Microreview of Financial Engines

Kevin Mercadante has a great review of Financial Engines on the Investor Junkie site. Here’s the key points I took away:

Founded in 1996, Financial Engines is a retirement plan advisory service for employees of participating employer retirement plans (which many online advisors work outside of).

They provide management services and advice so that either they can manage your plan, or you can do it yourself but armed with their information and input.

The service is made available through your employer plan, which is to say that it’s offered as an additional benefit — or in this case, a benefit within a benefit.

A very few employers make the service available to their staffs free of charge, but the range is between 0.20% and 0.60% of the value of your retirement portfolio, with the average being “just below 0.40%”. Based on the average, the cost on a $100,000 401(k) plan would be just below $400 per year. This is the fee you will pay to Financial Engines while using their service. It does not include administrative fees paid to your account administrator, or transactions costs to trade and maintain securities and funds. As far as account minimums, there are none.

Services:

Analyze your retirement plan saving options

Consider expense ratios, sales loads, asset turnover, transaction costs, management style of individual fund investments, among other services

Provide you with a Progress Report showing your account balance, the potential value of your account when you retire, and the adjustments they’ve made to reflect your situation and market conditions

As you approach retirement, you get detailed Retirement Checkups with expert advisor representatives who can help you stay on track

Their Social Security Planner is a tool that can show you how to maximize your income from that source.

Key Points from an Interview with Dr. Harry Moskowitz

aka the father of modern portfolio theory

“Perhaps the most important job of a financial advisor is to get their clients in the right place on the efficient frontier in their portfolios,” he told me. “But their No. 2 job, a very close second, is to create portfolios that their clients are comfortable with. Advisors can create the best portfolios in the world, but they won’t really matter if the clients don’t stay in them.”

In other words, MPT and behavioral economics have to work together. And Moskowitz figured that out early…

“There was a big difference in my views about how and why to use mean variance analysis (that’s academic-speak for MPT) in my 1952 paper and in my ’59 paper. In the ’52 paper the only portfolio constraints I was concerned about were to avoid negative returns. But by 1959, I was concerned about [how investors would react to] the portfolio construction: For the comfort of the clients, we put constraints on ‘risky sounding stuff,’ such as junk bonds, etc. We knew that might dampen returns, but it was better than if they chicken out in a down market.”

From an interview with Bob Clark.

Key Points from “Investor Behavior: The Psychology of Financial Planning and Investing”

“Policy-Based Financial Planning: Decision Rules for a Changing World” by Dave Yeske, managing director, and Elisa Buie, CEO of Yeske Buie. Based on their 2011 paper, Yeske and Buie provided a six-step process for creating effective financial planning policies for each client:

  1. Engage in the discovery process in which the financial planner learns about the client’s personal history, values, beliefs, goals and resources.
  2. Identify planning areas and best practices required by this client.
  3. Combine goals with best practices to create a proposed policy.
  4. Test the policy: Is this a good policy?
  5. Test-drive the policy with the client and listen to their feedback.
  6. Conduct periodic reviews and updates checking for changing circumstances.

“Advising the Behavioral Investor: Lessons from the Real World” by Gregg Fisher, founder of Gerstein Fisher. “While he cited common investor mistakes such as failing to rebalance, chasing yield and underestimating the impact of inflation, he also explored the less talked about failure to consider a client’s income stream as an asset; one that requires at least as much—if not more—offsetting diversification than their other holdings.”

“His unconventional approach is also evident in the considerable body of research he cited debunking the advantage of dollar-cost averaging versus lump-sum investments. Fisher suggested that “sub-optimal” investment strategies can also be the best investment strategies. “Instead of debating [whether MPT or behavioral finance strategies are better], an investment advisor should borrow from both. The result will be an investment portfolio and strategy that may be suboptimal from an MPT standpoint, but may be the right approach for the investors. In other words, sometimes ‘the right portfolio’ isn’t the right portfolio.”

