Having recently started my career at Lighthouse Financial Advisors, I am working to obtain every bit of knowledge I can from Robert and the LFA team. I am very fortunate to have this opportunity and aspire to receive my CFP accreditation in the near future.  It is important to me to not only “learn from the best,” but to follow the Lighthouse principles in my personal life.

One of the tools that we use when meeting with our clients is the Financial Life Cycle, the seven stages used to determine your financial position.  I am currently in the first of the seven stages – “Building the Foundation.”  In this first stage, my primary strategy has been to follow the “Five Fundamentals of Fiscal Fitness.”

 

1.)    Save at least 10% of your annual income:

As far back as I can remember, my mother had always taught me the importance of saving and to appreciate money.  I always wanted to see how much I could fit into my piggybank!  A few years ago I began using an Excel spreadsheet to better track my finances.  Once I receive my check I automatically try to put at least 10% into a separate bank account.  This helps keep myself from “wasting” money on unnecessary things that most people in their twenties do.

 

2.)    Have sufficient liquidity:

As my life progresses, the number of bills that I am responsible for increases – so it certainly makes saving money a lot harder.  As we suggest to clients, I try to have at least 10% of my annual income in a cash reserve account, with another 20% in a secondary reserve.  It seems crazy, but nothing in life is guaranteed and it’s always important to have a backup plan in case something unexpected happens.

 

3.)    Fully fund your pensions:

Just the other day Robert called me into his office to help with my initial investment in my first 401(k).  It does not matter what age you are, you should take advantage of tax deferred savings plans, especially any that your employer will match your contributions.

 

4.)    Have the right size house:

For most middle income Americans, your home is the most significant investment you will ever have to make.  We recommend buying a home 2 ½ – 3 times your annual income and holding a mortgage of 50% or more of its value.  If the value of the home reaches 100% to 125% of your income, sell it and trade up.  I have been working hard since graduating college and plan to take the leap to home ownership within the next year or two.

 

5.)    Pay off all credit cards and consumer debt:

It is important to be aware of the differences between bad debt, good debt and acceptable debt.  Avoid the bad, use the acceptable debt wisely, and take advantage of the leverage of good debt.  Through high school and most of college, my mom advised me not to open a credit card (and as I reflect, I realize she had valid reason).   I am now grateful that I didn’t “ruin” my credit at a young age, as many friends have done.  When I did start using a credit card, I always made sure that I never purchased anything that I couldn’t afford to pay off in the next month.  As a result, at 23 years old, I was able to purchase a car in my own name.

 

I hope this information has been useful, as well as insightful, as I know many of our clients have children and grandchildren in a similar stage of life. I encourage you to discuss these important “5 Fundamentals of Fiscal Fitness” with your loved ones.  My current success would not have been possible without the help of many great people in my life – especially my parents, Robert and Donna.

Wishing you all a healthy and happy holiday season!

 

As many of us continue to cope with the aftermath of Hurricane Sandy, this NY Times article (http://www.nytimes.com/2012/11/29/nyregion/cost-of-coastal-living-to-climb-under-new-flood-rules.html?pagewanted=1&_r=1&ref=todayspaper&) examines the costs that could force many from coastal life. It was estimated the fewer than 30% of NY homes affected had flood insurance. FEMA states that homeowners in storm-damaged coastal areas who had flood insurance — and many more who did not, but will now be required to — will face premium increases of as much as 20% to 25% per year beginning in January, under legislation enacted in July to shore up the debt-riddenNational Flood Insurance Program. This means that premiums will double for new policyholders and for many old ones within three or four years under the new law.

Avoiding the expense of flood insurance will become harder because the lenders who do enforce the insurance requirement will face higher penalties. It will take FEMA months to years to finalize the new flood maps which will reflect the damage from Sandy. It may take some time, but it should be a sound assumption that flood insurance and new building standards will be much more expensive and stringent.

Also please note:

  • NJ and NY declared Federal disaster areas will have until Feb 1st, 2013 to make any estimated payments.
  • While property taxes will likely increase in response to the rebuilding effort, NJ State law contains a provision which states that a property with a building or other structure that has been destroyed by a storm between Oct 1st and Dec 31st can have the assessment reduced to reflect the depreciation in value for that property. The landowner must provide the assessor with notice prior to Jan 10th, 2013. The assessor will value the property as of 1/1/2013 but will take into account any improvements made as of 1/1/2013. If you experience damage, we strongly suggest you call your town to have a re-assessment.
We wanted to share additional information that would be useful to our clients who have been affected by Hurricane Sandy:
The IRS on Friday announced that it will allow taxpayers who have been adversely affected by Hurricane Sandy to take hardship distributions or loans from their retirement plans (Announcement 2012-44). To qualify under the announcement, hardship distributions made on account of a hardship resulting from Hurricane Sandy must be made on or after Oct. 26, 2012, and no later than Feb. 1, 2013.

Under the relief provisions announced, a qualified employer plan will not be treated as failing to satisfy any requirement under the Code or regulations merely because the plan makes a loan or a hardship distribution for a need arising from Hurricane Sandy to an employee or former employee whose principal residence on Oct. 26, 2012, was located in one of the counties or Tribal Nations that have been identified as covered disaster areas because of the devastation caused by Hurricane Sandy. The relief also applies to employees whose place of employment was in one of these counties or Tribal Nations on that date or whose lineal ascendant or descendant, dependent, or spouse had a principal residence or place of employment in one of these counties or Tribal Nations on that date.

The IRS says plan administrators may rely on representations from the employee or former employee as to the need for and amount of a hardship distribution (unless the plan administrator has actual knowledge to the contrary), and the distribution will be treated as a hardship distribution for all purposes under the Code and regulations.

The relief applies to any Sec. 401(a), 403(a), or 403(b) plan that could, if it contained enabling language, make hardship distributions. It also applies to any Sec. 457(b) plan maintained by an eligible employer, and any hardship arising from Hurricane Sandy will be treated as an “unforeseeable emergency” for purposes of distributions from such plans.

The amount available for hardship distribution is limited to the maximum amount that would be permitted to be available for a hardship distribution from the plan under the Code and regulations. However, the relief provided by the announcement applies to any hardship of the employee, not just the types enumerated in the regulations, and no post-distribution contribution restrictions are required.

To make a loan or hardship distribution, a qualified employer plan that does not provide for them must be amended to provide for loans or hardship distributions no later than the end of the first plan year beginning after Dec. 31, 2012.

Under the announcement, a retirement plan will not be treated as failing to follow procedural requirements for plan loans (in the case of retirement plans other than IRAs) or distributions (in the case of all retirement plans, including IRAs) imposed by the terms of the plan merely because those requirements are disregarded for any period beginning on or after Oct. 26, 2012, and continuing through Feb. 1, 2013, with respect to distributions to individuals described above, provided the plan administrator (or financial institution in the case of distributions from IRAs) makes a good-faith diligent effort under the circumstances to comply with those requirements. However, as soon as practicable, the plan administrator (or financial institution in the case of IRAs) must make a reasonable attempt to assemble any forgone documentation.

Alistair M. Nevius, J.D.

November 16, 2012

 

As most of us in the tri state area returning to “normalcy” two weeks after Hurricane Sandy wreaked havoc throughout the east coast, many of you may now be contemplating the personal financial impact of the storm.  The information below from MoneyMattersNJ.com should help to answer some of your basic questions.  We of course encourage you to call or e-mail the office to discuss your specific situation in greater depth.

Rules for Casualty Losses
Losses for your personal-use property (such as your personal residence, household appliances, furniture and cars), are potentially deductible because the storm was a natural disaster. This deduction is limited to taxpayers who itemize their deductions.

If you have filed a claim for reimbursement (from insurance or otherwise) for which there is a reasonable prospect of recovery, no portion of the loss is deductible until the claim is resolved.

Generally, the amount of your casualty loss is determined by the decrease in fair market value (FMV) of the property as a result of the casualty, limited to the taxpayer’s adjusted basis in the property.

