Observations of an In-House Counsel by Gregory Tevis

Observations of an In-House Counsel

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Gregory C. Tevis

Observations of an In-House Counsel© – For several years I sent out a weekly email to the branch managers, branch administrators, operations managers and control persons in the Western Division of my firm. The email informed them of my schedule for the forthcoming week and included an “observation” which was designed to be helpful to branch personnel including Financial Advisors and their assistants. Branch managers commonly forwarded these emails to all of their branch personnel. I have accumulated these observations below and in the pages that follow. At the end of each observation I have indicated the date that the observation was included in an email.

• Behavioral Economics In 1996, I read a law review article ("Selling Hope, Selling Risk: Some Lessons for Law from Behavioral Economics about Stockbrokers and Sophisticated Customers," 84 Cal. L. Rev. 62 (1996)) by Professor Donald C. Langevoort. This article had some interesting comments on the psychology of investors. I kept those comments in mind during the succeeding years and observed whether those comments turned ©out to be valid in my opinion. Several of them described at least in part what I observed. Here are a few of my Observations:

Hindsight Bias

The natural tendency of an individual to overweight the probability that an event would occur after being told that the event had occurred.

Increase in Risk Assumption

An individual who frames a loss reacts by desiring to increase the level of risk in their investment portfolio to make up for the perceived loss.

Social Comparisons Increase Risk Assumption

Overconfidence

People exhibit overconfidence in their ability to predict future events leading to an underestimation of risk. Self Esteem

Self-esteem is a motivating factor in the investment arena. Successes are attributed to the exercise of skill. Failures are attributed to external causes. Risk assessment

Risk taken by an investor often takes the form of failing to perceive and appreciate the risk as opposed to its deliberate assumption. Stress

Mental recognition of risk causes stress. perception of risk, and thereby avoid stress.

Investors tend to avoid the

Trust

The transfer of trust to a financial advisor greatly reduces stress for investors. To avoid stress investors often transfer significant, if not absolute, trust to the financial advisor. Admitting Mistakes

The selection of a financial advisor presents investors with the opportunity to assume the greatest amount of risk. Investors often take advantage of the opportunity Eventually, however, if loss-framing occurs the investor’s prior resistance will be overcome. At that point the investor will conclude that their trust has been breached, and begin to complain, often criticizing (long) past investments and their dealings with the financial advisor (even at prior firms). -02/14/2006

Note: Over the years since 1996 I have continued to read material related to the psychological aspects of investment decisions. In the Observations that follow I have frequently incorporated principles discussed in the material I have reviewed. Some of my Observations do not deal with behavioral economic principles but do deal with problems encountered in the retail stock brokerage business.

• Portfolio evaluation tools As a consequence of the emergence of the management of client assets by brokerage firms we may expect that customer complaints and arbitrations in the future will focus on the acquisition and maintenance of an investment portfolio. Therefore, we may wish have to have some familiarity with: Standard Deviation – a measure of systematic and unsystematic risk of an investment or portfolio. Beta – a measure of the volatility of a stock or portfolio against a benchmark index. R-squared – a statistical tool used to determine the relevance of Beta. Alpha (Jensen Index) – a tool to measure the risk adjusted performance of a diversified portfolio. 4

Sharpe Ratio or Index – a tool to measure the risk adjusted performance of an undiversified portfolio. Sortino Index – a modification of the Sharpe Ratio using downside variance only. Treynor Index – another tool to measure the risk adjusted performance of a diversified portfolio. Duration – a tool useful in measuring the volatility of bonds versus changes in interest rates. Value at Risk - a tool that calculates the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence. We may also wish to be familiar with the interrelationships some of these tools have (e.g. R-squared and Beta). I don’t think it is necessary that we have to know how to do the actual calculations but rather have sufficient familiarity with these tools to know the appropriate circumstances for the use of a particular tool and the significance of the results of its application. -03/15/2006

• The road to hell is paved with good intentions Breaking a regulation to accomplish a client request is the single most common cause for the termination of the careers of FA s and CSA s. Each brick in that road has client accommodation stamped on its top side. -11/05/2006

• Hindsight Bias Revisited Hindsight bias: The natural tendency of an individual to overweight the probability that an event would occur after being told that the event had occurred.

The most common allegation I see in arbitrations is "knew or should have known." Often its resolution is the deciding issue. Its resolution also involves the involuntary and subconscious application of the principle of "hindsight bias" by the panel members. When you judge risk, you judge it with foresight and objectively. When panel members judge risk, they judge it with hindsight and not so objectively (using hindsight bias). Keep that in mind in deciding how you want to manage your risks. -10/30/2006 • Financial History People often judge the financial history of an account on an objective basis, that is, how would such an account history normally appear. You may wish to take that into consideration when a client wants their account to be operated on a subjective basis, that is, based on wishes of the client that diverge from the norm. In such a situation it may be helpful to document the client's wishes, our advice and the ultimate course of action. -10/10/2006 • Winners and Losers People tend to become more upset about holding onto a "loser" too long than selling a "winner" too soon. -10/03/2006

â&#x20AC;˘ Filling out forms When we provide a guess or estimate in filling in a blank on a client related form (on line or otherwise) we cause people who may later review the situation to disbelieve other true and accurate information we have in fact collected from the client. Often this reaction is subconscious and involuntary making it very dangerous for us to guess or estimate about client related information. In a client dispute or regulatory inspection guesses or estimates are revealed and cause us to be disbelieved at a time when our credibility is critical. So don't guess or estimate. -07/25/2006 â&#x20AC;˘ Aged Clients The advancing age of our clients causes us to face a very delicate and difficult problem - whether a client has become mentally incompetent. The law is quite clear but not very helpful: someone who is mentally incompetent at the time cannot give us a valid instruction. The first tip off I have seen when a client is approaching this status is that they begin to forget conversations they have had with you. The best way to deal with the situation is to keep your focus on where we may need to end up and that is with someone substituting as the client's authorized representative. We may need to gently but persistently suggest (and eventually insist) that a representative be put in place. How that can be accomplished requires too lengthy an explanation for this simple observation. When you need that advice get in touch with me and I will help. Bottom line is: donâ&#x20AC;&#x2122;t over react but do be on your guard.

-08/01/2006

• I sincerely wish the following were not true but it is: When someone ignores a rule, regulation or law in our business they affect the lives of other people. -08/14/2006 • Exceptions Requests for exceptions should be considered in the context that they will exist. The risk will remain long after the goal is achieved. -09/12/2006 • “Nobody eats just one chip.” When you discover misbehavior by an employee such as an unauthorized transaction, use of "vest pocket discretion", embezzlement, forgery etc., keep in mind the line from an old TV commercial that "nobody eats just one chip." Where you find one inappropriate act - you may find others. -07/18/2006

• Overconfidence

Overconfidence in predicting the future is counterproductive to successful investing. It is also a sign of a "heads I win - tails you lose" investor. -10/24/2006

• Watch Out The most dangerous investor I have seen is the novice who has become obsessed with the market. -09/05/200 8

â&#x20AC;˘ Watch Out Part Deux The most dangerous assets are those that are received in divorce or inheritance. Clients receiving those assets are not in touch with their true risk tolerance. -09/26/2006

â&#x20AC;˘ Over the past several months I have been forwarding some of my observations to you. Recently I ran into a customer complaint which reflected the combination of several matters I have discussed with you. A widow inherited assets (inherited assets are dangerous because the owner is not in touch with their true risk tolerance) and selected her own FA. The stress of her husband's death increased the propensity of the client to mentally transfer all accountability for account performance to the FA. Furthermore the widow had selected the FA herself (reinforcing her ego) thus causing her to ignore performance feedback that conflicted with her subconscious risk tolerance. This continued for an inordinate period of time but eventually she completely reversed herself (at a time when although the account was up the account had not progressed in accordance with her "mental accounting") and accused the FA of infractions which were unwarranted and added accusations that had no basis in fact at all. The bottom line: from an objective standpoint the FA did nothing wrong and the account was handled appropriately. Nevertheless we have to deal with the fact that there is a complaint. The foregoing factors of inheritance (lack of appreciation of true risk tolerance) stress over the death of husband (causing risk and accountability transference) and ego reinforcement (deflection of performance feedback) created an ongoing situation which generated an objectively unjustified complaint. In reality such a client subconsciously does not want to participate in or be responsible for the performance of the account. This client simply wants it to be "there" at the appropriate time in the future. My advice, when an FA gets a new client who has received assets by inheritance or divorce you have a much higher risk situation than you may 9

have normally perceived. Such situations demand much more time and attention than the normal client relationship. An ounce of prevention is worth a pound of cure. To avoid the unjustified complaint the FA s should proceed slowly and cautiously with such a client (keeping in mind that the factors I have discussed are at work) and then not only extensively orally communicate with the client but confirm the communication in writing. -10/18/2006

â&#x20AC;˘ Unexpected Events Everyday unexpected events occur. Keep that in mind in considering the completion of account paperwork and confirmation of client communications. Most importantly, however, tell the people you love that you do and do it often. -10/25/2006 â&#x20AC;˘ Turning on the Light In one of my earliest observations I stated: People exhibit overconfidence in their ability to predict future events leading to an underestimation of risk

I have observed that the reverse is also true: Failure to perceive risk leads to investor overconfidence

When a client appears to be overconfident about the outcome of an investment you may conclude that the light bulb of risk perception is not on. Consider turning on the light. -12/19/0 10

• More Behavioral Observations The more we dread an outcome, the more anxious we get, and the more anxious we get, the less precisely we calculate the odds of the outcome actually happening. It's called “probability neglect." Combine that with “hindsight bias” in the context of an arbitration (where the panel is viewing historical events) and you have a real problem. People are quite capable of repeating the same investment mistake. It may take time for them to forget the lesson they learned but eventually they do. People underestimate risk to a larger extent when they feel they have some control over the situation (transactional business) than they do when they do not have as much control (managed business). Optimism bias - is the convenient belief that risks that apply to other people don't apply to us. People rationalize risky behavior that also confers some benefit to their ego (such as rapidly trading stocks). -12/05/2006

• Don’t sell Insurance This past week I participated in a conference with a Financial Advisor, Branch Manager and client. The client stated “I am not an expert; my broker told me to do this so I did and I lost money. I want my money back it’s as simple as that.” The FA was stunned and after the meeting was over asked me if I had heard that before. I said many times. The FA stated that he explained the risks and got a firm order. He asked me for an explanation of the client’s reasoning. This is the explanation I gave: Clients do not like stress - They seek to eliminate it if given the opportunity 11

Clients do not like risk - They seek to transfer it if given the opportunity The prospect of making a decision causes stress - Clients seek to transfer the decision and eliminate the stress A transaction requires a decision - Little ones little stress, big ones big stress A client’s ego tells them they picked a good Financial Advisor - You’re their expert Clients eliminate stress by not making the decision - They transfer the decision to their expert Clients transfer the risk to you as well - You made their decision, it’s only fair The FA asked me for some advice and here is what I told him: Prevent the transfer of the decision/risk by taking extra time to get the client to verbalize the risks to you before you permit them to give you the order. The FA fought me a little on the fact that people like to transfer risk if given the opportunity. I asked him if he had heard of the insurance industry. I was asked to pass this on and so I am. En garde. - 12/12/06 • Kung Fu Fighting Resist the temptation to choose sides in a dispute between spouses, joint tenants, heirs or trustees. Avoid even the appearance that you have done so. Otherwise abandon all hope as the participants in these disputes draw no quarter and stop at nothing to gain an advantage. 12

Example: Last week the two trustees on a trust account simultaneously filed involuntary conservatorship proceedings (in different courts) against each other in an effort to wrest control of the trust from the other trustee.

You know - you just can’t make this stuff up. – 12/26/2006

• Betrayal Recent events have reminded me -

The checks and balances we have in place in our branches are not there because we are bad people. They exist because – sometimes people (especially people we have known for a long time) betray our trust. Nothing good comes from ignoring our checks and balances. Careers, lives and families are ruined when they are ignored. - 01/02/2007 • Remember Stuart People learn lessons from the market, but those lessons are not learned forever. Sooner or later those lessons are forgotten. By the look of recent television ads I think we can surmise that the lessons we learned from the tech wreck may be fading in the public’s mind. You may wish to consider this when managing risk. - 01/17/2007 • Whoops People don’t start out with the intention of creating the potential for a big problem. They cut a corner here and there and one day they wake up and …. - 01/23/2007

â&#x20AC;˘ Why Now This past week I read a statement of claim in arbitration against us demanding several million dollars in damages. The FA and the accounts left us in November 2002. The accounts went with the FA to the new firm and remained there until now. The claim says the FA engaged in unsuitable transactions, breached his fiduciary duty and churned the account at SB. The firm is also accused of failing to supervise. The FA is accused of doing the same things at the new firm which is also accused of failing to supervise. At this point you are probably wondering why it took so long for the client to come around to their current view. This case is a classic example of something I have previously mentioned in my Observations and justifies revisiting that subject. I reproduce my original Observation to you and underline the sections that apply to this case and explain "why now"? You may wish to consider these matters in managing your risk.

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Behavioral Economics

In 1996 I read a law review article ("Selling Hope, Selling Risk: Some Lessons for Law from Behavioral Economics about Stockbrokers and Sophisticated Customers," 84 Cal. L. Rev. 62 (1996)) by Professor Donald C. Langevoort. This article had some interesting comments on the psychology of investors. I kept those comments in mind during the succeeding years and observed whether those comments turned out to be valid in my opinion. Several of them accurately describe what I observed. Here are a few Hindsight Bias

The natural tendency of an individual to overweight the probability that an event would occur after being told that the event had occurred.

Mental Accounts

An individual's view of their current assets is not what they currently have but rather a mental picture of what they expect to have at some specific time in the future. Loss Framing

When an individual perceives that they will not have the assets specified in their mental accounts they "frame" a "loss" and consider it as a realized loss rather than a potential failure to reach a goal. Increase in Risk Assumption

An individual who frames a loss reacts by desiring to increase the level of risk in their investment portfolio to make up for the perceived loss. Social Comparisons Increase Risk Assumption

People exhibit overconfidence in their ability to predict future events leading to an underestimation of ris Self Esteem

Self-esteem is a motivating factor in the investment arena. Successes are attributed to the exercise of skill. Failures are attributed to external causes.

Risk assessment

Risk taken by an investor often takes the form of failing to perceive and appreciate the risk as opposed to its deliberate assumption. Stress

Mental recognition of risk causes stress. perception of risk, and thereby avoid stress.

Investors tend to avoid the

Trust

Once investors make a decision, changing direction implies that they have made a mistake. Investors tend to filter out facts suggesting that they made a mistake, thereby avoiding the perception of risk and its consequent stress. The selection of a financial advisor presents investors with the opportunity to assume the greatest amount of risk. Investors often take advantage of the opportunity. Once committed to the relationship with the financial advisor, investors will resist any notion that they are being exploited. Entertaining suspicion would force the investor to reconsider their initial commitment, admit that perhaps they made a mistake, perceive risk and incur stress. Contrary feedback must be immediate and unambiguous to overcome an investorâ&#x20AC;&#x2122;s resistance to a contemporaneous admission that they made a mistake. 16

Eventually, however, if loss-framing occurs the investor’s prior resistance will be overcome. At that point the investor will conclude that their trust has been breached, and begin to complain, often criticizing (long) past investments and their dealings with the financial advisor (even at prior firms). _ -02/14/2006 -01/30/2007

•

Walter you were right.

Clients are resilient and can accept bad news as long it is conveyed in a transparent manner. Last week I watched the self destruction of the careers and lives of two Financial Advisors all because of what started out as a failure to convey negative information transparently. You may wish to consider this in managing your risk. Oh what a tangled web we weave, When first we practice to deceive! -Sir Walter Scott •

Sitting Duck.

The oldest trap continues to catch people. When an FA agrees to a client's request that “you just do what you think is best" the FA becomes a ….. Whenever a client wants they can deconstruct the FA's career. -

02/12/2007

â&#x20AC;˘

Snap Clients often place an incredible amount of trust in their broker.

This past week I watched the career of a broker self destruct. It seems that the client loaned the broker over two hundred thousand dollars no questions asked. When the broker was late with repayment the client brought this matter to our attention for the first time. The client's trust did not slacken or unravel. It snapped like a rubber band that was stretched too far and stung. -02/20/2007

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Pride and Regret

Behavioral Economists tell us: Closing out a winning position promotes a feeling of success and pride. Closing out a losing position promotes a feeling of failure and regret. People sell winning positions (so they can lock in that feeling of success and pride) too soon and hold onto losing positions (to postpone and possibly avoid the feeling of failure and regret) too long. You may wish to consider this when counseling clients. â&#x20AC;˘

03/06/2007

Elderly Clients

Elderly people frequently become overly fond of their service providers often viewing them in the same context as close relatives. Recently I watched the careers of two Financial Advisors self destruct. It seems that each had an elderly client who gave them significant gifts. Later the clients became so elderly that someone else took over managing the financial affairs of the clients. That person took great exception to the gifts and... -03/13/2007 18

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Lewis Black on Modern Portfolio Theory (hypothetically)

The field of finance has provided us powerful investment tools, e.g. modern portfolio theory, capital asset pricing model (CAPM), the arbitrage theory and option pricing models. These tools provide great insight into expected risk and return. Keep in mind, however, that all of this has evolved based on the following two assumptions: - People make “rational” decisions - People are “unbiased” in their predictions about the future To that Lewis might say – those assumptions sound good except for the fact that ……. I would say people are subject to bias, frequently act in an irrational manner and make (it turns out) predictable errors in their forecasts of the future. We have to take into consideration behavioral economics (and modern finance theory) if we want to be smart in pursuing our careers. Failure to understand psychology as it relates to retail investing is in my view, the principle cause of unjustified client discontent. After thirty years in this business I think I can say with conviction – if you want to minimize your risk of an unjustified customer complaint, learn all you can about behavioral economics. -

An example

People place far too much emphasis on the most recent news about a subject and do not put it in the proper overall context. This overemphasis on the most recent news causes people to overreact to both good news and bad news. This overreaction is a principle cause of panic selling and impulsive buying in the retail investment world.

By the way did you know that a significant study shows that stocks investors sell tend to do better (subsequently) than the stocks that are purchased to replace them. (1) - 03/20/07

(1) Terrance Odean. "Are Investors Reluctant to Realize Their Losses?", Journal of Finance, Vol. LIII, No. 5, October 1998, 1775-1798. 19

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New Sheriff in Town

Whenever a new person is injected into the client/broker relationship such as a new trustee, custodian, conservator, guardian or attorney-in-fact (POA) that new person feels compelled (and may indeed be obligated) to review the history of the relationship and the account. Many times this new person has an agenda and may not be objective in his or her review. Most often I have seen this situation develop in relation to client death, incompetence or divorce and accounts for minors and elderly clients. Keep in mind that change in the client/broker relationship is inevitable. You may wish to manage your risk with that in mind - 03/27/2007 •

Mental Shortcuts

People use mental shortcuts to simplify and solve difficult problems of judgment and choice that confront them. These mental tricks (psychologists call them "judgmental heuristics") are subconscious and although they can be helpful generally, in our world they are often wrong and harmful. - Example People often make investment decisions based on small, statistically insignificant or inconclusive samples, e.g. last years hot investment sector or buying shares in a restaurant chain because the lines are long.

