s it just us, or does it seem like the last few years have been essentially government via Executive Order? I mean, sure, Obama had to deal with a completely useless Congress (is that too repetitive?) and Trump is trying to make it look like he’s getting a lot done right off the bat, but still. Do Executive Orders actually do anything? There is absolutely nothing guaranteeing the longevity of an order beyond the term of the administration...In reviewing all the Executive Orders Trump has issued so far, only one of them really directed a change in action. And that one has been halted in the courts. The others have all been basically directives to form committees to either review things or come up with a plan to maybe do things at some nebulous point in the future.
Here’s the problem, as we see it, with Executive Orders. They’re window dressing. It’s the equivalent of one of those wacky waving inflatable arm flailing tube men. Look at that! There must be something over there! What is it? Who knows. What does it do? How does it work? Not a clue.
In the rush to get things done and make a nice headline, all too often we find that the details are poorly thought through, leading to unintended consequences that can even exacerbate the original issue one was trying to address. That is the main problem - unintended consequences. It’s true in government. And it’s true in portfolio management.
Financial Regulatory Reform
Two of Trump’s Executive Orders concern things that are big deals in the world of financial regulation - the Dodd-Frank Act and the (maybe) upcoming DOL (Department of Labor) Fiduciary Rule. Why are they big deals? Because they are huge, sweeping changes to the way business is (or has been) done; and while stemming from the best of intentions, they have had significant unforeseen impacts to the markets. Unintended consequences, if you will. Let’s explore:
Dodd-Frank in a nutshell: Not an Executive Order, an actual honest-to-goodness law. Drafted in response to the Financial Crisis of 2007-2008. (Great! That sucked - technical financial term - let’s not go through that again). Solution: we need more regulation and better oversight of the derivatives markets and more protection for consumers. (Yes, let’s do it).
Fast forward three years - The law is finally passed! And is 2,300 pages long. (Umm...okay that seems perhaps a little unnecessarily complex, but sure).
Fast forward five more years - 60% of the law has actually been implemented! (Yay?) And a lot of that implementation has dealt with making banks “safer”. (Well that sounds good). So the banks keep more money set aside as reserves against a future issue (still sounds good), which means they’re not lending as much (oh wait…).
They also have been largely forced out of various liquidity-providing stock market activities they used to do (well clearly that’s unnecessarily risky), so those activities have been taken over by shadow banking entities (that’s a thing?), yes that’s a thing, these are institutions that are doing bank-like things but aren’t actually banks and therefore aren’t regulated the same way. So what happens is that when markets get stressed, these shadow banking liquidity providers just disappear. Because they aren’t regulated in a way that prevents that. Which has the effect of exacerbating volatility, especially on the down side, and ultimately hosing - again, technical financial term - the consumer. (But wasn’t that what they were trying to prevent in the first place?) Yes. Yes it was.
Well, that nutshell was apparently big enough for two people to fit comfortably inside, but there you have it. Is Dodd-Frank this terrible evil? Not at all. Has it had consequences that weren’t apparent at the time and should probably be addressed? Absolutely.
DOL Fiduciary Rule in a nutshell: So this one is a little trickier because it hasn’t actually been implemented yet. There are technically two standards that financial advisors are held to in the eyes of the law - the fiduciary standard (we’ll call this one “do what’s best for the client” or “put the client’s interests first”) and the suitability standard (we’ll call this one “just don’t do anything actively bad for the client” or “plausible deniability”). Advisors to ERISA-governed plans (think company-sponsored 401(k) plans) are held to the fiduciary standard, by law. Everyone else is held to the suitability standard, by law. There are some notable exceptions - those of us with a CFP® designation hold ourselves to the fiduciary standard in all cases, for example.
The DOL rule, at its core, basically seeks to hold all advisors to the fiduciary standard in all cases. This is perhaps getting into its own newsletter topic on compensation and alignment of interests, but there has been a lot of pushback from the financial services industry as a whole about how much disruption this would cause and how the end result would actually make things worse for the consumer. Again. Which is partly greed and self-interest, but not entirely inaccurate. Or, let’s take this to the Orwellian extreme and it’s not that far-fetched to imagine the government mandating how retirement accounts should be invested - say, at least 40% US Treasuries and at least 40% US company stock. For the safety of the consumer, of course.
You think we’re kidding? Have you heard of myRA? It’s an IRA from the Treasury that forces your savings into only US Treasuries. Ostensibly to help people save for retirement safely. Never mind that the government is royally screwed if they can’t find buyers for their massively inflated supply of Treasuries. And oh, look, here’s a pool of nearly $20 trillion in retirement accounts, wouldn’t it be great if that money were forced into, no, scratch that, used to buy Treasuries? For the safety of the investor. Win win! (If you didn’t read those last few sentences with sarcasm literally dripping from your tongue, please try it again).
Alright, enough dryness for now. And government conspiracies. We’ll update you here if and when anything happens. So go ahead and blink your eyes a couple times to get rid of the glaze, wipe the drool from the corner of your mouth and pay attention to this next part:
When it comes to portfolios, we feel that Executive Orders are not quite as obvious, but nearly as prevalent. For example:
Executive Order: Your portfolio will be balanced. 60% stocks, 40% bonds. Maybe that gets stretched to 80% stocks, 20% bonds if you’re in your 30's.
Executive Order: Invest for the long-term. Specifically, buy stocks, hold them for a long time, and ignore any interim ups and downs.
Modern Portfolio Theory. Efficient Market Hypothesis. Technical Analysis. None of these are strictly orders per se, but are generally treated as investment gospel and therefore carry the same weight. Here’s one more for good measure:
Executive Order: The best portfolio you could ever construct as an individual is the portfolio of the entire market. (Not kidding, there are at least three Nobel Prizes* behind that statement).
The issue we have with all of these is that you, the investor, are reduced to a number. It doesn’t matter why you are investing, what you need or want your money to be doing for you. It doesn’t matter what your individual risk tolerance is, what your goals are, what causes you stress or helps you sleep better at night. It doesn’t matter that perhaps the 20 years or so you will have your money invested might not be identical to the average financial conditions over the last 100 years that all these models are based on. It doesn’t matter that the last 8 years have seen global monetary experiments that have never been attempted before in the history of...history.
Now, it’s true that for the population as a whole, for the market as a whole, a balanced portfolio (60/40, 80/20, whatever two numbers you want that add up to 100) has provided better risk-adjusted returns over the long-term (read: the entire existence of stock markets) than just stocks by themselves (note that we said better risk-adjusted returns, not better absolute returns). But maybe you don’t want your risk adjusted. And you are (likely) not investing over the next 100 years. And you are not the population as a whole. You’re you...and despite what Christine O’Donnell might say, nobody else is you.
What do you want? Do you want to get as much income as possible from the safest possible investments? Do you want to take all the risk and try to turn $20,000 into $200,000? Do you like options strategies? Dividends? Biotech? Are you investing for 5 years? 10 years? 40 years? Does it sound like a balanced, 60/40 portfolio is going to be appropriate for everyone? Yeah, we don’t think so either.
So come talk to us. We’d love to work with you to make sure that your money is working for you - the way you want it to be, not the way Oceania wants it to be (...just to bring that previous Orwell reference full-circle; we’re not suggesting the Australian/Pacific Islands continent grouping has any interest in your investment portfolio). We look forward to hearing from you.
*Used colloquially. Technically speaking of course, there is no Nobel Prize in Economics.
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