Markets Are Efficient

I would like to thank Greg Phelps for today’s article about Efficient Markets.  Greg Phelps, CFP®, CLU®, AIF®, AAMS® is a 20+ year industry veteran.  His firm Redrock Wealth Management provides fee only fiduciary financial advice and retirement planning to clients in the Las Vegas area.


In 1965 Eugene Francis “Gene” Fama, (CEO of Dimensional Fund Advisors and Nobel laureate in Economics), proposed the core concepts of market efficiency. This concept can reduce your investment risk and help ensure you achieve the performance your financial plan requires.

Gene was the first to introduce the efficient market hypothesis. The concept is so simple it doesn’t take a financial genius to understand it. I’m actually shocked most investors – and Wall Street – doesn’t understand it.

I suppose there’s probably a good reason Wall Street doesn’t “get it”. Wall Street want’s you think they own the “secret sauce” to investing. If investing was easy (as EMH makes it) you wouldn’t need Wall Street’s overpaid analysts telling you what to invest in. They’d lose revenue, so Wall Street needs you to need them!

EMH doesn’t make headlines, and it’s not fun or sexy. In fact, EMH is just plain boring. But boring is good sometimes, boring is effective.

What is the “efficient market hypothesis?”guy-computer-investing

There are two types of investing “styles”, active investing and passive investing. If you believe in the efficient market hypothesis, you’re a “passive investor”. If you believe markets are inefficient, and you can outpace other investors by good security selection and/or market timing, you’re an “active investor”.

In my own words, here is the efficient market hypothesis:

A security is worth the highest price a buyer will pay and the lowest price a seller will accept at all times. Since information is available to the masses at the speed of the internet, current prices and future expectations are judged by all investors equally. Therefore you cannot buy an “undervalued” asset or sell an “overvalued” asset; hence you cannot “beat the market” consistently or predictably by trading individual securities.

 [1]Source: Eugene F. Fama, Market efficiency, long-term returns, and behavioral finance. Journal of Financial Economics, Vol. 49, Issue 3, September 1998, pages 283 – 306.

Simply put, there is no secret sauce to investing. A security is worth what it’s trading for at any given moment.

If securities are always fairly valued, is it possible to beat the market? Is it possible to know which one will outperform the next?

No, it’s not. Not according to EMH anyway. Of course, statistically speaking some managers and traders will always beat the benchmark indexes. By default, some must beat the index or no one would invest in anything but the indexes.

That being said, beating the benchmark index isn’t much more than luck. Throw enough darts at a dartboard, and eventually you’ll hit a bullseye!

The best price is the current price

When my boys were young, my wife and I spent an awful lot of time at local parks.  Every once in a while the boys would want to go running after the ice cream truck.

ice cream

Let’s say a milkshake was about $2.00, and a Creamsicle® maybe $1.25. Ice cream cones were the cheapest at $1.00, and a snow cone about $1.50.

Market forces set those prices. We trust market forces set efficient prices everyday. The price is always the most a buyer will pay, and the least a seller will sell for.

If milkshake sales struggle, you’ll likely see a drop in the price. If the ice cream truck driver keeps running out of ice cream cones, you’ll likely see the price of ice cream cones rise to maintain inventory and increase profits.

Prices are determined by supply and demand, i.e. market forces. Stocks, bonds, and every other investment are no different. Your house isn’t any different either, it’s only worth what a buyer with cash in hand will pay on any give day.

The collective wisdom of the masses

Millions of investors and managers are constantly analyzing and trading securities around the clock. They each have their own opinions on what direction a security is headed. Up, down, sideways? They all “think” they know.

For every buyer who thinks a stock or bond is going up, there’s a seller on the other side of the trade who thinks it’s going down. Who’s right… you or him?

For every overpaid highly educated analyst at your brokerage firm, there’s an equally overpaid highly educated analyst at your neighbor’s brokerage firm. Whose analyst is right… yours or his?