More about “mental shortcuts” in the future but for now be aware that clients use them to avoid digesting what they perceive as large amounts of information and to simplify difficult decisions. The best thing you can do here to manage your risk is to present information and advice to clients clearly and succinctly. If they don’t feel overwhelmed then maybe they won’t use a mental shortcut and will listen to the advice of their Financial Advisor. - 04/03/2007 20

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The Herd

Investors in combination exhibit some characteristics of a herd, and individually, some characteristics of herd animals. Normally herd animals are myopic (they focus on what they see directly in front of them - the grass beneath their noses) and graze peacefully. When they hear or see something out of their focus it startles them and they look to see what the other herd animals do in reaction. If there is a reaction, however so slight, then they disconnect their focus in front and instead obsess over what the other animals are doing. They follow and amplify the action of the others often - with dire consequences. The tragic thing is that what startles them in the first place is often quite harmless. It is the magnification of the reaction that is harmful. We can’t ignore the heard but we can understand it. You may wish to keep this in mind as you manage your risk and counsel clients to keep a broad perspective. -04/10/07 •

Anchoring

When asked to analyze something and make a decision most people fix on something before beginning. Often what they “fix” on is suggested to them. The fixed point is not evaluated it’s just used and often results in a bad decision. Behavioral economists call this “anchoring” and say it’s an unconscious and virtually inescapable phenomena. Clients will do this. Example What is the correct pronunciation of the capital of Kentucky –Louis ville or Louville?

The answer later

- 04/13/0

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Observations of an In-House Counsel

Recently I was asked why I write my observations. My answer is very simple - to help people be successful. This one though is personal. In view of recent events I was asked to republish one I gave last November. I do in relevant part.

Unexpected Events

"Everyday unexpected events occur. …. Most importantly, however, tell the people you love that you do and do that often." -11/14/2006 -04/18/07

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Anchoring part two (a conversation)

Ok four people emailed me the correct answer (Frankfort) but even they thought about the alternative pronunciations of Louisville and therefore used the suggested Anchor. At first they said they didn’t but eventually they confessed (never mind how that happened). But what if an Anchor (a reference point used to make an analysis, estimate or decision) is not suggested? Then people pick one (but don’t tell you what it is very often). This is even more dangerous if you don’t know that they are doing it or what they have selected as the Anchor. As an example, suppose I ask you to estimate something without looking up the answer such as: The weight of a 747 at takeoff (yes Bob*, of course with fuel - how many of those babies have you seen take off without fuel?). What psychologists tell us we do is to think of a reference point (in this case an object whose weight we think we know) and then we compare it mentally to the 747 in order to arrive at our estimate. There are a couple of problems with this approach. First what if our knowledge about the reference point is 22

wrong and second what if the relationship is inaccurately imagined. The answer is our estimate is wrong. In our business this can spell trouble for you even though you did not suggest the “anchor” or reference point. My adviceFirst understand that anchors are universally used in our financial world (e.g. standard deviation, 52wk high, 60 day moving averages, etc.). Second make sure the anchor that is used is appropriate and discussed with the client (you would be surprised how often the one that is used is not discussed). Finally continue to talk to the client sufficiently to make sure they are not using some unarticulated goofball anchor. Unless you do this you won’t be able to successfully explain the rationale for the original decision, analysis or estimate. Yes, Bob* of course when you have to, why else would you… Whatever, the rest of you I’m sure get the idea. What’s a person to do with Bob*? * Disclaimer: There is no Bob, Bob never existed and never will exist. Any resemblance to a real Bob is purely coincidental and unintentional. Ain’t that right Bob? -04/24/07

• I would rather Golf than Work Ongoing Observation to the Observation I made last fall (which was)– • "The road to hell is paved with good intentions." Breaking a regulation to accomplish a client request is the single most common cause for the termination of the careers of FA s and CSA s. Each brick in that road has client accommodation stamped on its top side. 11/05/2006

- and add a new phrase on some of those bricks

-05/04/200 23

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Put the Big Dog back on the Porch (a conversation)

In view of the recent run up of the markets I thought of the incredibly perceptive adage: “Don’t confuse brains with a bull market” Bull markets cause clients to become confident of their abilities in our world. This causes clients to want to abandon in whole or in part their carefully diversified portfolio approach and concentrate their positions a little or a lot, maybe even get a little feisty in the their trading frequency or ratchet up the old risk in their portfolio. My advice – Take a nice new blue magic marker and write the adage on the palm of each of their hands. When the market turns south those that didn’t listen will be singing this song popularized by various artists’ years ago.

• Right Place Wrong Time I was in the right place, but it must have been the wrong time I was sayin' the right things, but I must have used the wrong line I was on the right trip, but I must have used the wrong car Head is in a bad place and I wonder what it's good for I was in the right place, but it must have been the wrong time My head is in a bad place, but I'm havin' such a good time I've been runnin', tryin' to get hung up in my mind Really got to give myself a good talkin' to this time Just need a little brain salad surgery I got to cure my insecurity And I was in the wrong place, but it must have been the right time 24

I was in the right place, but it must have been the wrong song I was in the right thing, but it seemed like a wrong wrong 'Cause I was in the right world, but it seemed like a wrong, wrong, wrong, wrong, wrong Slippin', dodgin', sneakin', peepin', hidin' out down the street See my life shakin' with every who I meet Refried confusion is a-makin' itself clear Wonder where to, where do I go to get on outta here 'Cause I was in the right place, but it must have been the wrong time And I was sayin' the right thing, but I must have used the wrong line I took the right road but I must have took a wrong turn I took a right move but I made it at the wrong time I was in the right trip but I made it in the wrong car My head is in a good place and I wonder what it's there for 'Cause my skull is in a bad place

No John* I am not going to sing that on the Monday call – I can’t sing – you sing it. John*, quit singing the song and pay attention to the advice. Oh well, the rest of you get the ideas . I was in the right place…. *Disclaimer: John is a real person but in this case it’s just not Dr. John. -

05/10/2007

• Adam Smith For those of you who are still skeptical about the relevance of behavioral economics I recently ran across something that might change your mind. Adam Smith the Scottish Economist who wrote The Wealth of Nations also wrote The Theory of Moral Sentiments. In this latter book he observed that “we suffer more …when we fall from a better to a worse situation, than we ever enjoy when we rise from a worse to a better.” That is the definition of the behavioral economic concept of “Loss Aversion” that I touched on in my October 3, 2006 and March 6, 2007 Observations. •

Winners and Losers

People tend to become more upset about holding onto a "loser" too long than selling a "winner" too soon. -10/03/200 25

• Pride and Regret Behavioral Economists tell us: Closing out a winning position promotes a feeling of success and pride. Closing out a losing position promotes a feeling of failure and regret. People sell winning positions (so they can lock in that feeling of success and pride) too soon and hold onto losing positions (to postpone and possibly avoid the feeling of failure and regret) too long. You may wish to consider this when counseling clients. -

03/06/2007

That’s all I have for now. I will have more to say on Loss Aversion next week. -

05/17/2007

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Loss Aversion (a conversation)

People much more strongly prefer to avoid a loss than acquiring a gain. A famous study by Kahneman and Tversky demonstrated this point. During their study – A group of people was presented with the following choice and each individual asked to choose their preferred outcome: “In addition to whatever, you own, you have been given $1,000. You must now choose between: a. b.

a sure gain of $500 or, a 50 percent chance to gain $1,000 and a 50 percent chance to gain nothing.” 26

84 percent of the group picked the first alternative A second group was presented with a different problem: “In addition to whatever you own, you have been given $2,000. You must now choose between: a sure loss of $500 or, a 50 percent chance to lose $1,000 and a 50 percent chance to lose nothing.” 69 percent of this group picked the second alternative a. b.

It may not be immediately evident but these two problems have identical outcome possibilities. When phrased using “gains” the first group chose the smaller sure thing demonstrating that they weren’t really hot about trying to max out their gain. When phrased using “losses” the second group demonstrated their intense desire to avoid a sure loss, even incur more risk in exchange for the possibility of avoiding a loss altogether. Hard to believe but people will actually agree to incur a larger risk to avoid a loss over the risk they would take to obtain a gain. That propensity of course can lead to, shall we say, some “backfires.” My advice – You may wish to consider this when framing potential outcomes for clients. It may have an affect on the client’s decision. Make sure whatever effect you get is the one you intended and didn’t get by accident. Adam Smith was right (see last week’s Observation). No Mike* I didn’t get it the first time either. Sometimes you have to read this stuff several times. *Disclaimer: yes there really is a “Mike”; I am just not going to tell you who it is. -05/24/2007

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Escalator

When the escalator breaks people get hurt. Just try and make sure you’re not the one who broke it. This goes for everybody even FA s and SA s. -05/31/2007

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Lake Wobegon

"the women are strong, the men are good looking, and all the children are above average,"

Optimism bias is a mental shortcut (see my 04/03/2007 Observation). Nobel Prize winner Daniel Kahneman and a colleague produced research which tells us that our clients have a bias towards optimism generally and in one subtle yet important way that affects you. They tell us that investors often focus entirely too much on the unique facts and circumstances of a particular proposed investment. You might say they obsess over the specific facts and circumstances. The belief in the power of the possession of this information causes clients to adopt the adage I have quoted above (they are then above average when it comes to acumen regarding this investment decision). This is called the “inside” view. What they don’t do sufficiently is to take an outside view (psychologists call “reference forecasting”) that is, examine the experiences of a class of similar investments. Kahneman’s study and subsequent studies have shown that when investors use an outside view they produce much more accurate forecasts of investment results. Also such a view is much less likely to produce unexpectedly negative outcomes. I have seen the inside approach manifest itself time and time again in areas including a low priced stock (the line goes low price stocks are not good investments except this one is different), a desire to concentrate in a stock, shorting stocks and or options, timing the market. The list is too long to repeat here. My adviceWhen discussing an investment ask your client questions which are designed to instill an outside view (position the proposed investment in the framework of the history of similar investments). Be careful because the use of an inside view is ingrained and intuitive in your clients. Nevertheless you should strive to get a balance between optimism and realism from your clients when they are making investment decisions. If you do that you will 28

reduce the possibility of unexpectedly negative outcomes (we have already gone over how your clients feel about those). -06/07/2007

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I am not Karnack but

Recent events have reminded me that the term “error account” has the word “error” in it. So I posed the question to my crystal ball and asked: Why is that word in the title? The answer took a few minutes but it came back: Maybe because the error account is for errors. If it wasn’t an error (by error we do not mean to err in either an existential or metaphysical sense – given that no normal human has any idea what those words mean) in the first place you may very well get in trouble for using it and I, Greg Tevis, will tell you I told you so. The exchange might not let an FA (or CSA) off the hook because management let her/him use it. Ain’t that right Jimmy*? *Disclaimer: this observation was ghost written by the “Fabulous” Jimmy Chance - stockbroker extraordinaire. Jimmy prefers to introduce himself as Chance, James Chance. 06/13/2007

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Yes but this time it’s different

It never is. Why do you think they named it the “mean?” Maybe because of the harsh way you can be re-taught an old lesson when something reverts to it -06/18/200

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Saving Careers - Helping Families

"Out, damned spot! out, I say... --Yet who would have thought the old man to have had so much blood in him... What, will these hands ne'er be clean? No more o' that, my lord, no more o' that… Here's the smell of the blood still: all the perfumes of Arabia will not sweeten this little hand. Oh, oh, oh!” -Lady Macbeth -- Macbeth (V, i, 38)

I hate “White Out.” This year alone several people have ruined their careers using it. Each one of them has a family. You may wish to consider whether there is any legitimate reason to have “White Out” in your office any longer. While we are never going to be able to remove motive completely, we can remove opportunity – perhaps save a career and help a family. When the deed is done, the spot remains - even if “White Out” is used. Ask Lady Macbeth - she learned the hard way. -06/22/2

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When its mine it’s mighty fine, when its not it’s not worth a lot

People place a higher value on something if they own it than they do if they do not own it (the “endowment effect”). The behavioral economist Richard Thaler demonstrated this in a famous study. I suspect that this principle is the real basis for the personal bid and ask differential. Behavioral Economists (Kahneman, Thaler and Knetsch) also tell us that people have a bias in favor of the status quo. Not surprisingly they call this the “status quo bias” (clever people). 30

When you combine those two principles with the principle of Loss Aversion (which I have previously talked about) you can see that people really don’t like to let go of things they own, including securities. This, in my view, leads to many ills not the least of which is the tendency to fail to diversify and update one’s portfolio. Keep in mind that these principles act on a subconscious level and are involuntary which means your clients don’t realize that they are being affected in this way and can’t help it. These biases can hurt your clients. My advice – First, keep in mind that the biases exist and are silently working on your clients. Second, frame your discussions with your clients to combat this problem, if necessary discuss them with your clients. Once you make people aware of the biases and their operation I believe their impact will greatly subside. - 07/02//2007

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Risk/Reward Ratio

There seems to be a misperception by some FA s and CSA s about the risk/reward ratios of the firm vs. ratios of individual employees. Yes the firm has the deep pockets. However, the firm doesn’t have a career but people do. A firm can transform management or transform itself in other ways that people simply cannot accomplish. I would even go so far as to say that the reputation of a firm can recover sometimes just by the passage of time. You may wish to consider whether this is true for an individual’s reputation. If you are in this business for a career, then ask yourself a very serious question: Whether there is any circumstance or indeed any client/household that is worth the risk of your career or reputation 31

I think you know what my answer would be. •

-07/09//200

Zip your Lip

Financial Advisors continue to deconstruct their careers in connection with investments that happen away from the firm. Something as simple as a remark that “I don’t know anything about it but you may want to look into it” can be the cause. The simple fact is that you are an advisor in financial matters and you do it as a profession. My adviceResist the temptation, to make a referral, introduction, review something or even make a casual remark about something away from the firm. If asked tell them you can’t comment. If asked why tell them because I specifically told you that could not. I don’t mind being the bad guy. Nobody likes lawyers anyway. Ain’t that right Billy*. *Disclaimer: Billy Ray Wrightoff (formerly an FA) is a promoter and friend of Jimmy Chance. Jimmy does not recommend him. -

07/16/20

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Inherited Accounts

You may wish to refrain from making any comments at all about a departed broker when talking to a client about an inherited account. Whatever you say will not be repeated accurately or in the same context as the remark(s) you actually made. In this regard I am reminded of advice I have been giving for thirty one years as a lawyer on the subject of statements. It goes like this; when in doubt don’t say anything. If you don’t say anything then the person has to make up a chain of lies, first that you said something, second who heard it, third when and where the statement was made, and finally what it was that you said. It will be easy to disprove at least one link in that chain. If you say something, then they only have to make up one lie. 32

My adviceStick to statements about yourself and our firm when speaking to clients. You will be happy you did. -07/23/2007 •

Illusion of Control

People often have the illusion that they have control over the outcome of something when in reality they clearly do not. Take for instance the manner in which people throw dice in the game of craps. Studies have shown that people believe throwing dice softly will lead more often to low numbers and vice versa. Another example is the fallacy that in picking your own lotto numbers you increase your odds of winning. This illusion asserts itself in our business. People tend to believe that they have or will have some influence over an investment after investing. This illusion leads an investor to ignore important information before and feedback after the investment thereby increasing the risk that the investor has undertaken. It actually reduces the one control an investor does have and that is deciding whether to buy, hold or sell. In short we have no influence over whether an investment goes up or down. We only control our buy, hold and sell decisions. You may wish to take this into consideration when advising clients. -

08/06/2007

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Choice and Memory

People tend to remember the positive attributes you mentioned when deciding whether to follow a suggestion you made and tend to forget the negative attributes you mentioned. This is called “Choice-supportive bias” by behavioral economists. This bias is pronounced in elderly clients but affects all of us. 33

My advice – Keep this bias in mind when presenting an investment or other advice to a client. If this is a significant proposal or a proposal in a new direction you may wish to consider confirming the positives and negatives in writing to the client and summarize their decision. -

08/20/2007

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The Yearn to Confirm

People tend to search for or interpret new information in a way that confirms their opinions or beliefs. They avoid information and interpretations which contradict their opinions or beliefs. This causes big problems in our business for our clients, more frequently but not exclusively with positions they already hold. This is a bear of a problem for us. My advice – Be the clear thinker, with patience and persistence in your discussions with your clients you can overcome what behavioral psychologists call “confirmation bias.” While you’re at it make sure you don’t fall into that trap yourself. Two quotes from Tolstoy on Confirmation Bias: "I know that most men, including those at ease with problems of the greatest complexity, can seldom accept the simplest and most obvious truth if it be such as would oblige them to admit the falsity of conclusions which they have proudly taught to others, and which they have woven, thread by thread, into the fabrics of their life" "The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.” -09/04/200

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Experts are Lousy Teachers

The more you know about a subject the harder it is for you to teach someone who is not well versed in the subject. The reason for this is that the more you know about a subject the harder it is for you to conceive that the subject is difficult for someone else to understand. An exampleMicrosoft experienced this phenomenon to such an extent that it actually put in one way mirrors in a classroom to allow its software engineers to see how difficult it was for students to absorb lessons on the software the engineers created. The engineers could not believe the subject was difficult until they saw the students struggle with it with their own eyes. As a professional and expert in the financial business you’re in the same boat as the software engineers.

My adviceKeep the following in mind when you are trying to explain something to a client: The easier you think it is to understand the harder it actually is to understand. Be patient and take the time to make sure your client understands what you are trying to teach them. -09/10/2007 •

What is done is done

People often make a decision based on the time, effort and funds they’ve already committed and not on what would be the best decision going forward. It’s called the “sunk cost” fallacy and the production of the supersonic airliner the Concorde is a good example of the operation of this phenomena.

My adviceEncourage your clients to forgo this behavior (when deciding whether to sell or hold a position) and leave that stuff up to the experts, you know those folks in government who do it so well. -09/17/2007 •

Combinations

Sometimes principles of behavioral economics combine and create an increased effect on the client. An example Often a client will fix (anchor) on their purchase price when determining whether to sell a security they own. When the security’s current market price is below the purchase price (the “Anchor”) then “Loss Aversion” will cause the client to resist any advice to sell the security. If the market price is above the purchase price the opposite will occur and may even cause the client to bring up the idea of selling the security.

My advice – First be aware that the client will likely use the purchase price as their anchor when determining whether they want to sell or hold a security. Second determine whether the use of another anchor, for example the 52 week high, is the more appropriate anchor to ensure that your advice is not only in the best interest of the client but is well received. If the client insists on using the purchase price as an anchor expand your discussion about the reason that such use might not be helpful. Ps: sometimes but not always a client switches from the purchase price to the 52 week high as an anchor after the client has held the security for more than a year. This is especially true for clients who closely follow the market and their investments. -

10/01/2007

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Elder Abuse

Some Elder protection laws contain provisions making Elder Abuse crimes. Several Months ago I was approached by a local police department about one of our brokers. It seems that the new trustee of a trust (which has an account with us) contacted the police and alleged Elder Abuse under applicable law by the old trustee and complicity (aiding and abetting) by our broker. I successfully dealt with this very serious matter. As a result of this incident, I organized and recorded a panel discussion of three of our top outside defense counsel on the topic of Elder Protection laws and defensive driving techniques brokers may use to manage risk in dealing wi elderly or disabled clients. You may wish to have your FA s and CSA s as well as other branch personnel listen to this presentation. There are takeaways which I can distribute as well. -07/25/2007 â&#x20AC;˘

Elder Abuse continued

The NASD just released some information on arbitration filings. I reproduce the most popular claims. Note that number one on the list is a claim that automatically is associated with Elder Abuse. Last Week's observation dealt with a panel discussion of defensive driving techniques FA may want to consider to avoid accusations of Elder Abuse. This discussion goes along way in addressing defensive driving techniques on the issues identified below as well. My advice Get your manager to arrange for your branch to listen to the panel discussion. No itâ&#x20AC;&#x2122;s not mandatory, it does not count for CE and it is 54 minutes long but I believe that it will help you manage your risk. The panelists are our top outside defense attorneys.

