By Jason Zweig and Andrea Fuller

Many people seeking a financial adviser begin their search at LetsMakeAPlan.org, a directory operated by the Certified Financial Planner Board of Standards Inc.

The Board, which controls the CFP label coveted by financial planners, boasts of its high standards and has touted its directory of professionals as a place where people can find a screened, skilled and trustworthy financial planner.

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SURGING INDEX FUNDS, FEWER PUBLICLY TRADED STOCKS, COMPUTER-DOMINATED TRADING, WHAT’S IT ALL MEAN FOR INVESTORS?

And here’s the video itself:

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Pension funds, endowments, 401(k) retirement plans and retail investors are flooding into passive investment funds, which run on autopilot by tracking an index. Stock pickers, archetypes of 20th century Wall Street, are being pushed to the margins.

Over the three years ended Aug. 31, investors added nearly $1.3 trillion to passive mutual funds and their brethren—passive exchange-traded funds—while draining more than a quarter trillion from active funds, according to Morningstar Inc.

Advocates of passive funds have long cited their superior performance over time, lower fees and simplicity. Today, that credo has been effectively institutionalized, with government regulators, plaintiffs’ lawyers and performance data pushing investors away from active stock picking.

In developed markets, “the pressure has gotten so great that passive has become the default,” said Philip Bullen, a former chief investment officer at active-management powerhouse Fidelity Investments. He and others say active management can succeed with less widely traded assets.

The upheaval is shaking Wall Street.

Hedge-fund managers, the quintessential active investors, are facing mounting withdrawals as they struggle to justify their fees. Hedge funds, which bet on and against stocks and markets world-wide and generally have higher fees than mutual funds, haven’t outperformed the U.S. stock market as a group since 2008.

Some giants of passive investing, such as Vanguard Group and BlackRock Inc., are attracting lots of money and gaining clout in shareholder votes at public companies.

Although 66% of mutual-fund and exchange-traded-fund assets are still actively invested, Morningstar says, those numbers are down from 84% 10 years ago and are shrinking fast.

Performance is driving the upheaval. Over the decade ended June 30, between 71% and 93% of active U.S. stock mutual funds, depending on the type, have either closed or underperformed the index funds they are trying to beat, according to Morningstar.

Moreover, because matching the performance of stock indexes is far cheaper than trying to beat them, index funds’ expenses are a fraction of what active funds charge—sometimes 1/30th or less. With interest rates near zero, fees stand out more than ever.

There is a downside, according to active-investing advocates. Passive funds are designed only to match the markets, so investors are giving up the chance to outperform them. And if fewer managers are drilling into financial reports to pick the best stocks and avoid the worst—index funds buy stocks blindly—that could eventually undermine the market’s capacity to price shares efficiently.

That isn’t stopping one of the largest migrations of money in history.

“It is time to acknowledge the truth,” said a March shareholder letter from Cohen & Steers Inc., manager of real-estate and other specialized active funds. Stock picking in its current form “is no longer a growth industry.” Active-fund firms that don’t “position themselves for the sea change” will be “relegated to the dustbin of history.”

This month, active manager Janus Capital Group Inc. agreed to sell itself to a British rival to diversify and help compete with lower-cost providers.

Employer-sponsored 401(k)-style retirement plans have 25% of their assets in index funds, up from 19% in 2012, according to investment-consulting firm Callan Associates Inc. Public pension plans had 60% of their U.S. stock allocations in index funds in 2015, up from 38% in 2012, according to research firm Greenwich Associates. At endowments and foundations, the index-fund share rose to 63% from 40% in that time period.

The biggest passive portfolio, Vanguard Total Stock Market Index Fund, now has $469 billion in assets, nearly as much as the four largest active funds combined. Fidelity’s 500 Index fund, at $103 billion, may soon surpass the firm’s largest active portfolio, Contrafund, which holds $108 billion.

Bob Chesner recently converted the $7.5 million 401(k) plan he oversees as chief operating officer of Austin, Texas, law firm Giordani, Swanger, Ripp & Phillips LLP from a lineup of mostly active funds to index funds.

“I was very much a believer in active management,” he said. “I thought markets were inefficient to the point where active management made a difference.”

A few years ago, he noticed that the roughly 40 active funds in the law firm’s menu were recovering from the 2008-09 market meltdown more slowly than their benchmarks and the index funds that track them.

