{Reminder: this was written a couple years ago, since then things have begun to look more encouraging with regard to housing. Market conditions have changed as well but I thought some of this might be helpful anyway. -RM}

The market is not the economy. The market is a humbling beast, and it is based on the expectations of every active investor in the global economy. Do not argue with it, do not proclaim to be smarter than it, and do not try to predict what it is going to do. Do not buy solely on fundamentals, (i.e., this stock is undervalued by some measure and eventually it will be worth more). It could be “undervalued” for a reason; institutional investors dumped shares because they saw it as an undesirable place to grow their money. Supply and demand. More sellers than buyers mean downward pressure on prices. If the technicals do not confirm your fundamental hypothesis, wait until they do before you initiate a position.

Prime example: housing stocks. People buy these because they think they will turn around. Really? Based on what? The technical picture is not there, and trust that there is very little demand for new housing starts, and the situation will remain that way for quite some time. How many newly built homes are vacant? How many existing homes are back on the market in the form of foreclosures? Where are the buyers? How long will it take to close this gap and justify building new homes? Could be many, many years, my friend.

The broad stock market indices are remarkably strong on a technical basis right now. I wouldn’t be short this market in a million years. We are due for a near-term correction, but we have been due for quite awhile and the market keeps grinding higher. If that first obvious level of support is taken out, it opens the door for a larger move down. There’s an old saying… stocks, and in turn, their markets, go up like escalators and down like elevators… so my point is, given the run up we’ve seen, given that the past few months have lacked super-impressive volume to confirm the up-trend and create a reliable floor, a quick correction could very quickly build on itself and bring the markets down significantly more until longer-term support is found. In absence of that downside momentum snowballing into something bigger, a “healthy, run of the mill” correction (4-6% on the indexes) would prove to be a good buying opportunity. Given, of course that the market continues to show strength at critical points. It should be understood that there is quite a lot of money expected to eventually be coming back into the market, into so-called “risk assets.” It should also be understood that these particular investors, the institutions who move markets, play things very close to the chest. They know they move markets, so they move like ninjas – with stealth and with great power.

The market, on occasion, will show you its hand though. However, we see that most advisors don’t watch closely enough to pick up on this stuff. That’s understandable… lots of financial advisors don’t actually want to be responsible for making all the investment decisions with your money. They pass your assets off to a third party manager – a mutual fund (MF), managed account or variable annuity (VA.) And then they go off and try to find the next client. Less stress for them, less accountability and higher commissions when considering MFs and VAs compared to equities. When they make moves, they make them en masse with your money. They call it “re-allocating” or a “quarterly re-balancing”. They select a few ideas, and then put all of your money into them. If the advisor is commission-based, not fee-based, this ensures that at least four times a year they will have big commission months. For you this creates huge positions with correspondingly large losses if they are not right from the gate. When things go wrong, they simply talk to you for a few minutes about weathering the storm, manipulate your expectations by extending the time horizon, and go right back to looking for new assets to bring in. It’s the classic example of asset gathering versus money management. What often happens then is continued denial, a shift in sells rules to allow the manager to be right…. eventually. And then, only after staring a 20-30% loss in the face for a couple of quarters, on large positions, do they realize they might have been wrong. That’s when one more piece of bad news hits the wire, a small panic sets in, clouds their reason beyond repair, and bad things happen. Either an immediate panic sell, realizing a much larger loss than could have been avoided with proper discipline, or a shift to “longer-term outlook”, creating dead money. The best move is often the first move; the worst move is often doing nothing.

RM ~Feb 2011

Do it yourself – I would absolutely encourage everyone to manage their own accounts. This however, requires countless hours of reading, research and maintenance every week, and a level of expertise commensurate with a successful professional. Sometimes that’s not saying all that much though… But anyway, as a DIYer, you can never take your eyes off of your money. This is very hard to do, especially if you are the average mom and pop investing for the “long-term.” This is where you might see a selection go up 10% in a few months, and then reverse back to flat, netting nothing if lucky and losing money in alot of cases. The problem with the DIYers seems to be their avoidance of making a buy/sell decision. DIYers are quick to buy stock, and very reluctant to take a profit when it exists, preferring to “let it ride so I don’t gotta pay Uncle Sam, grrrrr.” Any number of events could reverse their fortune, and unfortunately DIYers are usually the slowest to react, capitulating and selling at the worst time, driven by fear of losing even more money. This usually happens after months or years of denial. I personally would never trust anyone besides myself to manage my money, that’s originally why I got into this business – to learn how to handle money. Unfortunately, this strategy has a high risk of failure for un-informed non-professionals. Dead money all over the place.