Top 5 Categories of Claims Involved in Arbitration Cases (in '06 and '07) 1. Breach of Fiduciary Duty 2. Negligence 3. Failure to Supervise 4. Breach of Contract 5. Unsuitability

0730/2007

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Another Brick in the Road

At the risk of being redundant I provide the following: People continue to deconstruct their careers over what can only be described as misguided attempts to be “efficient.” Filling in forms with fictional information isn’t being efficient its being foolish. When a client related form is incomplete, involve management in the problem - don’t undertake a resolution on your own. Unless you want to be -08/13/2007 •

Phone Records

Documentation serves several purposes, one of which is to serve as confirmation of a verbal account of events. It also serves the opposite purpose when the verbal account is inaccurate. Unfortunately an FA forgot that when asked whether he had conversations with clients before entering orders.\ This is silly. The old time and price excuse won’t work anymore. You can’t carry it overnight let alone longer than that. Call the client, get the order and then enter it. -08/27/2007 •

Time is after all money, no I mean really

People can be short sighted and that can affect their choices when you advise them about alternative investments. 38

For instance – People will take a small payoff if its immiment over a larger later payoff. On the other hand when the smaller payoff is more distant in time, people tend to prefer a larger even later payoff, even though the time lag from the smaller to the larger would be the same as before. My adviceRemember this principle of behavioral ecomonics (called “hyperbolic discounting”) whenever the time value of money comes into your advice analysis. Don’t let this bias get in the way of the correct investment decision. Make sure the client focuses on the correct time horizon for their investment objectives and risk tolerance and not the other way around. - 11/16/2007

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The most dangerous words (revisiting an earlier observation)

Something that catches experienced brokers and ends their careers is something that is also innocently expressed by clients. “Do what you think is best” are the most dangerous words a client can say to you. Clients don’t know what they are asking you to do. Please, if there ever is a time you listen to my advice, this is the time. Don’t act on that request. Get the necessary specific authority and if it is required to be in writing then get it in writing. The danger that you will fall into this trap increases with the length of your service as a financial advisor and length of your relationship with your clients. It does not decrease. -09/24/2007 •

Any strength when over extended is a weakness

That statement goes for the markets as well. Sooner or later it happens to every market. The real estate market is just the latest example. You may 39

wish to consider whether a market will over extend in the future. I think you know what my opinion would be. - 11/12/2007

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What happened

Here is my take: People (yes that means everybody) tend to overestimate the accuracy and precision of their knowledge and that often leads to overconfidence (and a lack of perception of the amount of risk they are undertaking) in making financial decisions. This in turn tends to burn them from time to time. Example– Long Term Capital, the hedge fund, had two noble prize winners and 24 people with doctoral degrees in economics or finance. They thought they had taken all relevant variables into account in their computer economic models. Well they hadn’t – they left out a few variables and their predictions were wrong, painfully so.

My adviceIf the geniuses can be wrong you and I can be too. That’s why diversification makes so much sense. It is premised on the concept that you will be wrong from time to time. You may wish to cite the example of the Long Term Capital geniuses when trying to talk some sense into your clients (except for brother-in-laws, there is no hope for those guys). -11/05/2007

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Deer in the headlights

Sometimes clients become subject to a predisposition to stand pat with their investments even when objectively that is not in their best interest. This is called the “status quo bias” and a recent behavioral economic study indicates that this predisposition increases with the increase in the number of alternative investments which are suggested to the client. You may wish to keep this in mind when counseling clients. -

10/16/2007

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… the Joneses

Just because someone drives it, wears it or lives in it doesn’t mean it’s paid for or that they can afford the payments. You may wish to remember this from time to time when managing the risk you incur in servicing your clients. -10/08/2007 •

Since Halloween is coming up

I continue to witness the destruction of careers through the use of white out. The reason continues to be “client convenience.” You may wish to take a second look at my previous advice, especially if you’re registered. Don’t forget the consequences to your U-5. There is no statute of limitations on this stuff – the dead body you buried can come out of the ground years later and come after you. I reproduce my original observation on white out below just in case you missed it.

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Saving Careers - Helping Families

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Some things to think about

You may wish to consider: Whether our society as a whole is aware that seniors are subject to suggestion and often lose the ability to question or resist suggestions as they get older? Whether our society as a whole is aware that seniors often lose the ability to digest disclosure or evaluate risk associated with suggested investments as they get older? Whether our society as a whole is extremely protective of seniors, even wealthy and sophisticated ones? Whether just the appearance of improper conduct toward seniors can have dire consequences? 42

If you are intrigued by the foregoing read the following recent press release: Jury finds Merrill liable for $6 million By Aaron Siegel October 22, 2007 A jury in Florida has ordered Merrill Lynch & Co. Inc. to pay $6 million for taking advantage of the late New Jersey philanthropist George Rothman and his wife. C. Wade Bowden, a lawyer representing the Rothmans' two daughters, said that the New York-based financial services giant took advantage of the couple's deteriorating mental condition to move their money into investments that would pay higher commissions, according to an Associated Press report.

The suit also claims that Merrill broker Karen L. McKinley falsely told Mr. Rothman in three letters that the investments carried no fees or sales commissions. Mr. Bowden said that the company made at least $2.5 million in fees on the Rothmans' $32 million investment in variable annuities, while Ms. McKinley made about $600,000. Merrill will seek to have the Oct. 1 verdict set aside, said Merrill spokesman Mark Herr, and will appeal if it stands. "The verdict is astonishing in light of the undisputed fact that the Rothmans, who were wealthy, sophisticated investors, made $10 million on the annuities at issue, and did not lose money," Mr. Herr said. "The verdict is unjustified by the facts and law." A jury in Palm Beach, Fla. must still determine whether punitive damages should be awarded.

Here the jury awarded damages to wealthy and sophisticated individuals who made money on their investments. Given the fact that the investments were annuities it is very unlikely that the fees and expenses were not prominently disclosed in writing. Apparently the fact that the investors were seniors was extremely significant to the jury. You are fee to take away your own conclusions from the foregoing. My advice â&#x20AC;&#x201C; If you havenâ&#x20AC;&#x2122;t listened to my panel discussion on elder abuse then do so now. Make very sure that you always put the interests of senior clients first and foremost in you mind. Never even give the appearance that you have not put their interests first. Our society does not like the appearance of impropriety when dealing with seniors even if they are sophisticated and wealthy. If the 43

appearance of impropriety exists disclosure may not save you from adverse consequences. - 11/12/2007 •

Don’t forget to evaluate the Stock

When people consider which stocks to buy they often consider some stocks they have previously owned. When the previous experience has been a realized gain they tend to buy more. When the previous experience has been a realized loss they tend to avoid the stock. How about stocks they still own? It depends on how the stock has done. If they have an unrealized loss they tend to buy more and if they have an unrealized gain they don’t. Why the switch? In the first instance they have closed the books on the position and have a feeling of either pleasure or pain from the previous experience. They repeat purchases with good memories and avoid purchases with bad memories. In the second instance they have not closed the books on the position. Remember that people tend to lock in gains and avoid losses. You don’t lock in a gain by buying more of a position you already own you actually postpone the gain. By buying more of a losing position they in effect are averaging down and in their minds are reducing the risk that they will have to realize a loss.* Notice something lacking here? An objective evaluation of the stock at the time the second purchase is contemplated. It doesn’t happen. You may wish to make sure it does. -12/17/2007 *Don’t believe me? Then take a look at an unpublished study of the trading patterns of over 700,000 investors. “Once Burned, Twice Shy: Naïve Learning, Counterfactuals, and the Repurchase of Stocks Previously Sold” Barber, Odean and Strahilevitz, March 2004. I will show you were you can find it.

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How we deal with the Universe (of stocks that is)

When considering the purchase of a stock (or stocks) there are literally thousands upon thousand of choices (domestic and international). So how do people proceed? It turns out, not as objectively as we might hope. First they decide what options to consider and then decide which of those options to choose. A recent economic study shows that people are prone to limit the “choice set” (options to consider) to stocks or even asset classes that have recently caught their attention either by (i) news, (ii) unusual trading volume or (iii) extreme returns.* My advice – This less than objective option selection process is subconscious and affects all of us including our clients. It does not lead to superior investment results. Therefore, be aware that we are subject to this fallibility, resist it and steer your clients away from it. *All that Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors, Brad M. Barber and Terrance Odean, 2006. It’s not published but if you are curious I can show you where to find it. -

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02/04/2008

Wait a minute, hold up, there is a flag on the field

Recently a broker called me and asked for my advice. The broker has an elderly client he has known for many years. This client has had the same attorney for many years. The broker didn’t know the attorney but knew of her. Suddenly the broker was presented with significant amendments to the client’s living trust and related documents. The documents among other 45

things installed a care giver as co-trustee and gave power of attorney to the care giver. The documents were drawn by a new attorney. This prompted the FA to call me. I stepped in immediately. I won’t tell you what I did but among other things, I protected the FA and the firm. The foregoing facts constitute a yellow flag on the field. Don’t handle this on your own. Involve management and get them to involve me. By the way I received a thank you from the client and the client’s long time attorney. -

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11/26/2007

More Better Blues

If a little is good is more of the same better? Most of the time that’s not true. In fact more may put you in a worse position than if you had none at all. Medicine (over the counter or prescription) is a good example. I am sure you can think of examples in our line of work. Any strength (well advised or not) when overextended becomes a weakness. You may wish to keep an eye out for this phenomenon as you manage your risk and your clients’ risk in the future. If you don’t you may find that one day all of a sudden you need to sing the…. And I will tell you I told you so. Ain’t that right

(fill in the blank) ?

*Disclaimer: I know who you’re thinking. No it’s not that person. - 11/19/2007

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A Simple fact

The defined benefit pension plan is for all intents and purposes extinct. This simple fact alone means that the most important job you have going forward in your career is to teach the next generation about investing. By that I mean to include: The why The when The how to If you don’t succeed at this task future American generations will suffer immeasurably. -12/03/2007

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Tough Love

Recent events have motivated me to revisit something I discussed previously: In investment discussions the client often does not actually perceive the risk you describe in connection with a potential investment. They block it out because recognition of risk causes stress and blocking its recognition eliminates the stress. The client's failure to mentally register the risk you describe in connection with a potential investment is the single greatest denominator in unjustified customer complaints. Since they blocked it out they honestly don't remember that you described the risk. When the investment goes south, guess who gets the blame for failing to describe the risk? They are not lying when they say you didn't describe the risk (as they honestly don't remember) but their assertion is false (and a lot of good that does you).

Ok so if that is the case, how do you get the risk you describe to register in the client's brain? The answer lies in getting the client to audibly verbalize the risks back to you in the discussion. I know you think that is hard to do but you can do it. Oh come on you sissies, stop your whining. As my drill instructor used to say "I already know you don't want to do it private - do it anyway!" You know, even after 37 years I still hate that guy. -12/10/2007

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Inherited Accounts Revisited

Please take a look at the link (at the bottom) and my observation below: ·

Inherited Accounts

07/23/2007

-----Original Message----From: Klein, Les [GWM-GCO] Sent: Monday, December 10, 2007 12:57 PM To: Tevis, Gregory C [GWM-GCO]; Twedt, Brad [GWM-GCO]; Ketchum, Stephanie W [GWM-GCO]; Venero, Dina S [GWM-GCO]; Hendricks, Karen [GWM-GCO]; Mierswa Jr, Thomas [GWM-GCO]; Barnett, Rohan [GWM-GCO] Subject: FW: UBS Loses $4.6 million employment arbitration

Interesting reading. Something to pass on to your business folks. -----Original Message----From: Glotzer, David [GWM-GCO] Sent: Monday, December 10, 2007 9:38 AM Subject: UBS Loses $4.6 million employment arbitration

To All: Please take a look at the attached article which discusses an arbitration filed against UBS and two brokers by a former broker who alleged that the two individual claimants disparaged him to clients in an effort to take his book of clients. UBS, which terminated the broker, is alleged to have fired him on the pretext that he sent unapproved documents to clients and then lied about it. http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20071210/REG/312100009/1009/INIssueAler t01 While the facts in this case seem extreme (which may have accounted for the over $2 million in punitive damages), the take away from this case is that care should be take to ensure that the FAs are not making disparaging comments about their colleagues for a perceived business advantage or any other reason, particularly when one of them resigns and joins a competitor. Clearly, there are risks to both the individual and the firm from doing so. Therefore, you should share this article with your teams, including those in the OSJs. -12/11/2007

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A personal message to the FA s and CSA s

As the holiday season progresses and the year ends, I would like to deliver a personal message from me to our FA s and CSA s: I know how hard your jobs are and how much you contribute to the success of this firm. You are the best. -

12/20/2007

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Tonight

The roads are going to very dangerous this evening. Please take extra care. -12/31/2007

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Now you know

Granting a power of attorney to someone causes the attorney-in-fact to have fiduciary duties to the grantor. -01/25/2008

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Say what was that called?

People are prone to decision making biases that impede them from making good choices. If that is so Why not exploit these biases to help them make better investment decisions? For instanceYou can help your clients make the right choice by making the right choice the default choice in your investment discussions. It is a way of helping them make the right choice without using an authoritarian approach. This tactic is called “asymmetric paternalism” * and it is simply a process which involves making the right choice the one that follows the path of least resistance. An exampleBottled water is now often becoming the default choice in school lunch packages and in fast food restaurant packaged children’s meals. If you look back you may realize that many companies (including ours) are modifying their 401(k) programs to take advantage of this process.* Those sneaky people. 50

You may wish to consider making the correct choice the default choice in your investment discussions with clients. Hey listen it’s not often I say it’s ok to be sneaky. Ok maybe just a little bit. *Two biases that asymmetric paternalism deals with are; Present-biased preference: the tendency of individuals to place disproportionately greater weight on the costs and benefits of their choices in the present than in the future.,e.g. the cost of giving up food one enjoys is immediate, while the benefits are realized in the future. Without a mechanism to enforce self-control, a person’s resolve often fails. Default or status quo bias: the tendency to favor the status quo or default option.

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-02/08/2008

the notes, the whole notes and nothing but the notes

To paraphrase the poet Robert Frost - Good notes make good neighbors. They do so in two ways. First, they back you up when you need it (no kidding everybody knows that). Second (and this one you may not have realized) - when other people know you are taking notes (or do so as a practice) they will not be as inclined to pick a fight with you. Here are a few tips: 1. When in doubt about taking notes - do so. 2. Always note something that is not usually or typically the case, especially the client's wishes or objectives. 3. Do not make judgmental comments in your notes. 4. Stick to the operative facts – significant facts that relate to what happened or will happen – do not write everything down. 5. If rushed use key words, short phrases, abbreviations. 6. Make the notes at or shortly after the event, occurrence or conversation. 7. Date your notes. If written on paper, initial them. 8. Put them some place where you can find them. 9. Don’t be afraid to let people know you are taking notes. 51

10. Scan your notes afterward to help you follow up on things that need attention. - 01/14/2008

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Stop look and listen

Some time ago I made an observation on the mental state of Elderly clients. If you want a copy of that one just let me know and I will send it to you. To update you, the number of times I have been consulted in connection with the problem of diminished or lack of mental capacity of elderly clients has increased. It is a vexing problem. I thought I might list things you may look for to spot the problem. Remember, in this area don’t try and handle it on your own. Get management involved and have them get me involved. If you watch for these signs you may just avoid getting run over by a bus. Here are some signs of lack or diminished capacity: •

Recent memory loss. All of us forget things for a while and then remember them later. People with diminished capacity often forget things, but they never remember them. They might ask you the same question over and over, each time forgetting that you've already given them the answer. They won't even remember that they already asked the question.

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Difficulty performing familiar tasks. People who have diminished capacity might look at documents you sent them but forget to fill them out and return them. They might even forget that they had received them.

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Problems with language. People who have diminished capacity may forget simple words or use the wrong words. This makes it hard to understand what they want.

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Time and place disorientation. People who have diminished capacity may get lost on their own street. They may forget how they got to a certain place, such as your branch office and how to get back home.

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Poor judgment. Even a person who doesn't have diminished capacity might get distracted. But people who have diminished capacity can forget very simple things, like forgetting to put on a coat before going out in cold weather. 52

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Problems with abstract thinking. Anybody might have trouble balancing a checkbook, but people who have diminished capacity may forget what the numbers are and what has to be done with them.

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Misplacing things. People who have diminished capacity may put things in the wrong places. They might put an iron (or month-end statements) in the freezer or a wristwatch in the sugar bowl. Then they can't find these things later.

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Changes in mood. Everyone is moody at times, but people with diminished capacity may have fast mood swings, going from calm to tears to anger in a few minutes.

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Personality changes. People who have diminished capacity may have drastic changes in personality. They might become irritable, suspicious or fearful.

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Loss of initiative. People who have diminished capacity may become passive. They might not want to go places or see other people.

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Susceptible to Influence or Suggestion. It is common for people with diminished capacity to be unduly susceptible to the influence or suggestion of others, especially people with which they have not had a long term or significant relationship (such as a caregiver or distant relative). -01/22/200

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A recently filed case

Last week I read an arbitration claim that was filed on January 15, 2008. The statement of claim is brief and to the point. It states that the portfolio in the client’s account was unbalanced and over concentrated in a particular sector. The sector did poorly and the account, if properly diversified, would have done much better. The FA is named personally as a defendant and is alleged to be liable based solely on the foregoing for fraud, breach of fiduciary duty, negligence and breach of contract. The account lost $40,000 on an out of pocket basis but the broker is being sued for the delta between what the value of the account would have been if 53

it had been properly diversified and the actual value of the account, namely, $400,000. Now we don’t know how this case is going to come out, but we do know that arbitration was filed and the FA s u-4 has to be amended. You may wish to revisit some of my earlier Observations. -01/28/2008

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A Word to the Wise

Recently we had an imposter make off with some of a client’s money via a third party wire transfer. The requests were made either verbally by cell phone or via an email. In both situations the cell phone number and email address were different than the information we had on file but no verification cross checks were carried out. Here are some tips to help prevent that: 1. In some countries there is much less security over client information so if your client lives in another country you may wish to be aware of the level of security they may face there – consider asking the client. 2. Some countries are experiencing problems in the area of identity theft and fraudulent requests for wire transfers – South Africa is an example – so if you get an unusual request be on your guard – perhaps talk to our CSIS people. 3. Have the person who knows the client best be the person to orally confirm the request. 4. When given client contact information in a request, cross check the contact information with the information we know is good. If its 54

different be doubly on your guard and consider sending written and oral contact information to the original contact points. 5. Examine a written request for (i) grammatical mistakes that you would not expect from the client (given your knowledge of the client from past oral or written communications) and (ii) variations in grammar or word usage (in this case the impostor signed the client’s name using the client’s middle name as well – something the real client had never done). If you find a difference consider having the person who knows the client best orally contact the client and engage them in a conversation which is designed to confirm the identity of the client and the legitimacy of the request. 6. If your client is going to make this type of request periodically consider setting up a series of security related questions (I suggest three in a series) to ask the client to confirm identity. . Make sure you use information that is not on a monthly statement such as mother's maiden name, where they were born or went to school. 7. Don’t depend on the client to review an email or voice mail you leave. Be persistent in your attempts to reach the client. Do you have to do these things. No but you don’t have to look both ways before stepping off a curb either. -

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02/08/2008

Never Underestimate the Power of the Dark Side of the Force

Many years ago a young statistical expert at the Rand Corporation was faced with a conundrum – how to allocate the asset classes in his investment portfolio. The genius that he was allowed him to develop the efficient frontier, a mathematical computation which dictated the best way to do that allocattion. But instead of following his own methodology, the inventor of the efficient frontier visualized his grief if the stock market went way up and 55

he wasn’t in it and vice versa. Then he split his investment allocation equally between stocks and bonds. Now this young man was Obe Wan (Harry) Markowitz, who eventually won the Nobel prize for his work in developing the concept of the efficient frontier. But even this Jedi master couldn’t bring himself to follow his own “advice.” So if he succumbed to his emotional state in managing his investments imagine how powerful this is on your clients. Resist and whether you are Luke or Leia… Yoda will be pleased. True story. -

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02/19/2008

Neuroeconomics

Neuroeconomics combines neuroscience, economics, and psychology to study how we make choices in financial matters. It studies the specific brain activity involved when we evaluate and make financial decisions. Distinguish neuroecomonics from behavioral economics in that neuroecomonics actually looks at the physiological activity in segments of the brain when an individual is contemplating financial matters. Neuroscientists are using a specific kind of MRI machine to conduct their research and the results so far are startling. I will have more to say in the future but here is an initial example of what we have learned. There are in essence two parts of the brain when it comes to decision making, the reflexive and the reflective. The reflexive part of the brain is common in virtually all animals and developed principally to allow us to protect ourselves from suddenly encountered danger or take advantage of suddenly encountered opportunity. These sections of the brain function almost exclusively in a level below the conscious state. In other words we are not aware that they are functioning. A good example is the reflex of your 56

hand going up to ward off an object coming toward your head. The eye detects the movement and sends the information to your brain which in turn sends instructions to your arms and hands to intercept the object. All of this brain activity (receipt of information and disbursement of instructions) occurs in parts of the brain that function under your conscious radar and in fact happen so quickly that your hands come up before you are consciously aware of the approach of the object. The reflective part of the brain on the other hand consists of the parts of the brain that are engaged in conscious contemplative thought. When we engage in the contemplation of financial matters our neuroscientists have determined that both the reflective part of the brain (which you would expect) and the reflexive part of the brain (which you might not expect) are involved. Sometimes one part of the brain actually “hands off” a financial matter to the other part of the brain. Examples – When you realize that you have suffered a loss on a position you have in your portfolio (say on an unrealized basis) your initial reaction is an involuntary emotional reaction and neuron activity is centered in reflexive portions of the brain. Then when you try and determine the amount of the loss neuron activity shifts from the reflexive to the reflective part of the brain which can perform the necessary mathematic computations. The reverse can also happen and here really is my take-a-way for today. When a client is presented with a very limited number of alternative choices for an investment neuron activity occurs in the reflective part of the brain while the decision is made. However, if the number of investment choices is dramatically increased neuron activity ceases in the reflective part of the brain and it shifts to the reflexive part of the brain. In other words, information overload causes us to shut down our conscious cognitive decision making process and pass it off to our subconscious reflexive part of the brain where we hit what amounts to be the reflexive default button. We either do not choose or make a simple choice such as choosing whatever is suggested (without reflective thought). I don’t know this but I strongly suspect that when faced with too many choices or too much information the client often makes an unarticulated choice and that is to make the choice to let the FA choose (in other words punt).