He used an example that shows how “based on information about a client, as well as experience with other clients in similar situations, an advisor might conclude that this client would panic and sell equities at a major loss at the market bottom. As a financial advisor, the best case may be to recommend that this investor pay off their mortgage and student loans before investing in risky assets. Again, no financial optimizer would recommend this strategy.”

“Post-Crisis Investor Behavior: Experience Matters,” by Joseph Rizzi, president of Macro Strategies LLC. “The financial crisis of 2008-2009 with its 50% drop in stock market value is seared into the collective investor memory—especially generation Y investors,” he wrote. “[Younger] investors are more focused on reacting to macro developments than asset fundamentals. The shift from ‘return on capital’ to ‘return of capital’ underlies the move away from equities into perceived lower risk fixed income by certain investor groups.”

See also this interview with Harry Markowitz

* I haven’t read this book yet. I’m summarizing this book review. I do this so when I want to know more about this topic and find this post I know which book I should go to for more.

Note to Self: Resist Accepting Millions of Dollars

Something to keep in mind just in case someone ever wants to throw several million my way…

I still don’t think you should raise as much as you can, for several reasons, but I’ll just highlight the most important. You will spend what you raise. If you raise $10 million, you will quickly ramp up to a burn rate of $800k a month, because the investors don’t want their money to sit in a bank account earning interest with 36 months of runway while you hire employees 2 and 3. The amount of money you raise sets you off on a course at a specific pace. Your board will want to know why you aren’t deploying capital. You will hire a marketing team because you can afford to hire a marketing team. You will hire a vp of sales before the product is ready because you can afford to hire a VP of sales. Companies that raise $10 million dollar A rounds don’t raise $5 million dollar B rounds, they raise $30 million dollar B rounds. If you have not accurately predicted how quickly you can grow the top line, you will quickly find that the cap table has gotten away from you, and you will have less flexibility to build the company the way you might like to if the market zigs when you thought it would zag. You want to give yourself the flexibility and room to react to market forces so that you can build the best company possible.

Cumulative Advantage

Duncan Watts summed up an experience on cumulative advantage this week in the NY Times, based on the article ($) of a year ago in Science. It’s of importance to anyone in the position of publisher, having to try and select which of many candidates to invest in, as well as anyone scratching their head wondering why Justin Timberlake is so popular.

In our study, published last year in Science, more than 14,000 participants registered at our Web site, Music Lab (www.musiclab.columbia.edu), and were asked to listen to, rate and, if they chose, download songs by bands they had never heard of. Some of the participants saw only the names of the songs and bands, while others also saw how many times the songs had been downloaded by previous participants. This second group — in what we called the “social influence” condition — was further split into eight parallel “worlds” such that participants could see the prior downloads of people only in their own world. We didn’t manipulate any of these rankings — all the artists in all the worlds started out identically, with zero downloads — but because the different worlds were kept separate, they subsequently evolved independently of one another.

This setup let us test the possibility of prediction in two very direct ways. First, if people know what they like regardless of what they think other people like, the most successful songs should draw about the same amount of the total market share in both the independent and social-influence conditions — that is, hits shouldn’t be any bigger just because the people downloading them know what other people downloaded. And second, the very same songs — the “best” ones — should become hits in all social-influence worlds.

What we found, however, was exactly the opposite. In all the social-influence worlds, the most popular songs were much more popular (and the least popular songs were less popular) than in the independent condition. At the same time, however, the particular songs that became hits were different in different worlds, just as cumulative-advantage theory would predict. Introducing social influence into human decision making, in other words, didn’t just make the hits bigger; it also made them more unpredictable.

Venture Capital Lacking Exit Opportunities

The VC bloggers have been discussing alternate funding models for a while, but this story from the New York Times on Sevin Rosen Funds giving back $250 million to $300 million to investors is more than just punditry, it’s walking the talk…

“If we really believe that there are fundamental structural problems in the venture industry, should we raise our fund and just hope that the problems will get better?” the firm wrote. The answer was no.

Prosperity vs. freedom in China

The recent Frontline documentary on China, The Tank Man, set a striking contrast of the 1989 Tiananmen Square protests against the business and economic boom created since then. They describe this flow one to the other as an unspoken social contract between the government and the people: we’ll give you jobs and prosperity if you accept the status quo on social freedoms. And yet they also point out the rapid growth in protests throughout the country. Is this a contradiction? Is the government just buying time?

