Talking Stocks with 5th Graders at Matt Elementary School

This morning I met with Mrs. Carnaroli’s 5th graders at Matt Elementary School in Cumming, GA.  They are learning about investing and the stock market by competing against each other, and thousands of other students in Georgia and across the country, in a stock-picking contest called the Stock Market Game.  They are given an imaginary account with $100,000 to invest as they see fit.  They decide what stocks they like, make the simulated trades, and the team that makes the most money during the eight week period wins.

The students are very smart and very competitive.  They asked a lot of challenging questions.  The most surprising questions I received pertained to the Great Depression.   I didn’t expect to be discussing economic history with 5th graders!  (And the answer, in case you’re wondering, is “No Virginia, this is not another Great Depression”).  The one question, every team asked me was, “What stock is going to do the best between now and April 17 (which is when the competition ends)”.  To which, I replied, “I have no idea what a particular stock is going to do in the next five minutes, but I am very confident concerning its five year outlook.”

I think the Stock Market Game is a marvelous exercise.  It helps youngsters to think analytically and critically, it tests their decision-making skills, it gives them an opportunity to negotiate with others and develop an investment policy as a team. It also gives them instant feedback on their decisions. This is probably one of the most interesting periods in stock market history to be participating in this competition. 

Here are some suggestions I made to Mrs. Carnaroli’s students:

1. The way you get money to invest is to spend less than you earn.  If you don’t save money, you will not be an investor.  All other lessons regarding investing rest on this one foundational pillar.

2. Diversify.  This protects against long-term losses and reduces volatility.  I explained that investing was like a baseball game.  One asset will be hitting a homerun, another will strike out, and a few others will make it to base.  Over the long-term (in my example 9 innings) you only need to hit singles to win the baseball game.  Of course, the nature of their competition is very short-term (the equivalent of half an inning) and much more speculative than a typical investor’s strategy might be.  They were interested in hitting home runs, not singles.

3. Buy companies that you know and like (i.e. you are familiar with the products they sell), that are profitable, and that trade at a reasonable valuation.  Apple was a very popular holding with the students, as well it should be.

The Stock Market Game ends in three weeks.  It is a great introduction to how the stock market works.   My only criticism of the game is that it treats investing like a homerun derby rather than a long-term disciplined process.  However, I recognize that students need to start somewhere and this is a great experience for them.  They are learning a lot and they are really enjoying themselves.  

What would be really fascinating is if the students revisited how their portfolios have done in one year, three years and five years from now.  That would be the most valuable lesson they could learn from this competition.

Life Goes On

Turmoil in the real estate and financial markets has taken a massive toll on our balance sheets and on our peace of mind.  Investor sentiment hit a forty year low towards the end of February.  Thankfully, we’ve seen an improvement in sentiment and a significant market rebound in March.  The reason the market is rebounding is that it is getting a better understanding of what the rules are and what it can expect from Washington, although visibility is still impaired.  There is more cash on the sidelines right now than there has ever been in the history of Western Civilization.  All we need is a catalyst and that money will pour out of money market funds and into real estate, stocks and bonds (all of which are cheap). 

Most of our clients are retired.  For retirees, the market volatility has been very stressful.  It’s caused many to cut back on their spending and re-evaluate their lifestyles.  But it hasn’t caused their lives to come to a complete stop.  They’re still as active as ever.  They have grandchildren being born, graduations and weddings.  Some are still taking trips. In recent months, our clients have been to Italy, the U.S. Virgin Islands, and all over the United States.  We have a family that is going to the Calgary Stampede in July.

This behavior personifies the “Life Goes On” thesis that will lead to improving investor sentiment and the eventual healing of our economy.  We’re still going to buy the essentials (whatever we deem those to be), we’re still going to make college tuition payments, and we’re still going to take family vacations.  And within reason, we should.

There comes a point where we have to look  fear in the face, accept the hand that we’ve been dealt, and move on with our lives.  That doesn’t mean that there isn’t uncertainty regarding the short-term future, but over the long-term, the picture is good.  Markets don’t boom or crash forever.  Eventually the pendulum swings back the other way.

The pendulum (i.e. the economic cycle) never stops moving.  We’ve been in a bear market since October of 2007 and we’re much nearer the end than we are the beginning.  The stock market will rise significantly before we know for certain that the recession is over.  If GDP growth gradually improves and becomes positive in the first quarter of 2010 (as Fed Chairman Bernanke has hypothesized), we are likely to see the market rally several quarters before that, which makes a market rebound in the next six months likely.  Remember, the stock market is a forward-looking indicator.

I believe we’re at the point in the market cycle now where people are making choices based on long-term hope rather than short-term fear.  We’re still going to see some spectacular short-term gyrations.  But the long-term destination of asset values will be much higher than they are today.

