The Taylor Frigon Advisor: Back to the old drawing board!

Back in January, we published a post in which we noted that "financial advisors" and other intermediaries were "reeling" and that they (and their clients) were probably at a point at which "they know that something needs to change, but they have not been equipped to know exactly what."

Now comes a story in today's Wall Street Journal confirming our assertions from that earlier post, and providing examples and quotations from intermediaries who are trying all kinds of new ideas in the wake of 2008, from leveraged ETFs to managed futures to computer algorithms designed to tell them when to get into and out of the market.

As the old saying goes, they have decided to say, "Back to the drawing board!" (a reference to an old pre-computer technology called a "drawing board," shown above). One wonders how many times they have said this before, and how many more times they will go "back to the drawing board" in the future.

We have previously pointed out that this kind of inconsistent investment philosophy -- this willingness to completely re-work the entire system of what principles govern where and how to invest -- is a common feature in the modern financial landscape, dominated as it is by intermediaries who do not actually manage money themselves but instead spend their time evaluating third party managers and telling their clients when to switch from one manager to another.

In fact, in January of 2008 we wrote a post entitled "Can your advisor answer this question?" in which we noted the deleterious results that such activities can have on investor returns over a twenty-year period. We believe that data from numerous studies showing poor long-term investment performance by investors should be linked to this kind of "back to the drawing board" behavior by their "advisors."

The Journal story referenced above also fails to point out that the kinds of "alternative investments" that advisors mention in the article, such as "currencies or managed futures that they believe will rise when stocks fall", are exactly the kind of "diversification" that caused catastrophic problems for many investors in 2008, as we noted in this post from November. That post also linked to a Journal article, entitled "No place to hide," which revealed that following the advice of "investment pros" who recommended moving into foreign funds, currency bets against the dollar, and commodity speculation during the first half of 2008 had resulted in many investors doing far worse than even the plunging U.S. equity markets by the second half of the year.

Another misconception in the article is that jumping in and out of markets is "actively managing clients' money" (see the third paragraph from the end of the article) and that anything else is a form of "buy-and-hold." Both of these assertions are incorrect.

Active management is a term used to distinguish between following a "passive" or index-based approach, and an approach based on the belief that one can find companies that will outperform the broader market over time (see for example the discussion in this previous blog post). "Buy-and-hold," on the other hand, is one form of investing that does not try to time markets, but by no means the only form. While we do not believe in timing market cycles, we also do not believe in holding a single company forever, the way "buy-and-hold" advocates might. The subtleties of that distinction are explored in a post we published entitled "Remaining calm without being blind or obstinate."

The article also notes that some advisors are turning to computer models to help them time market cycles, saying "We trust the computer." We would point out that such "black box" methods, in which an investor relies upon a computer algorithm to tell him when to buy or sell a stock, or when to get into or out of the market, are directly related to the kind of financial engineering and trust in computer models that helped cause the financial sector's disastrous meltdown in the first place, as we explained in "Beware of the witch doctors of modern finance."

We do believe that the events of 2008 should cause investors and advisors alike to consider going "back to the drawing board" and rethinking their entire approach to investing. However, it is clear that many are gravitating towards the same ideas that have been repudiated by the events of the past year.

Instead, we would offer a return to the kind of investing that was much more common prior to the dramatic spread of "modern portfolio theory" after 1974. We recommend investors think about investing as providing capital to businesses -- a concept which is entirely absent from the article referenced above.

Doing so is the best way to go "back to the drawing board" and to design a foundation for investing that will stand the test of time.

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For later posts on this same topic, see also: