Road To Independence

Last week I discussed the first stage of my portfolio construction process. Clearly, this was a difficult task to complete in a 400-500 word essay as it omits many important issues from the discussion. Before I move on to this week’s topic, let me make one thing perfectly clear, I do not believe I (nor anyone else) can predict market returns. However, I do believe it’s fruitful to determine the return needed to reach the goal. Then at least you have a benchmark against which to measure your progress. This week, we will begin to build the portfolio starting with bonds (I could have said “fixed income,” but I eliminated jargon from my vocabulary a long time ago).

My Approach: Core and Stability
With bonds, I use a “Core & Stability” approach. In general, bonds are primarily affected by interest rates which will rise, fall, or remain static. The worst environment for bonds is when interest rates are rising since as rates rise, bond values fall. There are other factors which affect bonds such as money flows (with mutual funds) and credit quality, but let’s stay with the topic of interest rates. First, I avoid long-term bonds. Even though there are periods when long-term bonds outperform, over longer periods of time, the returns in this category are similar to intermediate-term bonds, but intermediate-term bonds contain much less risk (as measured by standard deviation). Next, I will typically avoid bonds with embedded options (call features). This is because of their negative convexity (a discussion for another time). Finally, I am not a big fan of high-yield bonds, but do hold them on occasion. Finally, I will normally use mutual funds of ETFs. However, I will buy some individual issues if the portfolio is large enough.

Core
Here I include intermediate-term bonds, mortgage-backed bonds, and inflation protected bonds (TIPS). If interest rates are falling, intermediate-term bonds will perform well (as will most bonds). When interest rates are rising, I like TIPS because of their increasing floor (par value increases with inflation or CPI). If interest rates are rising, the economy must be growing and CPI will be positive. Finally, in a “static” environment, mortgage-backed bonds will fare well. I should note that I use GNMA’s here, and that mortgage backeds receive the smallest allocation of the three. Currently, I am overweight in TIPS.

Stability
Depending on the client’s willingness to assume risk, I will add some or all of the following: ultra short-term, short-term (government or corporate), and bank loan. These will help stabilize the portfolio which is my ultimate goal.

Summary
The intent is to achieve a positive return from the bonds regardless of interest rate movements.  As long as rates aren’t rising in large increments, this should be achievable. I should note that I’ve been using this approach since 1999. So far, so good.

When I started this blog back in May 2007, the intent was to write about the day-to-day issues I faced as an independent advisor. Now, after 140 postings, we’re going to try something a little different. Though I will still write about my weekly adventures, the topics will coincide with the focus of the magazine and will change on a monthly basis. This month’s topic will be investing. The topics are as follows: Portfolio Construction Overview; Bonds; Stocks; and Alternative Investments. Let’s get started.

Portfolio Construction (Overview)
First, let me say that there are a number of good ways to manage money and I do not claim to have cornered the market on this. What I can say with a high degree of certainty is that I have discovered a method which has worked well and will share it with you this month.

Actually, it was during the bear market at the beginning of this century (2000-2003) when I stumbled upon it. Here’s where it begins. Perhaps the most important question I can answer is this, “What’s the required rate of return my clients need to earn to make their goals a reality?”  Then, “How much risk will we need to assume to get there?” I only know of one way to arrive at the required return and that’s through financial planning.

After creating the plan, and assuming it is successful, I will “stress test” it by reducing the return until the probability of running out of money materializes. At this point, I know approximately where the threshold is, that is to say, the minimum return which will allow my client to live the lifestyle they desire.

Once this is known, I will begin with one of my model portfolios, and by running 1,000 or more trials with Monte Carlo simulation, I can forecast the probability of achieving this return for annual, five-year, and 10-year periods. It’s important to target an expected return which is higher than the required return. Let’s say the required return was 7.5%. If the expected return were the same, then I would likely have a 50/50 shot of success. Therefore, I target a return which is slightly higher than the required return so the probability of success will be higher.

Next week I’ll share how I build a portfolio which starts with the bond category. Stay tuned.

2010 is starting off with a bang! In fact, January may be my best month since I started down this “road to independence” just under three years ago. Moreover, income now exceeds expenses with some left over. Why has it taken almost three years? When your business is “fee-only” it takes much longer to get your income to the point where you can earn a decent living. Although it’s a slower, longer runway, once the plane leave the tarmac, the ride is great.

