment is believed to help rein in costs (so the theory goes).

The issue, as illustrated by James Daw, is that to purchase additional auto coverage post September 1 to get back to the pre September coverage will cost a household significantly more especially if you live in a large urban centre. On an apples to apples comparison, many households will actually be going backwards to get the same level of basic auto coverage. At the end of the day, we are paying more for less.

Finally, regardless of location, for those looking to reduce or cap auto insurance premiums, the tried and true words advice are always:

1. Raise your deductible. There is a temptation to have the insurer cover damage but I understand two claims of any amount will generally raise your premiums going forward. Think about how much it would cost you to pay the additional premium  year over year versus paying out of pocket $1,000 or $1,500 instead of the standard $500 deductible.
2. Don’t speed.  Speeding tickets, especially multiple speeding tickets, are known to increase auto insurance premiums dramatically. If you are caught speeding, consider challenging it.
3. Combine your insurance. Many insurers give discounts if you obtain auto and home insurer policies together.

Remove the costs of binding, packing and shipping and you would think that an e-book would be a relative bargain wouldn’t you? Although an e-book priced at between $12.99-$14.99 is a significant savings over a conventional hardcover retailing over $25, it is not exactly super cheap either since you have to factor in the cost of the e-book reader as well into each purchase of the book.

Book publishers, who have a reputation for being as lumbering as the music industry counterparts, argue that a large price difference will cannibalize sales in the traditional retail market. However, the Office of the Attorney General of the State of Connecticut are now investigating whether Apple and Amazon are using their combined market power to make the e-book market uncompetitive by keeping prices high and preventing competitors from engaging in a price war. None of the accusations have been proven in a court of law.

To make a long story short, when Apple introduced the i-Pad to the market, it negotiated with the publishing industry to move from a wholesale model, where the retailer or distribution channel sets the price, to an agency model, where the publisher sets the price. Although the margin on an agency model is generally less than on a wholesale model, the publisher gets to control the price and avoids massive mark-downs and discounts given by retailers to reduce inventory or boast sales.

According to the Attorney General’s office, Apple and Amazon also negotiated “most favored nations” clauses into their agreement with most of the big publishing houses. In plain English, Apple and Amazon have to receive the best price on ebooks. The accusation is that a most favored nation clause will encourage the publishers to not sell any ebooks cheap to a small ebook vendor since it would have to offer the same price to Apple and Amazon and cut their margins across the board.

What hurts Apple and Amazon’s case optically is that many e-books on Amazon increased in price from $9.99 to $12.99-$14.99 shortly after the i-Pad was introduced. One wonders if the investigation gets beyond mere conversations that Amazon may not throw Apple under the bus for a lenient settlement given other accusations of Apple bullying Amazon in online sale of music.

If history is any guide, a dominant technology company tangling with the regulators and law makers for years on end about its business practices, whether the accusations are substantiated or not,  is typically is a prelude to a gradual reversion to the mean.

For those interested in ebooks, some of the larger public library systems now offer downloadable books. The Toronto Public Library, for example, is now offering titles. Check your local library to see if it is available to you.

Canadian Couch Potato recently responded to a reader’s comment that her investing strategy based on purchasing exchange traded funds did not seem to be working. There are some very insightful comments from readers but what struck me was the reader was already questioning her investment strategy a mere 3 years after starting it which is way too short of a period of time to start second-guessing yourself.

The best and worst thing to happen to the investing public is the internet. It was provided us with research and information we otherwise would have great difficulty obtaining but it has given us collective ADD and a sense we should all become day-traders to be successful investors.

However, if you read a recent interview with billionaire T. Boone Pickens, his traditional investing horizon is 5 years (it is now 2 years for him because he’s 82 years old). 5 years is, arguably, even a short period of time for an investor with a 15-20 year plus investing horizon, remembering Pickens made his reputation as a corporate raider (now known as private equity post Gordon Gekko) and hedge fund manager- occupations not exactly known for patience.

If you looked at the interval of time between recessions in the U.S. since the end of WW II, the results are (in years rounded up), 3, 4, 3, 2, 9, 3, 5, 1, 8, 10, 6. In other words, even a minimum of 5 year hold period in a product or investing strategy would have outlasted or equaled 7 of 11 economic cycles of one recession to another since WWII. By jumping in and out under 5 years, an investor risks missing the run-up in a recovery or investing at the start of a down-turn.

(as a side note, note how much larger the last 3 numbers are to the first 8- the 9 year figure notwithstanding. It tends to show how historically anomalous the period of 1982-2007 was and how “normal” a recession should be in the natural economic cycle of any nation. In other words, hyperbole of a possible 2nd recession tends to ignore historical realities)

The exception, as Pickens referred to, is if you have a short investing horizon a minimal 5 year period may be too long.

