“Investing and speculating are widely confused. Investing is “to allocate capital into productive activities with the anticipation of operating profit.” Speculation is “to allocate capital in order to profit from politically caused distortions in the market place.”

If you can think of any counter-examples, please let us know!

Almost every page of the health care bill HR3200 from the House of Representatives has at least one statement that can alter your life. When those 1017 pages interact, they will produce effects not imagined by the bureaucrats and politicians who wrote this thing. The odds those unpredictable Black Swans are good for you are nil. They will hurt you.

As an example, consider this from the New York Times of 1 OCT 09 in regard to the current Medicare:

Medicare is putting in place a new policy that may sharply curtail the use of the cancer drug Avastin as a treatment for eye diseases.

But the way the bureaucratic gears mesh in this case, the move could end up costing Medicare itself hundreds of millions of dollars a year, and individual patients thousands of dollars.

What happened is that Medicare added a new reimbursement category for doctors to use for very small doses of an existing expensive drug. As the Times writes:

But Medicare has now introduced a special reimbursement code just for the smaller doses of Avastin. And starting Thursday, the reimbursement of Avastin dropped to about $7.20 for the dose typically used in the eye.

That would mean eye doctors — who purchase Avastin and then are reimbursed when using it on patients — would lose money administering the drug.

The new policy would give eye doctors a financial incentive to switch to Lucentis, for which they would be fully reimbursed even though that drug is significantly more expensive.

If doctors do shift to Lucentis, “this will have a huge economic impact on Medicare, in the range of hundreds of millions of dollars,” said Dr. David W. Parke II, chief executive of the American Academy of Ophthalmology. “Members view this as a bureaucratic decision that is maybe necessary, based on statutes, but highly short-sighted.”

This illustrates the obscenity the Congress is creating by rushing to a new, vast bureaucratic system with enormous perverse incentives and deep complexities that can only make life worse for everyone.

Read Full Article

As the magazine says in the article:

In selecting this year’s winners, Global Finance’s editorial team considered objective and subjective factors. Objective criteria included growth in assets, profitability, geographic reach, strategic relationships, new business development and product innovation. Subjective criteria included the opinions of equity and credit-rating analysts, banking consultants and others in the industry, as well as corporate financial executives. The winners are not always the biggest banks but, rather, the best banks – those with the qualities that corporations should look for when choosing a ban

You can read the article and the winners  here.

Watch Milton Friedman Video

Check-Up on Your Broker

(The reviewer is the brilliant Richard A. Posner. He is a judge on the U.S. Court of Appeals for the Seventh Circuit and a senior lecturer at the University of Chicago Law School.)

Shorting Reason
Richard A. Posner, The New Republic Published: Wednesday, April 15, 2009
Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism

By George A. Akerlof and Robert J. Shiller

(Princeton University Press, 264 pp., $24.95)

The economics profession has been greatly embarrassed by the economic crisis. The crisis began last September, with the crash of the banking industry (broadly defined, as it should be in this deregulatory era, to include investment banks and other financial intermediaries besides commercial banks), and of the stock market and other financial markets. It has since grown into the first depression since the 1930s, if one may judge from its global sweep, the pervasive anxiety that it has engendered among government officials as well as the business community and the public at large, and the trillions of dollars that nations have desperately committed to fighting it. The economists had assured us that there would never be another depression in the United States, because economics had discovered how to prevent depressions: if economic activity dropped, the Federal Reserve had only to push down interest rates, for this would induce banks to lend and consumers and businessmen to borrow, and the borrowed money would be used to finance consumption and production, restoring output to its level before the crash. Academic and government economists specializing in the business cycle were as surprised by the September collapse and the ensuing downward spiral of the economy as anyone, and were unprepared with plans for arresting it. Six months later they cannot agree on what should be done to recover from it. Not knowing what will work, the government is trying everything.