“That’s when it dawned on me that we were not doing something right,” he recalled.

In the spring of 2014, over lunch, Mr. Chesner and the two other members of the retirement plan’s executive committee decided on a change. By going with an all-index-fund lineup, the firm’s employees would save an average of 1.59 percentage points in annual expenses.

“When you look at the fact that people are living longer, that makes a huge difference” in retirement savings, said Mr. Chesner. “It’s almost a no-brainer.”

Lawsuits also are motivating investors to make changes. Over the past decade, Jerome Schlichter, a plaintiffs’ lawyer, has been suing corporations and, more recently, colleges and universities, contending the employers breached their fiduciary duty by allowing unreasonably high fees in their 401(k)-style plans.

Mr. Schlichter’s cases, 40 in the past decade including 15 this year, “are not saying that active management is per se imprudent,” he said. Instead, they put the burden on a plan to show there is a reasonable likelihood an investment will beat the market persistently after fees—“a pretty big burden of proof,” he said, given active management’s costs and record.

Companies and schools have generally defended their plans, calling them generous, well-designed and legal.

The Illinois State Board of Investment, which oversees a $16 billion defined-benefit pension plan and a $4 billion 401(k)-style plan for state workers, voted Sept. 15 to convert the 401(k)-type plan to an all-index-fund lineup.

Board members were motivated mainly by a desire to reduce costs and make investment choices easier to understand.

With index funds, “if you pick up a newspaper and see how the S&P performed, you will know how your portfolio did,” said board Chairman Marc Levine. “They provide perfect transparency.”

The fee lawsuits also influenced the decision, he said. At a recent meeting, the board’s attorney “walked us through the potential liability if there is harm to even a single participant,” he said. “It was quite a wake-up call.”

Board members worried participants are more likely to “chase performance” with active funds by piling into portfolios that shine one year only to lag behind the next, said Mr. Levine, a former investment banker. “If that manager concentrates the investment portfolio and a stock blows up, that’s a potential legal problem for us.”

The Illinois board will shift $2.8 billion from active funds at companies including Fidelity Investments, Invesco Ltd. and T. Rowe Price Group Inc. into index funds managed by Vanguard and Northern Trust Corp. The board expects the switch to reduce fees to 0.09%, from 0.37%.

Fidelity and Invesco declined to comment. T. Rowe Price respects the Illinois board’s decision, said a spokesman, but remains “confident in the value added by our actively managed strategies.”

When Stephen Sexauer, chief investment officer at the San Diego County Employees Retirement Association, took over last year, the public pension fund was paying an average of 1.1% in investment expenses, nearly twice what comparable plans in other California counties paid, without earning better returns, he said.

“You have to ask yourself, ‘If we’re spending all this money on fees, where’s the evidence of success?’ And it’s really hard to find,” he said.

So the plan moved 25% of its assets—$2.5 billion at the time—into index funds charging average fees of .05%.

Mr. Sexauer also placed $100 million in a so-called balanced portfolio of 70% stock index funds and 30% bond index funds. All the plan’s other investments will be pitted, in a kind of tournament, against that portfolio. If they don’t deliver, they will be axed, he said.

The internal index fund “is kind of like Pac-Man,” he said. “If it outperforms over time, eventually a capable administrative assistant might be able to run the entire investment department, and we’d be OK with that.”

“What’s going on is a generational shift,” said John D. Skjervem, 54 years old, chief investment officer of the Oregon State Treasury, which oversees $90 billion in public assets and trust funds. “Guys like me are moving in, and we had education that was empirically more rigorous than the prior generation’s.”

Mr. Skjervem has an M.B.A. from the University of Chicago Booth School of Business, known for teaching that markets are efficient and stock picking is largely a waste of time.

“When you adopt an empirical framework, you expose a lot of storytellers,” he said. “I’m very uncomfortable in the realm of the narrative. I want to listen to the data instead.”

Since Mr. Skjervem joined in 2012, Oregon has shifted about $4 billion out of active funds, or about 15% of the pension plan’s public-equity assets. Eventually, he said, the state may use traditional active management for as little as 20% of its total public stock and bond assets.

Over the past three years, Fidelity, historically renowned for its active management, has launched nearly two-dozen index mutual funds and ETFs, bringing its total passive lineup to approximately 50 funds. Currently 12% of the $2.2 trillion it manages is in index strategies, twice the level five years ago.