Two limitations apply to casualty loss deductions for personal-use property. First, a casualty loss deduction is allowable only for the amount of the loss that exceeds $100 per casualty. Second, the net amount of all of a taxpayer’s casualty losses (in excess of casualty gains, if any) is allowable only for the amount of the losses that exceed 10% of your adjusted gross income (AGI) for the year.

When to Take the Deduction
Since these casualty losses resulted from a federally declared disaster, you can claim the loss this year or in 2011 (the year before the loss was incurred). We will evaluate this option for you, as taking the loss via the filing of an amended 2011 income tax return may increase your tax savings and/or you may get your refund earlier than waiting to file your 2012 income tax return next year.

Information needed to claim the loss

  • Description of the property (or properties)
  • Their cost basis
  • The FMV before and after the casualty

Example
For instance, let’s review your potential tax loss if your personal vehicle that you purchased for $30,000 was destroyed in the storm which had a fair market value of $10,000 after three years of use. If your insurance company reimburses you $4,000, then your casualty loss would be $6,000. This $6,000 loss would be grouped with all your other storm losses subject to the $100 limit and 10% of your AGI.

Not every casualty results in a loss for tax purposes, and in some cases, you may have a “casualty gain.” For instance, suppose you purchased your home for $100,000 (your tax basis) and it has increased in value to $300,000. If your home is destroyed and you receive close to $300,000 in insurance, you will have a gain of close to $200,000. In certain cases, tax on a casualty gain can be avoided or deferred if the insurance proceeds are reinvested in replacement property.

Business Losses
Casualty losses on business property are basically computed in the same manner as personal property, except that the $100 deduction and 10% limit of AGI does not apply. Please feel free to contact us for further information.

>>Click here for more Hurricane Sandy tax relief information including postponed tax deadlines for individuals and businesses in New Jersey or New York, Disaster Unemployment Assistance to New Jersey residents, Disaster Treatment of Payments to Sandy Victims and Managing the Tax and Insurance Aftermath of Sandy.

I found the article below intriguing.  It helps explain specific issues Americans face, while preparing for retirement.  It was written by John C. Bogle, the founder and retired CEO of The Vanguard Group; also known for his famous book Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor.  In this article John goes into how Americans are directing far too little, if not any, of their earnings into a retirement plan that could help them reach their essential goals of becoming self-sufficient.  He identifies “seven deadly sins” that are putting our retirement system in a dangerous situation.  I know personally I am grateful for the knowledge I have obtained working with the Lighthouse team, guiding me to become financially successful and not let the seven sins hurt my retirement in the future.  We always look forward to any comments and discussions you may have on any of our posts.  Enjoy!

The Inadequacy of Our National Savings:  By John C. Bogle

Underlying the  specific issues affecting our retirement plan system is that our national  savings are inadequate. We are directing far too little of those savings into  our retirement plans in order to reach the necessary goal of  self-sufficiency. “Thrift” has been out in America; “instant  gratification” in our consumer-driven economy has been in. As a  nation, we are not saving nearly enough to meet our future retirement needs.  Too few citizens have chosen to establish personal retirement accounts such  as IRAs and 403(b)s, and even those who have established them are funding  them inadequately and only sporadically. These investors and potential  investors are, I suppose, speculating that their retirement will be fully  funded by some combination of Social Security, their pensions, their  unrealistically high expectations for future investment returns, or (as a  last resort) from their families.
Broadly stated, we Americans suffer from a glut of spending and a (relative)  paucity of saving, especially remarkable because the combination is so  counterintuitive. Here we are, at the peak of the wealth of the world’s  nations, with savings representing only about 3 percent of our national  income. Among the emerging nations of the world—with per capita incomes less  than $5,000 compared to our $48,000—the saving rate runs around 10 percent,  and in the developed nations such as those in Europe, the savings rate  averages 9 percent, with several major nations between 11 and 13 percent. Our  beleaguered pension system is but one reflection of that shortfall.
The Seven Deadly Sins   Let’s now move from the general to the particular, and examine some of the  major forces in today’s retirement systems that have been responsible for the  dangerous situation we now face.
Deadly Sin 1: Inadequate Retirement Accumulation   The modest median balances so far accumulated in 401(k) plans make their  promise a mere shadow of reality. At the end of 2009, the median 401(k)  balance is estimated at just $18,000 per participant. Indeed, even projecting  this balance for a middle-aged employee with future growth engendered over  the passage of time by assumed higher salaries and real investment returns,  that figure might rise to some $300,000 at retirement age (if these  assumptions prove correct). While that hypothetical accumulation may look  substantial, however, it would be adequate to replace less than 30 percent of  preretirement income, a help but hardly a panacea. (The target suggested by  most analysts is around 70 percent, including Social Security.)
Part of the reason for today’s modest accumulations are the inadequate  participant and corporate contributions made to the plans. Typically, the  combined contribution comes to less than 10 percent of compensation, while  most experts consider 15 percent of compensation as the appropriate target.  Over a working lifetime of, say, 40 years, an average employee, contributing  15 percent of salary, receiving periodic raises, and earning a real market  return of 5 percent per year, would accumulate $630,000. An employee  contributing 10 percent would accumulate just $420,000. If those assumptions  are realized, this would represent a handsome accumulation, but substantial  obstacles—especially the flexibility given to participants to withdraw  capital, as described below—are likely to preclude their achievement. (In  both cases, with the assumption that every single contribution is made on  schedule—likely a rare eventuality.)

Deadly Sin 2: The Stock Market Collapse   One of the causes of the train wreck we face—but hardly the only cause—was  the collapse of our stock market, on balance taking its value from $17  trillion capitalization at the October 2007 high in U.S. stocks, to a low of  $9 trillion in February 2009. Much of this stunning loss of wealth has been  recovered in the rally that followed, and as 2012 began, the market value  totaled $15 trillion. Nonetheless, our nation’s DB pension plans—private and  government alike—are presently facing staggering deficits. And the  participants in our DC plans—thrift plans and IRAs alike—have accumulations  that fall short of what they will need when they retire.

Deadly Sin 3: Underfunded Pensions   Our corporations have been funding their defined benefit (DB) pension plans  on the mistaken assumption that stocks would produce future returns at the  generous levels of the past, raising their prospective return assumptions  even as the stock market reached valuations that were far above historical  norms. And the DB pension plans of our state and local governments seem to be  in the worst financial condition of all. (Because of poor transparency,  inadequate disclosure, and nonstandardized financial reporting, we really  don’t know the dimensions of the shortfall.) The vast majority of these plans  are speculating that future returns will bail them out.

Currently, most of these DB plans are assuming future annual returns in the  7.5–8 percent range. But with stock yields at 2 percent and, with the U.S.  Treasury 30-year bond yielding 3 percent, such returns are a pipedream. It is  ironic that in 1981, when the yield on the long-term Treasury bond was 13.5  percent, corporations assumed that future returns on their pension plans  would average just 6 percent, a similarly unrealistic—if directly  opposite—projection as 2012 began.

Corporations generate earnings for the owners of their stocks, pay dividends,  and reinvest what’s left in the business. In the aggregate, the sole sources  of the long-term returns generated by the equities of our businesses should  provide investment returns at an annual rate of about 7–8 percent per year  over the next decade, including about 2 percent from today’s dividend yield  and 5–6 percent from earnings growth. Similarly, bonds pay interest, which is  the sole source of their long-term returns. Based on today’s yield, the aggregate  return on a portfolio of corporate and government bonds should average about  3.5 percent. A portfolio roughly balanced between these two asset classes  might earn a return in the range of 5–6 percent during the coming decade.