To digress a bit, it reminds me of a time back in mid-2001 when I left the brokerage firm where I worked and moved 1,651 miles away to run a bank subsidiary in the Northeast. This particular bank had 18 branches spread over two states and the subsidiary was established to provide financial planning and investment management services. As principal, my responsibilities ranged from managing personnel to growing the business to working with clients. I remember how long it took to get our income to the point where it covered our expenses. We did receive some commissions but most of our business was fee-based asset management. We also had an excellent referral network. Each branch had a monthly quota for referrals to the subsidiary. In fact, I remember a few months when we received as many as 80 referrals! We increased assets under management from $3.5 million to about $28 million in slightly less than two years. When I resigned, our recurring income was just about enough to cover expenses. Needless to say, I do not have such a referral network now and hence only receive about 8-12 referrals per year. Since my business model is “fewer clients with more wealth,” that works just fine for me.

Although I wasn’t aware of it at the time, a great conflict of interest exists in a banking environment. Banks thrive on deposits and bank brokerage operations thrive on gathering assets. When banks lose deposit money, even if it’s to their brokerage operation, it reduces the bank’s lending activity. The other day I was speaking with the president of a local bank who told me he was looking for an investment person and listed several qualifications. Some of the items on his list included: an existing book of business, a self-starter, etc. One of the items on his list was a person who wouldn’t take deposits away from the bank!

Oh how I love being an independent advisor!

As I approach the end of my third year as an independent RIA, I am very glad to have made the decision to leave the security and culture of the banking and wirehouse world. When I reflect back to my first year of independence, there were many bumps in the road. Establishing an infrastructure, settin my pricing, and clearly defining my offerings were only a few of the items on my plate during that time. I also had to bring in new clients while balancing on a financial tightrope.

Yes, there were a lot of decisions to make that first year. After the end of my second year things were better, but my income was still not adequate. Today, current income is not only sufficient to meet our business and personal expenses, but there is also a small surplus. One of the next items on the agenda is to start a health savings plan. Then, in a year or two, I hope to have a full time assistant and a retirement plan. You have to crawl before you walk and walk before you run. I think I’m walking pretty well now. However, to accomplish this I will need a few more clients.

Fortunately, over the past few weeks, I’ve received three new referrals. Why? Partly because I’ve asked for them. As I go through the client review process, I am incorporating the question, “Do you know of anyone who could use the services I provide?” If they do, I give them some business cards and the rest is up to them. I have also created a tab in ACT! on which I keep a record of the referrals I receive. The tab includes the name of the referral, the date of the referral, the result of the referral, and whether I have sent a thank-you to the referring party.

Referrals are very important, especially if you don’t want to spend a lot of time with seminars or cold calling. Generating business from referrals allows you to spend more time serving clients and not ‘shaking the trees’ for new ones. All of my clients have come from referrals or people I have met over the years. Moreover, referrals are the best source for new clients. If your focus is on satisfying current clients you can be assured that your pipeline will always remain full.

Operating an advisory business is a little like hosting a radio talk show; you never know what question or situation you’re going to encounter. Both require a broad base of knowledge or at least a quick reference to the answer, as no one can possibly know everything about every issue. If your business model is strictly investing clients’ money, you must stay abreast of the markets and the multiplicity of investment vehicles, an area which is ever expanding. However, when you add financial planning to your offerings, and comprehensive planning at that, you add a layer of complexity which can challenge the most astute advisor.

One more point to make. If you do not engage clients in financial planning, and you work for a company that has a “back office” for selecting investment choices, then your load may be slightly less, that is, if you aren’t under constant pressure to continue bringing in new clients. Enough ranting, let’s move on.

This week, I received a referral from a current client. This referral had engaged a nationally recognized company to prepare a financial plan for him and his wife. They said it would take about two weeks to complete. Two weeks later, no plan. Explaining that there was a slight delay, they assured the client that it would only be another couple of weeks. Two weeks later, still no plan. It was at this point that the client bid them a not-so-fond farewell. Now this client is engaging me to do what this other firm was hired to do. Without divulging any personal information, let’s take a look at what’s different about this situation.

First, I live and practice in a community property state. Moreover, the local market is not a hub for company executives. Hence, we don’t see a lot of executive benefits programs here. Therefore, when I encounter a new client from another state, I must become familiar with the nuances of the case. I must learn about the tax structure of the state and consider any effects that might exist on estate planning, etc. In this situation, the client hails from a common-law state. Since I practiced in New Hampshire for several years I had a familiarity with this.

The client also has stock options. I have done a lot of work with clients’ stock options in the past, both non-qualified and ISOs, but I have forgotten much of the details since I haven’t worked with these in a while. Therefore, I had to bone-up on the specifics of each. With tax hikes on the horizon, making good decisions on when to exercise these options is even more crucial since NQs require that you claim the portion that’s “in the money” (assuming you exercise the option) as regular income and pay Social Security and Medicare taxes as well.

The fact that each situation is different is one of the main reasons why I love this business. It’s never boring!

With 2009 behind us and a New Year and decade ahead, I’d like to take a moment to reflect back on the last few years to say “thank you” to some special people.