My advice – Be careful how much information (including choices) you “dump” on a client at once. Too much and your client won’t think about it but shut down the reflective part of their brain and engage in a reflexively arrived 57

decision. Later when they do reflectively think about it they may very well reach a decision which is different than the one they initially made (and given the nature of our business may be too late). Try and be efficient in selecting only relevant and necessary information that you deliver to your clients. If, nevertheless, it is necessary to give a lot of information to a client at one time then let them “sleep on it.” Don’t give them the opportunity to make a decision that their anatomy won’t let them make by conscious reflection. Now that’s a lot to absorb. So sleep on it. - 03/03/2008

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Some things to think about when assessing risk

First “Risk” has two components: Probability (of occurrence); and Magnitude (of consequence). Examples – … that an asteroid the size of New York City will hit the earth this summer. … that a skunk will get squashed in the middle of the road (my favorite song) this summer. Second When people review a risk which has been realized they amplify their assessment of the probability of occurrence in proportion to the magnitude of 58

the consequence. The bigger the consequence the more they amplify the probability. Example9/11/2001 The truth is that there is no correlation between the magnitude of consequence and the probability of occurrence. It is very tempting to make that correlation but very wrong to do so. Assess each component on its own. Third When something at risk does in fact occur people experience a level of surprise. The intensity of the emotional response of surprise depends largely on how unexpected the occurrence was. In large part this is dictated by the length of time since the last time the occurrence happened. Long time big surprise, short time little or no surprise, never happened before and the surprise is a whopper. If it is a recurring event then the intensity the of the emotional reaction is directly related to the number of times a sequence occurred before the pattern was broken.

Fourth Surprises can be negative or positive. A negative surprise carries a lot more emotional impact than a positive surprise. So when you have a negative event happen that has never happened before, and the magnitude of consequence is very significant, every neuron in your brain is directed in a manner which causes you to want to conclude that the event was bound to happen when in fact it was not. 59

Finally Keep those four points in mind as you assess a situation… “you don’t have to look and you don’t have to see cause you can feel it in your olfactory.” Catchy tune that one. For those of you that don’t listen to country music occasionally you miss some very intellectual lyrics. “Crossin’ the highway late last night, he shoulda looked left and he shoulda looked right. He didn’t see the station wagon car; the skunk got squashed and there you are! -02/25/2008 · •

…the whole enchilada not just a bite.

Recently I wrote a little about both parts of the brain, the reflexive and the reflective. Both parts have their advantages and disadvantages in dealing with financial matters. Today I would like to deal with the reflexive part of the brain and a peril it presents to us in our business. The reflexive part of the brain is built for speed and it is blazingly fast. In order to be that fast it uses a filter system. It filters out things it knows to be the norm and looks for things that are not. At the speed it operates it looks for sudden changes and assesses them as unexpected or not. As I said the reflexive part your brain is blazingly fast (it has to be) often finishing its job before the reflective part even becomes "aware." Because of that it gets first try at evaluating things and making decisions. It takes care of "the startle reflex", pattern recognition, judgments based on appearance and initial judgments on reward vs. risk. These judgments are often described as intuition.

Ok so how does this help us get along in the world? Well after we have experienced something for any length of time it lets us ignore most of the input and concentrate on what’s “important” in many situations in life. An exampleDo you remember when you were learning to drive and you drove the car in traffic for the very first time? It was panic city. Why? The answer is because your reflexive system did not have experience in driving so it couldn't filter out the unimportant input from the important input. It took in every bit of information without discrimination and frankly it couldn't process it. You were overreacting to everything on or (near) the road. Your knuckles were white, your palms (and everything else) were sweating profusely, your eyes were the size of tennis balls and you were concentrating on everything but not being able to “see” anything. Ahhhhh! Look out! Student driver on the road! Contrast that with your mental condition now when you drive. A piece of cake. Thank your reflexive brain for that. It detects input, filters it blazingly fast and focuses your attention on the small amount of input that signals change, especially unanticipated change. Remember I said it focuses you narrowly on unanticipated change. In the driving example it lets you comfortably drive along in traffic even at highway speeds with cars all around you and only notice the out of the ordinary. True the overall picture is changing, after all you are driving, but that is not your focus. Your focus is on the idiot who has just started to move over into your lane and is going to come too close (see how fast you are). That’s great for driving but how does this work out for investing. It turns out not so hot. This phenomena is responsible for our obsessive focus on a small change instead of the big picture. It explains why people obsess over the number of points the Dow drops in a day rather than the percentage. It explains our obsession with the drop in one stock in our portfolio rather than the portfolio itself. This reflexive process in focusing on the specific and ignoring the whole causes us to invert the importance of small events versus our financial life picture.

My adviceBe aware that we all, involuntarily and subconsciously, do this. We are mentally hard wired to act this way. So now that you know - consciously force yourself and your clients to invert the inversion, keep things focused in the proper perspective – if you have to, force yourself to, but focus on the..... -03/10/2008

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My message to Chicken Little: Shut up for a moment (and read this you idiot).

People believe that whatever is happening will continue to happen even if what is happening is against the odds. Study after study has confirmed this*. It doesn’t matter very much whether what is happening is something we like or dislike, we think its going to continue. Psychologists tell us that we do this by using a recent time frame or “sample” to draw our conclusion. The problem is that the sample is much to small to have any statistical relevance or justification for the conclusion. Its kind of like thinking that Newton’s first law of motion applies to events happening to us. The problem is that the analogy is false. Newton’s law is as follows: Every object in a state of uniform motion tends to remain in that state of motion unless an external force is applied to it.

What we forget is the part about “unless an external force is applied to it.” There are no events let alone economic events that occur in a vacuum. Each and every event that has, is or will occur had, has or will have external forces applied to it. Nevertheless, we convert the law into “every object in a state of motion tends to remain in that state of motion” or more specifically “everything that is happening tends to remain happening.” ExampleEveryone assumes that it is a good strategy to give the final shot to the basketball player who has had the highest percentage of successful shots at or near the end of the game, “the hot hand.” An extensive study of this tactic shows that this is a bad idea. You should go; it turns out, with the individual who has the season’s best shooting percentage. Yet we don’t do that. We take an incredibly small recent sample and bet the outcome of the game on it. Get that Mr. Little?

My adviceKeep this compulsive tendency in mind when evaluating prognostications about how long certain conditions will continue. I know things are a little scary right now but the only way to proceed is with courage and with the knowledge that all of us are working hard to get * The behavioral economic principles involved here are “recency” and “the law of small numbers.” - 03/17/2008

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Separating the Truth from Fiction

“Of all the offspring of Time, Error is the most ancient, and is so old and familiar an acquaintance, that Truth, when discovered, comes upon most of us like an intruder, and meets the intruder’s welcome.” Charles Mackay – Scottish Philosopher

If you don’t understand something ask for an explanation. If the explanation doesn’t make sense ask for clarification. If it still doesn’t make sense the problem is not you or your capacity to understand. It’s that “it” doesn’t make sense. Implying that people who “don’t understand” are dense is a common persuasive tactic of people who themselves don’t actually understand (or worse). The problems we often encounter are not caused by our lack of mental capacity, but by our willingness to go along with such an implication. -03/24/2008

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Going to the Dentist

Talking to a lawyer has been compared to it. You may find that sometimes though it’s not a bad idea. For instance, when someone else’s lawyer calls you and starts asking questions. That might be a good time to hang up and discuss the matter with me. I am sure you can think of other examples. -03/21/2008

Observations of an In-House Counsel I apologize for the length of this observation. When I wrote this several months ago it was relatively short. However, last Friday I read the obituary of a gentleman who was instrumental in having the public understand “Chaos Theory” something which is the foundation for my observation below. This gentleman was Edward Lorenz, a MIT PhD meteorologist who was responsible for getting us to understand that most systems are so complex and contain so many minute variables that it is impossible to predict how the system will act with any degree of certainty. In 1972 he gave a seminal speech entitled Predictability: Does the Flap of a Butterfly’s Wings in Brazil set off a Tornado in Texas?

In his speech he explained that : The flapping wing represents a small change in the condition of the system, which causes a chain of events leading to large-scale phenomena (change in outcome). Had the butterfly not flapped its wings, the trajectory of the system might have been vastly different – no tornado.

Mr. Lorenz expanded on the earlier work of pre-computer scientists in 1961 quite accidentally. He was using a computer to predict weather using a complex model. He wanted to run the model a second time but had to cut the second run short. When he resumed rather than start over from the beginning a third time he input the data anew but used the data where the computer had left off on his second attempt and then instructed the computer to resume from there. When he got his final second result he compared it to 64

the first final result and discovered that the predictions were radically different. He tracked the cause down to one small variable and the ultimate cause. It seemed that before shutting down during the second run the computer had rounded off the number of the variable at the sixth place to the right of the decimal place (e.g. 101.23675896 to 101.236759). From that accident he was able to demonstrate (and many others who followed in his footsteps did as well) that a minute change in one small variable in a complex system results in a radically changed overall outcome (hence the use of the word “Chaos” in his theory). Try as you might you cannot predict the outcome of any complex system – and that everyone, is why Peter Lynch and Warren Buffet are correct when they say they have no idea what the market is going to do. After all our financial markets are complex “systems” and therefore subject to “Chaos Theory.” Any change, however small, in any one of the vast number of variables that contribute to our financial systems will cause a radically different market outcome. Hence the following observation: ●

...from

the championship tees

Recently I heard an FA give some advice to a client that I thought I would pass along. The FA asked the client to stop thinking of an achievement of the long term return of a broad based index as an average return and thus not worth pursuing. Instead the FA asked the client to consider an achievement of the long term return of a broad based index in the same manner as they would consider shooting a round of par golf… Did you know? (Statistical information from the National Golf Foundation)

Par on almost all golf courses ranges from 70-72 Less than 22 percent of rounds played result in a score of 90 or less* The overall average score is 100* * most of those reporting lower scores are lying

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- 04/21/2008

For all you alpha chasing dogs out there

A recent article in Forbes* pointed out that stock market panics are more the result of internal forces than external forces and have three phases. First significant success, second unexpected bad news, and third the tightening of any loan or collateral requirements made in connection with investments in the market in question. The author then points out that during a crash prices do not revert to fair value but swing too far in their decline creating buying opportunity. What is really interesting is the interplay or combination of three behavioral economic principles that interact and cause people to pass up the buying opportunity after a crash. First “recency bias” causes us to believe that the crash will continue much longer that it will. Second “loss aversion” causes us to forego buying opportunities. Finally, the stress of the crash causes us to focus on the short term and ignore the long term investment horizon. The combination of these three principles causes us to forego investing after a crash. You may wish to consider this article and in particular its discussion of the interplay of behavioral economic principles. 66

published on Forbes website, “Anatomy Of A Market Crash” Michael J. Mauboussin 10.25.07, 6:00 PM ET -04/28/2008

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worse than a lollygagger

I am a fan of the movie “Bull Durham” and in particular one scene in the movie where the coach is criticizing the players. He tells them they are lollygaggers and that there is nothing worse than being one of those. Well there is and that is being a prog-nos-ti-cator. I have contempt for them. Here are some examples of great prognostication: Every year the magazine Business Week surveys Wall Street’s leading prognosticators and asks them where the market is headed in the year to come. Over the last ten years the consensus of the forecasts has been off by an average of 16%. (Idiots) On Friday August 13, 1982 the Wall Street Journal and the New York Times quoted one analyst and trader after another, every one telling tales of impending disaster relative to the market: “A selling climax will be required to end the bear market.” “…investors are on the horns of a dilemma” the market is gripped by “outright capitulation and panic selling.” That very day the longest bull market in a generation began – and most prognosticators remained steadfastly bearish until the bull market rebound was long underway. (Morons) We all remember this one – on April 14, 2000 the NASDAQ fell 9.7% to close at 3321.29. “This is the greatest opportunity for individual investors in a long time,” stated Robert Froelich of Kemper funds and Thomas Galvinson of Donaldson, Lufkin & Jenrette stated that “there’s only 200 or 300 points on the downside for the NASDAQ and 2000 on the upside.” Guess what? There were no points on the upside and more than 2,200 points on the downside. (Lollygaggers) 67

January 1980 gold was at a then record of $850 per ounce, U.S. Treasury Secretary William Miller stated: “At the moment, it doesn’t seem an appropriate time to sell our gold.” The next day, the price of gold fell 17% and during the next five years lost 2/3 of its value. (Prognosticator) I am sure you can think of a few gems yourselves.* My advice Try and be a di-vers-i-fi-cator. They’re not smarter - just lazy and don’t want to work too hard (kidding). But they end up richer (not kidding – say I think that is one prognostication I can live with). *the foregoing prognostications and results were taken from the book Your money & Your Brain by Jason Zweig. The attitude is mine. -03/31/2008d

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Mr. Big Stuff* - who do you think you are? You say you want the truth? (no I am not going to say you can’t handle it) Well, the most reliable way to prove the truth of an assertion is to try and prove that it is false. The classic mistake people make is to look for evidence that confirms the assertion – wrong! An example A money manager says that he or she adds value by selling stocks that have declined by (say) 20 per cent. Try and prove that the assertion (value is added) is false by asking: How did the “sold” stocks do after they were sold? Another example – 68

A consulting firm tells you it achieves superior results by firing underperforming money managers. Test the assertion (that they achieve superior results) by asking for data on the performance of those “fired” managers after they were fired. FinallySo you think you* are a good stock jockey. Take a look at three groups of stocks Those you own Those you have already sold Those you thought about buying but ultimately didn’t For those of you old enough to remember – here are the lyrics to the song, Mr. Big Stuff, for your reading pleasure and to add further emphasis. Written by Joe Broussard, Ralph Williams, and Carrol Washington

(Oh yeah, ooh) Mr. Big Stuff, who do you think you are Mr. Big Stuff, you're never gonna get my love Now because you wear all those fancy clothes (oh yeah) And have a big fine car, oh yes you do now Do you think I can afford to give you my love (oh yeah) You think you're higher than every star above Mr. Big Stuff, who do you think you are Mr. Big Stuff, you're never gonna get my love Now I know all the girls I've seen you with I know you broke their hearts one after another now, bit by bit You made 'em cry, many poor girls cry When they try to keep you happy, they just try to keep you satisfied Mr. Big Stuff, tell me tell me, who do you think you are? Mr. Big Stuff, you're never gonna get my love 69

I'd rather give my love to a poor guy that has a love that's true (oh yeah) Than to be fooled around and get hurt by you Cause when I give my love, I want love in return (oh yeah) Now I know this is a lesson Mr. Big Stuff you haven't learned Mr. Big Stuff, who do you think you are Mr. Big Stuff, you're never gonna get my love Mr. Big Stuff, you're never gonna break my heart Mr. Big Stuff, you're never gonna make me cry Mr. Big Stuff, tell me, just who do you think you are Mr. Big Stuff, you're never gonna get my love Mr. Big Stuff

In deep east Texas they don’t say “you’re right.” They say “you ain’t wrong.” Who would have thought that the Deep East Texans would even know about the scientific method? Bubba Newton? - 04/07/2008

Don’t worry. I’ll take care of it.

We had to excuse someone from employment recently under circumstances which caused me to think: Keep an eye on the person who wants to take care of everything for you. They may just do that, especially when and where you’re not looking. This is important to keep in mind because: • I sincerely wish the following were not true but it is: When someone ignores a rule, regulation or law in our business they affect the lives of other people. -08/14/2006 • “Nobody eats just one chip.” 70

When you discover misbehavior by an employee such as an unauthorized transaction, use of "vest pocket discretion", embezzlement, forgery etc., keep in mind the line from an old TV commercial that "nobody eats just one chip." Where you find one inappropriate act - you may find others. 07/18/2006

• Betrayal Recent events have reminded me -

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Measure twice, cut once

I don’t agree that perception is reality but it does have a powerful outcome on everything we do. You see how you perceive something influences your choices. Taking that one step further, your perspective dramatically influences your perception and that makes your perspective very important.* So do me a favor. Keep your perspective in mind whenever you are evaluating something. Make sure you are honest with yourself when you do so. Evaluate your perspective objectively. It won’t change your perspective but it will let you adjust for it as much as you can and greatly improve your chances of the best possible outcome for your choices. Then like any good carpenter - do this review a second time before putting your evaluation into action. *For instance your perception of an object (or even its location) changes as your perspective (viewing point) changes. The Empire State Building does not look immense and very tall when viewed from an aircraft at 35,000 feet overhead, but stand at its base, look up and tell me what you think. -05/12/2008

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Give me time to think

There is more truth to that phrase than you might imagine. Neuroeconomic studies show consistently that the brain is a modular place. Different modules (parts) of the brain handle different tasks. One area in which the use of Functional Magnetic Resonance Imaging (fMRI) machines in neuroeconomic studies has been helpful is the examination of what our scientists call “time inconsistency.” It turns out that when people make decisions about the far off future they use those portions of the brain (prefrontal cortex) which perform reflective (rational) analysis. But when faced with decisions about the near term people use those portions of the brain (limbic system) which perform reflexive analysis and act impulsively as a result. So what do we do with that knowledge? First recognize that this switch from the rational to the impulsive when you shorten the time frame is hard wired into the human brain (even yours). Accept it, it’s there and there is no changing that. Second, now that you have accepted the fact that it’s there, deal with it. There are two ways I see to deal with it. To the extent possible try and arrange things for your clients so that they can make investment decisions using the longest time frame possible. Nevertheless despite your best efforts, circumstances may dictate that the longest time frame is in the near future. When that is the case realize that your clients will be inclined to be impulsive and you should try and manage through that. Just knowing that they are going to use the reflexive parts of their brains and therefore want to decide impulsively will help you a lot. Forewarned is forearmed. * The following website (Business Week) has an article on this:

http://www.businessweek.com/print/magazine/content/05_13/b3926099_mz057.htm?chan=mz&. -05/05/2008

…use your head Fred…

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Asset allocation optimization programs* are a wonderful tool but should not be followed blindly. They are based on historical information from which estimates of future asset/class/market behavior are made. Those estimates are built into the model**. So when you input your data you are in essence adding a second set of estimates. Remember that. At best these programs improve the odds but they don’t guarantee anything. So when you are using them or looking at the results remember to… and add a note of common sense to your consultations. I think by now we have all figured out there aren’t any guarantees in our business (except for the two that shall not be named). *For the anal retentive: These programs use quadratic equations to optimize the input variables of expected return, standard deviation, and correlation coefficient for a given set of assets. The output indicates the expected behavior of an asset and its behavior in relation to the other assets in the set.