Deadly Sin 4: Speculative Investment Options   A plethora of unsound, unwise, and often speculative investment choices are  available in our burgeoning defined-contribution (DC) plans. Here,  individuals are largely responsible for managing their own tax-sheltered  retirement investment programs—individual retirement accounts (IRAs) and  defined-contribution pension plans such as 401(k) thrift plans that are  provided by corporations, and 403(b) savings plans provided by nonprofit  institutions. Qualified independent officials of their employers seem to  provide little guidance. What’s more, they often focus on spurious  methodology that is too heavily based on historical data, rather than the  timeless sources of returns that actually shape the long-term investment  productivity of stocks and bonds, misleading themselves, their firms, and  their fellow employees about the hard realities of investing.

Deadly Sin 5: Wealth-Destroying Costs   The returns in our stock market—whatever they may turn out to be—represent  thegross returns generated by the publicly owned corporations  that dominate our system of competitive capitalism (and by investment in debt  obligations). Investors who hold these financial instruments—either directly  or through the collective investment programs provided by mutual funds and  defined benefit pension plans—receive their returns only after  the cost of acquiring them and then trading them back and forth among one  another. Don’t forget that our financial system is a greedy one, consuming  from 1 to 2 percentage points of return, far too large a share of the returns  created by our business and economic system. So we must recognize that  individual investors and pension funds alike will receive only the net  returns, perhaps in the 4 to 5 percent range, after the deduction of those costs.  To significantly enhance that return, less conventional portfolios using  “alternative” investments will have to deliver returns that far exceed their  own historical norms. To say the least, that is one more speculative bet.

Deadly Sin 6: Speculation In The Financial System   Speculation is rife throughout our financial system (and our world). High  stock market volatility; risky, often leveraged, derivatives; and  extraordinary turnover volumes have exposed the markets to mind-boggling  volatility. As I note earlier, some of this hyperactivity is necessary to  provide the liquidity that has been the hallmark of the U.S. financial  markets. But trading activity has grown into an orgy of speculation that pits  one manager against another—one investor (or speculator) against another—a  “paper economy” that has, predictably, come to threaten the real economy  where our citizens save and invest. It must be obvious that our present  economic crisis was, by and large, foisted on Main Street by Wall Street—the  mostly innocent public taken to the cleaners, as it were, by the mostly  greedy financiers.

Deadly Sin 7: Conflicts Of Interest   Conflicts of interest are rife throughout our financial system: Both the  managers of mutual funds that are held in corporate 401(k) plans and the  money managers of corporate pension plans face potential conflicts when they  hold the shares of the corporations that are their clients. It is hardly  beyond imagination that when a money manager votes proxy shares against a  company management’s recommendation, it might not sit well with company  executives who select the plan’s provider of investment advice. (There is a  debate about the extent to which those conflicts have actually materialized.)

But there’s little debate in the mind of Lynn Turner, former chief accountant  of the SEC: “Asset managers who are charging corporations a fee to manage  their money have a conflict in that they are also trying to attract more  money which will increase their revenues, and that money often comes from  companies who set up retirement accounts for their employees. There is not  disclosure, from the asset manager to the actual investors whose capital is  at risk, of the amount of fees they collect from the companies whose  management they are voting on. It appears the institutional investors  (including managers of mutual funds) may vote their shares at times in their  best interests rather than the best interests of those whose money they are  managing.” In trade union plans, the conflicts of interest are different, but hardly  absent. Insider dealing among union leaders, investment advisors, and money  managers has been documented in the press and in the courts. In corporate  defined benefit pension plans, corporate senior officers face an obvious  short-term conflict between minimizing pension contributions in order to  maximize the earnings growth that market participants demand, versus  incurring larger pension costs by making timely and adequate contributions to  their companies’ pension plans in order to assure long-term security for the  pension benefits they have promised to their workers. These same forces are  at work in pension plans of state and local governments, where the reluctance  (or inability) to balance budgets leads to financial engineering—rarely  disclosed—in order to justify future benefits.

Extracting Value From Society   Together, these Seven Deadly Sins echo what I’ve written at length about our  absurd and counterproductive financial sector. Here are some excerpts  regarding the costs of our financial system that were published in the Winter  2008 issue ofJournal of Portfolio Management: “…mutual fund  expenses, plus all those fees paid to hedge fund and pension fund managers,  to trust companies and to insurance companies, plus their trading costs and  investment banking fees … have soared to all-time highs in 2011. These  costs are estimated to total more than $600 billion. Such enormous costs  seriously undermine the odds in favor of success for citizens who are  accumulating savings for retirement. Alas, the investor feeds at the  bottom of the costly food chain of investing, paid only after all the  agency costs of investing are deducted from the markets’ returns … Once a  profession in which business was subservient, the field of money management  has largely become a business in which the profession is subservient. Harvard  Business School Professor Rakesh Khurana is right when he defines the  standard of conduct for a true professional with these words: ‘“I will  create value for society, rather than extract it.’ And yet money  management, by definition, extracts value from the returns earned by our  business enterprises.”
These views are not only mine, and they have applied for a long time. Hear  Nobel laureate economist James Tobin, presciently writing in 1984: “…we are  throwing more and more of our resources into financial activities remote from  the production of goods and services, into activities that generate high  private rewards disproportionate to their social productivity, a ‘paper  economy’ facilitating speculation which is short-sighted and inefficient.”  (In validating his criticism, Tobin cited the eminent British economist John  Maynard Keynes. But he failed to cite Keynes’s profound warning, cited  earlier, that business enterprise has taken a back seat to financial  speculation.) The multiple failings of our flawed financial sector are  jeopardizing not only the retirement security of our nation’s savers but also  the economy in which our entire society participates.

At Lighthouse Financial Advisors, Inc. we feel that this is directly in line with our values and business model. Each of these 7 items are always on our minds! Our continued growth due to client referrals is much appreciated and leads us to believe that we are doing a good job recognizing what YOU, our clients, really want. We encourage you to let us know how we are doing and if you have any suggestions on how we can improve!

It’s not just about your product or service. Customers want you to be the type of person they can trust to get the job done. What do your customers really want from you? No matter what your industry, your customers want more than just great products and workable solutions. What they really want to know is that you–personally–are the type of person whom they can trust to get the job done. Here are the seven things they want to see in you:

1. Independent Thinking

Customers want to know that you’ll represent their interests, even it’s not in your own financial interest–and particularly when the proverbial chips are down. (Of course, it’s your job to make certain that the chips stay up.)

2. Courage

Customers want to know that you can be trusted to do the right thing. They expect you to tell them if buying what you’re selling is a mistake, or not truly in their interests. That takes real guts.

3. Pride

The best customers don’t want you to truckle and beg. Because they’re trusting you to deliver, they want to work with proud, successful people who can handle even the most difficult tasks.

4. Creativity

Customers don’t have the time to sit and listen to cookie-cutter sales presentations. However, they always have time for somebody who can redefine problems and devise workable solutions.

5. Confidence

Customers are taking a risk when they buy from you. They both need and expect you to exude the kind of confidence that assures them you’ll do what it takes to make them happy.

6. Empathy

Customers want you to see the situation from their perspective. They want you to understand where they are, how their business works, and the challenges that they face–not just intellectually, but in your gut.

7. Honesty

Above all, customers want you to be honest with them. In fact, the previous six values are built upon a foundation of honesty. Without honesty, you have absolutely nothing to offer any customer.

 

7 Things Clients Are Looking For: Sales Source – Geoffrey James

Assuming congress fails to enact legislation that would further extend the 2001-2002 tax reductions, the 15% long-term capital gains rate will expire 12/31/2012.  Of course, recent history suggests that no tax legislation will be forthcoming until late in the year at best.  Let’s focus on what the scheduled increase in capital gains rates could mean to you…

Taxpayers with ordinary tax rate of:

Current capital gains rate

Scheduled rates beginning in 2013

25% or Higher (taxable income over $70,700 MFJ/$35,350 Single)

15%

20% (18% for 5+ yr holding period if bought after 12/31/00)

10% or 15% (taxable income up to$70,700 MFJ/$35,350 Single)

0%

10% (8% for 5+ yr holding period if bought after 12/31/00).

