I was enjoying my Sunday morning coffee and paper a few weeks ago when I came across an article in the Boston Globe titled, “Warren’s Consumer Dream Dismantled.” The story was about how the Consumer Financial Protection Bureau (CFPB), under new Director Mick Mulvaney, was switching their focus from enforcement of rules and penalizing fraudulent financial institutions to educating those institutions on how not to screw their customers. Besides that last little jab I’ll leave the politics aside, but my interpretation of this Boston Globe article was that our government is going to keep the status quo: (1) Give you complete freedom….including the freedom to be coerced into terrible financial decisions by the entity looking to gain from said terrible decisions; and (2) create laws that technically protect people but lay the responsibility for that protection at the feet of often uninformed persons, again enabling the financial institutions to reap massive reward at your expense. In the case of your 401(k) plan those persons entrusted with protecting you are your plan fiduciaries. Spoiler alert: in many cases, especially with small and medium sized businesses, your fiduciaries do not know their responsibilities and even if they did they do not have the education or knowledge to be making sound financial decisions for you. We need to fix that and I’m going to show you how by first identifying who your plan fiduciary is and then the steps to take to enact changes in your plan.
Thousands of years ago one of your ancient ancestors was enjoying the spoils of a recent hunting trip when suddenly a saber toothed tiger jumped out of the bush. Your cave man relative had a choice, fight off the tiger or drop the food and run. They ran….and they ran fast. The human brain is an amazing thing, it has evolved over the eons to help us survive. Most of those eons involved surviving physical threats where flight over fight was often the smart choice.
The financial “threats” we face in the 21st century are diametrically opposed to the physical threats of ancient times. Stock market crashes, unlike hungry saber toothed tigers, often present opportunities as opposed to imminent death. My very simple example here downplays the complex neurobiology of the human brain that drives us to make poor financial decisions, but the end result is the same: humans are hardwired to be poor investors.
Corrosion is the slow decay of metallic materials that, over a long period of time, can lead to catastrophic failure of a structure. Investment fees act in a similar nature, slowly and constantly eating away at your returns and severely damaging your potential to buy that house, put your kids through college or retire when you want. The good news is that, like an engineer dealing with corrosion, you can avoid the damage if you make smart decisions to protect yourself.
“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.” -Warren Buffett
In 1952 a guy named Harry Markowitz introduced something known as Modern Portfolio Theory (MPT). Harry won a Nobel prize for his work which mathematically showed how and why risk and return for an individual asset should not be viewed on its own, but on how that asset impacts the overall risk and return of a portfolio of assets. My prior blog post on asset allocation explains the basic mechanics of how different asset classes can impact the risk and return of a portfolio. In this post we will dive a little deeper to show how the efficient frontier is constructed.
With investing, we all know that if you want to play it safe you buy bonds and that if you want more return and can stomach the risk you buy stocks. But what if I told you that there is a way to have your cake and eat it to, to have less risk AND more return. Normally if you hear this kind of claim from someone I would advise you to run from them and run fast. But in this case I think you should hear me out because engineering a portfolio comprised of the right mix of different asset classes can help you travel on the efficient frontier all the way to the bank.