**For those of you who still want to read footnotes: The expected behavior of a portfolio depends on the input data estimates applied to its assets. These estimates are based on past and/or expected performance. Any change or error in the estimates of these inputs affects the results vs. the prediction. Many factors can affect the accuracy and reliability of these estimates, including but not limited to the following: o

The nature of a company or a mutual fund can change

The time frames chosen by different data bases (which often form the sources of various inputs) are themselves different

Market and economic conditions change which in turns effects the programs performance parameters

Some type of investments do not have reliable performance parameters

Those are just a few - so don’t let anyone tell you, and if they do don’t believe them, that things that are hard wired into the models, such as asset class correlations, are uniformly accepted and don’t change over time. They aren’t and they do. With that said even those fancy schmancy Monte Carlo models, terrific tools though they maybe, still are imperfect and need human guidance and monitoring. They can’t replace you Fred.* *How’s this – a footnote of a footnote: Fred is a fictional character and bears no resemblance to anyone I have mentioned in my observations. Ain’t that right Fred?

previously

There now - that will teach you to read footnotes. -05/19/2008

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If it’s too good to be true then it isn’t

Recently two individuals were arrested in Orange County for running a $20,000,000 Ponzi scheme in which the investors were promised a 40% rate of return for investing in PIPES (private investment in public equities). The newspaper article announcing the arrest pointed out that many investors borrowed against their homes to make the “investment.” This is not a new story but rather an old one often repeated. Watch out for the “promise” of an “inordinate” return. A portion of the public never seems to learn. You might ask yourself why people (including ones you might assume would know better) keep investing in the big lie (and when they do, actually amplify their risk on their own initiative). Neuroeconomic studies show that the human brain is highly responsive to variations in the amount of reward at stake and much less sensitive to changes in the probability of receiving the reward. Anticipation is processed in the reflexive part of the brain* and probability in the reflective part. ** In the words of Jason Zweig, author of Your Money & Your Brain, (a book on Neuroeconomics), “when possibility is in the room [for a big score], probability goes out the window.”*** You may wish to consider this in managing your risk. If you missed my previous Observations which discuss the reflexive and reflective parts of the brain just let me know and I will send them to you. * The amygdala and hippocampus **The neocortex ***Contrary to what you might conclude this does not explain the “brother-in-law” phenomenon. Those guys are just plain stupid to start out with. -05/27/2008

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The Herd (part deux)

Recently a new book by financier George Soros was published. In this book Mr. Soros tells us, among other things, that contrary to classical economic theory the information passed around the investment community is largely if not entirely inaccurate. He then argues that classical economic theory has it all wrong when it says that the markets are efficient and sort out the wheat from the chaff thereby discerning the true picture. I will let you read his book for the rest of his conclusions but at this point I will say I personally think he in part is correct and in part wrong. In my view some (but not all) of the information passed around the investment community is grossly wrong and that is what concerns me today. Some time ago I made an observation about “herd” movement and analogized the market and its investors to a herd. I continue to believe that there is much to be gained from using this view from time to time as a tool to manage your risk. One aspect of the herd is that at times herd movement can be significant enough to cause the relationships between asset classes (called “correlation”) to act in an unexpected fashion. Ideally of course we want the asset classes in our portfolios to have the least correlation possible (if you can do it – even have a negative correlation). Normally those relationships hold up (or at least change very slowly over time). Occasionally herd movement turns too dramatic and it turns into a panic (stampede). When a panic happens the correlation relationships among asset classes in your clients’ accounts may alter. Your asset classes may become highly correlated defeating the diversification you built into the portfolio. In every instance I have observed, a panic has been preceded by extensive publication (and republication) of grossly inaccurate information in the market place, whether couched in the form of “fact”, “rumor” or “prognostication.” Usually this occurs in the form of a constant drumbeat. Individuals in the herd at first discount the “information” but after a certain 75

number of repetitions come to suddenly reverse themselves and accept it as the gospel truth. They then have an epiphany and “realize” that they have been wrong all along and well, you know – panic. You may wish to watch out for the foregoing as you manage your clients’ risk. If you missed my original observation about “the Herd” just e-mail me and I will send it to you. -06/02/2008

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For Father’s Day

The song “The Living Years” is particularly poignant for father’s day. I reproduce the lyrics in part below. I wasn’t there that morning When my father passed away I didn’t get to tell him All the things I had to say I just wish I could have told him in the living years

My father passed away in 1994. If your father is still alive why not take father’s day as the opportunity to tell him how much he means to you. -

06/09/2008

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Age and the brain – Tough Love (part duex)

Elder issues are becoming more important every day. With that in mind I would like to address what science now knows about the effects of advancing age on brain function. I want to exclude a discussion of diseases associated with aging such as dementia or Alzheimer’s and focus on the normal effects of advancing age on brain function. I will also exclude a discussion on the deterioration of physical abilities such as motor skills and sensory perception – just focus on brain function. The basic fact is that the brain’s performance gets worse as one passes middle age and progresses further and further into the senior years. It turns out there are two main areas where this deterioration occurs. The first is memory, something we don’t need a scientist to point out. Science has determined that memory starts to deteriorate in your thirties and continues to decline from then on (so don’t think it’s just your curse when you can’t find something you use everyday). The second area of deterioration is not as well known. Scientists call it the “executive function.” This is a set of abilities in our brains that allows us to (a) select behavior that is appropriate for the circumstance, (b) inhibit inappropriate behavior, and (c) focus on a particular task and ignore distractions. This deterioration begins later in life (usually in one’s seventies). Specifically there is deterioration in the brain’s processing speed, response speed and what is called working memory (the type that allows us to remember everyday numbers like our zip code). There is some good news in all of this. Some brain functions are not affected by age. Verbal knowledge and comprehension do not decrease with age but may actually improve. Cognitive and analytical skills continue at the same level if you use them. 77

Even better, as you pass the age of 60 scientists have determined that you become much more adept at regulating your emotions. The frequency that people experience negative emotions decreases until age 60 and then levels off. The frequency of positive emotional experience continues and does not deteriorate with age. Furthermore negative emotions pass more quickly with older adults. How can you protect your brain as you get older? Neuroscientists tell us that there is one major answer (and probably one you would not expect). Regular exercise that elevates the heart rate for 30 minutes or more several times a week is the answer. It does not have to be extremely strenuous. Fast walking works fine. Finally starting this regime even later in life improves and preserves mental functions. This even goes for something as serious as Alzheimer’s. The risk for that is reduced by two thirds for people who start in middle age and one third for folks who start as late as their sixties. My adviceThis one is specifically for the women and men who work for my firm in the Western Division. Get the exercise (mental and physical) I described above. As I said once before in an Observation, stop whining you sissy’s. Don’t tell me you can’t do it private – do it anyway*. The way things are looking nobody is retiring early. Later I will talk about using the foregoing discussion to help you deal with aging clients. * You know I still hate my drill instructor. If you missed my earlier Observation just let me know and I will email it to you. Oh and no I didn’t make all of this stuff up – I stole it from a new book by two neuroscientists. Email me if you would like to know the name of the book. 06/17/2008

â&#x2014;?

Gordon, you were wrong bud

This is an observation I have been working on for some time. Given developments this past week I thought this was the time to make this Observation. In doing so I am not commenting on current events but on an important underlying theme.

Honesty, rather than fear and greed, is the human characteristic that runs our markets. True fear and greed exist and effect markets and financial decisions but they donâ&#x20AC;&#x2122;t run our markets, honesty does. Why do I say that? Itâ&#x20AC;&#x2122;s very simple, almost sounds trite, but is nevertheless bedrock true. Honesty builds trust between individuals and trust is the keystone to successful interaction between individuals in a functional sophisticated society. Where trust is absent societies are dysfunctional. In those societies markets either do not exist or are dysfunctional themselves and little used. Our markets are the largest and most successful in the world because historically they have been trusted to be honest more than any other market in the world. Each honest act of a member of society builds on the trust that is needed to make that society successful. Each dishonest act tears away some of that trust. Honesty as a societal norm is absolutely essential if the society is to succeed. So are we honest and if so, why? The answer is that we are in our society. Honesty is a societal norm in our country (and in some others as well). Individuals learn societal norms as they grow up. Our brain records those societal norms in its long term memory and draws on them when confronted with decisions on future actions. FMRI studies have confirmed that there are two parts of the brain1 that are stimulated (neuronal activity) causing pleasure when a person conforms to a societal norm. So there actually is a physiological explanation for why you feel good when you turn a wallet into the lost and found knowing that the owner will never know that you did it or reward you for doing so. 79

Well if this is the case how do we explain the dishonest acts that occur, especially the numerous little acts of dishonesty that occur everyday by everyday people. We don’t know for sure yet but it may have something to do with the fact that certain portions of the brain2 are stimulated (giving a negative feeling) when a person violates a societal norm and that those portions of the brain are not stimulated by perceived trivial acts of dishonesty (such as refilling a drink at a convenience store after taking one sip, as opposed to taking a refill after downing the entire drink). Why significant dishonest acts occur is way beyond the scope of this observation, but for now just consider that a psychopathological condition may be involved in those acts. The takeaway from this observation is that beginning early in our lives we learn the norms of our society. Brain physiology causes us to store that information and react to our societal norms on a positive-pleasure/negativediscomfort basis. Our society has as a norm the concept of honesty and therefore the vast majority of our acts are honest. Honesty promotes trust which in turn allows the individuals in our society to interact with each other successfully and in sophisticated ways. Each act of honesty builds this trust and each dishonest act tears some of it away. As for our markets, unless you want to concede first place to someone else (and if you do you are no friend of mine), you should remind yourself of this concept3 periodically and support efforts by individuals, groups, associations and government to promote honesty4. 1. The nucleus accumbens and caudate nucleus. 2. Certain specific areas of the prefrontal cortex. The studies to date indicate a positive correlation between the subject’s perception of the probability of punishment for violating a social norm and the stimulation causing mental discomfort. This may explain the “trivial” violation exception discussed above. 3. Psychological studies have confirmed that individuals who are reminded of the societal norm of honesty thereafter increase their propensity to choose the “honest” alternative when confronted with a decision about future action. 4. Another societal norm is that group approval or disapproval of our actions is important to us. In our society the approval or disapproval of our peers is very important and is a significant motivating factor in our decision making process. Transparency in financial markets amplifies the ability of the “group” to view 80

and evaluate the actions of individuals (and groups, associations, corporations, etc.) in those markets. Because we care what people think, the positive/negative response to conforming to societal norms is promoted by transparency. We know in advance that people “will look and they will see.” Therefore, transparency promotes honesty which in turn... (well you can see where this goes). -06/23/2008

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Arbitrary Coherence

How do we decide what something is worth (or whether it is worth it)? It turns out we are subject to suggestion (you are thinking – no surprise there). The surprise is that the suggestion does not have to have any relationship to the item being considered. In an often cited study participants in an auction were asked to write down the last two digits of their social security numbers on the top of a form they were going to use to bid on auctioned items. An analysis of the submitted bids showed a direct correlation between the digits from the ssn’s and the bids, the higher the last two digits of the ssn’s the higher the bids even though the ssn digits had absolutely nothing to do with the items. The power of “first” suggestion is unbelievable. Hold on, it’s even more powerful than that. It turns out once a first suggestion is made we can’t get rid of its influence (the reason you think gas is so expensive is because when you were first introduced to its price it was much less expensive than it is now) unless – you follow the lesson of Starbucks. Ok, so how did Starbucks get people who were used to paying less than a dollar for a cup of coffee (McDonalds, 7-Eleven, etc.) to start paying a much higher price (and stand in a stupid line no less)? It’s not the same market as for gasoline –cheap coffee is still available and you used to drink it. Let’s face it Starbucks coffee may be a little better but it’s not that much better. The founders knew that we were wedded to a certain price for coffee and had to get us to perceive that what we were buying wasn’t the same object (even though it was). It takes a lot to break that spell (of first suggestion) we succumb to. So Starbucks created an American version of a European coffeehouse (think of the names of the sizes, styles, etc.) and sold us ambience and sophistication (why yes, I will have a grandé, half caf, soy, no 81

foam latté with a hint of mint thank you very much - for $4.95 - and oh yes let me have one of those $2.75 scones1 too) 2. Turning to our business, Arbitrary Coherence is the reason people stick with service providers even though they could have a better one. You may wish to consider the lesson of Arbitrary Coherence and the Starbucks technique when marketing yourself to prospects and referrals. Grey Poupon anyone? It’s from Dijon3 don’t you know. Seriously though we don’t have to fake it, we don’t have to run others down, but because Arbitrary Coherence is real we do have to make sure our prospects and referrals know just how and how much we are distinguished from the crowd. Don’t be shy about that. Vive la différence. 1. A scone is a biscuit invented in Scotland, a country otherwise known for the culinary delights of oatmeal and haggis. 2. Once wedded to the “new” norm you will not stoop to go back to the old one – none of that convenience store coffee for you - no way. 3. Dijon is a town in France (pronounced nasally as in Fronz). -Editor’s note: Mr. Tevis’ acknowledged ancestry is Scottish and French. All other points of origin disavowed him long ago. - 06/30/2008

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Demigod (Demon)

Corporate culture has a negative aspect I would like to address. I call it the deification (often later demonization) of senior executives. These folks are not demigods (or demons). They are not smarter (or vice versa) than before they got promoted (appointed, whatever) and their intelligence and acumen does not vary with the fortunes of the firm. They are humans just like the rest of us. Nonetheless this process goes on constantly, often the result of actions by their subordinates. We are neither unintelligent nor uneducated and don't help ourselves or the firm by buying into the process I have described. 82

We should overcome the temptation to do so. - 07/07/2008

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Answer: Catch-22 *

Why do markets gyrate? Well I was listening to Sam Zell on the morning business news recently and something he said reminded me of this principle – “recency.” People obsess on the most recent news. On the talking head business shows they have taken to flashing something across the screen and labeling it “breaking news” when by any objective standard this “news”, when you fit it in the whole picture, is not shall we say terribly important. Yet we obsess over recent news giving it way too much importance. As soon as new breaking news comes along then the old breaking news is forgotten and irrelevant. Placing too much emphasis on the latest news is the principle reason people overreact to new news both good and bad. The overreaction is reflected in the market by gyrations. It’s as simple as that. Now if you want an explanation here it is: Imagine the environment for a human 150,000 years ago. Scientists tell us that is when our brains reached their present development. The environment at that time dictated that to stay alive we had to be able to quickly assess any given situation. We had to eat and keep from being eaten. Both situations called for fast evaluations where to err on the safe side (react to possible opportunity or danger) was to our decided advantage. Think that there is possible prey - jump for it. Think you’re possible prey - jump away (or in the words of Monty Python ....) If you reacted and were wrong no big deal. If you didn’t react and were wrong well...

In this environment we learned to place great importance on the latest and greatest input and react quickly with the emphasis on reaction (as opposed to inaction). Our environment has evolved but our brains have not. The parts of the brain that do this assessment are not unsophisticated but rather highly evolved and sophisticated. Our brains can subconsciously pick up patterns after only two prior occurrences and use that pattern recognition to predict a future possible occurrence. This prediction process happens in less than 1/20 of a second. So much the better to pounce or run away. So who should we blame for these market gyrations? Our ancestors of course (after all it’s so simple even a cave...) The takeaway from this is that gyrations in our markets will occur as they are a product of our basic human nature. This is so even in spite of our fantastic cerebral cortexes (the reflective part of our brains). If you expose yourself to these gyrations without diversification then the fact that you are using the reflective part of your brain isn’t going to help you very much when the “herd” is using the reflexive parts of their brains - and that my friends is why timing the market doesn’t work unless of course you are in fact, Karnack. * Question: What do the Los Angeles Dodgers do with a 100 pop-fly balls? -

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07/14/2008

Retirement at the time and place of your choosing

Recent events have reminded me that in our business “Integrity” is the condicio sine qua non for a successful career. You may wish to consider whether taking advantage of a client, even when the client is willing or insists, passes muste Here is my definition of integrity: 84

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Honesty in the face of an interest to act to the contrary

Anyone can be honest when there is no contrary influence. integrity do so in spite of it.

Those with

When you fail to act with integrity sooner or later you ruin your career. - 07/21/2008

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. . . Keep

your eyes open

A court appointed conservator was recently sentenced to a lengthy prison term in my home county. The conservator, a former nurse and the operator of a home for disabled veterans had been appointed a conservator over elderly and disabled persons on numerous occasions by the courts. It turns out that the government had not checked out her background. Public records disclosed plenty. The conservator misappropriated over 1 million dollars from the very people she was supposed to protect. Doesn’t say much for the intelligence of the government does it?* You may wish to consider this episode in managing your business. My advice – ..... * My hamster has more intelligence than the government exercised in this case. Actually I don’t have a hamster, but if I did (even your everyday average hamster-nothing special now), it would have more intelligence.

-07/28/2008

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Bubba! Just what do you think you are doin?

Recent events caused me to write a parody of the Diamond Rio Country Song “Bubba Hyde.” The real song was actually written by: Wiseman/Nelson Barney works down at the A&P He drives a baby blue A.M.C. Ain't missed of day of work in 13 years He is a fire department volunteer He's got an investment strategy set in stone Be diversified is the tone Till now you've never seen a more regular guy But when the dow crashed and most thought they’d die Slapped on his Hai Karate after shave Put on his Elvis jacket custom-made Got in his patent leather zebra boots Fired up his imagination mighty fine Called up and got his broker on the line A - tradin till the closing bell A - speculatin - going straight to hell You ought to see him metamorphosize From Barney Hold ‘em into Bubba Trade Next Monday morning it's a suit and tie Attention shoppers there's a two-for-one buy Tuesday afternoon he mans the wheel Makes his round in the bookmobile He's got a Wednesday night canasta game Thursday's the tourney at the bowling lanes His friends would freak out if they only knew The trading animal he turned into Gets his confirms in the mail today Looks at them right away Barney Hold ‘em he gets the look That says he knows he is on the hook Slaps on his Hai Karate after shave Puts on his Elvis jacket custom-made Gets in his patent leather zebra boots Fires his imagination mighty fine 86

Calls up and gets his broker on the line Starts –a – talking these trades ain’t mine You ought to see him metamorphosize From Barney Truthful into Bubba Lies

Be careful out there. Market gyrations tend to cause clients to loose their long term focus and then do the strangest things. 08/05/2008

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...looking stupid is better than sounding stupid.