 

In addition to these rate increases, there is also a 3.8% Medicare surtax when a combination of unearned income and earned income exceed $250k MFJ and $200k Single.  Combine this with the return of the reduction in itemized deductions and personal exemptions, and “wealthy” tax payers could see capital gains tax rise from 15 to 25%, a 66.66% increase!

In a raising tax rate environment, the optimal strategy is to accelerate income this year (meaning you should stop harvesting losses and instead harvest gains).  If you are well under the $70,700 MFJ/ $35,350 Single taxable income limit, capital gains harvesting is a virtually risk-free opportunity.

For those above the 0% threshold, there is some risk; if current rates are extended you will have paid taxes earlier than necessary, but would provide a step up in tax basis.  We find the potential upside appealing and are likely to recommend using this strategy.

For those who already have capital losses carrying forward, it likely would be preferable to skip harvesting gains and allow the losses to continue to carry forward until 2013 when they can be applied at higher rates.

In short, 2012 may be the best year to realize capital gain.  If you feel this strategy may work best for you, please contact us to review your case in detail before year end.

Below is a profound article about a stockbroker who made it rich as a stock broker, but came to see to realize he was simply a great salesman without adding any value to his clients; only his own pockets and various companies he pushed products for.  This realization led him to become a Dimensional Fund Advisor (just as Lighthouse Financial Advisors) who take a long term, passive investment philosophy tailored to the individual client. This is a longer article than usual, but an enlightening read by a leading financial industry author of Liar’s Poker, The Big Short, and Moneyball.  As always, we welcome comments and discussion about all of our postings.  We look forward to your thoughts…enjoy!  

The Evolution of an Investor: By Michael Lewis

Like a lot of people who end up on Wall Street, Blaine Lourd just sort of stumbled in. He’d grown up happy in New Iberia, Louisiana. His father had made a pile of money in the oil patch, and Blaine assumed that he too would one day eat four-hour lunches at the Petroleum Club, hunt ducks on the weekends, and get rich. His older brother, Bryan, had left Louisiana to make what seemed like a quixotic bid to become a Hollywood agent, but Bryan was gay, even if he pretended not to be. (He’s now a partner at Hollywood’s Creative Artists Agency.) Blaine was distinctly not gay and felt right at home in Louisiana—right up to the moment when, during his third year at Louisiana State University, the price of oil collapsed and took the family business with it. That was when he realized he had no idea what he would do with his life. His chief distinction at L.S.U. was his ascent to the post of social chairman at the Theta Xi fraternity, and while that was nothing to sneeze at, he didn’t see how it qualified him to do anything else. His father, after informing him that there was no longer a family business for him to inherit, suggested that his ability to get people to like him might go far on Wall Street. That’s what first got Blaine thinking. “I didn’t know what Wall Street was,” he says. “I didn’t even know where Wall Street was.”

Really, he just wanted to be a success. How that happened, he didn’t much care. So in 1987, at the peak of the bull market, he landed a job with investment firm E.F. Hutton in Los Angeles. A few weeks into Blaine’s training program, E.F. Hutton collapsed following a check-kiting scandal and was sold to Shearson Lehman. Blaine’s training at Lehman consisted of a month long class, which focused mainly on overcoming customers’ objections, and a close reading of the bible on how to peddle stocks to people you’ve never met: Successful Telephone Selling in the ’80s, co-written by a Lehman managing director named Martin Shafiroff. A well-planned presentation creates a sense of urgency. If the prospect fails to act now, he will risk a loss of some sort.

Speak with confidence and authority.

The most important part of the presentation is the close.

Blaine set a goal for himself: Reach 100 people a day by telephone. Half the time, people hung up on him, but about one in every 300 calls led to a sale. He arrived at his office at 6 every morning to make sure he got the best lead cards. Even at that hour, the place was loud and frantic. Traders’ hoots and hollers screamed the firm’s need to move a specific block of stock; the TV on the wall blared potentially market-moving news. He was paid on commission and driven by fear of failure. “There were a lot better salesmen than me,” he says. “I just worked harder. I made more calls. And if you make more calls, you will get the sales. And it doesn’t matter what you say.” Most of the time, he just read from the same script as the other brokers: “Are you familiar with Warren Buffett? We have information from our sources on the Street that his next position is going to be in a company much like Cadbury Schweppes. [Pause] I know you’re busy, but I’d like to call you once or twice in the next six months when we have a substantial idea that will make you three to 10 times your money.”

When Blaine would call back 10 days later, it almost didn’t matter what he said, as long as he demanded an order and then fell completely silent. “Mr. Johnson, this is Blaine Lourd from Lehman Brothers. We see Abbott Labs going to 60, and I think you need to buy 10,000 shares of Abbott Labs today.”

Half the time, in the ensuing silence, Mr. Johnson would hang up. But the other half, Mr. Johnson would explain, usually pathetically, why he couldn’t right then and there buy 10,000 shares of Abbott Labs. And once Blaine had a specific objection, he had an obstacle he could overcome.

I’ve got to talk to my wife.

“Mr. Johnson, if you’re driving at night with your wife in the city, it’s snowing, and you have a flat tire, do you ask your wife to go out and change it?”

I don’t have the cash.

“Mr. Johnson, you have stocks in your portfolio that are underperforming. We’ll take you out of them to get you into Abbott Labs.”

Why Abbott Labs?

“We have it on good authority that it’s Warren Buffett’s next purchase.”

The older brokers in the office all threw around Buffett’s name, so Blaine did too. Buffett was useful because everyone knew who he was and everyone thought he had made his money picking stocks. Blaine was picking stocks just like Buffett but using different criteria. The traders in New York would accumulate a block of shares, driving the price up, and then get brokers like Blaine to unload the shares quickly at the higher price—whereupon the price would, often as not, fall. “Seven months in at Lehman, I was one of the top rookie producers,” Blaine says, “but every stock I bought went down.” His ability to be wrong about the direction of an individual stock was uncanny, even to him. At first, he didn’t understand why his customers didn’t fire him, but soon he came to take their inertia for granted. “It was amazing, the gullibility of the investor,” he says. “When you got a new customer, all you needed to do was get three trades out of him. Because one of them is going to work. But you have to get the second one done before the first one goes bad.

“It wasn’t exactly the career he’d hoped for. Once, he confessed to his boss his misgivings about the performance of his customers’ portfolios. His boss told him point-blank, “Blaine, you’re confused about your job.” A fellow broker added, “Your job is to turn your clients’ net worth into your own.” Blaine wrote that down in his journal. Then he caught a break. He met a girl who liked him. The girl went and told a friend about him. That friend was the business manager for the Rolling Stones. One thing led to another, and the Rolling Stones handed him $13 million to invest. It was that easy. This money constituted their tour fund, and they didn’t want to take any risks with it. “I went to my office manager and asked, ‘What do I do with this?’ And he looked at me and said, ‘I dunno.’ ” Blaine was seriously unnerved: He knew how to sell stocks to strangers, but that skill had nothing to do with preserving a pile of capital. “All of a sudden, I got a real client,” he says. “It wasn’t from some cold call. I didn’t want to lose the Rolling Stones’ money.” He decided to invest it in Treasury bills. “Right away, I’m in conflict with the firm. My colleagues gathered around this money and asked me, ‘How are you going to gross this thing up?’ ” Meaning how would they be able to maximize their commissions. “And I said, ‘What do you mean? It’s in T-bills.’ And they said, ‘We can’t make any money on this.’ And that’s when I said to myself, I gotta get out of here.”