The idea that monetary policy–raising interest rates (and therefore reducing the amount of money in circulation, because interest is the price of putting money into circulation rather than hoarding it) to check inflation, and lowering interest rates to check economic downturns–holds the key to moderating the business cycle, and therefore to preventing depressions as well as inflations, has been falsified. The Federal Reserve has pushed interest rates way down, but the amount of lending has been tepid and economic activity has continued to fall–hence the bailouts of banks and other financial institutions and the $787 billion stimulus package recently enacted by Congress. The stimulus, a program of deficit spending, seeks to replace the loss of private demand, and the resulting decline in economic activity, brought about by the economic crisis. It seeks to do this by public works, such as the construction and repair of highways and other transportation infrastructure, designed to increase employment, and by tax cuts and welfare payments, which are intended to increase incomes directly and by doing so to stimulate spending.

In 1936, John Maynard Keynes argued in his great book The General Theory of Employment, Interest and Money that government could use deficit spending to replace private demand with public demand, and by doing so put a nation’s unemployed to work. Over time, this position has encountered increasing opposition. Many influential economists came to oppose deficit spending on public projects, which injects the government deep into the economy and creates a risk of inflation and high taxes in the future. Increasingly economists favored the monetarist approach, championed most famously by Milton Friedman, which teaches that the proper management of the money supply is all that is needed to avert depressions, and that it can do so painlessly.

But now that monetarism has received a sharp blow to its solar plexus, much of the economics profession has thrown its support to the idea of a fiscal stimulus (while rightly critical of many of the details of the stimulus package enacted by Congress). Which is to say, it has thrown its support to Keynesianism. In Animal Spirits, two distinguished liberal economists, reflecting on the current depression, marry Keynes to “behavioral economics” and offer the resulting union as a replacement for conventional monetarist economics, and for rational-choice theory more broadly.

George A. Akerlof’s and Robert Shiller’s book is short, and aimed at the general reader (though the end notes and bibliography are strictly for economists), but it is intended to be taken seriously as a work of economic theory. Akerlof is an expert on frictions in consumer and employment markets. Shiller is an expert on speculative excesses, and he was one of the few economists to warn about the danger of the housing bubble that brought the economy low.

Their thesis is that the key to understanding depressions, and the ups and downs of the economy more generally, is psychology, which they call “animal spirits.” They relate this emphasis on psychology to the new field of economics called “behavioral economics,” which rejects the “rational man” model of conventional economic theory in favor of what its proponents consider a more realistic picture of human motivations and capacities. Akerlof and Shiller believe that if people were rational, there would be no depressions; but there are depressions, and so the rational model must be inadequate.

They want a pedigree, or a sacred text, to lend authority to their thesis, and they want to champion the liberal Keynes over the conservative Friedman. Hence their appropriation of the term “animal spirits” from a famous passage in The General Theory: “Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits–of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities…. Thus if the animal spirits are dimmed and the spontaneous optimism fades, enterprise will fade and die…. It is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.”

Akerlof and Shiller think that by “animal spirits” Keynes meant “noneconomic motives and irrational behaviors,” and they imply that he wanted government to “countervail the excesses that occur because of our animal spirits.” This is a misreading. The passage in The General Theory is not about excesses, and it does not argue that “animal spirits” should be damped down. It is about the danger of paralysis in the face of uncertainty (“if the animal spirits are dimmed and the spontaneous optimism fades, enterprise will fade and die”). As Keynes’s biographer Robert Skidelsky explains, The General Theory argues that “actual output is normally below ‘potential’ output; in depressions disastrously so. It is only in moments of ‘excitement’ that the economic machine works at full blast. This helps explain why economic progress has been so slow and fitful.”

Keynes picked up from the American economist Frank Knight the distinction between calculable risk, the sort of thing on which insurance premiums are based, and uncertainty in the sense of a risk that cannot be quantified. (Keynes had published a treatise on probability theory in 1921.) The fact that businessmen would venture to invest at all in the face of uncertainty was a puzzle, and the explanation, Keynes argued, lay in emotion. You would have to be high-spirited–say, like Columbus–to embark on a costly, uncertain venture. In other words: nothing ventured, nothing gained.