It’s not uncommon for me to be asked whether when accused we should immediately respond and strike back. Here is the answer I always give: Let’s wait for the dust to settle so we know what actually happened before we start running off at the mouth. Because looking stupid is better than sounding stupid. -08/11/2008

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Emotional Input into Decisions (Intuition)

I have offered several observations about emotional or intuitional reactions and how they affect judgment. My advice has been to keep the information in mind when counseling clients. I don’t want you to conclude that emotions are bad and prevent people from making sensible choices. It’s just the opposite. They help us make the right ones. How so? The answer lies in the fact that most of the time our decisions cannot be made entirely on logic because the information we have to make the decision is either incomplete or ambiguous or both. 87

In most cases you have to bring your intuition into the decision making process. Intuition occurs in a part of your brain called the obitofrontal cortex and as long as it’s working properly you have the ability to take into account the probable consequences of your actions. Life studies of individuals with damage to that part of their brains consistently tell us that these victims cannot successfully operate in our world – they cannot make decisions. So emotions are critical to our success. True they are harmful sometimes but they are also indispensable to our lives. Okay but what happens when emotions do get in the way. Our brain even has a process for that event. It’s called reappraisal. It is the process of reexamining the meaning of an event and the alteration of your feelings about the event. Have you been stood up for an appointment before? You were probably angry about that. If later you found out the person you were scheduled to see stopped to help an accident victim (or was the accident victim) you no doubt would reassess your feelings. This process goes on in parts of your brain called the prefrontal cortex and anterior cingulate cortex. So our brains are pretty sophisticated after all. Emotions most often help not hurt and even when they tend to get in the way our brains can reappraise the situation and come to the right conclusion. By the way the brain’s reappraisal capability improves with age. So there all you young whippersnappers - take that. - 08/18/2008

Yes I, the amazing Carnac, reveal the answer to yet another mystery of the universe! ●

As the all wise and powerful Carnac, that person who is often asked to answer the unanswerable question, I have been asked the following question by several FAs and CSAs: When I am looking at my computer screen, is there someone secretly looking back at me and watching what I am doing? And so I, the all wise and powerful Carnac, posed the question to my crystal ball. When it cleared of mist it gave me the following answer (computer speakers on for enhanced enlightenment): http://pages.suddenlink.net/baraboo57/checkingonu.html -08/25/2008

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Executive Functions

Several weeks ago I promised I would follow up with an Observation which gives some advice on how we deal with the effects of age on Elderly clients. I am doing so in this Observation. To date the evidence suggests that the significant areas of deterioration in brain function with aging clients occur in what has been characterized as the “Executive Functions.” Executive functions include the abilities to: Form goals. (Planning) Initiate and stop actions (Decision Making) Change course to meet changes in conditions (Adaptation) 89

Plan future behavior in the face of novel conditions Anticipate outcomes Think abstractly Watch for failures in the areas listed above. You may not spot them; they are subtle and often progress slowly. Medical professionals have trouble. So I did some research and came up with some additional tips to keep in mind. The fourth edition, text revised version of the DSM* was published in 2000, and is known as DSM-IV-TR. DSM-IV-TR (try saying that fast three times) identifies certain symptoms for us:

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Aphasia. Aphasia refers to loss of language function. A person with dementia may use vague words like "it" or "thing" often because he or she can't recall the exact name of an object; the affected person may echo what other people say, or repeat a word or phrase over and over.

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Apraxia. Apraxia refers to loss of the ability to perform intentional movements even though the person is not paralyzed, has not lost the sense of touch, and knows what he or she is trying to do. For example, a patient with apraxia may stop brushing their teeth, or have trouble tying their shoelaces.

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Agnosia** Agnosia refers to loss of the ability to recognize objects even though the person's sight and sense of touch are normal. People with severe agnosia may fail to recognize family members or even their own face reflected in a mirror.

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Problems with abstract thinking and complex behavior. This criterion refers to the loss of the ability to make plans, carry out the steps of a task in the proper order, make appropriate decisions, evaluate situations, show good judgment, etc. For example, a patient might light a stove burner under a saucepan before putting food or water in the pan, or be unable to record checks and balance their checkbook. 90

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Personality Changes and Emotional Instability. Patients with dementia sometimes become mildly paranoid because their loss of short-term memory leads them to think that mislaid items have been stolen. About 25% of patients with dementia develop a significant degree of paranoia, that is, generalized suspiciousness or specific delusions of persecution. Mood swings, anxiety, and irritability or anger are also frequent occurrences, particularly when patients with dementia are in situations that force them to recognize the extent of their impairment.

Ok so remember I was talking about the fact that one aspect of the effect of age on brain function is deterioration in “executive functions.” So how do we deal with that progression? First, recognize that as your clients age the norm is that the progression will occur. Look for signs of a decline in executive functions and try and recognize them when they do surface. The studies indicate that age 70 is the time that in most people this decline will begin but that should only be used as a guideline. Second, don’t panic when the signs surface. Communicate more often with the clients. Eliminate distractions and “noise” when you do. The clients can still focus and analyze, allow them to do so by restricting the amount of information you give them and the rate at which it is distributed. Follow it up with notes to nextgen and a written letter to them summarizing the discussion and their decisions. Third, when they can no longer absorb and analyze the information you are discussing with them its time to bring in the assistance of a trusted advisor (attorney or CPA), trusted relative or social worker. Often medical examination and assistance is necessary. This is best handled in cooperation with management. I am the default button. See the contact information below. * Short for the Diagnostic and Statistical Manual of Mental Disorders. This is “the” handbook for mental health professionals. It is published by the American Psychiatric Association and lists different categories of mental disorders and the criteria for diagnosing them. The DSM is the principle reference guide used worldwide by clinicians and researchers as well as insurance companies, pharmaceutical companies and policy makers.

** No Diane - Agnosia is not the cousin of Grand Duchess Anastasia, one of the daughters of Czar Nicholas II of Russia.

-09/02/2008

Standards do serve a purpose

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When the justification is that we have to because “well everybody else is doing it and we have to stay competitive” then its time to take a deep breath and remember what happened to Fannie Mae and Freddie Mac. -09/08/2008

Unexpected Events

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They do happen. Tell the people you love that you do and do it often. -09/14/2008

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For this Week

A few tips on maximizing your effectiveness during times of intense stress: 1. No matter what happens stay calm and convey that mental state to others –reassure other people that you can and will help. 2. The best way to stay calm is to focus on your tasks at hand - tune out distractions. - 09/22/2008 92

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09/29/2008

I would like to take the events of last week and put them in a perspective that you can apply to your business. Below this weeks observation I reproduce part of another Observation I wrote last fall that I think gets to the core of the problem for those that were in senior management positions during the time frame when the seeds of this unprecedented difficulty were sown. First something you may wish to consider for yourselves:

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Starbucks Revisited

Let’s distinguish between Pride and its cousin Arrogance. I think many people may mix up the two. Pride is inwardly focused Arrogance is outwardly focused Pride is an individual evaluation Arrogance is a comparative evaluation Pride is a feeling of self-respect and personal worth. Arrogance is a feeling of superiority to others. Pride is essential to personal success. Arrogance is self-destructive. Pride is what helped Starbucks succeed. Arrogance is what caused it to have to close 600 stores. This is a distinction we constantly need to keep in mind. 93

Now in my opinion the root of our present difficulty:

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What happened

Here is my take: People (yes that means everybody) tend to overestimate the accuracy and precision of their knowledge and that often leads to overconfidence and a lack of perception of the amount of risk they are undertaking in making financial decisions. This in turn tends to burn them from time to time and it kick starts the law of unintended consequences hurting others. 10/01/2008 Supplement: Senior executives in financial firms, quasi governmental entities (Fannie, Freddie), and regulatory authorities listened to and accepted the explanation (by senior but subordinate experts) of the “risks incurred” for various proposed offerings and undertakings. The senior executives and those making a proposal were far too confident that the analysis of the risk/reward balance on the proposal was based on accurate and complete underlying data. That is a classic and oft repeated mistake. This led to tragic overconfidence and the assumption of a level of risk that was unknown and unprecedented sending the law of unintended consequences off on a gallop. But make no mistake we all had a hand in this. Whining that it was someone else’s fault isn’t going to help. -09/29/2008

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Never again! Really? The Devil you say.

Last week I was asked to explain one comment in my Observation. That comment was that “we all had a hand in it.” By “it” of course I meant the present economic conundrum. By “we” I meant to include the population at large. I was then asked to explain my reasoning.1 I gave the following explanation: We are all subject to human imperfection. I have discussed many of those imperfections (cognitive biases) in my Observations because they do impact our business and our lives in general. One of them directly impacted us when the real estate bubble burst and that same imperfection impacted us when the tech bubble burst. The imperfection is: People have an irrational, compulsive and subconscious belief that a trend will continue far beyond what would be justified by a historical statistical analysis (remember my Observation about Chicken Little -03/17/2008). They are then unpleasantly surprised when the “trend” ends and things revert to the mean. Hence the following previous Observation: ·

Yes but this time it’s different

It never is. Why do you think they named it the “mean?” Maybe because of the harsh way you can be re-taught an old lesson when something reverts to it. -

06/18/2007

Ok how does all of the foregoing apply to our present situation? When real estate began to “take off” (late 90’s) and that market condition continued until then general public perceived it as a trend this “cognitive bias”, called recency or trend continuance, took over. People began to buy real estate with the conviction that values would continue to go up. They simply reasoned 95

that if the property turned out to be more than they could afford they could sell it at a profit. That outlook changed the way they perceived the risk of borrowing money (remember that I said in an Observation that when the possibility of making a large profit comes in the room a cognitive bias causes probability to head for an exit -05/27/2008). Ordinary everyday people began to take risks that they simply did not perceive as real. What began as a trickle became a torrent the longer real estate continued to appreciate. People began to believe that it was ok to, shall we say, fib on loan applications. They also saw logic in NINJA loans. Yes that’s how far logic strayed. All of us were aware of what was transpiring.2 We simply did not perceive how short the trend would last and how far and extensive the damage would be. Then the trend ended and now We know how mean the mean is. Of course the lending and financial industries had a hand in it - they encouraged and facilitated this to go on. People say that we should learn from this and never let it happen again. Well I am all for that but my hope is balanced by the simple fact that contrary to a precept of classic economic theory we are not “rational” when it comes to economic decisions. Our shortcomings are embedded in our DNA. The best strategy in my view is to remember our shortcomings as human beings and do our best with those in mind to avoid repeating our economic mistakes.3 Regulate yes, but don’t be foolish enough to think it will never happen again. Lewis Black, the satirist (03/20/2007 Observation) is no doubt going to have a field day with these peccadilloes.

1. There is no truth to the rumor that it was someone running for political office (no not the one you are thinking) that asked me. 2. Even those of us that owned property but did not refinance, take out a second mortgage, line of credit or trade up were yelling “run, baby, run – who cares if the kids can’t buy a home.” 3. In 1991 I read an article by Chris Argyrs in the Harvard Business Review, Teaching Smart People how to learn. The upshot of this article is that when events turn out badly we tend to engage in “defensive reasoning”, i.e. blame others for the outcome. In order to keep history from repeating itself we need instead to focus on the one thing we had and will have control over and that is our own conduct. That is why in my previous observation I said “Whining that it was someone else’s fault isn’t going to help.” -10/06/2008

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10/07/2008

Yesterday a manager got in touch with me and asked me to address something in an Observation. I learned from the manager that an FA at another firm took his own life - despondent over his clients' losses in the market. I said I would and then I read in the paper this morning about another similar incident. It was at that point that I knew I could not wait until next Monday. I know just what to say. By now most of you know I was on the "train.” I escaped unharmed although most did not. My heart goes out to the seriously injured and the loved ones of those that perished or were seriously injured. They are the ones that are suffering. Since then I have been asked many times how I am dealing with the stress I experienced. I always answer just fine. The truth is that as stressful as my involvement in the accident was for me that wasn't "real" stress. I know someone who had to pick up the shattered pieces of a family who fell victim to a suicide, a father who for 20 years has had to console two children who lost the older brother they adored. Now that is stress. I know him well - you see that person is me. 97

Please everyone lets keep some perspective, no matter how bad things may seem no one should have to suffer as a victim of such a tragedy. If you need help get it. If you see some one who needs help then help them get it. This was very hard - telling you - but something that had to be said. -10/07/2008

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Speaking Metaphorically

In several recent Observations I have talked about our notion of “trend continuance” and its adverse effect on us. Well I have some good news (we can reduce its effects) and some bad news (we can increase its effects). Here is how: We use metaphors constantly in our speech and writing. A recent behavioral economic study pointed out something you might want to consider in the future*. When someone uses a metaphor that relates investment price or market movement with the action of something living it's called an "Agent" metaphor. An example The Dow fell significantly at the open today but clawed its way back to break even by midday.

When an Agent metaphor is used it causes the listener to subconsciously conclude that an independent living force is causing the movement and that therefore the movement will continue on its own. Of course there is no basis in fact for such a conclusion. 98

When an "Object" metaphor is used the investment price or market movement is related to a non-living object. The movement is then viewed as being subject entirely to external forces. An example – The Dow fell significantly at the open today but rose to break even by midday.

Behavioral economists call the reaction to Agent metaphors as the expectation of "trend continuance." This study confirmed that "trend continuance" does not occur when Object metaphors are used. My adviceBe aware of this phenomenon and try and refrain from using language with your clients that gives investments or markets attributes of living things (stocks and markets don't "claw" their way back– cats do). You have a difficult enough job as it is so you don't need your clients adopting conclusions from your discussions with them that you did not intend. *"Metaphors and the market: Consequences and preconditions of agent and object metaphors in stock market commentary,” published in the March 2007 issue of Organizational Behavior and Human Decision Processes, Michael W. Morris and coauthors. -10/13/2008

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And miles to go before I sleep.

We can learn a lesson from the Poet Robert Frost.

Stopping by Woods on a Snowy Evening 99

Whose woods these are I think I know. His house is in the village, though; He will not see me stopping here To watch his woods fill up with snow. My little horse must think it queer To stop without a farmhouse near Between the woods and frozen lake The darkest evening of the year. He gives his harness bells a shake To ask if there's some mistake. The only other sound's the sweep Of easy wind and downy flake. The woods are lovely, dark and deep, But I have promises to keep, And miles to go before I sleep, And miles to go before I sleep.

Recently we lost a multi-million dollar award in an arbitration which involved one of the branches in our division. This award related to two accounts for which we never did any business and never made one dime in fees, commissions or income. In the expectation of business we committed to do something for a new client. What we committed to do would not result in any fees, commissions or interest income. We simply promised a client we would do something for them. Something we could have done. We didnâ&#x20AC;&#x2122;t do what we promised. The client claimed they were damaged by our failure to follow up on our promise. They filed arbitration. We had to admit we did not fulfill our promise but claimed that the client was not damaged. 100

The arbitrator did not agree with us and rendered the award. We didnâ&#x20AC;&#x2122;t make one dime off the relationship but did manage to lose over three million dollars. But I have promises to keep. And Miles to go before I sleep. And Miles to go before I sleep. You may wish to consider what promises you make in managing your risk. -10/20/2008

â&#x2014;?

Prognostication is a four letter word (and so is overconfidence)

I was all set with a different Observation for today but then a financial guru testified before Congress on Thursday. I read a transcript of part of his testimony and I just could not resist. What he said was: It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivates markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into 101

the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.

What he meant was: They thought they had it figured out but they didn’t and it turned out to bite everyone on the....* Overconfident Prognosticators, all of them, including the “guru” (and you know what I think of those guys). You may wish to reread my 03/31/2008 (“worse than a lollygagger”) and 05/19/2008 (“…use your head Fred…”) Observations. If you don’t have them I will send them to you. I already sent them to the “guru.” Oh and by the way - “I am Greg Tevis and I approved this message.” *reminds me of when I was young and used to set off firecrackers with my buddies.

Once we set off several hundred in a row without a failure. Then one of didn’t go off after being lit. Georgie Wade stuck his head over the darn thing; it flared up and burnt his eyebrows off. -10/27/2008

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…use your head Fred (part deux)

Several weeks ago I talked about the need to filter the use of optimization models through your head. For those of you that don’t use optimization models let me use something else to demonstrate the same point. I’ll use 102

standard deviation which is universally touted as “the” ultimate measure of risk. You know where that’s not so true. Bonds are a good example. Take long term government and medium term junk bonds for instance. The LTGs may and often do have a higher standard deviation than the MTJs which would lead one to conclude that the LTGs have more risk than the MTJs. Hmmm that doesn’t sound right. It isn’t. Why? Because standard deviation with respect to bonds measures interest rate risk but not default risk. Default risk is present in MTJs but not LTGs. If an MTJ goes into default standard deviation becomes irrelevant as a measure of risk. The chance of default is always present with an MTJ and has to be factored in when assessing risk of the bond. Like I said use your head Fred.* *for those of you who still insist on reading footnotes: Given the foregoing, those of you who do use optimization models you might want to take a look at the inner workings of the model you use and see how it treats fixed income products. My comments in regard to the imperfection of risk measurement regarding bonds apply equally to any variant of “duration” you want to use.