He quit Lehman Brothers and took a job at the Los Angeles office of Bear Stearns. But Bear wasn’t any better. He says he was pressured to make transactions rather than give good advice. The stories he told himself to feel better about his career became less and less plausible. The nicest thing he could say about himself was that he hadn’t broken the law. He hadn’t bankrupted anyone or anything like that. But when he stepped back from his job and really looked at it, he realized that a huge amount of his time and energy went into making people feel happy about his advice when they should have been furious. The problem was the constant tension between company and client, caused by the firm’s inability to know what the market or any particular stock was going to do next. “I always thought there was going to be a place where the client wouldn’t be compromised and the broker wouldn’t be compromised,” he says. “But it was the same everywhere. It was all about getting people to transact.” And these weren’t bucket shops; they were Wall Street’s most distinguished firms.

He gave up on picking stocks and started picking fund managers instead. He’d sell his customers not on Cadbury Schweppes but on some mutual fund that his Wall Street firm was promoting. “I thought it was better than me picking stocks,” he says. “But ultimately, these guys who ran the funds were just picking stocks like I was. And they weren’t any better at it.” The only thing that changed was Successful Telephone Selling in the ’80s. It now had a new title: Successful Telephone Selling in the ’90s.Still, he was a 29-year-old earning $200,000 a year, and he was, as he puts it, “ramping up the lifestyle.” Rival firms noticed his success: He left Bear Stearns for Dean Witter, which would later become Morgan Stanley. Blaine’s business grew to the point where he became somewhat famous. Name a prominent director or big-time movie star, and there was a fair chance that Blaine Lourd was giving her financial advice. He lived near the beach in Malibu, drove fancy cars, and indulged an expensive taste for young women who had moved to Los Angeles to become movie stars. He routinely ranked in the top 10 percent of revenue producers for whichever firm he happened to be working for. In his best years, he grossed more than $1 million. His father had been right: His persuasiveness and ability to get people to like him went far on Wall Street. Only now he had a problem. He was quickly becoming the world’s unhappiest man. He often woke up with a sinking feeling in the pit of his stomach; more often, he woke up with a hangover. Like a lot of his fellow stockbrokers, he started drinking too much. “Everyone I worked with had a drinking issue,” he says. “Or a drug issue. You can’t continually hurt people and feel good about yourself.” One day, he woke up to find he was a 37-year-old late-1990s cliché: the self-loathing Wall Street salesman. He wondered what had gone wrong and began mining his journal to write a memoir. His book, which was influenced in part by a 1940 financial-industry critique, would relate the sadness of his father’s financial collapse, the sorrow of leaving home, and the sordidness of his financial career:

The sole function of a stockbroker/financial consultant/investment counselor is to get customers. So how does a stockbroker go about getting customers? The best way is to be born rich. Rich guys make good stockbrokers because generally they are lazy and so can do little harm to the client’s long-term financial well-being by trading in the game of chance. The next best way is to circulate among them and to convince them with a pleasing personality that you have the ability to buy everything before the big rise—and to sell everything before the big decline.

I was not rich.

One day, someone may look back and ask: At the end of the 20th century and the beginning of the 21st, how did so many take up financial careers on Wall Street that were of such little social value? Just now, the markets are roiling, money managers and investment banks are reporting disappointing returns, and people are beginning to wonder if they chose the wrong guy in Greenwich, Connecticut, to take 2 percent of their assets and 20 percent of profits. But what if the problem isn’t the guy in Greenwich but the idea that makes him possible: the belief that the best way to invest capital is to hand it to an expert? As a group, professional money managers control more than 90 percent of the U.S. stock market. By definition, the money they invest yields returns equal to those of the market as a whole, minus whatever fees investors pay them for their services. This simple math, you might think, would lead investors to pay professional money managers less and less. Instead, they pay them more and more. Twenty-five years ago, the most successful among them took home a few million dollars a year; in 2006, more than 100 money managers made more than $100 million, and a handful made more than $1 billion. A vast industry of stockbrokers, financial planners, and investment advisers skims a fortune for themselves off the top in exchange for passing their clients’ money on to people who, as a group, cannot possibly outperform the market.

For Blaine Lourd, American stockbroker, the mere fact that he landed in the middle of this industry and became a success was reason enough to hate himself. But in Santa Monica, as Blaine twisted himself into ever more intricate knots to disguise his inability to pick winning stocks or money managers, his antithesis was rising. It was a firm founded in 1981 on a simple idea: Nobody knows. Nobody knows which stock is going to go up. Nobody knows what the market as a whole is going to do, not even Warren Buffett. A handful of people with amazing track records isn’t evidence that people can game the market. Nobody knows which company will prove a good long-term investment. Even Buffett’s genius lies more in running businesses than in picking stocks. But in the investing world, that is ignored. Wall Street, with its army of brokers, analysts, and advisers funneling trillions of dollars into mutual funds, hedge funds, and private equity funds, is an elaborate fraud.

The firm, Dimensional Fund Advisors, was co-founded by David Booth, who had worked at the University of Chicago as an assistant to Eugene Fama. As a graduate student in the early 1960s, Fama coined the phrase efficient markets. D.F.A. sold its clients on passive investing: Instead of looking for trading opportunities and paying stockbrokers and fund managers, D.F.A. bought and held baskets of stocks chosen for the sort of risk they represented. It didn’t call these baskets index funds, but that is more or less what they were. And they—along with the idea they embodied—were growing at a sensational rate. In 1989, D.F.A. was managing $5.2 billion; by 1998, the number was up to $28 billion. Then the internet bubble burst, and even more people fled the stock-picking game. In the summer of 2007, when I visited, the firm had an astonishing $153 billion under management, $90 billion of which had come from individual investors, through a network of professional advisers.

Back in the old days, when investors believed that they were paying for some mysterious wisdom, the buildings housing Wall Street firms were stone on the outside and dark wood on the inside. Now that investors have learned to fear what they can’t see, the firms are in buildings made of as much glass as can be incorporated into a structure without compromising its ability to stand. The day I arrive at D.F.A.’s offices, I find 150 financial advisers in a glass box, waiting to be educated in a seminar that lays out the D.F.A. way. The coffee and pastries are free, the men and women wear suits, and the conference room has the antiseptic feel of any other 21st-century firm. But the atmosphere is entirely different from Wall Street. There’s no chitchat about the market, even though it has been bouncing around wildly. Instead, two speakers discuss how, knowing what we now know, anyone could present himself as a stock-picking guru. “If you put a thousand people in barrels and push them over Niagara Falls,” one of them says, “some of them will survive. And if you take those guys and push them over again, some of them will survive. And they’ll write books about how to survive being pushed over Niagara Falls in a barrel.”

The other speaker paces back and forth in the well at the front of the room. “Have you seen the show Mad Money?” he says. “It’s repulsive.”No one disagrees. That they are here, preparing to join the thousand or so converts authorized to sell D.F.A.’s funds to investors, implies their agreement. They’re all salesmen, but salesmen peddling an odd idea: Don’t listen to salesmen.

In the beginning, back in the 1980s, D.F.A. didn’t sell to individual investors at all. The funds sold themselves by word of mouth. Finally in 1989, D.F.A., with some reluctance, agreed to allow financial advisers to steer clients’ money into D.F.A. funds, but only after those advisers had demonstrated their purity of heart. They must never, ever, sell individual stocks, try to time the market, or suggest to investors that it is possible to systematically beat the market. D.F.A. required its aspiring anti-salespeople to fill out questionnaires and submit to telephone interviews. If they passed those tests—which thousands failed—a team from the firm would dignify them with an office visit and grill them on their beliefs about the stock market. “One of the reasons we visit them,” says Weston Wellington, one of D.F.A.’s principals, “is just to see the office. If there are TVs blaring CNBC and people running around screaming, we say, ‘Wait a minute here.’ ” The final test of ideology is the conference. Having demonstrated sufficient cynicism about Wall Street, the financial advisers must pay their own way to Santa Monica, California, and listen to speeches that explain why, if anything, they should think even less of Wall Street than they already do.

One question naturally arises: What makes someone good at selling this curious attack on the modern financial system? I ask Joe Chrisman, the interface between D.F.A. and the thousand independent financial advisers who have qualified to sell D.F.A. funds, “Of all these proselytizers, who is the most effective at taking an investor who thinks he can beat the market and turning him into someone who quits trading and hands his money over to D.F.A.?”