You’re not right; your analyst isn’t either. Your neighbor isn’t, and the magazines aren’t. In fact no one is right, but the collective thoughts of the masses are! Marbles

Have you ever been to a fair where they ask you to guess the number of marbles (or beans or pennies) in a jar? If you’re the closest to the correct number you win a prize.

As it turns out it’s not the smartest guesser that’s usually closest; it’s the average of all guesses that’s closest. This is called swarm intelligence 2, and it simply states that masses of average intelligence are better than any individual’s intelligence.
Many studies have been done on swarm intelligence. In 2008 researchers did a study at the Max Liebermann Haus of the Stiftung Brandenburger Tor (in Berlin, Germany). They had a jar with 569 marbles in it and participants were asked to guess how many marbles were in the jar. Out of 2,057 guesses the average guess was 554. It’s pretty amazing how close the masses were to the correct number of marbles.

Swarm intelligence shows that in a large group, the average of all guesses is most accurate, not the “smartest” guy’s guess. So I ask you, if there are masses of investors pricing stocks, bonds, and ice cream every second – what makes you think you’re right and they’re wrong?

[2] 2011 The Association for the Study of Animal Behaviour; Swarm intelligence in humans: diversity can trump ability; Stefan Krause, Richard James, Jolyon J. Faria, Graeme D. Ruxton, Jens Krause.

The upcoming election is no different

Recently, I’ve had many many investors saying “the markets will tank if Trump is elected”. The funny part is for every investor making that claim, the next client comes in and says “the markets will tank if Hillary is elected”.

So who’s right? Client A or Client B? The stock and bond markets are where they are right now based on all available information. Securities are priced fairly at all times based on knowledge and expectations for the future.

What’s even more curious is the Brexit vote. Masses of investors expected it to fail. Very few thought it would pass. Polling showed it would not pass as well.

When Brexit passed, the markets tanked – for a minute! It’s the old “buy on rumors, sell on news” theory. Investors bid up a stock in anticipation of upcoming earnings reports. Typically, no matter how good the news it the stock will sell off after reporting.

I suspect like Brexit, the stock market will drop no matter who is elected President. I also suspect it will be a short term blip on it’s permanent march towards higher long term prices.

Is there a secret sauce to investing?

You’re not smarter than the markets. I’m not smarter. Fortunately, no one else is either! Statistically however, some do get lucky. You must understand that “luck” is not “skill”.

Of course you don’t know what corporate insiders know. You don’t have inside information that would make buying a stock cheap – or selling a stock high – possible. If you did and acted on it you’d be on a fast-track to jail!

Aside from inside information, a stock is always worth what it’s trading for. The same goes for bonds, or your house, and every other investment. They’re worth what someone will pay and what the counterparty will accept based on all available information on any given day – not a penny more or less.

To reiterate, you cannot “beat the market”. I realize you’ve been told for years through slick ads and entertaining TV shows that you, or your advisor/manager, could pick the best stocks, or buy the best bonds. This is the great lie of the financial media.

And what exactly are the best stocks or bonds anyway? Do they beat the market? Do they have the highest return or the lowest risk? Maybe the highest dividend or interest rate?

The fact is the best stocks or bonds are all the stocks or bonds in an asset class because asset classes outperform the best and brightest investment managers far more often than not. Just take a quick look at the SPIVA Scorecards. They clearly show that the majority of indexes beat active managers. Over long periods of time, the percentage of managers losing to the index increases.

Since all information is available worldwide at internet speed, every security is fairly valued and markets are efficient. Since markets are efficient, you cannot beat the market consistently or predictably, therefore there’s no point in taking the risk of trading individual securities.

So what does this mean to you and your financial planning?

When it comes to your finances, the most important thing you need to do first is have a plan! Planning trumps all investment opportunities, because failing to plan is planning to fail (Benjamin Franklin).

