In a recent article about conflicts of interest and financial advice, I wrote the following:

We [bloggers] make money recommending companies that have affiliate programs. For example, I earn a commission if you open an account at Scottrade through one of my links. I earn nothing if you open an account at Vanguard. Similarly, it’s more profitable for me to recommend Ally Bank than Bank of America.

Apparently Ally Bank didn’t like that.

Within just a few hours of publishing that post, I received the following email from my account manager with the affiliate network that manages Ally Bank’s affiliate program:

[Ally Bank is] not pleased with the insinuation that they “payoff” affiliates for recommendations on publishers sites. They want you to modify the language to make it clear that they do not pay affiliates to recommend Ally Bank, however Ally Bank pays affiliates to place their ads on their sites. Ally Bank is concerned that this language may come off wrong to customers.

I don’t have a problem with a company paying salespeople a commission to sell their product. I do have a problem with a company trying to keep that fact a secret.

Ads or Recommendations?

In my opinion, Ally’s position that they pay for advertisements rather than recommendations is nonsense.* The “ads” in question do not pay a flat rate per month. Nor do they pay per pageview or whenever a visitor clicks on the “ad.”

Instead, we’re talking about an arrangement in which Ally Bank pays a commission to a web publisher whenever a visitor clicks a link from the publisher’s site to Ally’s site and opens an account.

When you pay a commission, what do you get? You get people to sell your product. Paying a commission is the very essence of paying people to recommend your product.

Ally Bank pays for recommendations, and that’s exactly what Ally Bank gets. (If you don’t believe me, Google “Ally Bank review” and see if you can find a negative review anywhere in sight.)

Don’t Believe Everything You Read

I bring this up not because I have any ill will toward Ally. In fact, as a customer, I’m quite happy with their services, and I plan to keep my own money market account there.

Rather, I bring it up because I think it’s important to know that what you read online is often influenced by behind-the-scenes payments. Ads don’t stay nicely segregated in the sidebar, header, and footer of a site. Often, they’re the content itself.

*From a legal/regulatory perspective, Ally may be absolutely correct that their affiliate program counts as advertising rather than buying recommendations. I have no idea. But I doubt that’s their concern here. It seems unlikely that the legal nature of the program is affected by how I describe it in my blog posts.

Investment planning involves a lot of guesswork — there’s no way around it. For example:

• We don’t know what tax rates we’ll be faced with in the future.
• We don’t know what rate of return our investments will earn.
• We don’t know what rate of inflation we’ll have to keep up with.
• We don’t know whether our job income will match inflation, outpace inflation, or disappear entirely at some point due to a layoff.

Yet we can’t develop an investment plan without entering something for each of those figures. End result: If the first digit of a financial estimate (how much income you’ll need in retirement, how much you need to save each year, etc.) ends up being correct, it was a pretty darned good estimate.

Online Calculators

ING recently released a site (“ING Your Number“) that seeks to tell you how much money you’ll need saved before you can retire. It gives the number right down to the dollar.

What it doesn’t give you is any information with which to judge the quality of the estimate. And I have my doubts about that quality. For example, both of the following seem like flaws to me:

• It doesn’t ask about your asset allocation or even state what asset allocation it assumes you’re using.
• It suggests a 7.8% withdrawal rate for a 64 year old who plans to retire at 65 and who expects to live until age 95. That’s far higher than most financial professionals or academic literature would recommend.

If you want to use a retirement calculator that gives you a ballpark figure, go for it. But if the website doesn’t explain how that estimate was calculated, it’s difficult to know whether you can trust the calculation.

Asset Allocation

Asset allocation works the same way: It’s a guess. (An educated guess, but still a guess.) That’s why, for example, all the lazy portfolios look so different.

• Some allocate 20% of stocks to international markets. Others go as high as 50%.
• Some use only short-term Treasuries for the bond portion of a portfolio. Others use intermediate-term Treasuries. Others use TIPS. And still others use a “total bond market” fund that includes corporate bonds as well as Treasury bonds.
• Some recommend dedicating a portion of the portfolio specifically to real estate investment trusts (REITs). Others don’t.

But there’s no way to know which portfolio will have the best results until after the fact. (Side note: I’d be wary of any advisor or writer who claims that he does know with certainty which allocation is best.)