-11/03/2008

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Sam - I hope you like this one

“Suppose you were an idiot and suppose you were a member of Congress. But I repeat myself.” Mark Twain

Remember the phrase “don’t confuse brains with a bull market”? I am sure you do and you no doubt remember that recently the talking heads on TV were saying that the price prospects on oil were bleak – that it couldn’t fall below (you pick the number) and that it would hit (you pick the number). Then last Thursday the price of oil hit a 20 month low. 103

Even in a bear market morons will insist on being prognosticators. But I repeat myself.* If prognosticators are more often wrong than right how do you as a financial professional deal with that? Diversify your client portfolios and align the allocations of asset classes with the investment time horizon of the client (adjusting appropriately over the passage of time) and you wonâ&#x20AC;&#x2122;t have to worry about prognosticators. *Occasionally prognostications turn out to be true, the reason that they do however, has nothing to do with the reasons the prognosticators put forth. This prophecy phenomena works on the same principle that a broken clock correctly tells the time twice a day -11/10/2008

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Counterfactual Comparisons1

Years ago I traveled up to the bay area to meet a senior executive at Oracle. He had a complaint about his account. His complaint was "lack of performance." You see he said that his account had appreciated 29 percent the last year but his wife's had appreciated 36 percent and he was "angry." When I met and talked with him I could tell that his anger was real. After a while in the conversation I asked him if he had a goal in mind for his investment capital. He said no not a specific one. I pressed him further. I asked whether, if he did not have a goal did he have a personal objective or at least a personal benchmark as opposed to just comparing himself to someone else? He said no, just to make money. I said, after all, his wife could have lost 36 per cent and he could have lost 29 percent. To that he said that he would have been happier than he was now. Imagine that - a well educated intelligent business executive saying he would be happier with a 29 percent loss than he was with a 29 percent gain. Now when you take out the external comparison and use only a self (internal) comparison then such an attitude seems ludicrous. But there it was in the flesh. 104

What can you learn from this? First, when someone compares their results with something external (such as another person’s results) they react emotionally and irrationally. Second when they use a self determined goal (internal bench mark) they do not but rather act rationally. Third, if you fail to get your clients to commit to a personal goal or objective, you invite an emotionally created unjustified complaint2. By getting your clients to commit to internal objectives you won’t eliminate all sources of discontent but you will eliminate a very powerful and very unfair source (that of social comparison – you know the one where you were perfectly happy with your car until your neighbor Fred3 got a newer one). 1. Leave it to the social scientists to come up with these two words to confuse us about a concept rather than clarify it. 2. As in a U-4/CRD amendment. 3. You don’t even care that Mr. Doofus took out a second on his house to buy the damn thing. You just can’t stand the fact that the guy who makes your skin crawl has a newer car than you. See where this leads – emotional outcry and a bad decision (you buying a new car when you really didn't want one). -11/17/2008

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Why you still own “it” 1

Understandably people have difficulty believing they have ridden a particular stock down (say from slightly above __ to its present price). The answer isn’t that their IQ is below average or that they are otherwise somehow intellectually deficient. The answer lies in normal human psychological traits which only very experienced professional money managers (say for example Buffett ,Munger or Soros) overcome. What are those traits? The first is what behavioral economists call “anchoring” and the second is what is called “loss aversion.” The first is not always a necessary ingredient unless the owner tends to hold the stock over 105

time. The longer the time the more significant “anchoring” becomes as a cause of “riding it down.” Anchoring is a well documented tendency people engage in when asked to analyze something and then make a decision. They establish a reference point – often one that is suggested to them. In the markets the suggested reference point is the price of the security. What price? Almost always it’s the purchase or acquisition price initially. As time goes on (studies say approximately 12 months) the reference point or “anchor” becomes the high for the period in question. For us that morphed into a price somewhere between __ and __ (I will explain why we didn’t lower it as the market price declined or at least to the extent of its decline). What happened to us is that we did not use our actual cost basis but instead used our reference point as our “basis” for making our decision. Anchor is a good choice for the word that describes this trait. It’s heavy and it’s very stubborn and resistant to change once it is set in its place. There is a second trait that comes into play here and is the real killer. That trait, again well documented, is “loss aversion.” Two prominent economists conducted a study on this phenomenon (other studies followed and confirmed). In short we now know that people have an intense desire to avoid taking a loss from an unrealized (potential) state to a realized (actual) state. Neuroeconomic studies tell us that those portions of the brain which are associated with the emotions of fear and regret become highly active when subjects are forced to decide whether to realize a loss or postpone it. This explains two things. First, why the reference point (anchor) we pick to evaluate whether something is a loss is what economists call “sticky upward” (or when the market price goes up people will move their reference point up but will not move it down when the market price goes down). Second it explains why we ride the stock down – neurons are firing in the portion of your brain (the amygdala) that is telling you to avoid the regret one experiences when the “game” score is final and its a loss (book it Danno). This is subconscious and involuntary (meaning compulsive). Don’t feel so bad, two geniuses were also significantly affected by this, Newton and Clemens. 106

Advisors such as Buffett and Soros tell us: never lose track of why you are holding the stock. From time to time reevaluate a particular holding and when you do - evaluate whether you would then make a purchase of the stock (assuming you had some money). Such an evaluation should be a major component in your decision to hold vs. sell 2. Oh and be aware what your anchor is and why you are using it as opposed to a different reference point. 1. Behavioral Economists use the term “disposition effect.” 2. When we have a position that is declining and has been from time we undergo stress. If that decline continues for a sufficiently long time that stress becomes chronic. Chronic stress is debilitating and eventually it overcomes “Loss Aversion.” Chronic stress is the chief cause for investors “throwing in the towel” and abandoning a position that has declined over a significant period of time. This action is taken by mere mortals who are attempting to end the chronic stress they are experiencing. They are seeking emotional relief by disassociating themselves from their “predicament” and they do so by ending the “pain.” It is ka-put, enough already with the stress, who needs it. Emphasizing the “would I buy it now” approach goes along way to relieve this stress and will help eliminate the sale of a good stock at the very time it should not be sold.

-11/21/2008

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On becoming a veteran

Recent speeches given by Secretary of Defense Gates and senior US Military officers have focused on the vast base of modern combat knowledge the junior and field level officers in our armed forces have accumulated since March 2003 and the need to effectively preserve and pass this information along. It was gained at such a cost that we cannot afford to waste it. By analogy I think that as we go through these extraordinary times in the financial markets let’s try and remember to effectively preserve and convey what we learn to those that come into the financial system as clients or employees too late to learn these lessons themselves*. They don’t have to 107

listen but you just never know, maybe some of them will. This was not an academic exercise. The scars are real. *For instance the lessons I have learned this time differ somewhat from the lessons I learned as a result of market action in October 1987. In 1987 those lessons related to the effects on clients for their personal use of leverage. In 2008 the lessons I have learned relate to the effects on clients for the use of leverage by third parties (individuals and businesses). -12/01/2008

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OK so now what?

Recently I wrote about “why you still own it.” Now I think it’s important to discuss “OK so now what.” What I mean by that is while we are sitting here thinking we are the dumbest bag of hammers on the planet for riding “that sucker all the way down” we have to step back and say “ok we did it and we are going to have to deal with it – so now what do we do?” In my footnote for the earlier Observation I emphasized that you should understand that market action like this puts you under stress and the longer this goes on and the lower the market goes the more chronic the stress becomes. I stated very plainly that you should not let chronic stress and your desire from relief from that be the cause of the divestiture of your economic assets. In large part your decision should be based on an objective analysis of the assets you hold. A good way to make the decision to hold or sell an asset is to objectively evaluate whether you would buy the asset if, hypothetically, you had some cash. Notice I used the word “objectively” and remember that in my view true objectivity is impossible in the investment world. The best course for us then is to become aware of the emotions affecting us and the biases in investing they cause and then armed with that knowledge try and overcome them (or at least take them into consideration) when making our analysis and decisions. In short, we need to recognize and acknowledge our situation, the 108

emotions we are experiencing and the consequent biases to which we become subject and deal with them as strongly as we can. OK so how about now? Well in the current market negative emotions are predominant. While all negative emotions have the same vector (direction as in “lower” or if you are in California "bummer" dude*) they do not have the same effect on investment decision making. A short list of negative emotions includes disgust, sadness, fear and anger. The negative emotion of disgust has been confirmed in behavioral economic studies to cause people to “expel.” They want to get rid of assets they own. They do not want to buy new items – their reflexive brain is screaming - get out of the market. Sadness on the other hand does not cause the desire to “expel.” Studies have confirmed that sadness causes investors to value items that they own less and increase their perceived value of things that they do not own. Sadness reverses the “endowment effect (July 2, 2007 Observation “If it’s mine its mighty fine and if its not it’s not worth a lot”). In other words sadness causes people to (subjectively) want to turn their portfolio over. Although the endowment effect is not good for us, its reversal isn’t either. The negative emotions of fear and anger have the opposite effect on investors. Fearful investors have been confirmed in studies to be uncertain and pessimistic in their outlook. This causes them to be risk averse. Risk aversion increases a subjective desire to sell and flee to “safe assets” even when their account is perfectly balanced and diversified. As we now know even safe assets can take a drastic decline, so fear is a dangerous emotion because it causes clients to want to de-diversify (is that a word?). Angry investors oddly enough have been confirmed to have a belief that they have control over their situation. They are much more certain about the future than uncertain. As a result angry investors are much more optimistic about the future and are not risk averse but risk takers. When investors become angry (not disgusted) they amplify their risk. If you need convincing take a look at how the markets behaved once the initial shock and fear over 109

September 11, 2009 dissipated and the American public became “angry” – investors caused the markets to engage in strong rallies. Anger may in fact be a beneficial emotion in our current market conditions. The takeaway here is: identify the negative emotions you or your clients are experiencing, remember what biases then come into effect and what they temp someone to do, deal with that temptation and do your best to recommend or make objective decisions. That’s enough for this week. Next week I am going to talk about the fact that people compulsively believe that the way they “feel” (their current emotional state) will be the way they “feel” in the future and how this hurts our ability to plan for our financial futures. * For those of you not currently sitting on a surf board this word is correctly pronounced "dahoude."

-12/08/2008

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and why you won’t do it

This is a follow up to two previous observations “Why you still own it” and “Ok so now what.” So far I have told you that you are compulsive in two ways. First you compulsively avoid realizing a loss and two you compulsively let negative emotions direct your investment decisions at the worst possible time. I asked you to be objective or at least try during a trying time. (If you did not receive either of the previous Observations just let me know and I will forward them to you). Now for the bad news, here is why you won’t do the right thing even though you are now aware of how you got into this predicament and how to get out (with at least some dignity). If we have one failing that tops them all this is it: we compulsively and subconsciously (meaning we don’t know its happening and can’t help it from 110

happening) let our current emotional state override our future requirements (in every facet of our being including economic considerations). Behavioral economists call this “projection bias”1 and its consequences have and will continue to plague all of us. In short, studies have repeatedly shown that we project our current emotional state into the future. We simply do not imagine that we will have a different frame of mind later2.This occurs despite the fact that we can remember that we have had distinctly different emotional moods (or states) repeatedly in the past. We simply cannot empathize with those prior moods and cannot project them in the future3. By the way this bias goes for all moods not just negative ones4 - some positive moods can have deleterious effects on investment decisions. How can feeling really good be dangerous in the investment arena? Studies have confirmed that when clients feel flush with cash they cannot bring themselves to plan for the need to engage in future saving (such as for retirement) or decide to continue saving (when objectively it is necessary). A negative emotional state such as fear5 causes us to de-diversify, because, among other reasons we cannot imagine that we will not be afraid in the future. Now here is the secret to overcoming this bias. In a word it is discipline. Develop and follow a financial plan using an independent source, in the case of your clients that’s you Ms/r Financial Advisor. By using an independent source to develop, review and follow your plan you will mitigate this bias to the extent possible6. For your clients you may wish to use an Observation I have written previously and reproduce below: ●

A simple proposition

Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome. Risk management is a scientific approach to dealing with risk by anticipating possible losses and designing and implementing a process that minimizes the impact of losses that do occur.

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No one avoids losses altogether. Those that have a sound financial plan minimize the effect of those losses while not impeding the effects of expected and fortuitous gains. It’s pretty simple really, when you get down to it. A financial plan is simply risk management for the individual.

The takeaway from today’s Observation is: Someone’s current emotional state is a great danger to their future economic well being because they are subject to a powerful cognitive bias, the projection bias. The only way to avoid it is to develop and follow a sound financial plan using an objective independent source. 1. Do not confuse this cognitive bias with a defense mechanism identified and named (the same name) by Sigmund Freud. The defense mechanism identified by Dr. Freud relates to the tendency of individuals who have negative thoughts to imagine that others have those thoughts as a means of justifying their own negative thoughts. The two concepts are quite different. 2. This explains why when you go to the grocery store when you are hungry you buy much more than you need and guess what, you buy food heavy in calories (a/k/a junk food). This example confirms something I am saying above and that is despite the fact that we have had plenty of experience with the negative consequences of this bias we do not overcome it. 3. This is referred to in some literature as the “empathy gap.” 4. Behavioral economists classify moods as “hot”, “cold” and “neutral.” There are some statistical differences in projection bias depending on the nature or type of the mood but projection bias occurs in all categories. 5. Fear and the projection of this emotional state into the future is the prime reason that people do not buy at the depth of a market plunge but wait for a clear indication of a bull market before going back in (the answer to “why you won’t do it” under the current circumstances but will when, in fact, your current emotional state does change). 6. Remember that I have consistently said that true “objectivity” does not exist in the investment world. -12/15/2008

• Two Marketing "techniques" we compulsively fall for: 1. “I could tell you but then I would have to kill you” - secrecy

See I have this "secret" black box I invented. You give me your money and I push it in one side of the box and out comes your profits from the other side of the box. Trust me - look at all the other people I have been doing it for. 112

2. “Well let me check and see if you are good enough to be chosen” - exclusivity

We used to have a jazz club in studio city. Musicians jammed there on their "nights off." Place was a dump and always empty. Owner put up a rope in front and had a big guy with a clipboard in his hands stand next to the door. Place was still a dump and full every night. My comment: maybe now some people might want to pay attention to behavioral economics. Here is this week’s Observation:

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“Every

Be from Missouri

generation

laughs

the

old

fashions,

but

follows

religiously

the

new.”

Henry David Thoreau

That principle, so expertly articulated by Mr. Thoreau, explains why time and time again we get burned by the new “thing” in our business. When something “new” comes along in our world study it carefully before you decide whether to embrace it – you’ll be glad you did.*

*Madoff didn’t use the “new” pitch; he used the “secret” pitch.

When it’s secret don’t even think about it.

-12/18/2008

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New Year's Eve

Let's be safe on this occasion. I want everyone one of you safe and sound come January 1st. -12/29/2008

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“Prognosticator” Awards

As I previously observed just because we promote someone to a position of authority doesn’t make them any smarter. Let me demonstrate by announcing the first annual “Prognosticator” awards: At the Goldman Sachs annual shareholder meeting in April 2008, its CEO announced that in regard to the credit crisis “we’re closer to the end than the beginning. I think we’re getting to the point where people are seeing the light at the end of the tunnel.” - Then of course sometimes the light isn’t coming from the end of the tunnel. Indy-Mac’s CEO announced in response to bearish movement on his company’s stock “given the decline in our stock price, some people have questioned Indy-Mac’s survivability in the current environment. I am here to tell you that I believe we have turned the corner and that our business is improving.” - Then of course there is always Chapter 11. The CEO of Bank of America announced repeatedly in the spring and summer of 2008 that B of A would not cave in and cut its dividend despite the fact that other banks were recognizing mounting loan losses. The market didn’t believe him (the stock continued to decline) and so he fought back. “Given our view of things we do not expect to cut the dividend, nor do we expect to have to raise capital. We get investors and analysts calling us 114

saying. ‘You’ve got to cut your dividend because the market is saying you should cut your dividend.’ We’ve reminded them that the market over the short term is not always right.” - Then of course sometimes it is. The entire Management Team of the Reserve Fund asserted in written material in July that it had the “world’s most experienced money fund manager, expertly qualified to help you address ongoing challenges in the market as well as help address your questions you may have around the soundness, safety, and security of your cash.” - Then of course there is the opportunity (less than two months later) to become only the second fund in history to go below a dollar. On July15th Management of Wachovia (with its stock down 20% in a matter of hours) publicly stated that it was “a fundamentally strong and stable company on solid footing.” - Then of course there is stable and there is “stable” (as in a place where there is a lot of horse manure). In the summer the Fed Chairman pronounced that (shareholders take heart) Fannie and Freddie were “in no danger of failing.” Fannie’s CEO when asked whether it was likely that Fannie would take advantage of a government buy out, replied it was “highly unlikely.” - Then of course “highly unlikely” is a relative expression. On Sept the Secretary of T declared (in relation to the Lehman bankruptcy filling) that “he never once considered it appropriate to put taxpayers money on the line” to save the brokerage firm. On Nov 13th the T man stated to NPR that he believed that the banking system had been stabilized. Two weeks later.... - Then of course does no really mean no? -

Then of course there is that word stabl(ized) again.

Then of course there is former Management of AIG (you pick your own quote here because there are just too many). The foregoing instances were taken from a December 31, 2008 article in the Los Angles Times. The attitude was (well who let the dogs out) mine. 115

The takeaway from these awards each year will be the same. A material portion of the “information” which enters the public forum is not only wrong but astoundingly so (even when the information comes from people who have virtually unlimited resources). Nevertheless this information does affect our markets. This is another reason to diversify. It’s not a perfect defense but its best one we have. The foregoing folks attempted the impossible and that is to predict the outcome of a complex system. Edward Lorenz would simply ask them: “If a butterfly flaps its wings in Brazil...” Prognosticators you gotta love ‘em. -01/05/2009

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You can’t and it will

Apparently some of our Financial Advisors think that with regard to the accounts of blood relations and in-laws they can (shall we say) take certain liberties. These Financial Advisors seem to think that nothing will happen if they do. So, on that note, I offer some advice (see above). Please add two more bricks to that road*. Mr. Morgan - play that album one more time for me. *For those of you who missed my earlier Observations on "the road to hell" let me know if you would like copies. -01/07/2008

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A lesson we all should learn

“It isn't what we don't know that gives us trouble; it's what we know that ain't so.” - Will Rogers

An earlier Observation on behavioral economics bears repeating. Risk taken by individuals and businesses often takes the form of failing to perceive and appreciate the risk as opposed to its deliberate assumption.1 116

How does this2 happen? ·

By overconfidence that the information one is going to base a decision on is (i) complete and (ii) accurate. By overconfidence in one’s ability to analyze the information that is available.

This propensity is a killer in the higher echelons of the business world. I can’t help those folks but I can help you detect it in a client. Look for these signs: · · · · ·

The tendency to want to purchase higher risk securities The tendency to want to under diversify (or concentrate) The tendency to want to trade too often The tendency to reject your opinions or advice The tendency to reject or avoid discussion with you

If you see one or more of these chances are you have an overconfident investor on your hands. My adviceDon’t go along with an overconfident investor. Use some firm control over them in reforming that overconfidence. If you can’t, punt them, there are too many fish in the sea. Since they are overconfident they don’t perceive and appreciate the risk they are assuming. This makes them classic “heads I win, tails you3 lose” investors. 1. If you would like a copy of the earlier Observation just let me know and I will send it to you. 2. A partial quote from a Dow Jones story last Friday relating to fourth quarter 2008 losses at Merrill Lynch may be illustrative of this phenomena: “Bank of America Chief Executive Kenneth Lewis on Friday rejected the suggestion that he and his team didn't conduct enough due diligence before agreeing to buy Merrill, saying forecasts didn't suggest Merrill's assets would drop so suddenly in value.” 3. By “you” I mean Financial Advisor. Since the client did not perceive the risk, they will blame you for not making it “clear.” That blame may involve a blemish on your CRD or worse. For those of you reading 117

this footnote, unreformed overconfident investors simply do not present a favorable risk reward relationship for you. If you don’t follow my advice I will try and help you but among other things you will have to listen to me tell you I told you so. I am insufferable when I do that. If you don’t believe me just ask your branch manager. -01/20/2009

Careful how you judge

●

Changing one’s mind may not be a flip flop; it may be a sign of an open mind. Compromise may not be weakness; it may be a sign of tolerance and respect for contrary opinion.