Buy and hold has been exposed as passive, dangerous, and negligent given the events of the last four years beginning 2007. From the year 2000 to the year 2010, the S&P 500 index went virtually nowhere. 0% return over ten years. Now that’s dead money! If you must follow a buy and hold, longer-term strategy, be sure that you are 100% sure you can ignore drastic fluctuations and stay invested over full economic cycles, i.e., 20+ years without caving to the emotional and psychological aspects of investing. And do yourself a favor and build something into your little “long-term model” that makes it ok to want to take money off the table when things get scary. And once you’ve built that in, go to cash the first time you feel uneasy, or scared for your money, and the thought of wanting to secure it enters your mind. The experience of being 100% in cash after netting what initially felt like a less-than-backflip-inducing 6 or 12% return, while the world around you crashes and crumbles for six months is a feeling that cannot be properly described; it can only be experienced. It’s wonderful.

Mutual funds are an ok investment if you plan on holding them for more than 20 years. Not kidding, 20 years. The only long-term investors I’ve seen in my practice that have had good success have all held their stocks or MFs for 60, 40, 20 years…. even then, for optimal performance, you’d want a no-load, Morningstar rated 5-star fund, you’d want to watch out for a change in fund manager, and be prepared for drastic fluctuations in account value over the years. Mutual funds often lag other managed pools of capital, meaning that fund managers are typically slow on the uptake with respect to emerging trends, or stocks slowly falling from favor. A random side note… large endowments require approval from the board of directors to change investment strategy, and these meetings happen quarterly, just so you get an idea of how slow some large pools of assets can be.

Often times in the beginning with me, a new client will remark and say “wow, you trade like almost every week, what are you doing?” My reply is that when you invest money with a mutual fund, the manager is running a commingled pool of assets and trades everyday as well, making small adjustments, realizing profits and losses, re-allocating when situations change and such. Or at least that’s what he’s supposed to be doing. However, because of the way MFs are structured, the investor in them does not see the interior moves within the fund; the only thing reported to investors is the daily change in net asset value of the fund. This provides some marginal conveniences to the investor, such as simplicity of tax reporting, and the ability to “buy and forget”, provided of course, the market continually goes up and everything the fund owns is roses. But it also presents the problem of something very bad happening intra-day, deciding you want to sell, and then not being able to redeem shares until the fund re-calculates with the results of that day’s large losses. Illiquidity really kills you when it matters most.

As an investment manager, it does not matter whether you are running $4M or $400M, it’s all about percentage gains and losses. I could very easily go to work at a mutual fund company, with the goal of rising through the ranks and eventually being given the reigns to a portfolio. Of course, with this decision comes a measly salary compared to the responsibilities of the job, countless bureaucratic issues and other business-culture nonsense to deal with, and constraints on what moves I can make in my trading. For example, many funds have specific objectives (i.e., only invest in bio-tech, or energy companies, or small-cap stocks with a market value of less than $100M.) If I was ever going to manage a large fund, it would be structured much more like a hedge fund, with zero restrictions from above on moves that I could make. Until then though, it’s far easier to work with a small group of retail clients and apply what I know as a portfolio manager.

Managed accounts – Sometimes I get cold calls on my cell phone from third-party firms pitching their managed accounts to the tune of four or five calls a week. They want me to recommend to my clients that I take their assets and hire this third-party to manage them, putting me in the position of middle-man and buck-passer, as well as the only person who would talk to my clients if shit hit the fan. I generally hang up within 20 seconds. Managed accounts are very similar to MFs; they are trending as the passive financial advisor’s alternative to mutual fund investing. Advisors at large firms are constantly pursued, pitched and steered towards managed accounts, and sometimes they are the firm’s own proprietary products! This makes sense for the large firm; it creates operating efficiency, allowing the money managers to focus on managing money, and the financial advisors to focus on bringing in new assets full-time. This stems from the older methodology of a firms “buy-sell list”, where the firm would publish a report saying XYZ stock is a buy and ABC stock is a sell, and then they would have the firm’s brokers on the phone all day buying and selling stock in line with the firm’s analyst’s recommendations. I can tell you from my experience, that when many wall street firms place a “buy” rating on a stock, they are often late and often have ulterior motives; perhaps their investment banking division has a vested interest in a stock they helped bring to market going higher, or their prop trading desk is stuck in losing position. Yes, they’d sell those losing shares to their own clients. Read the news. And also when the independent institutional buyers dry up, they attempt to push the retail investors into the stock to help maintain the price. All the while, you’ll see the smart money sell into this new wave of buyers. When I see upgrade after upgrade on a stock, it often raises a red flag, and I look to be extra cautious on the stock and I tighten my stops. Analysts, on average, are not right as often as you would like to believe. Sometimes it’s not even the analysts fault, being pushed to upgrade a stock from the higher-ups for many different reasons. I’d never accept a job as an analyst either. Not enough compensation for the job and the garbage that comes with it.

