The Wrong Bet. This Isn't Investing.

Investing: laying out money or capital in an enterprise with the expectation of profit.

Gambling: any behavior involving risking money or valuables (making a wager or placing a stake) on the outcome of a game, contest, or other event in which the outcome of that activity depends partially or totally upon chance or upon one's ability to do something.

It's interesting how we can get our vocabulary all confused. Consider the revelation by Robert "Bo" Collins of MotherRock LP (a hedge fund ) that it was closing down after making the wrong bet on the direction of natural gas prices. Investors were told they were unlikely to get any of their money back (See: "Hedge Fund Takes Huge Losses On Bad Natural Gas Bet," WSJ, 9/18/06).

So, my question is: did the investors in MotherRock believe that Bo was investing their money or betting with their money? I'd be curious to know more about the "investors." Certainly, they were more substantial than the average Joe Lunchbox who isn't at all confused between making a 401(k) investment and buying a lottery ticket. No, these were likely folks of above-average wealth. Which then begs the question: why did they feel the need to take the risk associated with giving their money to Bo to bet on natural gas prices?

My definition of investing assumes a person has a financial objective or goal in mind. He or she is then willing to take just enough risk to meet that financial objective -- and no more. The name of the game is to maximize returns while minimizing risk.

Investors who gamble are a lot like those who participate in extreme sports. It's about maximizing risk. The risk is the thrill. The more exteme the risk the more the thrill. In neither case should the participant be surprised when the word 'demise' is used in connection with their name.

My theory on risky behavior is confirmed by a new study from U.C. Berkeley's Haas School of Business entitled "Power, Optimism, and Risk-Taking." Quoted in an article ("Power Tied to Risky Behavior, Study Says," Contra Costa Times, 9/19/06), one of the study's authors said:

"There seems to be this link between rising to an incredibly powerful position and engaging in incredibly risky behavior."

"We looked to a psychological theory that when people possess power, a lot of power, sometimes unmitigated power, they become blinded to the kind of risk involved in certain behaviors."

"They become more focused on the potential upside. They become optimistic that the risk can pay off."

Watch for more news in the weeks as more bad betting comes to light.

The Missing Questions

One of the professional publications I semi-regularly read is Financial Planning. A little news item in the August 2006 issue caught my attention. A company that regularly surveys and researches the investment industry asked advisers how they choose the mutual funds they use. I looked down the list of responses to compare how I would have answered such a survey. The factor cited by most respondents as extremely important (59%) or somewhat important (39%) was whether the fund had a consistent style of investing. Sure. I can buy that. I proceeded to look down the list of other factors. What struck me were the factors that were missing. Not mentioned was whether the fund had a sufficiently high front-end load. I’m sure a number of advisers (using the term in a liberal fashion) count that high on their list. More importantly, also missing was whether the fund had low expenses (low expense ratio and low portfolio turnover). Low costs to my clients are very high on my list of important factors. Yet, this factor was completely absent from the survey. It wasn’t even a write-in candidate.

Any smart investor faced with the choice of Fund A or Fund B that are the same in all respects other than annual costs will choose the fund with the lower cost. Why? Because they learned in first grade that a 1.0% annual cost means 1.0% less goes into your pocket. Compound that over a lot of years and you come up with a significant number. Costs do matter – whether advisers consider them important or not.

4,000 Financial Plans a Month!

A recent Investment News article (“Vanguard Creating 4,000 Plan per Month,” 9/5/06) revealed that the Vanguard Group is churning out financial plans at a clip of about 4,000 per month. Just think of all of the paper. But, more importantly, how are they able to meet that with that many clients, help them consider and establish their long-term financial and non-financial goals, review their investment holdings and savings vehicles, assess their risk profile, and implement an appropriate diversified investment strategy? And, what about the periodic ongoing meetings to review and refine the whole financial plan and integrate risk planning (insurance), tax planning, and estate planning? The answer is that they can’t possibly provide meaningful planning advice of this magnitude.

You see, Vanguard and a lot of other advisors (and those who pretend to be advisors) see the planning process as mainly about numbers. And, often those numbers are the ones that move to their pockets from their clients’ pockets. But, even if we’re talking about a client’s financial numbers, real planning is more than just printing out a ream of charts, figures, and projections on a one-time basis. Real planning is a consultative approach that fleshes out what’s really important to a person – long-term goals, circumstances, hopes, and fears. Those issues become the basis for planning one’s financial future. Any resulting charts, figures, and projections are only a part of the roadmap to achieving what’s important. And, the roadmap is but a snapshot in time. Because goals, circumstances, hopes, and fears are ever-changing, so must one’s planning adapt to those changes. The roadmap needs to be regularly consulted, adjusted, and re-oriented. Planning is not a static, one-time event. It is a process.

Churn out 4,000 plans a month? I’ll settle for ten meaningful new planning encounters per month. And, many trees will be saved in the process.

Roth IRAs for Everyone

For a number of years I’ve advised clients against nondeductible IRAs. As a quick review, nondeductible IRAs are for folks with incomes too high to be eligible for regular deductible IRAs or Roth IRAs. Nondeductible IRAs offer no upfront tax deduction, but the earnings and growth of the IRA are taxable when withdrawn. And, that’s why I haven’t liked them. Assuming you’re not doing a lot of trading in your IRA, most of the IRA’s growth will be in appreciation. Outside of an IRA that appreciation gets taxed at low capital gain rates. However, if distributed from an IRA the appreciation gets whacked with the higher ordinary income tax rates. I just haven’t believed the tax deferral of the IRA overcomes the higher tax rates upon withdrawal.

Congress has recently (Tax Increase Prevention and Reconciliation Act of 2005, passed in May 2006) changed my mind. Beginning in 2010 anyone, no matter the income level, can convert a regular IRA or nondeductible IRA to a Roth IRA. The hitch? You have to pay the tax either at the time of conversion or 50% in each of the years 2011 and 2012. So, why do I think this is a good idea? I figure just about everyone under age 60 (and some those over age 60 also) should have a Roth IRA. The problem is that most of my clients have been locked out of Roth IRAs due to the income limit. Now they can have a Roth IRA by funding a nondeductible IRA for 2006-2009 and then converting to a Roth in 2010. The tax shouldn’t be too oppressive since only the earnings and growth will be taxable. And, there’s the special two-year tax spread.

I’ve never had an IRA (for the above reasons). Count me in for 2006.