What happens in a depression, and makes it a psychological event as well as an economic and political one, is that the economic environment becomes so uncertain that people freeze. Not only are businessmen afraid to invest, but consumers are afraid to spend; instead they hoard cash. Right now our banks, dubiously solvent and harassed by an angry Congress, are hoarding. Consumers are hoarding, too; the savings rate has shot up, and the increased savings are taking safe and rather inert forms–CDs, money market accounts, government securities, even currency and gold–that do not stimulate investment. Until animal spirits revive, the economy will not recover.

Keynes thought that if government put the unemployed to work, their animal spirits would rise, along with those of the contractors who hired the unemployed to perform the government’s contracts. Even more important, people who were still employed but afraid they would soon be unemployed would regain confidence if unemployment fell and the threat to their own jobs thus receded. Feeling more confident about their future, they would begin to spend, and business would begin to invest. The vicious cycle of falling consumption, production, and employment would turn into a virtuous cycle of rising consumption, production, and employment. Keynes worried about stock market speculation, because he thought that speculators based their decisions on guesses about the psychology of other investors rather than on which companies had the best prospects and therefore should attract new investment. But he did not relate speculation to an excess of animal spirits.

Akerlof and Shiller believe that the key to understanding depressions lies in motives or behaviors that they regard as non-rational or irrational. They list “confidence,” “fairness,” “money illusion,” the temptation to “corruption, ” and susceptibility to “stories” and treat all of these as manifestations of “animal spirits.” Only “confidence” comes within shouting distance of Keynes’s understanding of animal spirits. But Akerlof and Shiller give it a negative charge that is alien to Keynes.

People buy common stock when stock prices are rising. They (notoriously) bought houses during the early 2000s when house prices were rising. Since almost no one can predict the ups and downs of the stock market or the housing market, these purchases must have been motivated, Akerlof and Shiller argue, by something other than a rational investment strategy. But this is not at all obvious, or implied by Keynes’s usage. Stocks have generally been a good investment, at least when held for a considerable period. And since no one is able to time market turns, no one knows when the market is overpriced and therefore when one should sell rather than buy. Indeed, the idea of selling at the “top” of the market is incoherent, because if it were known that stock prices had peaked, no one would buy. Buying stock, or buying a house, is at any time a guess about the future, a venture into the unknown. Yet that does not imply irrationality.

In the early 2000s, interest rates were very low because of a mistaken decision by Alan Greenspan (but who knew?); and since a house is a product purchased with debt (a mortgage), houses became a more than usually attractive investment. The housing stock expands only slowly because it is so durable, so the increase in demand for houses outran the increase in supply (new housing starts), causing prices to rise. Since very few economists and no government officials warned of a bubble, it was not irrational for people to think that houses were a good investment, even though house prices had risen steeply since the 1990s.

They were wrong. But mistakes and ignorance are not symptoms of irrationality. They usually are the result of limited information. Ben Bernanke, in October 2005, just before the housing bubble began to leak air, denied that the rise in housing prices was a bubble. Was he irrational? That the errors of experts can lead to disaster is hardly a novelty, but it does not follow that only an irrational person would heed the advice of experts.

Akerlof and Shiller rightly associate booms with “new era” thinking, but wrongly deem such thinking irrational. Stocks soared in the late 1920s because it was a period of rapid economic growth based on rapidly rising labor productivity and new products such as the massproduced automobile, new methods of retailing such as the chain store, and new methods of finance such as installment buying and the purchase of common stock on margin. There was no reason to think that existing stock prices reflected an exaggerated expectation of increased wealth in so dynamic an era. The late 1990s were likewise heralded as a new era, this time on the basis of expectations that the computer would transform the economy. The early 2000s seemed to most people still another new era, this one based on the seemingly magical conjunction of low interest rates with low inflation, rising asset values, and new financial instruments that were believed to enable greater lending and borrowing with less risk. In all three cases the new era turned out, at least in the short run, to be a false dawn, and an asset-price crash ensued. Given the uncertainty of the economic environment, stressed by Keynes, such disappointments are not surprising, and they do not show that investors are irrational.