Fidelity executives are “trying to help educate the marketplace that there is a difference between all active and good active,” said Tim Cohen, the firm’s head of global equity research. In research released in March, the firm found that among the 25% of all active U.S. large-stock mutual funds with the lowest fees between 1992 and 2015, those from the five largest firms outperformed their benchmarks, on average.

That message hasn’t been an easy sell. “It’s been a tough period for the industry, and flows certainly reflect that,” Mr. Cohen said.

Federal regulations are pressuring investment fees, accelerating the move to indexing, which is an easy way to cut costs. In 2012, the Labor Department started requiring greater fee disclosure in 401(k) plans. The fees on retail mutual funds in large 401(k)s have since fallen by 12%, according to Callan Associates.

In April, the Department of Labor’s new so-called fiduciary rule is scheduled to go into effect. Financial advisers overseeing individual retirement accounts will have to demonstrate that their decisions are in the best interests of their clients, a change that is expected to lead to more fee-based accounts rather than accounts that use commissions with the potential to lure brokers. By using index funds in accounts already bearing an annual fee, brokers can help keep overall costs down.

BlackRock this month said it would lower costs on more than a dozen ETFs in light of the new rule. Morningstar expects the regulation could push as much as $1 trillion into passive investments.

Mr. Bullen, the former Fidelity executive, now manages money for wealthy families and uses a mix of passive and active funds. He also serves on the investment committee of the approximately $480 million endowment of the Whitehead Institute for Biomedical Research at the Massachusetts Institute of Technology.

Though several of the eight committee members are current or former heads of active firms, the committee reached a unanimous decision to cease using active funds for publicly traded securities, according to Mr. Bullen and others.

“The case for passive is being made so well and so clearly,” said Mr. Bullen, “it has become common wisdom.”

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Source: The Wall Street Journal

http://www.wsj.com/articles/the-dying-business-of-picking-stocks-1476714749

Measured before inflation, interest rates have never been so low in so much of the world.

On July 5, the day after the U.S.’s 240th birthday, the yield on 10-year Treasury debt fell below 1.4% for the first time in the nation’s history.

World-wide, $13 trillion in debt is yielding less than zero; in “normal” times, when those bonds might have yielded 3% or so, investors would have earned roughly $400 billion on them annually. Now, investors are spending, rather than earning, tens of billions of dollars a year to hold those bonds—much as you might pay a storage company to keep your heirlooms safe for you.

However, this is far from the first time that interest rates have gone negative—once you account for inflation to measure what economists call “real” rates. Adjusted for changes in the cost of living, the yield on Treasury bills was negative in 18 out of the 27 years between 1933 and 1959. Over the same period, intermediate-term Treasurys had negative real yields in nine years. In the 1940s and again in the 1970s, negative real rates were common world-wide.

Nor is this the first time stocks have hit records amid negative rates. In 1958, short-term Treasury bills yielded minus 0.2% after inflation. Stocks nevertheless rose 43.4% that year to reach what then were all-time highs.

None of this means there is nothing to worry about. Returns on stocks and bonds are almost certain to shrink, and investors all around you are likely to take reckless risks as they become increasingly desperate for income. In a world turned upside down, sanity will be your most valuable asset as an investor.

Today’s yield drought is “unprecedented in our lives and limited experience, but it’s not at all unprecedented in history,” says Thomas Coleman, a former hedge-fund manager who runs the Center for Economic Policy at the University of Chicago’s Harris School of Public Policy. “What’s fundamentally different now is that we have negative real rates without high and unexpected inflation.”

In other words, earning nothing on your bonds isn’t the result of sudden shocks from inflation, as it was in the 1970s. It is the deliberate result of central-bank policies that have failed to produce inflation.

Banks (and governments) in Europe and Asia have kept lending to delinquent debtors in order to avoid marking down the value of their bad loans. That has kept the banks from extending credit to worthwhile borrowers. So the European Central Bank and the Bank of Japan have sharply cut interest rates to “try taxing the banks in a way that induces them to hold less cash and to lend more,” says Carmen Reinhart, an economist at the John F. Kennedy School of Government at Harvard University. Until lenders finally write down the value of their bad debt, she says, the “financial repression” of low interest rates will keep transferring massive amounts of wealth from savers to borrowers.

Rates probably won’t rise until almost no one on earth is expecting them to. When that happens, it will hurt.