Apple’s R&D investment – too low or too high?

Innovation has nothing to do with how many R&D dollars you have. When Apple came up with the Mac, IBM was spending at least 100 times more on R&D. It’s not about money. It’s about the people you have, how you’re led, and how much you get it.
— Steve Jobs, Fortune, Nov. 9, 1998

This Street.com story on Apple’s under-investment in R&D has been making the rounds with the exclamation that more money does not equal more innovation. As a principle, I agree with that, and in fact it’s one of MIG’s axioms that “innovation is not expensive”. But by this we mean you can’t simply throw money at the problem, you have to tap into the capabilities of people. That said, money — especially to a hardware company with proprietary software — doesn’t hurt, and it’s worth looking more deeply into Apple’s situation to understand what’s going on.

  1. The Street article compares the most recent R&D spending as a percentage of sales (“While sales have grown at a compounded annual rate of 27% over the last four years, R&D spending has grown at an average rate of just 5.6% per year over that period.“). This masks the exponential increase in recent sales (65% net sales in Q4 2005). Since innovation is a function of how people work, scaling R&D simply to match sales could be futile and possibly harmful as an organizational development change. Just because accounting usually measures R&D as a percentage of sales doesn’t mean it should be managed that way.
  2. In absolute terms, Apple’s R&D investment is up $59 million in Q4 2005 over Q4 2004. For all we know this might be a good, sustainable R&D investment rate for them.
  3. The IDC analyst quoted in The Street article of course doesn’t know the reasons for the drop in R&D investment (nor do I). The article does mention an equally plausible theory is that Apple is learning how to be more innovative with less money, e.g. through management innovation that ultimately leads to other kinds of innovation. And isn’t doing more (sales) with less (R&D investment) a good thing?
  4. The comparison to other companies in Apple’s industry is a good idea, but the comparison is restricted to R&D as a percentage of sales. It ignores the effectiveness of that R&D investment vs. other factors and the directionality of the R&D-to-sales relationship. Just consider where, with regard to new markets, Apple is heading and where Sony is heading.
  5. Where the article really misses the point, IMHO, is by saying, “But even with all of Apple’s market and business prowess, the company is still, fundamentally, a technology company.” It may not be in the IT analysts’ interest to say so, but the nature of R&D investment is changing (at least in Apple’s industry) from solving tough technical problems to solving tough design problems.
  6. Finally, it’s ironic that analysts who have historically criticized Apple’s returns now criticize their frugality! I tend to think the traditional IT analysts will always find a way to not love warm, fuzzy Apple.

When everyone realizes Apple faces more design than technology issues, analysts will start to ask how much companies are spending on R&D of people rather than R&D of technology.

Krugman’s Rules for Research

Paul Krugman, Princeton economist and New York Times columnist, has some interesting small pieces on his site, like How I Work which includes his Rules for Research…

  1. Listen to the Gentiles, Pay attention to what intelligent people are saying, even if they do not have your customs or speak your analytical language.
  2. Question the question, In general, if people in a field have bogged down on questions that seem very hard, it is a good idea to ask whether they are really working on the right questions. Often some other question is not only easier to answer but actually more interesting!
  3. Dare to be silly, What I believe is that the age of creative silliness is not past. Virtue, as an economic theorist, does not consist in squeezing the last drop of blood out of assumptions that have come to seem natural because they have been used in a few hundred earlier papers. If a new set of assumptions seems to yield a valuable set of insights, then never mind if they seem strange.
  4. Simplify, simplify, The strategy is: always try to express your ideas in the simplest possible model. The act of stripping down to this minimalist model will force you to get to the essence of what you are trying to say (and will also make obvious to you those situations in which you actually have nothing to say).