Aside from quality financial planning, like my colleague Dave Fernandez at Wealth Engineering does, investing should be looked at as a tool to execute your plan. While the tool is important, the plan is critical.

Since all the stats show index investing beats active investing, become and index minded investor first. Thereafter, you can search for ways to tilt and tweak indexes to improve returns. Mutual funds by Dimensional Fund Advisors are a good place to start!



401(k) Options When You Leave Your Employer


Regardless if you are retiring or moving to a new employer, once you leave your current job you will need to decide what to do with your 401(k). You have a handful of choices. I have outlined the benefits and disadvantages of each option below. Your personal circumstances may favor one option over the other. I highly recommend you discuss your options with your fee only financial advisor whenever you transition employment so he/she can help you determine which pathway provides the best choice for your unique financial situation.

1) If you have a balance of $5,000 or greater you can likely leave it in your current plan as most 401(k)’s provide a deferral option.

a) This is the easiest decision and likely no action is required on your part. Although, I am always amazed how many investors choose this default option when there are better choices as described below.

a) Every 401(k) plan has its own unique set of investment options. Your current plan may have a limited choice of investment options such as being overly U.S. centric. We live in a global economy and I believe portfolios should provide a decent amount of international options on both the stock and bond side of investment choices.
b) Many 401(k)’s have incredibly high internal expenses. It is not uncommon to see mutual fund choices with expense ratios north of 1.5%. It is very important to keep an eye on your overall investment expense exposure. The more you can lower your investment expenses, the higher probability you can keep returns compounding for your long-term financial benefit.

Be aware that if your balance is less than $5,000, you will want to take action on one of the below choices as your employer may have the option to automatically cash your 401(k) account out or transfer you to an IRA. Cashing your 401(k) account out can have large tax consequences as outlined later in this article.

2) Rollover your balance to your new employer’s 401(k) plan.

a) This is a good way to consolidate financial assets, especially if you have more than one 401(k) from past employment. I always favor consolidation and simplification where possible.
b) This could be a great choice if you have an excellent set of diversified investment options that are low cost.

a) It is not uncommon for your benefits department at work to occasionally choose a new custodian or a new set of investment options in your 401(k) every few years. You have less control in this situation as you are forced to invest in whatever options are provided. What may look great today could easily change unexpectedly.
b) Your new 401(k) may have poor investment choices, and/or investment options with high expenses.

Most 401(k) rollovers are initiated from the 401(k) you are leaving. Your human resources department or benefits office may require that you fill out a termination/rollover packet of paperwork. Some 401(k) custodians may take direction over the phone. Collectively you and your fee-only financial planner can determine what is the next step to move forward and he/she can help with completing any necessary paperwork.

3) Rollover your 401(k) to an IRA

a) This is typically my favored option. Once you set up an IRA you have the whole investment universe of options to invest in. This could be mutual funds, ETFs or stocks. It is easy to build a well-diversified portfolio when you have such a wide array of investment options to choose from.
b) You have control over your money. You can always move your IRA to another investment custodian if you prefer a change of investment options.
c) You will have control over investment expenses. There are a number of low cost investment options available via no-load mutual funds and ETFs at a number of investment custodians.

a) If you are still working, you may end up with one extra investment account in a separate IRA. This is a minor disadvantage. The benefits of investment selection and cost control provided with rolling your 401(k) to an IRA easily outweigh the disadvantage.

4) Cash out your 401(k)

a) None, other than liquidity if you are in a situation desperate for cash.

a) This is typically the worst decision you can make as any balance withdrawn is a taxable withdrawal. Your 401(k) custodian is required to withhold 20% in federal taxes, but your tax exposure could be higher depending on your marginal tax bracket.
b) You will owe state income taxes on the withdrawal if you live in a state that taxes income.
c) If you are under age 59 ½ you would also be subject to a 10% early withdrawal penalty.
d) If you have an outstanding 401(k) loan balance, the loan would also become a taxable event and be subject to the taxes and penalties described above.
e) You will miss out on any future tax-deferred compounded growth by cashing out your 401(k) today.