In my younger days, I thought my success or failure would depend solely on my effort or lack thereof. I reasoned that if I worked hard and learned everything I could that would be enough. Sure, those things are important. They are in fact, vitally important. But to be successful, I believe you must have the help of others.

When I ventured out on my own in April 2007, I had plenty of help. A local attorney sent me a few referrals, as did an accountant. Then there are the referrals from satisfied clients. People like to help other people and it’s especially rewarding to know that they respect your work and you as a person.

Again, to be successful, you must have the help of others and it is in this spirit that I’d like to say “thank you” to a few people to whom I owe a debt of gratitude. I should mention that this list is not in order of importance nor is it entirely complete as there are others I could include. Here’s the list:

My wife Kitty: Her love and support was instrumental in my decision to leave the corporate world and become an independent advisor. Even when I waivered she held steadfast in her belief in me. I am so glad I listened.

Jamie Green and Investment Advisor Magazine: Jamie afforded me the opportunity to do something I truly love to do; write. I am excited about the future.

Readers of IA: Without whom I would not be writing, thank you!

Matt Schifrin and Forbes.com: Thanks for the opportunity to write for you as well.

The Greater Baton Rouge Business Report (local publication): Thanks for knocking on my door and quoting me in your publication!

My Clients: Thanks for the trust and confidence you have placed in me. I do not take this lightly.

TradePMR: Thanks for a great platform on which to operate my business. I’m looking forward to many years together.

My Fellow Advisors: It is the collective thoughts and ideas of all of you which make our business great. Keep on doing what’s best for the client!

God: Thank you for leading me down this path. It’s been a great adventure!

To everyone else: Have a great 2010!

As the fourth quarter (and year) comes to a close, it will soon be time to meet with clients and review their accounts. With this in mind, I’d like to share some of what I will be discussing with them. In the past I’ve always reported on performance. I’ve also discussed their portfolios’ composition and the funds and ETFs they hold. In 2009, I added my fiduciary score for each mutual fund and ETF to the review. This time around I plan to add an additional component to the review that you might call “factors involved in getting to the performance numbers.”  In other words, I plan to discuss which trades worked out well and which ones didn’t.

In 2009, I did well with a couple of ETFs but not so well with a bank loan fund I bought in 2008 and sold recently. The client needs to know that I am willing to discuss my failures as well as my successes. I believe clients appreciate an advisor who is honest enough to say, “I missed that one.”

Another issue involves the cost of trading or “transaction costs.” Now some of you might be thinking that discussing the costs of trades may open a Pandora’s box. I look at it differently and here’s why.

We all know that mutual funds come in a variety of share classes and that each share class has a different expense ratio. Let’s say we have the choice of buying an A share with no transaction fee or an institutional share with a $20 fee (that’s the fee with my custodian). Because the A share has a higher expense ratio it will underperform the institutional share. Let’s assume the A share has an expense ratio which is 0.50 basis points higher than the institutional share. If you bought a $20,000 position then the difference in expenses would be about $100. Subtract the $20 transaction fee and you are still $80 ahead. The larger the position you buy, the more advantageous it is to buy the institutional share and pay the fee.

I inform clients that I will buy the cheapest share class available to reduce their expenses. At some point in the future I may decide to pay this fee for larger clients, but at this point, the client pays it.

Thanks for reading!

I’ve been thinking a lot about strategies to improve efficiencies in managing client assets. What brought me to this point was the price of oil falling below $70 a barrel. You see, I had exited my oil position several months earlier after the price rose to $71 from $35; it was one of those times to take some profits off the table. Now, I’m considering getting back in. My challenge is doing this for several clients without entering the trades one account at a time. TradePMR, my custodian, offers the capability of creating model portfolios, assigning each account to a model, then buying the new position in each account with a few clicks of a button. A better option may be to create a “basket.” With a basket you can purchase a security for several accounts and each client receives the same price. However, some accounts need 3%, some 4% and some 5%. To facilitate this, I have created three account groups: conservative, moderate, and aggressive. Then, I can create a basket for each account group as they have a different allocation percentage for oil.

The Tax Angle
Another account group I created is entitled “taxable accounts.” At the end of the year, I need to know what the tax ramifications are for each taxable account. For instance, if an account has a $10,000 gain, is there a position I can sell to create a loss and minimize the tax due? The information I need consists of interest and dividends, realized and unrealized capital gains, for the year and whether the gains are short or long term. The bottom line is that I don’t want my clients getting a big tax bill.

My question to you is, how are you managing this process in your practice?