How to Avoid Your Own “Madoff Moment”

There are five fundamental issues that all investors should understand about their financial advisors and the companies that employ them. I call them the five “C’s”:

1. Character

The most important aspect of an advisor-client relationship is character. Who can we trust? It’s the most critical and the hardest trait to judge in choosing a financial advisor.

Father Todd Belardi, LC, is the Formation Director of the Boy’s School at Pinecrest Academy, a private Catholic school in Cumming, GA that was recently honored as one of the “Top 50 Catholic High Schools” in the country. He is responsible for the integral formation of the boys, so I thought he would have a unique perspective on assessing character.

Father Belardi defines character as “an ensemble of virtues, or the capacity to choose wisely as a matter of habit.” He considers the following aspects in assessing character:

- The presence of a spiritual life
- Family life and priorities: is the person a good husband and dad?
- Genuineness: do they put the interests of other before their own? Is he hard working? Does he have a strong will? Is he faithful to his word? Does he do what he says he’ll do? Does he serve in the community?

Most people choose to trust someone simply because they like them. I fall into that category. I like just about everyone that I meet. But merely liking someone is not a good enough reason to trust them with your life savings.

2. Competency

What skill set does the advisor bring to the table? Most advisors begin their careers as insurance salesmen and then branch out into financial planning as their experience broadens. Initially their careers are product sales driven. If they survive that stage of their career they move into giving financial advice. Anyone can call themselves a “financial advisor”.

The Certified Financial Planner (CFP) license is the benchmark for financial planning compentency in the United States. CFP licensees have met rigorous educational requirements and have taken an oath to act in their client’s best interests. This is also known as a fiduciary oath. A fiduciary is legally, ethically, and morally obligated to put the client’s interests before his own. Many product sales oriented advisors are not held to that standard.

3. Compensation

What is the advisor incentivized to do? Is he paid a commission to sell a product, a fee for giving financial advice, or a fee for managing portfolios (or a combination of the above).

Many professionals that hold themselves out as financial advisors are actually selling insurance products (life and annuities being the most popular – because they are the most lucrative for the product seller). I’m not suggesting selling insurance is a bad profession. It’s a great profession and I know some awesome agents. But there is a conflict of interest when an agent can win a trip to Maui if you put your life savings in a certain product. I met a couple whose former advisor sold them a variable annuity to place in their charitable remainder trust so the insurance salesperson could win a trip. Unfortunately, it was not the right product for their needs. That’s the downside to product-focused advice.

I’m a member of the National Association of Personal Financial Advisors (NAPFA), the nation’s leading organization dedicated to the advancement of Fee-Only comprehensive personal financial planning. It’s made up of like-minded Certified Financial Planners that are client focused rather than product focused. This removes the conflicts of interest that plague the product-driven financial industry.

4. Chemistry

Shared values are a very important aspect of chemistry. I married my bride because we have the same values (and she’s smart and beautiful). Consequently we get along very well because I know where she’s coming from and she knows where I’m coming from.

In an advisory capacity, I’m working with families that have similar values to mine. It allows me to give them the best advice possible to accomplish their goals.

Communication and rapport are also critical to the success of any relationship.

5. Custodian

Trust but verify!!!

The safest place to keep your assets are in brokerage accounts with the big custodians. I use Charles Schwab for our client’s accounts. There are tons of reputable custodians out there (Fidelity, Vanguard, TD Amertrade, etc.). I like the big third-party custodians because clients can view their accounts online and the custodians send them a monthly statement. When a trade happens, clients get a trade confirmation explaining what it is that was purchased and at what price.

I avoid limited partnerships like the black plague. I’m not a big fan of them because the limited partners have no control or say over their money or the terms in which they can get it back. They are also less stringently regulated and have less transparency. Many speculative investment managers use these vehicles for this reason. Hedge funds are commonly limited partnerships as are energy investments (0il and gas drillers are the most common). Obviously, I’m not saying that all hedge funds and all oil and gas investments are bad. Some are quite profitable. But I’m not investing my clients’ money in them.

Another reason I avoid limited partnerships is because they are effective vehicles for perpertuating fraud. Ponzi schemes are easily implemented through limited partnerships. The vast majority of limited partnerships are run by ethical general partners, but the downside to being a limited partner outweighs the benefits for my clients.

Write checks out to the custodian directly, never to the advisor or his firm.  I’ve had dozens of people write checks to me or Dogwood Capital Management only to tell them, “No, you’ve got to make the check payable to ‘Schwab’” with your account number on it.” In Madoff’s case, his investors were writing checks to his firm which was responsible for the fraudulent reporting that enabled him to do what he did.

Accounts should be registered in your name or the name of your trust (however you manage your finances). If you have your assets in a pooled account (like a limited partneship), you do not have easy access to your funds.

These five “C’s” can be very helpful in assessing whom you are entrusting your life savings with and can go a long way towards preventing an investor from experiencing his own “Madoff moment”.