There are a couple of other scenarios to be aware of before deciding on one of the above choices:

1) What if you have a loan balance against your 401(k)?
a. You typically have 60 days to pay back a 401(k) loan after leaving employment. After 60 days, your loan balance will likely be considered a taxable distribution and you will be subject to taxes and possibly a 10% early withdrawal penalty if you are under 59 ½ years old.

2) What if you have greatly appreciated employer stock in your 401(k)?
a. You may have a tax preference option called Net Unrealized Appreciation or NUA which allows you to transfer the stock out of the 401(k) and pay ordinary income taxes on the cost basis and capital gains taxes on the gains.  You will want to review this option in detail with your financial advisor and CPA prior to making any decisions.

In closing, I highly recommend you notify your financial advisor of any employment changes which could impact your 401(k) options.  Once he/she is aware of your options, they can help you determine what the best course of action is for your personal financial situation.  Your financial planner can also join in a conference call with your benefits department and/or 401(k) custodian to make sure you both understand all of your options and what steps are required to move forward.

How Do I Choose A Financial Advisor?

We believe that when choosing a financial advisor you should consider the following attributes:

1. Choose a financial advisor that is also a Certified Financial Planner (CFP®). This is considered the premier designation in the financial industry. A financial planner with this designation has passed a 10 hour board certified exam, has 3 plus years of financial planning experience and has an undergraduate degree. The curriculum for a Certified Financial Planner is based on comprehensive financial planning including many disciplines such as: investment planning, retirement planning, tax planning, insurance planning, estate planning and college planning.

2. Seek a Registered Financial Advisor that operates under a Fiduciary Standard vs. the brokerage industry’s suitability laws. A Fiduciary Standard is the highest legal standard of care available in the industry. See our article regarding “What is a Fiduciary and Why Does it Matter” for more information.

3. You should seek a financial planner that is compensated in a fee-only manner vs. one who sells financial products, insurance or annuities for commissions. See our article titled “What is the difference between Fee-Only versus Fee-Based?”, for more information on financial advisor compensation systems.

4. Choose someone experienced with clients similar to your type of financial situation.  Ask the advisor what their typical client is like, profession, total assets, life situation, advice needed, etc…

5. A financial advisor should be independent and not affiliated with any particular company or financial products. An independent financial planner has the ability to recommend what is in your best interest, not that which provides them with the highest commission.

6. Keep interviewing advisors until you find one that you feel you can trust. Hiring a financial advisor is a big decision and your financial future is at stake. Your relationship with your advisor should be based on trust and comfort.

7. Ask for a copy of your financial planner’s code of ethics to ensure their interests are the same as yours.

8. Beware of any promises made regarding performance or statements made regarding the ability to greatly outperform markets.

9. Ask your advisor if they are willing to put their fee structure, recommendations and any disclosures in writing. If not, that should raise a concern.

What is a Fiduciary and Why Does it Matter?

You may be reading this article if you are looking for a financial advisor but not quite sure which one to choose or what issues to consider before hiring one. A good starting point is to determine if your potential financial advisor is working under a fiduciary standard and legally bound to act in your best interest, or if he/she is working under a suitability standard, which is considered a lower standard of care.

Fiduciary standard of care versus suitability standard of care

The words “fiduciary” and “suitability” may be new to you, so let me provide you with an overview of each term as it relates to your investments and overall financial well-being.

Core ValuesIn the financial advice industry, the fiduciary standard is considered the highest level of care a financial advisor or financial planner can operate under. Under the fiduciary standard, your financial advisor has a duty of loyalty and care to you, is required to legally act in your best interest, and must put your financial interests above his or her own. This is similar to the same legal level of care you would expect from your doctor, lawyer or CPA. In addition, if there are any conflicts of interest, they must be disclosed in writing, along with any fees or compensation.

