Sadly, I can no longer work on Wall Street, so I get to experience it only the way most people do: as a customer. Slate has asked me to write about this. Specifically, they have asked me to create what might be described as a Wall Street User’s Guide—aka a “Self-Defense Manual.” As with my previous Slate assignment, covering the Martha Stewart trial, the ironies and concerns of my writing about this subject are many. I’ve addressed them in this detailed disclosure statement.
This User’s Guide starts the same way many people’s investing begins, with a visit to a financial adviser. A few weeks ago, I met with an adviser at a full-service brokerage firm, a chipper New Yorker ensconced in a midtown office tower. At the adviser’s suggestion, I had previously submitted financial details—assets, risk tolerance, time horizon, objectives, etc.—and the adviser had developed a “proposed investment program.” Having vaporized a chunk of my portfolio by loading up on Internet funds in February 2000 (great insider timing!), my primary objective was to avoid losing money. Having also vaporized my immediate employment prospects (regulatory nightmare), my secondary objective was to generate some income.
The adviser handed me a presentation book and skipped to the punch line: With careful asset allocation, manager selection, and portfolio rebalancing, my proposed investment program should generate average returns of about 10 percent per year. Ten percent a year? In the late 1990s, this would have garnered a yawn. Today, however, with interest rates near half-century lows and stocks still (arguably) overvalued, it sounded great—especially if, as the adviser suggested, it came with low risk and volatility. We burrowed into the presentation book.
The good news: Most of the advice inside was responsible and sane. The program emphasized asset allocation (instead of stock-picking), diversification (instead of swinging for fences), and patience (instead of trying to predict near-term market performance). The program was also personalized (if yours isn’t, head for the elevators). It didn’t tout the adviser as a stock-picking wizard (if yours does, sprint for the elevators). It illustrated that the projected return was only a median, that the actual average yearly return over the 10-year horizon might be as much as 6 percentage points higher or lower (responsible financial projections are more akin to sawed-off shotgun blasts than laser beams). It disclosed all fees, in both percentage and dollar terms.
Overall, I was impressed. If I were to follow the proposed program (and I will follow some of it), I believe that, over time, I would make a little money without taking much risk. I would pay a lot of fees, but such is the cost of using a full-service brokerage firm. What I wouldn’t do, in my opinion, is generate anything like a 10 percent average return (in the presentation book, the projected return was closer to 9 percent, but this, too, seems a stretch).
When gazing at a presentation book filled with beautiful pie charts, graphs, and tables created just for you, it is easy to forget that projected returns are just black marks on a page. Far more important are the assumptions and logic underlying them. As I flipped through the book, I searched for the “Assumptions” page. And that’s where the bad news began: There was no “Assumptions” page.
I asked the financial adviser how the projected returns had been calculated. The adviser didn’t know (uh oh). The adviser also didn’t know, at first, whether the projected returns were before fees and transaction costs—or after. (The adviser soon determined, not surprisingly, that they were before; and, just like that, the 9 percent median return dropped to about 7 percent). The projected returns were also before taxes and inflation, but expecting to see fully adjusted returns (after fees, transaction costs, taxes, and inflation) in a sales presentation is fantasy.
The presentation didn’t have an “Assumptions” page, but I did eventually discover a small heading called “Assumptions.” And here, finally, I found what I was looking for (I think). The assumptions, in summary, were as follows:
|Asset Class||Est. Return /Yr||RecommendedAllocation|
|3-month T-bills||4.47 percent||10.0 percent|
|Municipal bonds||7.15 percent||30.0 percent|
|International stocks||4.53 percent||7.5 percent|
|U.S. stocks||11.81 percent||37.5 percent|
|Funds-of-funds||9.75 percent||15.0 percent|
So this was how I was going to generate about 10 percent per year with limited downside: I was going to get 11.81 percent a year from stocks, 7.15 percent from muni bonds, and 4.47 percent from T-bills. The numbers were so precise, so reassuring (they were even expressed to two decimal places!). Alas, they, too, were simply black marks on a page.
Predicting future market performance is not an exact science, and those who pretend it is do so at their peril. There are almost as many valuation/prediction methods as there are investors, and few of them are all “right” or all “wrong” (none, to my knowledge is perfect). This said, some methods are better than others, and, in my opinion, the brokerage firm’s leaves something to be desired. An explanation of why I think the firm’s assumptions are probably aggressive (even before fees, costs, etc.) will be the subject of the next piece. For now, suffice it to say that they call for:
- T-bill yields 3.5 percentage points higher than current yields, which would require a sharp rise in interest rates (which is obviously possible).
- Municipal bond returns 3 points higher than current yields, which would be challenging in a rising interest-rate environment, in which bond prices decline.
- Equity (stock) returns 2 points higher than the average return for the last 200 years, which would also be challenging in a rising interest rate environment.
Such performance is not inconceivable (if “conceivability” were a prerequisite for market behavior, the 1990s would not have happened). It is, however, unlikely. It is also deserving of a detailed explanation.
Click here for Part 2: Stocks are a great investment “in the long run.” But how long is the “long run”?