Since 1913, U.S. stocks have gained an annual average of 9.3% when interest rates fall, but only 2.3% in periods of rising rates, according to finance researchers Elroy Dimson of Cambridge Judge Business School and Paul Marsh and Mike Staunton of London Business School. Bonds have returned an average of 3.6% annually in periods of falling rates, but only 0.3% when rates rise, the researchers calculate. The results include the effects of inflation.

Nevertheless, even at today’s emaciated yields, bonds remain a powerful hedge against declines in the stock market, says Fran Kinniry, an investment strategist at Vanguard Group.

Treasury bonds rose 1% on June 24, when the British vote to exit the European Union knocked U.S. stocks down almost 4%.

With such slim prospective returns on offer, you will have to lower your expectations and raise the amount you save.

“Investing is always a partnership between you and the markets,” Mr. Kinniry says. In the 1980s and 1990s, when stocks and bonds alike racked up double-digit average returns, the markets did most of the work. “But now you are going to have to be the majority partner,” he says.

In this weird world, if you want to have more money, you will need to save a lot more money.

Source: The Wall Street Journal

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Finding out whether you can make fun of an idea, I argue, is one of the best ways to learn whether you should take it seriously.

Click here to watch the video.

Here are the slides I used in the talk.

Source: Talks at Google, YouTube

https://www.youtube.com/watch?v=OIZ-mPbYPIc

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I had fun talking with Shai Dardashti of The Manual of Ideas about The Devil’s Financial Dictionary. With luck, you’ll enjoy it, too.

The video is in several segments, each about three minutes long.

Click on each link to view.

Part One

Part Two

Part Three

Part Four

Part Five

Source: The Manual of Ideas

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The video, produced by Chris Meyers, is in several segments.

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Part One

Part Two

Part Three

Part Four

Source: The Museum of American Finance

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In their book, a business “phishes” when it exploits the informational and emotional weaknesses of customers in order to sell them goods, services or investments that might be harmful. (Think of cigarettes, gambling, flawed pharmaceuticals such as the withdrawn arthritis drug Vioxx, or complex investments with hidden risks like the mortgage securities that were at the heart of the 2008-2009 financial crisis.) A “phool” is anyone who falls for such phishing.

While some of the argument may seem obvious—surely it isn’t a surprise that some people cheat at least some of the time—“Phishing for Phools” contends that free markets can create fertile opportunities to profit from dishonesty.

Mr. Akerlof is a professor of economics at Georgetown University and the husband of Federal Reserve Chairwoman Janet Yellen; Mr. Shiller, a professor of finance at Yale University and author of Irrational Exuberance. The two discussed the book in a recent interview.

Q: Why do businesses “phish” for “phools”?

Robert Shiller: A fundamental concept of psychology is that people often make decisions they’re not happy about. That’s why people go see therapists! If businesses have a chance to profit by tempting us into making decisions that are good for them but bad for us, they will take it. They have just as powerful an incentive to provide us with what we don’t want as to provide us with what we do want.

Q: What is “reputation mining” and how can it lead to deception?

George Akerlof: Let’s say you have this reputation for selling wonderful avocados. Then you have the opportunity to start selling people awful avocados if that’s more profitable. We think that’s how things [happened] in financial markets [before] the 2008 financial crisis.

RS: Financial markets are a special case because they present, for most people, a very difficult judgment about the future: What is this market going to do? It invites a kind of exploitation of them by storytellers, people who will play tricks on them to get their money to manage. In many cases, they’re more salespeople than market researchers.

Q: Are there different kinds of phools?

RS: An information phool is someone who has been fed a biased set of information so that they then would make erroneous judgments. A psychological phool is someone who is affected by his or her own feelings, emotions and psychological anomalies. Information phools and psychological phools are everywhere, and you might be one of them. We know that we are.

Q: But why isn’t phishing competed away? Why don’t customers do business only with those who treat them fairly?

RS: Often the glitch in your defenses is very subtle and even the phisher doesn’t know exactly how it works. Also, businesses play tricks, and [their] competitors play tricks. Businesses often have tight profit margins. They can’t give money away. So they have to play the same tricks themselves. Professionals develop skills in manipulating people, and there’s a survival of the fittest for them: The very best ones amplify and are everywhere in their impact.

