Slate's Bizbox
wall street self-defense: How to understand Wall Street.

The Wall Street Self-Defense Manual, Part 1What you won't learn from your broker.

By Henry Blodget
Posted Tuesday, July 20, 2004, at 7:03 PM ET
Illustration by Robert Neubecker

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

Recommended Allocation

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

Total

9.1 percent

100.0 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"?

Print This ArticlePRINTDiscuss this in The FrayDISCUSSEmail to a FriendE-MAIL
Share on FacebookPost to MySpace!Share with MixxDigg ThisShare with RedditShare with del.icio.usShare with FurlShare with Ma.gnolia.comShare with SphereShare with Stumble Upon
Henry Blodget is the editor of Silicon Alley Insider.
Illustration by Robert Neubecker.
Join the Fray: our reader discussion forum
What did you think of this article?
POST A MESSAGE | READ MESSAGES

Remarks from the Fray:

Of particular interest was the asset allocation and the assumptions of returns. I was pleased to see a reasonable asset allocation although I would not identify this as "low risk". True low risk would require less allocation into stocks and more allocation into T-bills -- but that is a bit of a nit though it does point out that the meaning of "low" may not be universal.

While any one of the assumptions on returns could be hit or exceeded there is no way all of them could be hit or exceeded. In fact, the only one in our current environment that appeared reasonable was International stocks. And, what kind of message does this send.

Lastly, forget about trying to pick individual stocks. The average investor would do much better by selecting an Index fund that is tied to one of the major indicies. If you want a reason for this look no further than the performance of Warren Buffett's Berkshire-Hathaway over the last half-dozen years.

Shucks, given these parameters, there is little reason to even use a full service broker. Common sense goes a long ways in determining asset allocation and purchasing an Index fund certainly doesn't require full service research and strategic investment planning. Indeed, Jack Grubman's "full service" research gave "full service" a bad name.

--DallasNE

(To reply, click here)


Having been a wirehouse broker for 12 years, in my opinion, most financial plans are boilerplate and not worth the paper they're written on. Most average retail investors, be they retirees, corporate executives, widows, or professionals do not understand that Wall Street is a sales bazaar, no matter what fancy titles are given to their "advisors." Financial Consultant, Financial or Investment Advisor, Vice-President, Senior Vice-President, Investment or Retirement Planner, etc. are all euphemisms for salesperson. In my experience most folks pay way too much in fees and do not stay fully invested for long enough periods of time in order to mitigate market risk and realize the hope of positive returns. These are very uncertain times and one should be especially vigilant when investing. A viable strategy for many is a type of fixed annuity called an Equity-Indexed annuity. These guarantee principal, some minimum return, and the upside potential of a portion of the S&P 500, and they cost nothing. Since there are no management, or admin. fees, you will not be "advised" at the brokerage firm to buy this product because the firm does not derive an on-going fee income from them.

--Brkr

(To reply, click here)


Well, when I compute the return using the initial asset allocation, I get 8.823%. Clicking on the footnote on the 9.1% claimed return, I see that to get that number, you effectively change the asset allocation over time, letting higher returning assets grow to a larger proportion of your portfolio.

Given that, I think a more fair description of this asset allocation scheme would describe the distribution of assets *at the time the portfolio is returning 9.1%*. It would also be interesting to see what the asset allocation distributions look like at the *end* of this period. After all, if the portion of your portfolio that's going into stocks grows a significant amount, you've got a higher risk profile than the initial #s indicate.

--PghMike

(To reply, click here)

(7/21)

Washington Post
The Washington Post
OPINIONS
Topic A: Obama's Speech
| Pundits and diplomats respond.
Robinson: Sunshine in BerlinToles: Obama the UniterTelnaes: Meanwhile, McCain
PLUS » Stumped: Bring Back Bill Clinton