Annuities, variable annuities in particular, deserve a word as well. Anytime an advisor sees new assets come in and the investor claims to be a long-term investor, you will always see them consider trying to sell the investor a variable annuity. The annuity companies are very good at attracting new money. Countless riders are added to the policies, some guaranteeing the greater of either the highest anniversary value, highest all-time value (high water-mark), or an arbitrary annual return, say 10% guaranteed annually on the separate account upon redemption of the fund or annuitization of the policy. They have even gone so far as to structure the thing so that the investor does not see a fee charged, at the same time paying the advisor a sales concession almost double that of a MF. Up to 8%, last I checked, on the assets deposited in the VA! In short, there is no other product on the market right now that advisors are more incentivized to sell than the VA. They present a wonderful option. VAs usually require a 10 yr lock up period though, meaning you cannot change your mind and take an early withdrawal without paying a significant penalty, assume say 10% of the assets. Given the promises they have to deliver on, it should be obvious to you why they need your money for ten years. And frankly, given the collapses in the banking and insurance industries that we’ve all just witnessed, they give me pause. A lot can go wrong in ten years. But in short, VAs are a financial advisors dream sale. Bring in a new client, present a no-lose situation, lock up their money for ten years, collect an obscene commission ($80,000 on a $1M annuity), not have to manage the money, never have to talk to the client, and once again, they are freed up to go find more assets. Then in ten years try to sell them another one. Sometimes a VA is a great choice for an investor; more often than not though, they are pushed on an investor when they are not optimal due to the high sales concessions.

If you happen to like all that the annuities have to offer, that’s great. Buy a no-load VA from a fee-based investment advisor (not a commission broker/registered representative) and you’ll be in much better shape. Consider that the highest concession paid to brokers available amongst MFs is about 5%, and the highest stock commission allowable by FINRA guidelines is 4-5% on a round-trip transaction. This is usually much lower due to competitive forces. (For example, before I became a fee-based advisor, I would usually charge between 3-3.5% on the buy side; and to compensate for the higher turnover associated with an actively managed account, I would always move money to the sidelines (sell stock) for a small fee (less than $50) regardless of the size of the position. I would also do this on the buy side sometimes, with reducing the drag from commissions in mind. This arrangement worked well.) But given how the compensation scale lines up, you can see why the VA is so popular among brokers and financial advisors. If you’re a commission broker, and you can sell just one $1M annuity, you’ve got yourself a down payment on decent home from the commission on that sale alone. REITs, limited partnerships and private placements also have very high payouts to brokers, are also highly illiquid and rarely prove to be profitable to investors from the positions I’ve seen in people’s portfolios.

Another thing to consider: Ask your financial advisor what their payout ratio is. This will usually cause them to stammer and mumble some answers back to you in an attempt to weasel out of answering the question. The reason is this: many wire house advisors only work off of a 35-50% payout grid. Meaning they only earn 35-50 cents on every commission dollar charged to the client. Many regional houses will start someone off at 60-70% and try to keep them below 80-90% for as long as they can. You can see why such advisors, especially young ones, are always looking for the big commission ticket – because they’ve signed a bad deal with their firm and still need to eat. What kind of person would manage people’s money and give half of their earnings away to the broker dealer? That’s ridiculous. Right now I am paid out on a grid that starts at 90½%, and goes as high as 97.5% as my production increases. If I were to open my own RIA firm, that number would be 100%. Stupid people sign stupid deal sheets – these are questions you should be asking to be sure your financial advisor has a good business mind. Make sure he has a high payout, otherwise I’d say he’s either a rookie or an idiot.

RM ~Mar 2011

Simply put, all else being equal, taxes due to the government are directly proportional to the money you’ve made. If you’ve never had to pay taxes on investments, forgiving significant write-offs elsewhere, you’ve never made money in stocks, unless of course we’re talking about qualified retirement accounts, and you will eventually have to pay taxes on those as well. Pay the taxes early and often, so that your desired moves are not hampered by large tax ramifications years down the road. If you hold profits long enough, you begin to think that’s your money. It’s not. Some of it belongs to the government. Would you rather square up with the government every year, or would you rather owe them 15% of a position that has grown 1000% over 20 years, a position that you’ve grown accustomed to thinking of as entirely yours over the years? Do you really want to be required to write a check to the IRS for $180,000 when you’re retired? Of course not. That money has become part of your retirement plan… you count it in your net worth, don’t you? C’mon… do yourself a favor and keep a current tax liability line-item handy to deduct against your net worth, because that money’s not yours.