The long and the short of it is that it is not so much that a strategy is misguided but a poor investor does not give any strategy or product enough time to come to fruition. It is analogous to, short of a disaster, cutting a first date short halfway through dinner and deciding he/she is not worthy of a second date. How you know with such a small sample size?

Investing horizons also becomes a great litmus test for the quality of an investment advisor. If he/she cannot stick to a prudent strategy or product they recommended to you for 5 or more years, it may show they are merely salespeople churning through your portfolio for commission.

The holy grail of investment products for many investors would be something that delivers both protection of principal and delivers high yields/returns (I would define high yield as over 5-6%. The demand for these types of products always exist but tend to increase greatly during time of market uncertainty. The issue is that, while some of these products work as advertised, many fall short of the expectations.

But, banking on the short-term memories of the investing public, the investment industry resorts to financial innovation to replace one generation of failed product – good bye principal protected note- with another generation- hello “factored structured settlements” or funds promising both capital preservation and high yields.

Regardless of the name or marketing quirk, there are always a few things to remember about products which attempt to protect principal while promising yield/return.

You can’t have your cake and eat it too. To quote Larry MacDonald on the same topic: “A fundamental principle of investing is that there is generally a trade-off between risk and return. If you want safety of principal, you have to accept a lower yield; if you seek a higher yield, you need to take on more risk.” This is not to say that one cannot invest in a product that aims to protect principal and provide high yield/return but…

You get what you pay for in life. Principal protection products  are generally achieved in one of four ways: (i) insurance (the principal protected note method); (ii) active management through constant re-balancing of a portfolio or purchasing of derivative instruments (options, shorts etc.); (iii) relatively heavy costs involved in setting up a structured product; or (iv) a combination of all three. In other words, there’s a cost to protecting the principal side not to mention the usual costs of delivering high yields/returns; in hindsight, it is possible to have your cake and eat it too but it will be one expensive cake.

Liquidity is a concern. Logic dictates that a manager of these products would have a hard time delivering on principal protection and even modest returns if investors are selling the products constantly. The need to maintain cash to meet redemption requests may either result in: (i) not enough money left to purchase instruments to protect principal; or (ii) leaving little to invest in yield/return. The manager’s simplest solution then is to prevent, or severely limit, redemption of the product. You can’t fault the manager for this but it should alert an investor not to buy any products if they require cash in the short to medium term.

These types of products are neither good or bad in the abstract. They are created to fill a need but there’s a cost to everything in life. As usual, investors need to be aware whether there is a sufficient trade-off between potential benefits and those costs.

For the DIY crowd, Preet previously outlined how to create you own principal protected note. Please feel free to share if you have other principal protection strategies.

Good luck.

Every year, Canadian Lawyer Magazine releases its legal fee survey. The survey’s accuracy is subject to some question since it depends on the voluntary participation of lawyers cross country. With a relatively small sample size of almost 600, a regional concentration or a cluster of results in the low or high end of the fee schedule can distort the results. Nevertheless, the survey does provide some broad guidelines on how much you should be paying for a lawyer.

If you are an average employed Canadian, the most likely reasons to see a lawyer are: (i) draft a will; and (ii) sell or purchase a home; and (iii) documenting a divorce. For the middle transaction, a simple sale of a house costs on average $827  (the $827 average does not include the cost of title insurance, taxes and disbursements). A purchase and sale will, on average, run a typical Canadian almost $1,300 based on the survey results.

Lawyers charge on average $344 for a “simple” will (one presumes a simple will is all to spouse and then all to kids in the event spouse pre-deceases the testator) and $156 for a power of attorney. It is not clear whether this is for one power of attorney or $156 for each of power of attorney for personal care and power of attorney for property. Assuming it is $156 for each power of attorney, estate planning would cost approximately $650.00 before taxes.

However, in the age of multiple marriages, kids from different relationships, deceased with assets in other jurisdictions, testators which are deeply in debt, support obligations to elderly parents or grown children is there such a thing as a simple will anymore? I will post on this in a future post but wills and estate planning are become less than simple as the family unit evolves.

Under the heading of “only the lawyers get rich”, lawyers charge on average $1,200 for  an uncontested divorce and over $12,000 for a contested divorce including a high of over $50,000; the high fees for a contested divorce probably arises from child custody disputes/arrangements.  It is for this reason that the family bar has begun to move towards collaborative family law. It is definitely an option worth exploring if you are contemplating or are in the middle of a separation.

Obviously, you get what you pay for in life so use the survey results only as a broad guide. On a more practical level, do try to actually engage in a conversation with a lawyer rather than starting out with “how much does it cost?”

All law is contextual so even if you do not like the price quote, a conversation or consultation will at least flesh out some issues you may not have been aware of. A good analogy would be you would not hire a contractor to renovate the kitchen without having them actually look at it first.

If you do not know how to find a lawyer, call your local law society. Most have referral services. The Law Society of Upper Canada, which regulates lawyers in Ontario, has finally made their lawyer referral service free after charging a modest fee for years.