Nor are booms the result, as Akerlof and Shiller curiously argue, of “corruption scandals.” They think that economic downturns are preceded by increases in corruption, and they give examples. The oddest is the widespread violation of the prohibition laws in the 1920s, but they also note the financial scandals exposed by investigations of Wall Street that Congress conducted in the ensuing depression. They think that mortgage fraud was a major cause of the present crisis. How all this relates to animal spirits is unclear, but in any event they are wrong about the causality. Warren Buffett had it right: until the tide goes out, you cannot know who is swimming naked. A crash exposes frauds; it is rarely caused by them. Bernard Madoff’s Ponzi scheme fell apart when, as a consequence of the stock market crash last fall, his investors–their wealth diminished and their animal spirits crushed–tried to withdraw money from his phony hedge fund. The scheme itself was not a cause of the crash.

There was more than the usual amount of mortgage fraud during the housing bubble, but it was not the cause of many millions of people overpaying for houses, as we know with the benefit of hindsight that they did. Cheap credit and soaring house values were the immediate causes of the bubble and of all that followed when it burst. The underlying causes were the deregulation of financial services; lax enforcement of the remaining regulations; unsound decisions on interest rates by the Federal Reserve; huge budget deficits; the globalization of the finance industry; the financial rewards of risky lending, and competitive pressures to engage in it, in the absence of effective regulation; the overconfidence of economists inside and outside government; and the government’s erratic, confidence-destroying improvisational responses to the banking collapse.

Some of these mistakes of commission and omission had emotional components. The overconfidence of economists might even be thought a manifestation of animal spirits. But the career and reward structures, and the ideological preconceptions, of macroeconomists are likelier explanations than emotion for the economics profession’s failure to foresee or respond effectively to the crisis.

That animal spirits droop in a bust is no more anomalous than that they soar in a boom. To freeze and to hoard is a perfectly sensible reaction to an increase in economic uncertainty, whether one is a businessman or a consumer. It is individually rational behavior, though bad for the economy. Rich women think they are helping the economy by cutting down on luxury purchases; they are merely increasing unemployment in retailing.

While for Keynes “confidence” (or “animal spirits”) was the key to getting out of a depression, for Akerlof and Shiller it is something to be chilled down in order to prevent booms that might turn into busts. This inversion of Keynes may explain the strangest statement in the book: that “both presidents are heroes of ours,” the two presidents being Herbert Hoover and Franklin Roosevelt. Both are “heroes” because both ran budget deficits and created new agencies to regulate the economy.

But there is a significant historical difference that Akerlof and Shiller overlook. In the three years of depression during which Hoover was president, confidence drained out of the economy. The depression touched bottom at the end of his term, and turned around within days of Roosevelt’s inauguration. As Gauti Eggerstsson recently explained in the American Economic Review, Hoover’s adherence to the gold standard, and his determination to keep government small (so no Keynesian stimulus) and raise taxes to try to balance the budget, created a rational expectation of continued economic contraction, dampening the economy’s animal spirits. Roosevelt’s decision, made promptly upon his taking office, to go off the gold standard (in effect), push up prices (in order to end deflation), and engage in massive (for the time) deficit spending, created an expectation of economic recovery. This expectation had positive effects on the economy even before the new policies could take effect. Roosevelt restored confidence, which Hoover had killed, and renewed confidence restarted the economic engine.

A weakness of Akerlof’s and Shiller’s book is a failure to define their target: the rational model of human behavior. If rationality means omniscience, then it is indeed an unsound premise for economic reasoning. If it means reasoning unaffected by emotion, then it misunderstands emotion. The word “emotional” has overtones of irrationality, but actually emotion is at once a form of telescoped thinking (it is not irrational to step around an open manhole “instinctively” without first analyzing the costs and benefits of falling into it) and a prompt to action that often, as in the case of investment under uncertainty, cannot be based on complete or even good information and is therefore unavoidably a shot in the dark. We could not survive if we were afraid to act in the face of uncertainty.