U.S. jobs aren’t shorter, but they are riskier

James Surowiecki’s Lifers reviews some statistics and concludes that — contrary to popular belief — long-term employment in the U.S. hasn’t disappeared at all. But what has changed is the amount of risk employees are expected to shoulder in terms of…

  1. Benefits: Health benefits and pensions have decreased
  2. Stratification:Companies now tie compensation more closely to performance, so that people at the top take home much more, relative to their colleagues, than did the high-fliers of thirty-five years ago.
  3. Unemployment:People who are unemployed stay unemployed, on average, about fifty per cent longer now than they did in the seventies, and only about half as many receive unemployment insurance as did so in 1947.

Yale political scientist Jacob Hacker has called this “the great risk shift.

Gross National Happiness

Perhaps a better framing of the Index of Sustainable Economic Welfare (ISEW) is GNH: Gross National Happiness. Jigme Singye Wangchuck, king of the Himalayan nation of Bhutan, says GNH consists of “economic self-reliance, a pristine environment, the preservation and promotion of Bhutan’s culture, and good governance in the form of a democracy.

On a related note, I just returned from Italy where the Slow Food movement has morphed into Slow Cities, an emphasis on local sourcing and less harried lifestyle. Spreading to other parts of Europe, the media reported the conflict between the desire for slower cities and the perceived need to compete with countries like China and India.

The Economist reassures us that manufacturing jobs shifting to the east is natural, and that those are actually less safe, less desirable jobs. The “rich nations” will provide more services, which are difficult to export. And…

People always resist change, yet sustained growth relies on a continuous shift in resources to more efficient use. In 1820, for example, 70% of American workers were in agriculture; today 2% are. If all those workers had remained tilling the land, America would now be a lot poorer.

An approach for working in China: Economics

Given the destructive human rights situation in China, how do we decide to interact with companies there? I don’t think no action is a choice; the sheer amount of influence the Western world and China exerts on each other through commerce alone makes it impossible for any one person or company to remain unaffected.

Free marketers like the Cato Institute argue that “America should not play the dangerous game of pitting human rights activists against free traders. American prosperity and global prosperity are better served by open markets than by well-intended economic sanctions.” But this does nothing to address the human rights problems, and we know that ‘all it takes for evil to triumph is for good men to do nothing.

And there’s no doubt we should be careful about it, as even seemingly innocuous efforts like Yahoo!’s can draw undesirable attention.

One option is to exert pressure politically. The U.S. government is already doing this to a limited extent. But given we cooperated much less with the communist Soviet Union and apartheid-ridden South Africa, it’s surprising we cooperate so much with communist, oppressive China. Politicians could use this issue in order to embarrass opponents for their cow-towing China-friendly behavior, but given the reflexivity of the dollar that’s a long shot. A subtle variation on this would be to embarrass anyone not willing to reduce our debt because it’s handing control of our economy to Asia, which in turn will give us more leverage with Asia on issues like human rights.

Index of Sustainable Economic Welfare (ISEW)

I was exposed to the ISEW by Josephine Green of Philips at the ID Design Strategy conference. She struck me as the female John Thakara: highly intelligent and morally scolding, and dropping in your lap the challenge of solving the problems she just convinced you are vitally important.

To understand how ISEW differs from, say, measuring GDP, first look at them graphed together:

graph showing GDP going up and ISEW going up then down

Then read the description:

The ISEW is one of the most advanced attempts to create an indicator of economic welfare. It is an attempt to measure the portion of economic activity which delivers genuine increases in our quality of life – in one sense ‘quality’ economic activity. For example, it makes a subtraction for air pollution caused by economic activity, and makes an addition to count unpaid household labour — such as cleaning or child-minding. It also covers areas such as income inequality, other environmental damage, and depletion of environmental assets.

And hear how the proponents respond to criticism:

Some commentators say that the use of such ‘non-statistical’ judgements invalidates the utility of ISEW. However, this is even more of a problem for GDP when it is used as an indicator of progress — for its own value judgement is that these adjustments be set at zero.

In the past you might have gotten traction with a name like ISEW, but I’d like to see it reframed — possibly with the help of the Longview Institute — into an idea progressive political candidates can run on. For now, we can all start chipping away at the use of GDP.