The latter traits in each one of those bullet points are precious commodities. When they occur lets not condemn them. * On another note I read a stunning book last week “The Worst Hard Time” by Timothy Egan. It tells the story of the causes of the dust bowl of the 1930s and takes you through the first hand experiences of the people that lived in the high plains and the American public in general. If you truly want to understand the “causes” of the current financial tumult I suggest you read this book. The book also describes the work of one determined and brilliant fellow who in large part taught the country how best to end the tragedy. Some in government might want to revisit his lessons. *Leave that reaction up to the talking heads they invite onto the 24hour news channels. Those guys are dumber than brother-in-laws and you know how I feel about them. Speaking of “dumber”, I am told that a “commode” is not a toilet but rather a small cabinet that frequently has a chamber pot inside. My guess is someone may have had a pot on their head when they bought that commode. -01/26/200

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If you can’t figure this one out take a little walk the message may come to you ●

Something happened last week that caused me to write this Observation. In August 1971 I was a corporal in a Marine rifle (infantry) company. We were participating in a field exercise. The exercise was a lengthy one and we had been out in the bush for an extended period in horrible weather. After finally coming in out of the field in the afternoon we were given the opportunity to line up at a field kitchen for our first hot meal in a long time. My fellow grunts (marine infantry) were not in a very good mood despite the respite. It was a tradition in my company (imposed by our CO) that officers and senior enlisted were to take to the rear of the chow line. I was kind of in the middle. Almost immediately one of the grunts at the front of the line began to badmouth the chow and others joined in. Our CO noticed and came to the front of the line to settle things down. One of our grunts was asked what the problem was and I remember to this day his exact words in response. “Sir, we are grunts, we are the corps, they are cooks, we deserve better, why do we have to put up with them?” And so our CO nodded and went over to our top shirt (senior enlisted man in the company). The CO told him to call the company to formation which he did. His next command was “Company, left face. Forward, march.” We did - for three hours - and then were called to halt. “Company, right face.” Our CO then came to the front of the formation and addressed his grunts “You asked whether you had to put up with them - you don’t. Are there any other requests?” We stayed at that spot all night - marched back the middle of the next day. -02/02/2009

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The “Certainty Effect”: Why they got so upset about ARS

The psychological impact on people is much greater when an outcome which was certain becomes less certain than when an outcome was probable before and has become less probable (even when it’s a greater degree of reduction). In other words if an outcome is absolutely certain (100%) and thereafter becomes less certain (say by 10%) the emotional impact is much greater than if the outcome had been probable (say 90%) and reduced by a larger factor ( say 20%). Why? Behavioral Economic studies confirm that people universally prefer absolutes because they cannot really absorb the difference between different probabilities (say the difference between 60, 70, 80 or even 90 percent probability). Except for absolute certainty these differing probabilities all mean the same thing to people. Since they cannot process the differences they embrace the absolute.* This goes as well for what our scientists call the Pseudo (“perceived”) Certainty Effect. To my point: Many perceived - as an absolute certainty - that the auctions would continue to occur** (thus ARS were perceived as absolutely liquid). In February 2008 this emotional trait kicked in and did so in spades. My advice: Remember this quirk of human nature. When you are discussing outcomes or products with clients ask yourself, is there an objective or outcome that is perceived/desired to be certain, if so remember that you may have to deal with a dramatic emotional reaction if it turns out it wasn’t certain after all. So do your homework and make certain it is certain and if it’s not make sure your client understands that it is not (even when the uncertainty is incredibly small). * Which if you think about it explains why insurance is constructed in the fashion it is. **The basis (scientific, mathematical or intuitive) for the belief in certainty is irrelevant and does not affect the operation of this human emotional reaction. -

02/09/2009

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Emotional Contagion

Neuoreconomic studies have confirmed that emotions are contagious. Part of the reflexive portion of the brain, the Amygdala, plays a central role in transferring emotions when certain cues are received. These studies confirm what social scientists have long advocated. Stated simply: Given that emotions function to help humans adapt to social situations it makes sense that one person’s emotion would affect another’s. Just as herd animals would benefit from rapidly passing messages about risk and reward, emotional contagion seems to be adaptive for humans to function in groups. This system can enable a rapid communication of opportunity and risk, mediate a group interaction, and help humans attend to social rules and norms such as maintaining harmonious interaction with a powerful ally".*

Emotional contagion is now shown to be, you guessed it, hardwired into our brains and therefore subconscious and involuntary. Emotional contagion is not confined to group interaction. One recipient can replicate the emotional condition of someone who is interacting with them. Furthermore, emotional contagion is not confined to face to face interaction but can occur via voice or written communication. In short we look for clues in the emotional state of someone we are interacting with and due to our evolution then subconsciously and compulsively mimic those emotions. After separation that emotional mimicry tends to fade. Negative emotional states tend to be conveyed to a greater degree than neutral or positive emotional states. So how does this affect you the FA or CSA? The emotional state or states you are experiencing when communicating (whether talking, leaving a message or drafting a letter or email) with a client will to a certain extent be transferred to the client. That transferal may cause the client to react to your communication in a manner which would not have occurred if the emotional transferal had not occurred. After time passes the transferal subsides and the client may “change their mind.” You can’t eliminate the emotional cues you give off in client communication but you can reduce unintended transferal. Before communicating with a client I advise you to check yourself emotionally. Get things under control as best you can. If you are in an agitated emotional state try and avoid client 121

communication at that point and work on getting back to a neutral emotional state. *Melissa Bayne & Joshua Freedman. White Paper: Emotional Contagion (2007). http://6seconds.org/modules.php?name=News&file=article&sid=267 -02/17/2008

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Go ahead – make my day.

“Bernie and now Stanford – take the time or you could lose your last dime” - this isn’t a quote from a famous person just me

People spend a great deal of time and effort checking out investment ideas but virtually none checking out who advises them. A little balance might help. I said this in a slightly different fashion in an earlier Observation: “The selection of a financial advisor presents investors with the opportunity to assume the greatest amount of risk. Investors often take advantage of the opportunity.” -02/14/2006 As far as investments go let me say this concept one more time: If it sounds too good to be true (Stanford’s marketing pitch) it isn’t. To paraphrase Clint Eastwood as Detective (Dirty) Harry Callahan: I know what you're thinking. "Did he return sixteen percent or only fifteen?" Well, to tell you the truth, in all this excitement I kind of lost track myself. But being as he says this is his secret investment device, the most powerful in the world, and would blow your head clean off if he told you, you've got to ask yourself one question: Do I feel lucky? Well, do ya, punk? 122

Do ya have the concept yet*? Well do ya? -02/20/2009

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Why do I dwell on behavioral economics? “Such is the brain of the ant. It has a simple program of responses that generally work out all right, but which are imprudently used by rote in many cases.” - Charles Munger

We don’t have any control over how our investments perform. No we don’t. We do not have control over how a stock or bond performs. We do, on the other hand, have control over our investments. By this I mean we do have control over our investment decisions and therefore which investments we have and when we have them. Mistakes we make then do make a difference, a very big difference. Mistakes in investment decisions are 99.9% caused by human error. In the past once human error has been identified as the cause of a mistake our inquiry stopped. That is too bad because that causes future repetitions of the mistake. “It is necessary to learn the cause of the mistake in order to have any possibility of preventing a repetition.” -not a quote of someone famous – just me

Ok what causes these mistakes? Human bias and by that I do not mean some prejudice, but rather, some predisposition inherent in all of us by virtue of our evolution over time as humans1. This predisposition (to view, judge or conclude) causes us to be subjective and not objective in analyzing a potential decision.

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What is critical to understand is that these predispositions are just that. What I mean is that these biases are not conscious but subconscious. We are – biased that is – we just don’t know it. For many of the biases that afflict us, knowledge2 sets us free – to make better decisions and thereby less mistakes3. That is why. 1. In behavioral economic parlance a bias is often referred to as a "heuristic" or mental shortcut for decision making. This is exactly what Munger is describing in the quote above. 2. Knowledge of these biases helps you adjust for your biases and the same biases in other people (investors). Some biases even when known cannot be corrected but even those can be accounted for. 3. For Financial Advisors it sets you free to render better advice and help prevent mistakes you and your client’s may be inclined to make. -03/02/2009

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Well you can knock me down...

Add to my annual Prognosticator awards* (Jan 5, 2009 Observation) the following: There is this

News Release Wells Fargo Increases Dividend 10 Percent 21st consecutive year of increased dividend San Francisco — July 16, 2008 Wells Fargo & Company (NYSE: WFC) today announced a quarterly common stock dividend of 34 cents per share, up 10 percent from the previous dividend of 31 cents per share – the 21st consecutive year Wells Fargo has increased its dividend. The dividend is payable September 1, 2008, to stockholders of record on August 8, 2008. The Company has approximately 3.3 billion shares outstanding. “This increase, which reflects the Company’s performance and our confidence in its long-term growth, is possible because of our time-tested vision and values, diverse business model and our talented team that collaborates so well as One Wells Fargo to satisfy all our customers’ financial needs,” said Chief Financial Officer Howard Atkins. “Wells Fargo is one of only a few financial institutions that have continued to increase its annual dividend, which now exceeds $4.5 billion.”

They continued in a January 28, 2009 press release “Given our strong balance sheet and business momentum, the Board of Directors declared a common stock dividend of $0.34 per share. We have no plans to ask for additional TARP capital.” 124

Then of course there is that word momentum. Perhaps they meant “moment” (as in give me one) “um” (as in let me think about this) - suddenly cutting the dividend 85% less than six weeks later. Although doing so was "very difficult," President and Chief Executive John Stumpf said Friday (March 6, 2009) the move was "absolutely right for our company and our shareholders because it will further strengthen our ability to grow market share and to continue our long track record of profitable growth." A more-normal dividend will return "as soon as practical." .....

Step in my face, Slander my name All over the place. Do anything that you want to do, but uh-uh, Honey, lay off of my dividends Thanque Thanque very mucha This song is just to good to pass up: sing it for me - it will make you feel better today. (Words & music by Carl Perkins) Well, it's one for the money, Two for the show, Three to get ready, Now go, cat, go. But don't you step on my blue suede shoes. You can do anything but lay off of my blue suede shoes. Well, you can knock me down, Step in my face, Slander my name All over the place. Do anything that you want to do, but uh-uh, Honey, lay off of my shoes Don't you step on my blue suede shoes. You can do anything but lay off of my blue suede shoes. You can burn my house, 125

Steal my car, Drink my liquor From an old fruit jar. Do anything that you want to do, but uh-uh, Honey, lay off of my shoes Don't you step on my blue suede shoes. You can do anything but lay off of my blue suede shoes. Well, it's one for the money, Two for the show, Three to get ready, Now go, cat, go. But don't you step on my blue suede shoes. You can do anything but lay off of my blue suede shoes.

White Book? I don’t need no stinkin white book.** *For those of you who didn’t get that Observation and want it, just let me know and I will send it to you. **Oh I’m going to hell now. -03/09/2009

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Silo (noun, something that is kept separate or compartmentalized; verb, to keep

separate)

When someone embezzles funds from the branch or branch clients, how do you think we take a look? Well let me tell you how it may occur. We investigate and determine exactly what happened chronologically, moment by moment ad infinitum. We do that by pulling documents directly and indirectly related to what happened. We interview everybody who was directly and indirectly involved in or touched the events as they transpired and those that should have been directly or indirectly touched or involved. We pull out all the procedures that relate directly or indirectly to what happened. We determine what procedures were followed and by whom. We determine what procedures were not followed correctly –for how long, by whom and why or who caused 126

that failure. We determine what procedures were not followed at all – for how long, by whom and why or who caused that failure. We determine what exceptions were requested and what were granted – by whom and why. We determine who knew what, when they learned it and what they did thereafter. . We cross check everything, documents, records and versions of events. So now re-read this (especially if you’re in a silo):

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Betrayal

Requests for exceptions should be considered in the context that they will exist. The risk will remain long after the goal is achieved. -09/12/2006 127

When the escalator breaks people get hurt. Just try and make sure you’re not the one who broke it. This goes for everybody even FA s and SA s. 05/31/2007

-03/23/2009

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Mental Accounting

A dollar is a dollar. We all know by watching the recent Congressional hearings in which our financial bigwigs testified that money is fungible (or maybe it was the committee members that said that), one dollar is just like another. That is true but people don’t treat their dollars that way. Don’t believe me. Think about finding a dollar on the street* (free money) and think about a dollar in your paycheck (earned money). Don’t think about them the same way do you? Economist Richard Thaler is a proponent of a behavioral economic theory to which I subscribe. Simply stated it says that people, rather than treating their dollars as identical or fungible, divide them up into separate nontransferable piles. Then they assign different unrelated risk tolerances to those piles. This causes them to treat what are in fact identical assets in radically different fashions. Some they treat as if they are to be disposed of as quickly as possible and some they “guard with their very lives.” The upshot of this phenomenon is that folks do a terrible job on their own with their assets. They don’t diversify in any rational fashion but rather use an emotional attachment (or in the case of “found” money detachment) to dictate how they treat an asset and how they put it to use. That’s where you come in as a Financial Advisor, you need to be aware of this eccentricity people have and manage around it. If you don’t get their assets diversified, they won’t. *Don’t like the found money example? Then substitute “tax refund.” -03/30/2009 128

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Take this to heart

This next point is, in my view, a very important concept for anyone in management. It’s a career maker or career breaker. Most often careers in management are ended not because of what they knew but what they didn’t know. Many times that is because what they needed to know was not brought to their attention. All of the people that work for you and all of the people that work with you are extremely intelligent and if you foster the correct environment care about their work and their firm. They constantly observe things that you may not see or notice. Little things that may mean a lot. Do you know whether those folks feel free to speak up and let you know? How about letting others know that may be able to process the information and help out? If they don’t feel free to do so then that is the best way to ensure that your career will end prematurely. Make sure that people who work for or with you know you want and encourage them to bring their observations to the attention of those that need to know. Now I suggest you circulate this to those who work for and with you. Let them read it and let them know that you did as well. -04/06/2009

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Somebody was not listening

So I repeat a recent Observation

You can’t and it will

Now add another brick in the road to.... I never said I would not tell you “I told you so” and now I have. -04/13/2009

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Rich client Poor client

“A major difference between rich and poor people is that the rich people can spend their lives suing their relatives.” -Warren Buffett

Keep the foregoing in mind as your clients progress in age. Cross your T’s and dot your I’s, make notes, send confirming letters (especially reflecting their desires and decisions) and when a transition is occurring try and avoid any perception that you are preferring one faction or another. -04/20/2009

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Observations of an In-House Counsel 130

Last week I spent a considerable amount of time on the phone with a client who was very upset. She complained about her account but dwelled on the manner in which she was treated. In listening to similar complaints last week (all with the same refrain) it occurred to me that although the advice I repeat below from an earlier Observation is applicable in all market conditions it is absolutely critical in a bear market, the more so the longer and deeper the bear market continues. ●

Take the time, do it right, you will be glad you did

Doctors who spend more time with their patients get sued far less often (there is a significant statistical difference just between doctors who spend an average of 18.3 minutes versus 15 minutes with a client). An even bigger difference shows up in how they talk to their patients. Those least likely to get sued make “orienting” comments. For example: “let me first examine you, then we will talk the problem through and then we can take time to address your questions.” But most importantly all of those least likely to get sued used a particular tone of voice to talk to their patients. Those that used a dominant tone got sued the most. Those that used a concerned tone got sued the least. Put your clients on a par with you when you speak to them, take a little more time with them and orient them through the process of the discussion. “A lawyer's time and advice are his stock in trade” – Abraham Lincoln

So is your time and advice. Please pay attention to what the medical profession has learned about managing their risk. Your CRD will thank you. -

04/27/07 04/27/09

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Observations of an In-House Counsel

“It is not greed that drives the world, but envy.” - Warren Buffett

Social Comparisons Increase Risk Assumption

Individuals engage in social comparisons in investing and increase the level of risk in their investment portfolio when they perceive that they are falling behind their peers in their investment performance. I have periodically talked about “Loss Aversion” a human trait that in essence means that we subconsciously have an intense desire to avoid realizing a loss. I have explained that at least part of the reason is that we like to avoid regret and so long as we have not realized the loss we postpone the feeling of regret. Now add to that the concept that we have a more intense feeling of regret over a loss which results from actions we take than the feeling of regret over a loss which results from our inaction. Behavioral studies have shown that this explains why we resist changing our answers on a test before handing it in. Not changing an answer (inaction) produces less regret if we get the question wrong than the other way around – that is changing the answer (action) and then getting the question wrong*. This additional information should go into your data bank on why we hold onto losing positions too long. *By

the way those studies show that in most instances our intuition was correct and we should have changed the answer. It was our fear of intense regret that kept us from doing so. -05/04/2009

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You bet, why I can remember....

Clients often judge the probability of a desired (or feared) investment outcome on the basis of how easily they can bring to mind instances of the occurrence of what they desired (or feared).* This process is in no way objective or scientific. The more easily an occurrence of a similar event is subject to recall the more we view the event we desire (or fear) is likely to occur. Your job as an FA is to look beyond recalled events, dig deeper, do a proper job of due diligence. *This phenomenon is called the “Availability Heuristic.” -05/13/2009

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Observations of an In-House Counsel

Initially I wrote the two Observations below for separate publication, however, an excellent Op-Ed editorial in yesterdays LA Times caused me to revise them slightly and send them together. Here is the link to the editorial http://www.latimes.com/news/opinion/commentary/la-oe-mcmanus172009may17,0,1238468.column

For all you alpha chasing dogs (part duex)Sentiment Diversity and its breakdown ●

If as I have often said individual investors are in some ways irrational in their approach to financial decisions, can the market (which is made up of the totality of investors) be deemed at times to be rational? The consensus from the experts is yes. When it is, there is what they call a “diverse” market environment. The best way I can describe that is to say that everybody has different opinions at one point in time and as far as the market goes these 133

different opinions basically cancel each other out. The market kind of just sits there smiling at you or moves gradually. There are times (it turns out sometimes that are predictable) that this diverse state breaks down. This is referred to as a “diversity breakdown.” When investor opinion is not diverse it is by definition consistent (or at least more consistent) and that means everybody (or most of them) thinks the same way about one or more financial matters or the market in general. So when we have a diversity breakdown we have material price movement, either with respect to a stock, sector or the market as a whole. So what can cause diversity breakdown and why do I say that when that happens the markets are not being rational? Let me list a few causes for diversity breakdown and you be the judge of whether the market is being rational. Remember that the operative word is “sentiment” not “rational thought.” Studies have found that the ratio of sunshine to cloud cover affects market performance. Other studies have found seasonal variation correlations in market performance. Another study found a correlation between stock market performance and the number of geomagnetic storms (sun spots). Finally events that affect the sleep quality of society have been found to affect market performance (in this instance markets tended to perform relatively poorly after a shift from standard to daylight time and vice versa). All of the foregoing affects the mood of a large percentage of our population in the same way which in turn affects investment sentiment. Happy investors are inclined to be optimistic and grumpy investors are inclined to be pessimistic. Optimistic investors are inclined to take risks or increase them and pessimistic investors are inclined to avoid risks or decrease them thereby affecting market and price levels. Market trends themselves have been found to affect societal sentiment and hence either create or encourage diversity breakdown and market movement. In a market run up more and more people develop an optimistic sentiment. As this happens the diversity breakdown becomes more pronounced leading to a reinforcement of an upward move in the market (despite the fact that when asked to assess the status of the market subjects overwhelmingly say the market is at that point overvalued). The opposite (pessimism) occurs during a market decline. So if all this is true what is my point? 134

The point is that if you believe there is Alpha out there and you can understand the factors that can affect the collective mindset of society and can recognize one when it occurs you will have the opportunity for gain or for loss avoidance.1 Today we have one of the most significant cases of diversity breakdown in the market. Investor sentiment is significantly aligned right now (negative) in the recession. So

â&#x20AC;˘

Remember this

We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful. -Warren Buffet

Letâ&#x20AC;&#x2122;s step back for a moment. During the last 24 months nothing has changed but public sentiment. Nothing has changed regarding our ability to manufacture goods or provide services.2 Nothing has changed regarding our natural or human resources. The only thing thatâ&#x20AC;&#x2122;s changed is that we have gone from being optimistic to pessimistic. Indeed at this point we have become frightened, of what is not entirely clear, but it is not a fear of a disruption in our supply of natural or human resources, or in our manufacturing or service capabilities. Yet the consequences being visited on us are real. The good news is that public sentiment can be fixed and it will swing back. It does not turn on a dime when it comes to the economy. Whether you are a democrat or republican, whether you believe in monetary policy or fiscal policy, whether you agree that either policy is currently being applied correctly, I think you will agree with me that we will see a change in sentiment when people simply get tired of being afraid. That will happen. No I am not going to tell you that we are at the bottom and now is the time to invest. I am going to point out however that in several recent Observations I have mentioned human traits that cause us to be habitually a day late and a dollar short on the top and bottom of a market cycle. 135

I am telling you that now is the time to plan. When you put your plan into action and what your plan is something that is up to you but now is the time to plan. 1. For the “A” type personalities reading this footnote the phenomenon described above is called the “Affect Heuristic” by people who like to use non-descriptive names for things. Say what? 2. The extension of credit is a service. In our economy the extension or withdrawal of credit to businesses and individuals is largely dependent on sentiment (optimism or pessimism) not on the availability of currency. That is why, despite the injection of vast sums into the credit market, lending has not increased. In other words sentiment drives the credit market not the other way around. Therefore, I believe the statement I make above goes for the extension of credit as well. -05/17/2009

• Observations of an In-House Counsel For the joint venture, I have been assigned new duties and, after 23 years, will no longer serve as Division Counsel. I would like to take this opportunity to make

• A Final Observation It has been both an honor and a pleasure to serve you. -05/20/2009

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