Irrationality is not the courage to act. Irrationality is to be found in the cognitive quirks that we owe to the human brain having evolved in a very different environment from our present one. We are poor at evaluating low-probability events because in the ancestral environment (as evolutionary biologists call it) there was little that could be done about such events. The sense of the irrational that merchants exploit–that a price of $5.99 is meaningfully less than $6.00–is a trace of the limited value in that environment of being able to evaluate fine differences. These quirks do not explain depressions.

As one reads this book, one has the sense that deep down Akerlof and Shiller believe that being rational is the same as being right. That is a mistake. It prevents them from entertaining the possibility that what has now plunged the world into depression is a cascade of mistakes by rational businessmen, government officials, academic economists, consumers, and homebuyers, operating in an unexpectedly fragile economic environment, and that what is retarding recovery is not the “unreasoning fear” of which Franklin Roosevelt famously spoke but the rational fears–the reasoning fear, to use Roosevelt’s idiom–of businesspeople, consumers, and officials who confront economic uncertainties for which no one had prepared them.

Akerlof and Shiller invoke “fairness” and “money illusion” to explain the puzzling behavior of employment and wages in a depression. It may seem obvious that employment would fall in a depression. But it is not. If demand for a firm’s products falls, the firm will have less revenue, and therefore it will have to cut its costs, including its labor costs, to survive. So why not just cut its workers’ wages and explain to them why? If they stalk off in anger, the employer should have no difficulty in hiring replacements at the lower wage, for in the unsettled conditions of a depression it will be attractive to other workers. Or suppose, as often happens in a depression (and may still happen in our current one), the general price level falls. In a deflation, the same amount of money buys more, because prices are lower. So one might expect an employer to say to his employees, “Since the purchasing power of the dollar has risen, I am going to cut your wage, as otherwise, by receiving the same amount of money when its purchasing power has increased, you would be receiving a wage increase, which makes no sense in a depression.” (Among the paradoxes of depression is that we want wages to fall, so that producers will have lower costs and will therefore produce more and so hire more workers. This is not understood by the politicians who are pushing for legal changes that will encourage unionization. They should wait until we are out of the woods.)

Wages do fall in a deflation, but not as far as prices; and employers do generally prefer to economize on labor costs by laying off workers rather than by reducing their wages. The resistance of workers to having their wages cut in a deflation, a resistance that in the Great Depression of the 1930s produced a sharp rise in real incomes for many workers while others were on breadlines, is ascribed by Akerlof and Shiller to workers’ sense of “fairness”–of their sense of entitlement to their existing wage–and to “money illusion,” by which they mean the failure to distinguish between the amount of money one receives as a wage (the nominal wage) and the purchasing power of the wage (the real wage). They also argue that employers deliberately “overpay” their workers in order to boost morale and loyalty. But this does not explain why nominal wages are not cut during a depression in order to maintain (not cut) real wages.

There is a simpler explanation for unemployment in depressions, one that dispenses with irrationality. A worker who, rather than being paid a flat wage, is paid a percentage of his firm’s income would be unlikely to complain when his wage dropped in a depression; he would know that his wage was variable, and he would plan his life accordingly. But if paid a fixed wage, he is likely to count on it as a steady source of income. Since depressions are rare and have unpredictable consequences, he will not have been able to protect himself from the consequences of a depression-induced cut in his wage. He is going to be upset to find that he is working as hard or harder but being paid less, and he will not be reassured by being given a lecture on deflation and purchasing power, because he will not understand or believe it. And whereas wage cuts make the entire work force unhappy, layoffs make just the laid-off workers unhappy, and since they are no longer on the premises they do not demoralize the remaining work force by their unhappy presence. The employer, for this and other reasons–such as wanting to economize on benefits and overhead and induce the remaining workers to work harder lest they be laid off too–is likely to prefer laying off workers to cutting wages. (Unemployment insurance is a factor as well.)

