Last year, hundreds of hedge funds, special mutual funds generally open to wealthy investors which specialize in alternative investments like derivatives, shut down due to the economic crisis. Three of the ten largest hedge funds to close were funds that invested exclusively or almost exclusively in Bernard Madoff’s Ponzi scheme, leaving investors with nothing. While I mention that hedge funds are investment vehicles for the rich and famous, it’s worthwhile to note that you don’t have to be rich to be affected by this. 971 employees in Connecticut, for example, are feeling the same pain wealthy clients like Steven Spielberg and Jeffrey Katzenberg feel because their pension funds were pooled together and invested, much like one wealthy client, in Madoff’s funds.
The lack of diversification played a roll for individual losses. But how much is the fault of the investors? Presumably, the firemen in Fairfield are not given any choices for their pension fund. Also, hedge funds promise or at least imply diversification; this is how investors “hedge” their bets. An investor in a hedge fund would then assume that although the money is held in one and managed by one individual, that individual is sufficiently providing the diversification they promised.
In the case of the feeder funds, the hedge funds invested almost exclusively with Bernie Madoff. This extra middle layer passed the responsibility of diversification on to Madoff, who was never sufficiently clear about his “investments.” Of course, we now know that there was no “investment” and thus no diversification.
How well are your investments diversified? Is it enough for a investors who has weighed risk against potential reward to diversify among stock investments, like large-cap, small-cap, international, etc.? Do you rely on one mutual fund, like an index fund or a target retirement date fund to handle your diversification? Are you diversified into precious metals, and are you satisfied with using exchange traded funds or do you own gold or silver in physical form?
Typical investors can at least trust that a mutual fund in their portfolio does not lie on the prospectus. But when you invest in a hedge fund that is supposedly diversified, how diversified is it?
Three of the largest hedge funds to fail last year, Fairfield Sentry (managed by Fairfield Greenwich Group), Rye Investment Management (managed by Tremont Group Holdings), and Kingate Global Fund (managed by Kingate Management), were Madoff feeder funds, designed to provide access for “smaller” wealthy investors to the exclusive Bernard Madoff. Investors trusted their financial advisers who suggested the invest in these hedge funds. Thse advisers trusted the hedge fund managers who in turn trusted Bernard Madoff, one person, to provide sufficient diversification within his secret “investment” scheme. Or perhaps “trust” isn’t an issue when reputation and the promise of sustainable, high returns is involved.
A Look at the Hedge Funds That Closed, New York Times, March 19, 2009
The New York Post presented an article about David Shorr, a shareholder of Lehman Brothers, who lost $6 million as the company filed for bankruptcy. David spent many years as an employee of Lehman Brothers, building up compensation in the form of stocks which are now worthless.
“What the hell was he thinking?” asked Shorr, who placed much of the blame on the hard-charging executive who has been one of the country’s highest-paid CEOs. When asked if he had any hopes of recovering his nest egg, Shorr just shook his head and waved his hand. “It’s gone,” he said with a sigh.
David Schorr is now a wealth adviser at Morgan Stanley. As a wealth adviser, you would think that he were familiar with the concept of diversification. While the CEO of Lehman Brothers may not have guided the company through the financial mess, as an investor, David has a responsibility to his future self to maintain an asset allocation that isn’t exposed to any one company.
It’s a lesson that many former Enron shareholders may have learned.
Diversification isn’t a guarantee; for example, if American International Group (AIG) had been allowed to fail, the global markets could have tanked, destroying even better-diversified accounts. But diversification limits your exposure to any one company, so it is less likely to lose your entire life savings due to a singular event.
In my 401(k), my employer matches a portion of my contributions, and a portion of that match is in the form of company stock. Every once in a while, I sell that stock and rebalance the allocation among mutual funds to limit my exposure to my company’s performance. Since my salary and benefits are also tied to my company, the less company stock I rely on, the better.
I will admit that I haven’t limited my company stock as much as I should. The last time I diversified out of company stock was over a year ago when the stock was at its highest point; its value, like that of other financial companies but to a smaller extent, has dropped since then.
I Lost $6M Overnight!, Braden Keil, New York Post, September 16, 2008
A researcher at Central Michigan University surveyed 600 finance professors at major universities to determine their investment philosophies, practices, and the differerences between the two. You would think that those involved in higher education, teaching about market analysis, options and futures, and discounted cash flow analysis, would use these techniques when handling their own investments.
Apparently, most don’t.
About two-thirds of the professors, in fact, have the bulk of their assets in index funds, the low-cost baskets that essentially own the entire market. These academics more or less practice the basic lesson of modern portfolio theory: Diversification is the key to holding down your risk and maximizing your returns. That leaves a third who have gone astray, however.
So what about the remaining third? Surely these professors analyze the details of every stock they own and will know before buying the relevant information to determine the company’s chance of increasing its value. Again, this group of professors ignores their own advice as well, preferring to make purchasing decisions on recent performance. That is, they chase the hot stocks, too.
Of the portion of professors who believe in the “efficient market hypothesis,” which says that a stock’s price already takes all information into account, about 25% still believe they can beat the market by timing its fluctuations. They believe that the market cannot be timed — unless by them.
I don’t expect all professors to follow their own advice at all times. After all, they’re training their students to be finance professionals, fund managers, and analysts. In many cases, the professors are not finance professionals, they are professors. They’re not paid for their trading skills, they’re employed for their teaching skills.
What Really Matters When Buying and Selling Stocks? [James Doran and Colbrin Wright]
Don’t try to invest like the pros [Money Magazine]
Ben Stein has been making the rounds through the media in support of National Retirement Planning Week, a celebration of preparedness. He recently met with Terri Cullen from the Wall Street Journal and sat down for a quick interview.
Ben shared his opinion regarding the three biggest mistakes people often make in regards to the topic of the day.
Mistake #1: Not Starting Early Enough. Ben says the government should require auto-enrollment in 401(k) or 403(b) retirement plans, with an optional opt-out clause. He also suggests that teens with part-time jobs while going to school should have the self-discipline to save a small portion of their earnings ($10, $20, or $25 a week or month) into a retirement plan such as an IRA. The small savings will not dent today’s enjoyment of life, but the magic of compounding will do wonders for your quality of life by the time you’re 65. Start saving later, and it’s much more difficult to catch up.
Mistake #2. Not Being Diversified. Ben Stein’s advice is to diversify your investments among a number of different spectra: company size (large cap vs. small cap), company objective (value vs. growth), location (domestic vs. international), and level of market development (emerging markets vs. developed). I haven’t focused too deeply on some of these dimensions. He’s not a fan of target date funds because of the inclusion of bonds. He feels bonds are basically useless investments, especially if money markets are providing similar returns without the risk. Ben’s worried about terrorism or hyper-inflation, which would mean bad news for bonds.
Mistake #3. Not Curbing Your Spending. Lao Tsu said, “There is no catastrophe worse than lavish desires.” Ben admits this is his main mistake — it required constant effort to keep up with his lavish lifestyle. He has eight houses. Even he admits that is too much for one person. Is excessive spending overlooked as a threat to solid retirement? When it comes to spending in the present time, it comes down to a matter of personal choice. As long as one is educated so he understands that spending $x now will mean he will have $x · 1.08n where n is the number of years until retirement (assuming an 8% annual growth rate), he should be allowed to make that decision and not criticized. However, if expenses are accelerating at a higher rate then income, there will be danger ahead.
View Terri Cullen’s interview with Ben Stein here, after sitting through a commercial.
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