Finance or Pay Cash
I presented an updated financial plan to a client this week. As I wrote last week, the decision is whether to finance or pay cash for a new home. The client has no debt at this time. Financing came out slightly better, but we’ll see what the client decides. The presentation included a Historical Plan Summary with past plan data for comparison purposes and a scenario merger. The merger combines key data for all three scenarios in one consolidated report so the client can easily see how they differ. Again, we’ll see what they decide.

Profits From the Dollar
I also unwound my bearish dollar position this week. This is another example of taking some profits off the table. Who knows, maybe the greenback will stage a comeback, at least temporarily.

Finally, I’d like to wish you all a Merry Christmas and thanks for reading!

I consider a significant part of my value offering to clients to be the unique financial planning analysis I provide. Moreover, the specific tool I use for this has evolved a great deal over the past several years. Each page of the output contains very useful information without a lot of “fluff” which is so common in many of the “out-of-the-box” tools on the market today.

After all, the better the information, the better the decision , and good-decision making adds real value.

Many of us create a customized plan or analysis for our clients. But what frequently happens is the plan ends up on a shelf or in a filing cabinet rarely to be referenced again. Just as the initial plan was important for gaining a perspective on a client’s financial situation, future plan revisions are equally important.  Just as the initial plan provides a point-in-time analysis, future plans allow the client and planner to compare projections to actual results and track progress toward the client’s desired goals.  . Therefore, planning is not a static exercise, but a very dynamic one

Last week, I spent some time updating a client’s financial plan and compared it to the initial plan created a little over two years ago. There is a question on the table for this particular client: “Should I pay cash or finance our second home?” Without planning, you might base this decision on whether or not your investment return is expected to exceed the mortgage rate. That’s part of it, but I believe there’s more. Yes, money is cheap right now.

Allow me to digress for just a moment. It was an “easy money” policy which got us into this mess and the same policy is presented to get us out. Basically, it was Washington’s desire to create homeowners from lower-income individuals and their punitive threats to lenders for non compliance which changed the face of lending and Wall Street. This policy is centered on pushing loans out the door.

With an easy money policy which includes low interest rates (Keynesians arise), borrowing, when it make sense, can be a wise move. Actually, the best time to borrow is when  rates are low and higher inflation is expected. Both of these conditions exist today. Now let’s get back to my client.

I ran three scenarios: Pay cash; finance for 30 years; and finance for 30 years, but pay off the loan when the client’s current house sells in three or four years. The answer? The financing options resulted in the best outcomes while paying cash was the worst. I expect the decision will come down to the client’s comfort level with debt and whether he feels the need to maximize his investments. We’ll see.

I’m a firm believer that everything happens for a reason. I have also learned that being an independent advisor can sometimes be as challenging as it is fulfilling. This week I had an experience which I call “the week from techell” (tech-hell). This happened after a CMS upgrade.

Two weeks ago I discussed how I had acquired an additional user license with ACT, my contact management software. During installation we had to get a tech on the phone as we encountered issues which exceeded our knowledge (contrary to popular gender norms, I like to ask for directions). After an hour the tech had us up and running. That was the end of the day before the Thanksgiving break. When we returned to work and opened ACT, it ran about as slow as the old dial-up Internet on Valium. Click here, go get a cup of coffee, and maybe it will be ready when you return. All the “efficiency” we had hoped to obtain was gone. Efficiency down = frustration up! Surely there must be something we could do.  

I called ACT tech support. I waited on hold for over an hour before reaching a person. I was on the phone with him for another 2.5 hours and he was unable to resolve the situation. He said it seemed the problem was with my particular database and recommended that I speak with their database maintenance group. He e-mailed my database to them and asked me to fill out their online form. What he failed to tell me was that they charge for this service. Since this problem manifested when I upgraded to their new version and added an additional license, I took issue with that. So after wasting over four hours on the phone, I wasn’t any closer to resolving the issue. Moreover, the tech changed many settings on my computer to try and improve its processing efficiency even though the problem wasn’t with my computer, it was with the program.

Twice during the call I suggested getting another tech on the phone that may be more familiar with this issue.

The next day, I was seeking one of two outcomes, fix the problem or give me a refund. I called sales reasoning that I could get to a manager quicker through the sales department than through service. When they  answered,  I immediately asked for a manager and told them I had already spent way too much time trying to debug the program and was not about to spend any more time with a lower level tech. I asked for their highest level tech and they granted my request. Twenty minutes later my problem was fixed and now ACT runs faster than ever! I suggested they train their level I techs on this issue to minimize situations like this.

A few days later my assistant could not open her Microsoft Outlook (#&%#^#!*%)! We eventually fixed it, but she lost a lot of her personal data! Fortunately, our business data was preserved. Oh, I also had an issue with Excel which reformatted a lot of cells (which were not dates) to the “date” format.

Like I said, it was “the week from techell.”

Hope this week is better for me, and you . . .