This explanation for unemployment in depressions is consistent with Akerlof and Shiller in giving weight to cognitive and emotional factors (workers do not understand deflation, unhappy workers can demoralize the workplace), but it avoids jargon and condescension and the fascination with irrationality. Yet it may be too simple to please an academic economist. One reason why Keynes fell into disfavor among academic economists, and why Akerlof and Shiller want to dress him in the garb of a behavioral economist, is that although he was a brilliant economist and remains a hero of liberal economists, he was not a formal or systematic thinker. He belonged to the era before economists insisted on mathematizing the discipline. The General Theory is beautifully written–and full of loose ends and puzzling omissions. Keynes was a self-taught economist and a part-time academic. He had a rich and varied non-academic life as a government official and adviser, journalist, speculator, academic administrator, and member of the Cambridge Apostles and the Bloomsbury group. Having observed how people, including himself, behaved in the real world, he was unself-conscious about incorporating into economic theory such unsystematized and untheorized concepts as “animal spirits” (and its opposite, “liquidity preference”–the desire to hoard cash rather than spend or invest it).

The complexity of a modern economy has defeated efforts to create mathematical models that would enable depressions to be predicted and would provide guidance on how to prevent them or, failing that, to recover from them. The insights of behavioral economics have not done the trick, either. Shiller is to be commended for spotting bubbles, but few if any other behavioral economists noticed them; and he and Akerlof offer no concrete proposals for how we might recover from the current depression and prevent a future one. They want credit loosened, but so does everyone else–so did Keynes, who criticized our government for tightening credit in the early stages of the Great Depression.

We will discover soon enough whether the measures taken by the Obama administration are reviving the animal spirits of producers and consumers. The intentions are good. But the lack of focus, the partisan squabbling, the dizzying policy oscillations, the delays in execution, and the harassment of bankers are bad. By increasing the uncertainty of the business environment, these things are dampening the animal spirits–the courage to reason and act in the face of an uncertain future. Seventy-three years after the publication of The General Theory, it may still be our best guide to recovery from our present distress, not least because of its common-sense psychology.

#mce_temp_url#

Dr. Larry Summers’ Ideas Flushed Out?

Skill vs Luck in Money Manager Choice. How Can You Decide?

we discussed some of the research that shows that while money management skill does exist, it is extremely rare and there are no criteria for identifying individuals who are skillful. We then touched a few ideas for you to apply when choosing a money manager.

We’ll be more comprehensive and specific in this post. We’ll follow and elaborate on the points raised today in an article in the Wall St. Journal:

Seven Questions to Ask When Picking a Financial Adviser

by Shelly Banjo

13 APRIL 2009

http://online.wsj.com/article/SB123913983139498483.html

The key assumption is that the client doesn’t have the time or expertise to manage his own investments and seeks a professional advisor to help.

In the end, it all boils down to having wise conversations for action.

1. What’s in the advisor’s background?

Investors should know the difference between advisors who have a fiduciary duty to their clients, and those, like stock brokers, who do not. Registered investment advisors have a fiduciary duty to make their highest priority their client’s best interest, even over the advisor’s own interests.

Registered investment advisors (such as your humble servant) must pass a test (Series 65 Uniform Investment Advisor Law Examination) or have certain forms of certification, such as being a Certified Financial Planner (CFP), as a necessary qualification to legally be an advisor.

A registered investment advisor must also disclose a substantial amount of detail about his business such as any formal investigations and disciplinary actions initiated by regulators, along with any customer disputes, certain criminal charges and financial disclosures, including bankruptcies, and education, address and fee structure. These disclosures (form ADV part 2) are found online at

http://www.adviserinfo.sec.gov/IAPD/Content/Search/iapd_OrgSearch.aspx

2. What do the advisor’s clients say?

Ask for references from the candidate advisor, and try to get references not initially named by the candidate. References can give you lots of information about how the advisor actually operates.

By the way, registered investment advisors are legally forbidden from soliciting or using testimonials themselves in advertising, but of course, references are free to volunteer anything they choose.