Wash sale rule – is not so much a factor when dealing with IRAs, since taxable gains are not factored on annual basis, only upon distribution. In taxable accounts, the wash sale rule (simplified) disallows claiming a loss on a security if that security (or a similar one) is re-purchased within 30 days of the sell. This is important to take into account if you would like to use that loss to offset realized gains come tax time. However, while this should be kept in mind, most of the time it is not important since the losses realized under this methodology should be very, very small relative to gains, unless you have been able to hold a ton of winners past a year without getting taken out. And so if you see that you want to buy a stock back after taking a small loss because you were wrong at the onset, chances are, if you are right this time, there is more money to be made buying it back, building a position if it works, and realizing a profit; as opposed to how much would be saved by having that small amount to offset against gains or your taxable income at the end of the year.

Long-term vs. short-term gains. Long term gains are currently taxed at 15%. Short term gains are currently taxed at a level determined by your income tax bracket, and your income will be affected by those short-term gains, as well as any dividends collected. This is considered passive income (as opposed to earned), but you are still taxed on it. In general, when investing in an upward trending market, you want to hold onto your winners and sell your losers. So if a position is close to going long term (the 1 yr mark), you may want to make a judgment call and relax the stops on it, but I would recommend tax considerations on stock moves to be one of the last things you think about. Most of the money made in stocks when being active is made in time periods far less than one year. This outcome is dictated by the rules we have in place to protect profits and limit losses, encouraging continual compounding. So unless everything goes up with only minuscule pullbacks for more than a year, don’t get stuck trying to duck the difference in taxes. Longer term that will put you behind. But you can always use a handy tool called Gains keeper to easily assess your situation, and determine the best thing to do given extraordinary circumstances.

Once again, it’s very simple. If you made money, you’ll owe taxes. If you lost money, you won’t owe taxes, at least on that trade. If you are one of these people that does not want to make a decision because the IRS wants their cut, and this creates anxiety for you, have a nice day and good luck to you.

Gainskeeping software. A common concern for investors is dealing with tax-time worries. They figure that the more often they buy and sell, the more of a pain it will be when tax time comes around. And this is true if they attempt to keep records in a notebook (or Excel) and work solely off of those. Let’s face it; some people are never going to learn to use computers. But times have changed. All broker/dealer firms with any decent kind of technological platform have access to some form of gains keeping software. With my firm, there is a $25 annual charge for this service, and it takes literally no longer than ten minutes per account to run a report and send it out to the client, and this can be done on January 1st. That’s six weeks before most 1099s are sent out. This summarizes net short and long term gain/losses; giving you the number you’ll need to do your taxes. It has cost basis info on both a tax lot and a consolidated basis, and there are itemized trade runs (all buy/sell transactions for the full year.) All other sorts of wonderful stuff that can help you analyze last year’s performance can accompany this summary, complete with totals, so that you don’t even have to do simple addition. Any firm that tries to make you feel bad for needing cost basis info come tax time, or acts like it’s a service that justifies a higher level of compensation all else equal, is quite frankly, full of you-know-what. They’ve already chosen to forego giving you readily available tax analyses way before you receive the 1099, which usually comes in late-February. You could do an analysis of prior year account performance with the New Year only days old! Firms would much rather you have as little information as possible on your account though; this is why monthly or quarterly account statements for a lot of firms don’t have as much information as you would always like to see on there. Employing a long-term strategy in a world of unknowns is a crap shoot; so in the event the investor suffers losses that year, they don’t want the investor to see that, especially when fees and commissions charged can be a line-item for your consideration as well. Gainskeeper software. Use it. It’s a valuable tool.

So spending the first four months of the New Year with inactive capital, waiting for April 15th before making financial decisions, is no longer something you need to do. Keep records on all your other finances, call your accountant early in January and give him your best estimates. I have a great accountant. He spends ten minutes on the phone with me plugging in some numbers, and I know how my tax situation is going to play out weeks before the 1099s start to flow in. I pay him about $350 a year. I don’t know whether that’s high or low for the industry, but spending that $350 is worth it to me. Come April 15th, when everyone else is running around freaking out, my returns have been done for about 6 or 7 weeks, and new, clean dollars have been at work for almost two months. And, when I have something come across my desk in my business that I don’t know the answer to, he advises me at no cost. So get yourself a good accountant and get your taxes done before March hits. Then you have clarity to make decisions early in the year, avoiding yet another dead money trap. Why would you wait until right before May to put money back to work? I don’t “Sell in May and go away” but other investors do, and you might notice this effect if you watch the markets long enough. Not to mention that winter turns to spring right about this time of year, and there’s much more pleasurable things you could be doing in April than your taxes. Keep on top of your tax liability, set aside the government’s share, and keep your money working for you.

RM ~March 2011