“That’s easy,” he says. “Blaine Lourd.”

When Blaine Lourd started out on Wall Street, he had a mop of dark hair and the wild smile of a Baroque painter’s idea of Bacchus. He was still young, thin, and handsome, but as his career progressed, the smile changed, becoming, like his eyes, narrower and more calculating. He was turning into one of those men that old friends fail to recognize at their 20-year high-school reunions. But here was the thing: The difference between who Blaine had been and who he had become was entirely a matter of how he had set about making himself a success. He’d been raised to go through life happy, without thinking too much about it, but the career he’d chosen had proved contrary to his upbringing. He’d violated his nature, and his appearance was paying the fine.

Then something happened. In 1996, at the beginning of the greatest speculative bubble in the U.S. stock market’s history, he attended Dean Witter’s conference for brokers whose sales ranked in the firm’s top 5 percent. There, he found himself seated beside a broker in his sixties, who struck up what Blaine says was “a cynical conversation about the state of our industry.” The conference’s speakers gave the usual patter about finding opportunities in the stock market, and the older fellow must have noticed Blaine straining to take it all in. “He’s looking at me like, You’re smart enough to know better than this. But I’m not smart enough to know better than this. And he says to me, ‘You need to read Charles Ellis’ book The Loser’s Game.’

“Blaine bought the book—it’s actually called Winning the Loser’s Game—and took it with him to Aspen on his Christmas vacation. There, on the first page, he read “Investment management, as traditionally practiced, is based on a single basic belief: Professional investment managers can beat the market. That premise appears to be false.”

Ellis, who had spent 30 years advising Wall Street firms, went on with charts, graphs, and more evidence than he needed to convince Blaine of the truth of that statement. The problem wasn’t Blaine; the problem wasn’t even the firms he worked for. The problem was the entire edifice of modern Wall Street, in which some people—brokers, analysts, mutual fund managers, hedge fund managers—presented themselves as experts and were paid fantastic sums of money for their expertise. But essentially, Ellis argued, there was no such thing as financial expertise. “I read this book,” Blaine says, “and I thought, My whole life is a lie, and everyone around me is facilitating this lie.”It took him stints at three firms to figure out that Wall Street wasn’t going to let him act on his new conviction. From Dean Witter he went to Oppenheimer, and from Oppenheimer he went to A.G. Edwards. “I was now an efficient-markets theorist,” he says. “But there was no product for an efficient-markets theorist.” At the peak of the internet boom, he sunk a bunch of his clients’ money into a fund called Roxbury Capital Management, which advertised itself as a value investor. But then he noticed that Roxbury was buying big-name tech stocks after huge run-ups, and he pulled the money out. He looked around for money managers who minimized transaction costs, but when he found them, he’d discover that they weren’t on the list recommended by the firm he worked for. “All these money managers were saying to us, ‘Put your money with us and hold on for the long term,’ but they were turning over their portfolio every quarter. They weren’t holding for the long term.” He brought up his new qualms with senior managers, but they seemed to only pretend to listen. “They knew that if they bought into efficient-markets theory, they’d break their entire belief system and ultimately collapse their revenue stream.”

He was no longer cynical; he was outraged. At the end of every year, he’d circulate memos showing that 80 percent of the money managers the firm promoted to clients had underperformed the market. (An example of Blaine’s market commentary: “This is a nonstop jack-off to try to predict what is going to happen.”) He received no reply and realized his colleagues didn’t care. So he saw their indifference and raised it: He stopped attending the lavish conferences the firms threw for top producers. “A fancy dinner, a round of golf, and a motivational speech by Wayne Dyer all about overcoming obstacles,” Blaine says. “It had nothing to do with the market. It was about pumping you up and rewarding you for your salesmanship.” He told his clients he shouldn’t pick stocks for them or dump their money into actively managed mutual funds. Instead, he’d put it all in index funds. For this service, he took an annual fee of 1 percent of their assets. “It was working great,” he says. “Everyone was happy. I was happy. The clients were happy.”

A.G. Edwards was not happy. Blaine was still generating profits for his firm. Of the 6,000 A.G. Edwards brokers, he still ranked in the top 30. But for every dollar that passed through his hands, he was slicing off a surprisingly small piece for himself and A.G. Edwards. This brought a letter from the head of sales, saying that while managers appreciated how much revenue he generated, they wanted to see him generate 10 percent more. They want me to churn these accounts, he thought. He fired off an angry reply and refused to trade. A few months later, he received a visit from a local manager. It makes the Securities and Exchange Commission unhappy, the manager said, to see brokers getting paid for doing nothing. The U.S. government wanted Blaine to churn his accounts. “At that point,” he says, “I was done.”In June 2006, he quit and set up his own office in Beverly Hills. He called his new firm Lourd Capital Management and started doing from outside the established Wall Street structure what he had tried to do inside it. All but a handful of his 200 clients at A.G. Edwards left with him. He cast about looking for a home far away from Wall Street where he could put his money, and remembered a friend telling him about D.F.A. It was as if the place had been created with him in mind: an entire firm premised on the theory that all of Wall Street floats on bullshit. He called D.F.A.’s phone number. “What do I gotta do to drop a ticket today?” he asked. That’s when he learned that he couldn’t join the new religion until he proved the sincerity of his faith. Before he could give D.F.A. his money, he had to fill out an eight-page questionnaire about his investment philosophy. This he did, with a feeling that “most of the questions were designed to trick you into saying something you weren’t supposed to say.” Next came the phone interview, which he assumed he passed, since two D.F.A. employees visited his office soon thereafter. “I sat around here answering their questions for two and a half hours,” he says. “Afterward, I thought we were done, but one of them just said, ‘I think we can continue with this process.’ I thought, Are you kidding me? There’s more? And they said, ‘You gotta go to a class.’ ”

The show at D.F.A. breaks down roughly into two acts. Act 1 consists of speeches from impressively credentialed academics who can explain why the efficient-markets hypothesis is scientifically indisputable. The hypothesis is an odd idea with an even odder history. In 1900, a French graduate student named Louis Bachelier completed a dense thesis called Theory of Speculation, in which he concluded that prices follow a random walk—that is, no information about past prices enables a trader to predict future ones. Bachelier described the market as an “aggregate of speculators” who “at a given instant can believe in neither a market rise nor a market fall, since, for each quoted price, there are as many buyers as sellers.” It made sense, but Bachelier’s superiors thought he was either out of his mind or dealing in trivia and blackballed him for any job recommendations.

Then, nothing. For 60 years, people traded stocks happily, gave stock market advice freely, and paid brokers handsomely without anyone’s uttering a peep about the theoretical futility of it all. Stock markets boomed and crashed, and financiers jumped out the windows of tall buildings. Yet it occurred to no one to pick up where Bachelier had left off. In retrospect, it’s clear that an economic incentive to pursue the idea was missing. The only people who understood the stock market well enough to wonder if its efficiency made predictions irrelevant were the ones who made their living selling those predictions. But in time, the American economy grew so prosperous and complicated that it could support an industry of people who did nothing but analyze stock market prices without a view to personal profit and loss. Professors of finance, these people were called, and they made their living publishing papers on their subject for an audience of dozens.

In the early 1960s, the efficient-markets hypothesis finally took off, thanks first to Paul Samuelson, who reminded everyone of Bachelier’s paper, and then to Eugene Fama, who tested it against actual U.S. market data. Fama discovered that the Frenchman had got it exactly right back in 1900: A person could learn no useful information about future stock market prices by examining past performance. Chart reading, graph plotting, momentum analysis, and all the rest of the more esoteric Wall Street techniques for predicting stock-price movements were hokum. Fama went further: No public information at all is of any use to a trader trying to beat the market. Balance-sheet analysis, industry insight, articles in the Wall Street Journal, a feel for the character of a C.E.O.—these are all a complete waste of the investor’s time, as what’s already known is factored into stock prices too quickly to act on it, and what isn’t known is inherently unpredictable. “The true news is random,” says Burton Malkiel, a Wall Street banker turned Princeton professor who published the most famous book on the efficient-markets hypothesis, A Random Walk Down Wall Street. “That’s what people had trouble grasping. It’s not that stock prices are capricious. It’s that the news is capricious.”

