Moved to www.peoplesfinancialadvisor.com/personalfinance

Please go to www.peoplesfinancialadvisor.com/personalfinance to read my newest posts.

Thank you

Rebuilding Trust in Financial Markets and Advisors

While on a New York media tour for our new company, Peoples Financial Advisor,  I heard one question more frequently than any other: “What are you doing to rebuild people’s trust?”  At the time,  financial reporters were losing their jobs because trust was in very short supply. 

Trust is the foundation of all business, including the advertising dollars that support media.  Without human trust, a modern economy cannot exist and capital markets cannot function.   Money itself is an invention of human trust.  Whether it’s in the form of clay tablets, coins or plastic credit cards,  money is nothing more than a “promise to pay” and belief in the promise.   So I don’t think the problem is public trust.  The economy is still functioning and as far as I can tell everyone is still using money. We are by nature an optimistic people.  We want to trust our government, financial institutions and advisors.  

But we’ve just learned that we’re never more vulnerable than when we trust.  Misplaced trust created the economic bubble.  The loss of almost twenty trillion dollars or 40% of personal wealth is a measure of our financial vulnerability when we, the public, misplace our trust.  I personally think the new found skepticism is healthy.  I believe the personal losses in our real estate and financial portfolios were the “price” of a valuable lesson for all of us.

So what am I doing to rebuild trust?  From 16 years of counselling and building non-profit organizations I learned that the way to win trust from others is to focus on being trustworthy.   I want Wall Street to spend fifty billion dollars a year on becoming trustworthy instead of  advertising to win trust.   I want the media to acknowledge it has the same conflict as the cigarette industry.  I want the financial media to post warnings that it cannot survive if it doesn’t arouse emotions and sell copy and “this advice may be hazardous to your financial health.”  I want regulatory reform to require an authentic fiduciary standard of care for anyone offering financial or investment advice to the public.

As for individual investors, what were our expectations before the collapse?   Were they reasonable?   Did I expect for-profit  financial institutions and advisors who sell products to put my interests ahead of profits and compensation?   Did I believe that I or my advisor could beat the market by looking into the future to pick winners and avoid losses?   What lesson will we learn from our losses?   Will we blame advisors, the media, politicians,  financial institutions or capital markets?   Will we learn not to trust anyone or anything?   Will we return to the days of putting our money in the mattress and not asking anyone for advice or help?    If so, we may be setting ourselves up for more disappointment.    

It’s true, we are never more vulnerable than when we trust, especially when it comes to money and love.  But it’s also true that if we never trust we will never experience financial freedom or rewarding relationships.   Perhaps some of us just need to rebuild our trust in ourselves.  Everyone has the ability to learn.  Everyone has the ability to make better financial decisions.   Trust me on this.

Someone once said broken trust is like a glass vase.  You can glue it back together, but it will never be the same.  I agree to a point.  If people learn from their losses,  their trust will be reinforced with wisdom.

How to Avoid Being “Madoffed”

The simplest and best way to protect your investments from advisor fraud, is don’t give the advisor opportunity.  In other words, don’t give him custody of your assets.   Don’t give your advisor power to buy and sell securities without your permission.  Give him a limited power of attorney to execute trades with your signed permission only.   Don’t authorize your advisor to pay himself (deduct his fee) out of your account.    Ask for an invoice and pay the fee with your credit card or a check.    The more control you give the advisor over your money, the greater the risk of being defrauded.

If keeping control creates too much work for you, then at the bare minimum require the advisor to use an independent financial institution to hold your investments.   Such an institution is called a custodian because it provides custodial services for advisors and their clients.  An independent custodian gives you an extra layer of protection because it, not the advisor,  generates the reports and values your assets.    You should be very nervous if the only report you receive is the one prepared by your advisor or a custodian controlled by our advisor.

If the independent custodian is not a well-known name like Schwab, TDAmeritrade or Fidelity, you will have to do some additional background checking.   Get the firm’s name and contact information.   Call and ask for evidence that  custodial services are provided to other advisors.   Request copies of reports from an independent auditor.  Visit the physical office.  I’ve read that Bernie Madoff’s custodian had a small office in a remote location, with just a couple employees and no independent auditor.   Do a Google search and check the yellow pages.   Verify to your satisfaction that the custodian is truly independent and trustworthy.

Finally, I believe you can greatly reduce the risk of being defrauded by abandoning the strategy of active management altogether.  There is no evidence that an active money manager can beat the market.   Read the all time best seller ”A Random Walk Down Wall Street” by Professor Burton Malkiel or  ”Winning the Loser’s Game” by Charles Ellis.    I can’t prove it, but I suspect that most, if not all the Ponzi schemes and acts of fraud were committed by advisors who believed they could beat the market, even after subtracting their expenses.   An advisor who sells his ability to predict the future (ie. pick winners and losers) has created almost impossible expectations (and pressure) for himself and his investment performance.

Don’t Turn Down Free Money!

One key to building wealth is “Don’t turn down free money!”  When you maximize contributions to your qualified retirement plans you accept free money from three sources:

1)      The taxes you normally owe the government,

2)      The interest earned on the government’s tax dollars which are now inside your retirement plan and

3)      The interest earned on the interest.

By maximizing your pre-tax contributions you accept the government’s “free” money, build wealth faster and are able to retire sooner.

Let’s assume you are married with a household income of $48,000/year, and you are my neighbor in Colorado.  Let’s also assume you are contributing 6.25% of your salary or $3,000 annually to your 401(k) plan.  Should you increase your contribution by $1,800/year to get to the lifelong minimum savings rate of 10%?

If you are in the 15% federal tax bracket, you are paying an unnecessary $350 in federal and state taxes, by not contributing the additional $1,800.  In other words, Uncle Sam and the State of Colorado will reduce your taxes by $350 if you will put an additional $1,800 into your retirement plan.  That’s an instant 19.4% return on your savings.

In reality you are only putting $1,450 of your own money into your retirement plan because the additional $350 is the taxes you would have to pay Uncle Sam and the state if you did not defer your income.  Sometimes, I call this $350 in deferred taxes the “government match”.  It’s as if our government is paying you $350 to motivate you to save $1,450 of your own money.  Isn’t this a great country?

In the table below we have calculated the value of this “free money” ($350/year tax savings) invested in a conservative portfolio of stocks and bonds* over 1-, 10- and 20- year time periods.  The table assumes you remain in the same tax bracket every year.

Tax savings each year	$350
Tax savings + earnings after 1st year (*)	$380
Added wealth after 10 years (*)	$5,430
Added wealth after 20 years (*)	$16,830

(*) Annual return 8%, average fund operating expenses 0.3%.

There’s an additional bonus.  Money in qualified retirement plans is protected from creditors by federal law (ERISA).  Even though OJ Simpson was convicted of murder in civil court, the judge could not use OJ’s NFL pension money to pay the monetary damages he awarded to the victims’ families.  Is it any wonder that many experts call Qualified Retirement Plans the “World’s Best Tax Shelter”?  Maximizing contributions to your qualified retirement plans is the fastest way to build wealth that can’t be taken from you by creditors.

Check your own “free money” numbers at:  http://www.peoplesfinancialadvisor.com/financial_checkup.php