It’s OK to Guess

Guessing is fine. It’s unavoidable, in fact. But it’s important to recognize that you are guessing. Thinking that you have reliable figures because you got them from an online calculator or that your portfolio is bound to achieve a certain return because you read about it in a popular book sets you up for severe disappointment.

One of the articles submitted this week to my roundup was an interview with a fellow who works as the co-manager of a new micro-cap value hedge fund. After taking a look at the fund, I thought I’d use it as an example of why I suggest that most investors stay away from such investments.

But first, let’s dispel a myth. One of the reasons commonly given for not investing in hedge funds is that they’re high risk. That’s not necessarily true. As with mutual funds, there are many different types of hedge funds. Some invest in high-risk assets; others invest at the low-risk end of the spectrum.

My primary reason for steering investors away from hedge funds is the same as my reason for staying away from any actively-managed fund: High costs. And, with hedge funds, boy can they be high!

“2 and 20″

The typical hedge fund expense structure is the “2 and 20″ model, whereby the fund charges an annual fee of 2%, plus 20% of any gains. This is, as you might imagine, quite the hurdle to clear.

Very few investors have shown an ability to consistently outperform their passive benchmark by more than 2% per year, as would be necessary to justify the use of such a fund in place of a low-cost index fund. (In fact, because of the 20% performance fee, they’d have to outperform by well over 2% per year.)

A Low-Cost Hedge Fund?

Interestingly, this particular fund from the interview actually had much lower costs than many hedge funds:

• It charges no flat annual fee,
• Its performance fee is only calculated on returns above 6%, though it’s calculated as 25% of those returns, and
• Its losses are carried forward to offset future gains prior to any fee being paid.

In short, as hedge funds go, this is actually fairly reasonable.

Still, it’s anything but low-cost. By way of illustration, if a small-cap value fund with that expense structure had simply tracked the results of its index over the last ten years, here’s how much it would have charged per year:

• 2000: 3.72%
• 2001: 1.76%
• 2002: No fee.
• 2003: 3.77%
• 2004: 4.43%
• 2005: 0.07%
• 2006: 3.36%
• 2007: No fee.
• 2008: No fee.
• 2009: No fee.

Even with four years out of ten having no fees at all, such a fund would still have been charging more overall than the typical actively managed small-cap value fund, which in turn would be charging far more than a good, cheap index fund.

Given the usefulness of expenses as a predictor of performance,  I’d suggest that most investors stay away from any investment that promises to take such a large share of your returns.

Last week, I had the opportunity to attend the 2010 Morningstar Investment Conference.

During a panel conversation with four top Morningstar researchers, the moderator asked a question about the studies that are done from time to time, which tend to show that Morningstar’s star ratings don’t work all that well as predictors of future performance.

Don Phillips, President of Fund Research at Morningstar, had a great reply:

“The star rating is a grade on past performance. It’s an achievement test, not an aptitude test…We never claim that they predict the future.”

Pretty straightforward answer, no? The star ratings aren’t even intended to predict future performance. They’re simply a calculation based on how each fund’s risk-adjusted return has compared to that of its peers (with a very heavy emphasis on the most recent 3 years of performance).

That, combined with the fact that there are more successful predictors of performance available (i.e., expense ratios), leads to one obvious conclusion: Don’t base your fund picks on how many stars they have.

It also leaves me with a question: What good are the star ratings if they’re not useful for picking funds?

An article titled 3 Stocks That Can Do Well in This Economy was recently submitted for my weekly roundup. I didn’t include it, as I wanted to discuss it more thoroughly.

The author, Mark Riddix, made a compelling case for the success of the three companies in question. But I wasn’t entirely satisfied as to why the stocks of those companies would be good investments.

Quick reminder: The fact that a company is growing (or is going to grow) does not by itself mean that its stock is a good investment. For a stock to be a good investment, there must be reason to think that its future growth is not already reflected in its price.

Said differently, for a stock to earn above-average returns, the company must do better than the market expects it to.

You vs. The Market

Let’s imagine that you’ve found a company that you’re confident is going to grow, and based on your calculations it looks like the market is underestimating that future growth. In other words, it looks to you like the stock is underpriced.

Whenever you think that the market has priced a stock incorrectly, there are two possible explanations:

1. You know something the market doesn’t know, or
2. The market knows something you don’t know.

If the current market price for a stock is below what you think is appropriate, either you know something positive about the stock that the market doesn’t know, or the market knows something negative about the stock that you don’t know.