The essence of the randomness message was that investors must simply accept the miraculous God-given returns of the stock market as a whole and resist the temptation to try to exceed those returns. They must never believe they possess special wisdom and judgment; the stock market has no use for human wisdom and judgment. Fama attempted to go even further. His most radical hypothesis was that an investor would not be able to profit even from private, inside information about a company. His data ultimately forced him to reject this notion, but not before he noticed how little insiders profited when they traded on what only they knew. The rest of Fama’s hypotheses became academic gospel.

Forty years later, the combination of professional money managers’ fantastic ineptitude and the power of Fama’s argument has driven more than $1 trillion out of stock picking and into index funds. What’s odd about index funds’ rise is that it has occurred in spite of mounting evidence that markets aren’t perfectly efficient after all. In the early 1990s, a counterview was hatched on the fringes of academic finance. How can the market be rational if all the people in it are not merely nuts, but nuts in the same way? If people are crazy enough to pick stocks, time markets, and pump up mutual fund managers who, in turn, don’t know what they’re doing, then why aren’t people crazy enough to create systematic inefficiencies that smart investors can exploit? For the better part of three decades, the efficient-markets theorists brushed aside the question with a flick of the wrist: It doesn’t matter if individuals are mad. If crazy people drive prices out of whack, arbitrageurs will rush in and bring them back into line.But by the late 1990s, the question could no longer be dismissed so easily. What if the asset being mispriced—say the entire U.S. stock market—offers no obvious arbitrage opportunity? The same behavioral-finance professors who delighted in uncovering cases of human irrationality paused to point out specific mispricings that arbitrageurs failed to correct. Economists Richard Thaler and Owen Lamont penned an academic paper about the strange case of Palm and 3Com. After the companies announced an opportunity to get one and a half shares of Palm for every 3Com share, investors found themselves unable to do the math. When the market opened the next day, the firms’ prices didn’t come close to reflecting the deal’s terms. “If the market can’t multiply by 1.5,” Thaler says, “then how can we expect it to get the right level of the S&P?”

And what about investors who systematically beat the market? Fama insisted that they simply don’t exist. If millions of monkeys throw a bunch of darts at the Wall Street Journal, at least one monkey would pick a group of winning stocks.

At D.F.A.’s training seminar, the firm now offers a more nuanced pitch. “It seems to me a foolish argument,” Ken French, a Dartmouth finance professor and D.F.A. board member, tells the audience of financial advisers. “Can Warren Buffett beat the market? I don’t want to have that fight. Let’s agree for a moment that Warren Buffett is a wonderful stock picker. And he’s magnanimous. He wants to share his skill with investors. How would he do that? He can’t! The value of Warren Buffett’s skill is already in Berkshire Hathaway’s share price.” If by some miracle an investor comes along who can beat the market, it is he, not you, who will extract the value.

Now in his late sixties, Fama serves as a consultant to and board member of D.F.A., where his main role is to buttress the convictions of each new platoon of financial advisers and reinforce the idea that investors who try to pick stocks or time markets are fools. He looks and moves less like a finance professor than a retired bantamweight, but he’s no longer much interested in the fight. Forty years of preaching has taught him that his audience either agrees with him or never will. And so he speaks dully, like a man talking to himself. But he makes his point. In his years of researching the stock market, he has detected only three patterns in the data. Over the very long haul, stocks have tended to outperform bonds, and the stocks of both small-cap companies and companies with high book-to-market ratios have yielded higher returns than other companies’ stocks.

These are the facts. The question is how to account for them. Fama’s explanation is simple: Higher returns are always and everywhere compensation for risk. The stock market offers higher returns than the bond market over the long haul only because it is more volatile and thus more risky. The added risk in small-cap stocks and stocks of companies with high book-to-market ratios must manifest itself in some other way, as they are no more volatile than other stocks. Yet in both cases, Fama insists, the investor is being rewarded for taking a slightly greater risk. Hence, the market is not inefficient. Everything else in the stock market he dismisses with a single word: noise. “You can tell a story every day about stocks,” he concludes. “That’s what the media are all about. They tell a story every day about today’s stock returns. It’s businessman’s pornography.”

Businessman’s pornography, as it happens, is Act 2 of the D.F.A. show. With more than a little relish, Wellington, who gives as his credential his having a “master of anecdotal evidence,” gets up and picks apart Wall Street’s phony expertise and the media that feed off it. “What has been the role of the financial media?” he asks and then answers his own question with a series of damning slides. There’s a shelf of financial bestsellers whose titles now sound absurd: Ravi Batra’s The Great Depression of 1990; James Glassman’s Dow 36,000; Harry Figgie’s Bankruptcy 1995: The Coming Collapse of America and How to Stop It. There’s BusinessWeek’s 1979 description of “the death of equities as a near permanent condition,” and SmartMoney’s cover story “Seven Best Mutual Funds for 1996,” whose selections later underperformed the market by 6.7 percent. In 1997, SmartMoney found seven new best mutual fund managers.

They finished 3.4 percent below the market. In 1998, the magazine’s newest best funds came in 2.2 percent below the market. Soon after, Wellington says, “SmartMoney stopped its annual survey of the best mutual fund managers.”He punctuates the porn show with some general lessons. One is that the financial press isn’t in the business of supplying useful information; it’s in the business of feeding people’s lust for predictions. “You keep buying the magazine regardless of how the forecasts turn out,” Wellington says, “and they’ll keep supplying the forecasts.” Another is that if the best mutual fund managers can’t pick stocks well, how can you? A third is that even putatively great money managers exhibit no ability to identify other great money managers. When Peter Lynch retired from his sensational career running Fidelity’s Magellan Fund in 1990, his successors proceeded to underperform the market. “If you wake up in the morning and see Warren Buffett’s face in the bathroom mirror,” Wellington says, “go ahead and buy some stocks. If you see anyone else’s face, diversify.”

And on he goes, persuasively, but as he does, his comments evoke an obvious question, one that no D.F.A. financial adviser dares ask: If all financial advice is worthless and the only sensible strategy is to buy an index fund that tracks the market, why would anyone need a D.F.A. financial adviser? Why, for that matter, should anyone pay D.F.A. the 50 basis points it takes off the top of its oldest fund? D.F.A.’s answer to this is interesting: It can beat the index. The firm doesn’t ever come right out and say, “We can beat the market,” but over and over again, the financial advisers in attendance are shown charts of D.F.A.’s large-cap funds outperforming Standard & Poor’s 500-stock index and D.F.A.’s small-cap fund outperforming the Russell 2000.

In each case, the reason for D.F.A.’s superior performance is slightly different. In one instance, D.F.A. found a better way to rebalance the portfolio when the underlying index changes; in another, it came up with improvements in capturing small-cap risk. All these little opportunities can be (and are) rationalized as something other than market inefficiency, but they are hard to exploit, even with the help of D.F.A. The lesson of efficient-markets theory is that when anyone from Wall Street calls you up with financial advice, you should be very afraid. But it isn’t fear that prompts investors to embrace D.F.A. It’s greed.”

It was a propaganda session,” Blaine says, groping for the best analogy to describe D.F.A.’s seminar. “It was beyond A.A. It was Leni Riefenstahl, but the right way.” Truth be told, for the whole two days of the seminar, he had the unsettling sense that he was being watched. He kept his head down and avoided saying anything that might cause D.F.A. to suspect he was still an ordinary stockbroker. (“Had you said, ‘I think small-cap value stocks are inefficient,’ I think you could get kicked out.”) They weren’t teaching him; they were deciding whether he believed what he needed to believe to sell their investment advice. This was new.