Q: The book argues that incentives will inevitably lead some people to manipulate and cheat others. Doesn’t every five-year-old child learn on the playground that some kids cheat when they trade candy and gum? Doesn’t everybody already know what you’re saying?

GA: Everybody thinks they know it. But people think of manipulation and deception as things that take place on a one-off basis, not as something that’s inevitable. Phishing is as universal as the benevolence of the butcher and the brewer and the baker that Adam Smith talked about.

Q: You ate cat food to research a common way you think consumers may be phished by marketers.

RS: The labels on the cans said things like ‘roast beef paté’; things that we would see in a restaurant. So I said, if they say that, it must be something like that. I tried tasting it, and they all tasted pretty much the same. They tasted like cat food. There is an artificial reality that is created by marketing.

Q: How can investors minimize the risks of being phished for a phool?

GA: They should bear in mind that asset prices reflect the stories being told about those assets. Those stories do not just reflect economic fundamentals; significant parts of them are generated by those whose livelihood depends on making a sale. For this basic reason, financial markets are filled with phishing for phools.

RS: Investors should always remember that a profitable phish is to design investment pitches around their preconceptions. A search of the phrase “stocks have always outperformed” on Google Ngrams shows that the phrase first appeared around the bottom of the market in 1982; its use exploded until the market peak in 2000. Why? Because with a rising market it was advantageous for phishermen to suggest that this up market would continue forever.

Source: WSJ.com

http://www.wsj.com/articles/phishing-for-phools-a-q-a-with-george-akerlof-and-robert-shiller-1442346235

Video interview with Akerlof and Shiller:

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1. Don’t fixate on the news.

The more often you update yourself on the market’s fluctuations, the more volatile and risky it will appear to you — even though short, sharp declines of 5% to 25% are common. The U.S. stock market has, in the past few years, been extraordinarily placid by historical standards. Even the sudden drops of the past few days are well within the long-term norm. Fixating on fluctuations in the short term will make it harder for you to remain focused on your long-term investing goals.

2. Don’t panic.

While stocks are certainly not cheap, they aren’t wildly overpriced, given today’s levels of interest rates and inflation. U.S. stocks are trading at 24.9 times the average of their long-term, inflation-adjusted earnings, according to data from Yale University economist Robert Shiller – down from 27 in February. Over the full sweep of bull and bear markets in the past 30 years, they’ve traded at an average of 23.8 times adjusted earnings.

3. Don’t be complacent.

You should use the latest turbulence as a pretext to ask yourself honestly whether you are prepared to withstand a much worse decline. Did you make it through the epic bear market of 2007-09 without selling all your stocks? Are you extremely well diversified, with plenty of cash, some bonds, and with large and small stocks from markets around the world? Then you can probably weather a further decline. But if you sold in earlier bear markets or you are heavily concentrated in a few stocks or sectors, you should consider raising some cash or diversifying more broadly to protect against the risk that you will take even more drastic action at the worst time.

4. Don’t get hung up on the talk of a “correction.”

A correction is typically defined as a decline in price of 10% on a widely followed index like the S&P 500 or Dow Jones Industrial Average. The term doesn’t have official status, however; until fairly recently, declines of 5% and even 15% or 20% were often called “corrections.” A market decline of 10% has no real significance in and of itself. What matters is the outlook for the future; that doesn’t depend on whether the market is down 10.2% rather than 9.8%.

5. Don’t think you–or anyone else–knows what will happen next.

After a market drop, or at any other time, no one knows what the market will do next. The one thing you can be fairly sure of is that the louder and more forcefully a market pundit voices his certainty about what is going to happen next, the more likely it is that he will turn out to be wrong. Stocks could drop another 10% from here, or another 25% or 50%; they could stay flat; or they could go right back up again. Diversification and patience — and, above all, self-knowledge — are your best weapons against this irreducible uncertainty.

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Because these biological responses are automatic and involuntary, it is vital for investors to put policies in place — in advance — to limit the damage that uncontrollable impulses can do in the heat of the moment. In the Resources listed below, I link to several of the articles I’ve written over the past 15 years about neuroeconomics that suggest rules and procedures investors can follow to minimize the potential for error at the worst possible times.

Click here to watch the video.

Source: CFA Institute Enterprising Investor blog, http://blogs.cfainstitute.org/investor/2015/07/06/some-neuroeconomics-tips-for-improving-investment-decision-making/

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