3. How does the advisor get paid?

Advisors get paid according to what they do for you. The main issues in compensation these days are to use structures that avoid conflicts of interest (such as sales commissions on financial products) and which also reward performance. Stock brokers, whose job includes selling financial products, are often thus conflicted and should tell you so. Registered investment advisors are usually not conflicted (if they don’t sell financial products) , but they must disclose any conflicts and commissions if such exist.

Advisors are forbidden to charge a fraction of profit to any client. While paying your advisor proportionally to his profit generated seems like a good idea to align advisor interests with your own, the SEC believes such an incentive structure would entice advisors to take excessive risk to achieve high profit (even though such high risk could possibly cause losses for both advisor and client).

The usual solution is for advisors to charge a small fraction of the assets under management each quarter. Fees will rise and fall with the asset base.

4. Where are the advisor’s checks and balances?

The client should get a written description of how the candidate advisor would choose a third party money manager in any situation for which the advisor himself wouldn’t be managing the money himself.

5. What’s the advisor’s track record?

We showed how uninformative track record can be. However, clients should demand a formal description of the process by which the advisor makes investment decisions (selecting, entering, holding and closing positons). Most registered investment advisors describe this in an Investment Policy Statement (IPS). The IPS  also defines the universe of permissible asset classes. The advisor’s process must be formally constrained to support the client’s risk profile (obtained from  extensive interviews of client). Clients can use the IPS to decide if the advisor’s process suits the clients style and preferences.

6. Can the advisor put it in writing?

These days, it is fully expected that professional advisors will specify their services in a Client Contract along with their detailed fee structure for those services. This contract is a great document for client and advisor to formally define their relationship and make formal disclosures. In this context, the SEC requires the advisor to provide his Form ADV Part 2 directly to the client five days before the contract is signed.

7. What do other pros think?

Clients should get third party opinions on the advisor and his decisions from time to time.

“The economy is not like a machine at all. It is rather more like an ecosystem that no one can run, fix, or regulate. The hubristic sort of person who thinks he or anyone can run an economy is the victim of what Hayek called the “fatal conceit.” If given power, the planner will end up making the rest of us the victims of his false metaphor.”

Read the whole, elegant piece below:

Black Swans, Butterflies, and the Economy
By Max Borders • March 2009

http://www.thefreemanonline.org/featured/black-swans-butterflies-and-the-economy/

One side blames the market. The other blames government. We get two causal stories going in opposite directions and a lot of animus. But both perhaps are missing something important in this titanic debate about our current financial crisis. It’s time we exposed a complicated truth about the economy of the 21st century.

Nassim Nicholas Taleb is famous for introducing us to black swans. Though these rare creatures have long been used among academic philosophers to explain the shortcomings of reasoning by induction (“Every swan I’ve ever seen has been white, therefore all swans are white.”), Taleb uses the black swan as a stark metaphor for the inevitability of highly improbable events. In other words, black swans are rare, but one will swim by eventually.

As far as Wall Street-particularly the people with a large stake in getting things right-is concerned, this financial crisis involved a confluence of events. Some of these black swans were set in motion by government, like flexible lending standards to extend home ownership, Fannie and Freddie, and a mortgage-friendly tax code. Others were set in motion by willfully ignorant bankers, big shot risk-modelers, and people believing they could live beyond their means. It all came together in a fantastic cascade of failure. The trouble is, no one-neither government nor market actors-can predict such a large-scale event. Black swans happen.

The other important thing to remember is that the economy is a chaotic system. Most of the time chaotic systems achieve a sweet spot between order and chaos, which is a good thing if an economy is to be robust. Chaotic systems, though, change constantly and involve dynamics that are highly sensitive to initial conditions.