A couple of months after attending the seminar, Blaine succeeded in getting $100 million of clients’ money into D.F.A.’s funds. He worked from his own little space in Beverly Hills, which was, in its most recognizable feature, as unlike a Wall Street brokerage firm as could be: It was completely silent. No TV blaring CNBC. No squawk box. No urgency. “There’s one decision,” he says. “We decide how much to allocate to various funds, and then we’re done.” He wonders why he would need any sort of real-time financial information at all. “What am I going to do: Chart a stock? I think more and more brokers will move to an efficient-markets strategy, because all of their products go bad. They just do.” The hours he once spent obsessing over financial news, he now devotes to SportsCenter. Even his memoir, into which he put so much effort, is on hold. “It’s funny,” he says. “I don’t write as much as I used to, because I’m happy now.”

Last year was, by far, the biggest year of his career. The assets under his management are up 40 percent since he left A.G. Edwards. He’s still making money, but his purpose in life has been turned on its head. Investors used to come to him for tips. Now the same clients come to him so he can prevent them from listening to tips—or hunches, or the latest rantings on cable TV. (“They’ll call and say, ‘Well, Maria Bartiromo just said . . .’ “) His biggest problem is dealing with new prospects. “They come in here, and their funds have underperformed the market by 300 basis points, and the first question out of their mouth is ‘Who’s your guy?’ We have to reeducate them: There is no guy. The guy is the market. The guy is capitalism.”

His job, as he now defines it, is to tell investors that the smartest thing they can do is nothing. He acts as a brake on, rather than an accelerator for, their emotions. For that, he takes between one-half of a percent and 1 percent annually, which is more than they’d pay if they simply bought index funds on their own. “I tell them, ‘Look, if you can control your own emotions and you want to go to Vanguard, you should do it.’ And every now and then, someone asks the question, ‘Why do I need you, Blaine? What are you doing?’ And I say, ‘Howard, be careful or I’m going to send you back to Smith Barney.’ And they laugh. But they know exactly what I mean.”Blaine seems for all the world like a man who has made a separate peace. He works surrounded by large black-and-white photographs of the Louisiana bayou of his youth. If he were required to explain his career now to his 18-year-old self, he wouldn’t need to apologize. Every now and then, he feels the old itch to be a player, but, as he puts it, “When I pick a stock, I do it for my own account, never for clients.” He’s never going to make the really big money (“This isn’t a business model that funds a private jet”), but as long as his clients need him to protect them from Wall Street and themselves, his career has a higher purpose. There’s a hitch, though. Like a reformed addict or an escaped prisoner, he’s now defined by what he isn’t rather than by what he is. What happens when what he does is no longer new? What happens when it’s no longer all that uncommon?

Blaine still takes great pleasure in describing just how screwed up the American financial system is. “In a perfect world, there wouldn’t be any stockbrokers,” he says. “There wouldn’t be any mutual fund managers. But the world’s not perfect. In Hollywood, especially, people need to believe there’s a guy. They say, ‘I got a friend who made 35 percent last year.’ Or ‘What about Warren Buffett?’ ”

Then he pulls out a chart. He graphs for me the performance of one of D.F.A.’s value funds, which consists of companies with high book-to-market ratios, against the performance of Warren Buffett’s Berkshire Hathaway since 1999. While Buffett’s line rises steadily, D.F.A.’s rises more steeply. Blaine’s new belief in the impossibility of beating the market doesn’t just beat the market. It beats Warren Buffett.

 

Taxpayers making more than $250,000 (married filing jointly (MFJ)), or $200,000 (single), may experience 2013 marginal tax rate increases ranging from 13% to 189% over current 2012 rates  – Taxable estate of $5,120,000 will see an increase of 22,659,990.00% over 2012 – if your estate is over $5,120,00 have your food tested at all family holiday parties. (SEE CHART BELOW)

It’s anyone guess if congress will take any action prior to the end of the year. So having a plan in place early is critical. If you own a crystal ball I would love at least 10 minutes.

  • Wages & Self-Employment Income over $250,000 (MFJ), $200,000 (single), or $125,000 (married filing separately (MFS)) will be subject to an additional .9% Medicare Hospital Insurance Tax – depending on your W-4 on file with your employer once you cross these thresholds your employer is automatically required to withhold the additional .9%
  • Qualified Dividends will now be taxed as ordinary income. Tax rates increase from 15% to (39.6 + 3.8) 43.4% for $250,000 (MFJ), $200,000 (single), or $125,000 (married filing separately (MFS))
  • Long Term Capital Gains increase from 15% to 20% or 23.8% for MAGI over $250,000 (MFJ), $200,000 (single), or $125,000 (married filing separately (MFS))
  • Plus all passive income from Interest, Rents, Royalties, Annuities for MAGI over $250,000 (MFJ), $200,000 (single), or $125,000 (married filing separately (MFS)) is subject an additional 3.8% Medicare Hospital Insurance Tax
  • Federal Estate and Gift Tax Exemption drops to $1,000,000 from $5,120,000 – Taxable estate of $5,120,00 will see an increase of tax of $2,266,000 from zero

Income Type

Maximum Marginal Tax Rate

Maximum Marginal Tax Rate

New Medicare Hospital Insurance tax (HI tax)*

New Net Investment Income Tax (other than earned income)*

Combined Maximum Marginal Tax Rate

Net Percentage Increase

Current Law (Pre-1/1/13)

(Post-12/31/12)

(Post-12/31/12)

(Post-12/31/12)

(Post-12/31/12)

(2013 vs. 2012)

Wages and S/E income > $250,000 (MFJ)/>$200,000 (Single)

35%

39.6%

0.9%**

N/A

40.5%

15.7%

Long-Term Capital Gain — Maximum Rate***

15%

20%

N/A

3.8%

23.8%

58.67%

Qualified Dividends

15%

39.6%

N/A

3.8%

43.4%

189.33%

Passive Interest, Rents, Royalties, Annuities, Other (IRA’s not Subject)

35%

39.6%

N/A

3.8%

43.4%

24%

Flow through Income — Active Trade/Business

35%

39.6%

N/A

N/A

39.6%

13.14%

Flow through Income — Passive Trade/Business

35%

39.6%

N/A

3.8%

43.4%

24%

Estate & Gift Tax Rates  Federal Exemption from $5,120,000 drops to $1,000,000

35% over 5.12 Mil

55% over 1 Mil

N/A

3.8 % added on to Trust & Estate non-distributed income

55%

22,659,990.00%

Our next blog will discuss strategies and planning – unless of course I get my hands on that crystal ball!

The Fidelity Amex 2% cash back should be considered when evaluating reward credit card reward programs.  Every month, 2% of your purchases are automatically credited to a Fidelity Investment account of your choosing (we usually recommend a brokerage account to ensure you don’t over fund a Retirement account).  There are other rewards options for travel, merchandise, etc – but we prefer the monthly deposit for ease of management.

Key Features

  • No Annual Fee
  • 1% foreign transaction fee
  • Remember Amex not accepted everywhere
  • Not a travel rewards card

There are other cards that offer a higher teaser rewards rate or earnings categories, but the simplicity draws us to this one.  This is a retail card and Lighthouse Financial Advisors cannot apply on your behalf.  If you are interested, please use the link below.  As always do not hesitate to call us if you need to clarify which Fidelity account to direct the cash back to.

http://personal.fidelity.com/misc/buffers/retirement-rewards-card.shtml.cvsr

If you put $3k worth of expenses on this card monthly, $60 is coming back to you every month.  At a 5% growth rate, this grows to over $9,300 in 10 years, and over $24,500 in 20 years.  That is a very tangible slush fund for you to use with no hassle of the typical credit card rewards program…all for about 10 minutes of your time to set up.

Do you have a rewards card you love, if so we would love to hear about it (send yours to luke@lfadvisors.com  and we’ll publish the best shortly).