The fiduciary standard is aligned with Registered Investment Advisors (RIAs) who are licensed under the SEC or in their state of business. RIAs are governed under the Investment Advisors Act of 1940.

In contrast to the fiduciary standard, the suitability standard means a financial advisor can provide advice and financial products that are considered suitable for you based on a basic understanding of your financial situation. One of the key defining differences in this definition is that “suitable” means there could be better investment options, but what is being recommended to you meets a suitable or reasonable solution. For example, the financial advisor may have access to investment options that are lower cost, better diversified or pay a smaller commission to the advisor, but the advisor could choose to recommend the investment option that pays him or her a higher commission as long as the investment product was deemed suitable for your financial situation. I think you can see the potential conflicts of interest that could exist in such a scenario. Whereas the fiduciary standard requires that a financial advisor eliminate any conflict of interest, or at least disclose any conflict of interest in writing, the suitability standard has no such requirement.

Commonly financial advisors that are aligned with a broker-dealer and practice under the suitability standard are stock brokers, insurance agents or may work at a bank. They are licensed under a different governing body called FINRA.

How do I determine if my financial advisor is acting under a fiduciary standard or a suitability standard?

  1. The easiest way is to ask them directly. Will you be acting under a fiduciary standard of care and are you willing to put that in writing?
  2. Are you a Registered Investment Advisor (RIA)? Can I see your form ADV? The form ADV is the regulatory document under the SEC or their state of business that provides an overview of their RIA firm, services to be provided, fee structure and discloses any typical conflicts of interest.
  3. Another option is to ask them what types of securities licenses they hold. A financial advisor providing advice as a fiduciary is licensed as an RIA under the Series 65 license. A registered representative selling financial products under a suitability standard is typically licensed under a Series 7 (stock broker’s license) and/or Series 6 (mutual fund and variable annuities) license.

What about the new fiduciary regulation that was to go in effect on April 1st 2017?

Due to great consumer demand for working with a fiduciary, the Department of Labor created a law that was to go in effect beginning April 1st 2017 that would require all financial advisors working with IRAs or retirement accounts to provide advice under a fiduciary standard. Many are calling this “fiduciary lite” as it was not quite as stringent as the fiduciary standard that RIAs currently operate under. However, it was a much needed step in the right direction for the financial services industry. Unfortunately, the new presidential administration requested a hold on this new law and asked that it be further reviewed before being implemented. At this point we don’t know if it will be delayed for only a period of time, face changes prior to implementation, or be completely eliminated altogether.

So where can I find a financial advisor or financial planner that operates as a fiduciary?

The good news is there is a great option currently in existence that will allow you to work with a fiduciary based financial advisor – The National Association of Personal Financial Advisors (NAPFA), or On their website you can search nationwide for a financial planner that is near you. In full disclosure, I am also a member of NAPFA. One of the great things about NAPFA is all financial advisors that are affiliated with this organization proactively chose to act as a fiduciary for their clients. Not only do they act as fiduciaries, but they are also fee-only and do not sell any commissioned financial products. For more information on types of financial advisor compensation, please see my article titled “What is the Difference Between Fee-Only and Fee-Based?”

In conclusion, if you want unbiased and transparent financial advice, then consider working with a Registered Investment Advisor that holds themselves out as a fiduciary and is willing to put that in writing.


What is the Difference Between “Fee-Only” and “Fee-Based?”

Do you know how your financial advisor is compensated? Two common forms of financial advisor compensation are called ”fee-only” and “fee-based.” They sound very similar, but they have vastly different meanings. Whether your advisor is “Fee-Only” or “Fee-Based” can have a huge impact on the type of advice you are provided and the types of investment products which are recommended to you.

Let me provide a made up example related Coin stacks with letter dice - Feesto the medical industry to help differentiate the two fee compensation terms. Not everyone has worked with a financial advisor, but we all have visited a doctor.