An Ecosystem, Not a Machine

Sadly, we’re getting a whole lot of precisely the wrong kind of thinking in response to this crisis. Indeed most of the bad thinking arises from viewing the economy through the lens of a false metaphor: economy as machine. We’ve heard pundits accuse the government or banks of being “asleep at the switch.” But in a complex system, there is no switch. We’ve heard people ask how to “fix it,” “run it,” or “regulate it,” suggesting if just the right sort of genius controlled the rheostats, we’d get just the right sort of economy.

The economy is not like a machine at all. It is rather more like an ecosystem that no one can run, fix, or regulate. The hubristic sort of person who thinks he or anyone can run an economy is the victim of what Hayek called the “fatal conceit.” If given power, the planner will end up making the rest of us the victims of his false metaphor.

It is ironic that Alan Greenspan-once adored by the press but now pilloried by it-is being blamed not only for wielding a laissez-faire ideology that supposedly caused the crisis, but also for failing to predict a black swan. Greenspan was a single, powerful government bureaucrat in charge of gathering enough data to determine the “right” interest rate for a multitrillion-dollar economy. Given the size of that task, he did pretty well for many years. But he was one man. He was housed in a government building. He held an unelected office and made decisions in a bureaucracy that has a monopoly on money and influences the price of credit, at least in the short run. One can hardly call that free-market fundamentalism. Whether Greenspan offered artificially cheap credit or not, interest rates were only one factor among many. To have asked him to predict the best of all possible worlds and adjust interest rates accordingly would have been to ask him to be an oracle channeling the knowledge only God would have. Greenspan is not omniscient. Nor is Bernanke. No one is. But to “run” an economy would require not only omniscience, but omnipotence as well-a power that would bend the actions of millions to its singular will.

Whatever your ideological persuasion, the economy is a complex system that cannot be planned, designed, or have its black swans regulated away. Far from the caricatures sketched in the papers, this is precisely what serious free-market types have been saying for years. That’s why it’s a little more than silly to blame free-market ideology for the current mess, and a little more than mendacious to claim that government fingerprints won’t appear all over the crisis when the postmortem is done.

Hunting Black Swans with Shots in the Dark

The timeless nostra of the politician are to prime the pump (machine metaphor) and to regulate. It seems so simple. But that response is deceptively linear. If you could ask FDR, might he now concede his policies stretched the Depression out for a decade beyond what was necessary? He listened to J.M. Keynes and a coven of interventionists. If we agree that our mixed economy is a complex system, then we also have to agree that the benefits the partly free market confers are an emergent property of that system. If we attempt to regulate away the rare, unforeseen black swan event, the costs of our hubris will be terrible, for we will regulate away untold benefits, too.

In the real world the question may come down to whether we should accept a couple of years of painful market adjustments or decades of recession caused by the blunt instrument of politics. Devastating unintended consequences and unseen effects will follow government attempts to clean up a mess made in great measure by its own hand. Why? Because no one possesses a God’s-eye view of the economy. Government intervenes within the system as part of it, not from outside of it. Nor is the economy an instrument to be manipulated to positive effect-at least not over the long term. That is why Keynes got it so terribly wrong and why the economy must heal itself from within in a distributed, holistic way.

People want government, like God, to come down and fix the unfixable, or explain the inexplicable. That’s why they’re finding it easier to blame greed for our current financial crises. But greed is rather more like gravity: When you fall, you can blame either Newton or the banana peel on the ground.

The profit motive is a good thing when it operates in an environment where bad bets are punished with losses and good investments are rewarded. Only government can distort that healthy profit-and-loss system, giving people incentives to make bad decisions. And it’s in this environment that greed is no good to anyone. It turns out, however, that greed-or better, rational self-interest-can help our economy stabilize faster than government ever could. As the lubricant of our economic system, self-interest will cause a million market actors to recalibrate and to direct resources to projects that create value in our society. We the people will temper our irrational urges and mitigate our risks if government restores the rules that let profit and loss bring discipline. But if government continues to change the rules to bias the market in favor of irrational behavior, rent-seeking, and corporatism, the chaotic aspects of the system will continue to wobble out of equilibrium. Black swans will become commonplace.

(This article was forwarded to me by Dr. Terry McGarty)