Scenario #1 is the jackpot. But thinking you’re in scenario #1 when you’re really in scenario #2 sets you up for a nasty surprise.

How Can You Tell the Difference?

So how can you tell which scenario you’re dealing with? I’d argue that in most cases, you can’t. And if there’s no way to know, betting that you have more information than the rest of the market seems unwise to me.

The only two situations in which I’d be comfortable betting against the market would be:

1. I’ve done enough research that I’m confident I know every single material fact about the company, or
2. I have a specific reason to think that I have information that has not been noticed by the rest of the market.

Of course, each of those conditions is rather difficult to satisfy. And I suspect most of us have no interest in doing anywhere near the amount of research that would be necessary to do so.

I think most of us would be better off buying, holding, and rebalancing a lazy ETF portfolio.

My three stocks to buy right now? VTI, VEU, BND.

Dave Ramsey has helped many people get out of debt. And for that, he’s (rightfully) earned those people’s trust.

After somebody digs his/her way out of debt, the next step is often to start investing. And it’s only natural that people who have come to see Dave as a financial mentor turn to him for investment advice.

That’s unfortunate though, because Dave’s investment advice leaves much to be desired.

Dave Ramsey on Asset Allocation

Ramsey provides the following advice on asset allocation:

“I do not own any bonds and do not suggest them as part of your investment plan.”

He also recommends against CDs, fixed annuities, and REITs. In other words, Dave’s suggesting a portfolio that’s almost 100% stocks, regardless of your age.

He never even mentions the fact that such a portfolio would expose most retired (or soon-to-be-retired) investors to a meaningful risk of running out of money as a result of a poorly timed bear market.

Dave Ramsey on Roth IRAs

In several places on his website, Ramsey makes statements to this effect:

“The best way to start investing is with a Roth IRA.”

There’s no discussion of how to choose between a Roth or traditional IRA. Not even the briefest mention that, for many investors, going the tax-deferred route would be better.

Dave on Financial Advisors

Dave has the following to say about brokers (commission-paid salespeople who sell front-load mutual funds) as opposed to fee-only advisors:

“I do not personally choose fee based planning. (paying 1% to 2.5% annual fees for a brokerage account). With an A share mutual fund, I pay an upfront load of 5% to 6% once. But with a fee based account, also known as a wrap account, you agree to pay a 1% to 2.5% fee every year – forever. As your account grows, the 1% to 2.5% fee will really add up.”

Unfortunately, this is a grossly inaccurate comparison.

First, he ignores the additional ongoing costs of actively managed funds. Typical front-loaded funds (like those Dave recommends) include operating expenses in the range of 0.75-1% per year. In contrast, with a fee-only advisor, you’d have access to index funds and ETFs, which charge in the range of 0.2% per year.

Second, he overstates the cost of a typical fee-only investment advisor. According to a survey by Rydex SGI, the median fee for registered investment advisors is just 0.90%. If you shop around, you can find advisors who charge significantly below that rate.

Dave Ramsey’s Endorsed Local Providers

Many people I’ve spoken with think that Dave’s recommendation of brokers over fee-only investment advisors has more to do with his business model than it does with giving good advice.

If you go to Ramsey’s website, you’ll see that most of his investing articles end with the suggestion to meet with an “Endorsed Local Provider” of investment services. If you fill out the form, your contact info is sent to a broker in your area, and Dave gets a fee for providing that broker with a prospective client.

But why does Dave recommend commission-paid advisors rather than fee-only advisors? Why send people to a broker–where there’s an inherent conflict of interest between the advisor and the client–rather than to an advisor who charges, say, a flat hourly or annual fee?

Best-selling author Eric Tyson puts it this way:

“By referring people to commissioned-based brokers, the referral fees don’t have to be disclosed as they would be with a fee-based advisor. A registered investment advisor would be required to disclose to the client that Ramsey’s company was acting as a solicitor and would have to disclose the fee being paid to Ramsey as the solicitor.”

Why give bad advice?

If I had to guess, I’d say that Ramsey doesn’t find investing to be as interesting or important as the get-out-of-debt side of personal finance. And as a result, he doesn’t spend much time learning about it. And for the record, I don’t think there’s anything inherently wrong with that.

I do think, however, that he does his readers/listeners/followers a disservice by discussing investing without taking the time to learn more about it.