Let’s assume you decide to visit your doctor because you have a health issue. Upon the visit, your doctor analyzes your health problem, provides you with a recommendation, possibly sends you to a specialist for further diagnoses, or gives you a prescription to take to your local pharmacy. In return for the doctor’s time and expertise, you likely paid him/her an out of pocket co-pay and/or your health insurance pays them a fee for your visit and any particular procedures or testing done. This scenario would be considered fee-only. You received a recommendation and the doctor received a fee.

Now let’s assume you visit your same doctor for the same health issue. But we further assume that the doctor’s compensation comes from two sources: 1) a fee for an initial assessment of your health issue and 2) the doctor also receives a commission for any particular health recommendation, procedure, referral to a specialist or pharmaceutical prescription sold. What if we take this one step further and also assume that not only does your doctor receive a commission for his/her recommendations, but that their commission based revenue can only come from a select group of products or procedures chosen by the health organization they are affiliated with? Do you see any potential conflicts of interest in this scenario? Would this cause you to question if you were receiving the best medical recommendation, or, if what your doctor recommended was potentially based on what paid your doctor the highest commission? This would be considered a “fee-based” compensation arrangement. The doctor receives a fee for the initial visit but also receives commissions for specific recommendations, procedures, referrals or prescriptions sold.

Consumers are fortunate the fee-based arrangement does not actually exist in the medical industry. However, it is common in financial services.

The two examples above can be directly substituted into the financial advice industry. Fee-Only means the only source of compensation your financial advisor receives is from fees paid directly to the advisor from clients. This could be in the form of an hourly fee, a retainer fee or a fee based on a percentage of the assets under investment management. Regardless of the type of fee, the point is that the client pays only a fee and no other type of compensation is charged. No commissions are received. No financial products are sold such as load mutual funds, commissioned based fixed and variable annuities, equity indexed annuities, whole life insurance or universal life insurance. The advice and compensation is totally independent of the financial products recommended.
Fee-Based is a term the brokerage and insurance community developed to counteract the success of the Fee-Only classification. The terms certainly sound similar and consumers are confused, so their strategy seems to be working. I can’t tell you how many times I have received a phone call from a consumer looking for a new financial advisor and one of the first things they say is that they are looking for a fee-based advisor. I always enjoy having that conversation and explaining the terminology differences as most consumers are greatly surprised.

Where Fee-Based can be confusing and potentially misleading is that not only does an advisor receive fees, but they can also accept commissions from financial products recommended such as load based mutual funds, or annuities and insurance. This system creates the potential for a huge conflict of interest. If an advisor, like the doctor above, has the opportunity to recommend a particular financial product that pays him/her a commission versus a financial product that does not pay a commission, do you think they could be incentivized and influenced to recommend the commissioned based product? Or, what if their product inventory only allows the choice between a select group of commissioned products based on the affiliation of their broker dealer? Would this raise a question – are the financial products offered to me what is best for my financial situation, and, do they make use of the best potential options considering the whole universe of financial products available?

No compensation system is perfect and free from all conflicts of interest. And certainly there are some great fee-based advisors doing amazing work for their clients. But we strongly believe the fee-only compensation method most closely aligns the interest of consumers with their financial advisor. We are proud and fortunate to belong to a great organization called (National Association of Personal Financial Advisors), which represents a like-minded group of fee-only, fiduciary based financial advisors throughout the United States.

So when deciding which advisor you would like to hire, we would suggest that you ask how the advisor is compensated, request that they disclose their compensation in writing and look for someone who is paid as a “Fee-Only” advisor to eliminate as many conflicts of interest as possible.

Or, if you decide to work with a fee-based, commissioned advisor, at least look for one that is licensed under a fiduciary regulation. The fiduciary law requires that all compensation is disclosed in writing. Thus if you are going to pay commissions for advice and financial products, you will at least know what you are paying for. You can learn more about being a fiduciary by reading my article titled “What is a fiduciary and why does it matter?”