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The Happiness Equation

To say that “money isn’t everything” is more than a cliché. Studies in the early 1970s demonstrated that a sense of well-being, or happiness, had not increased commensurately with income over the previous half century.1

That trend continues as the modern world has arguably made well being more elusive than ever. Fortunately, positive psychology arose in the 1990s, attempting to find the key to understanding what makes people flourish. It has spawned the so-called happiness literature that seeks modern truth by weaving together science and ancient wisdom. How to be happier is now the most popular course at Harvard and Yale.2

Business people and entrepreneurs are also contemplating some of these age-old questions. Mo Gawdat, a serial entrepreneur and Chief Business Officer at Google X, tried to engineer a path to joy in his book, Solve for Happy, by expressing happiness as an equation.

HAPPINESS ≥ Your Perception of the EVENTS of your life − Your EXPECTATIONS of how life should behave

According to Gawdat’s model, if you perceive events as equal to or greater than your expectations, then you’re happy—or at least not unhappy.

Investors wanting to increase their wealth and well-being should consider his model. You can’t control many events that affect your portfolio, but events themselves are not part of the equation. Fortunately, you have some control over the two variables driving happiness—your perception of the events and your expectations.


First, let’s review some fundamentals about expectations in the financial markets.

1. Stocks have higher expected returns than safer investments like Treasury bills.

If it is widely known that stocks are riskier, prices should reflect that information, and, for the market to clear, investors are incented to bear that risk with higher expected returns. The higher expected return for stocks is known as the equity premium and, historically, it has been about 8% annually in the US.

2. All stocks don’t have the same expected return.

The price of a good and service is set by market forces and results from many inputs, such as the costs of raw materials, labor, shipping, and advertising, as well as competition and perceived value. As a consumer, you don’t need to understand all the inputs to make an informed purchase. You look at the price relative to alternatives in the market and ask if the product is worth the price—and the lower the price or the more you get, either in quality or quantity, the better the purchase.

Similarly, a stock’s price has many inputs. Expectations about future profits, different types of risk, and investor preferences are just a few examples, but you don’t need a model to understand all those inputs or how they impact market prices. All available information should already be reflected in the price, which tells you something about expected returns. Whether you are a consumer or an investor, you want to pay less and receive more.

Therefore, expected returns are a function of the price you pay and cash flows you expect to receive. Companies that are smaller and more profitable, with lower relative prices, have higher expected returns than those that are larger and less profitable, with high relative prices. These patterns are referred to as size, profitability, and value premiums. They have historically ranged from slightly more than 3.5% to just under 5% in the US.

3. Expected premiums are positive but not guaranteed.

Although expected premiums are always positive, realized premiums may be positive in some years and negative in others. You may even experience a negative premium for several years in a row. Exhibit 1illustrates that the probability of a positive small cap premium over one year is only slightly more than a coin flip, and it is roughly 65% for the equity premium.

The probability of earning a positive premium also increases with your time horizon, but it isn’t a sure thing since underperformance is possible over any time frame. Nobel laureate Paul Samuelson said, “In competitive markets there is a buyer for every seller. If one could be sure that a price will rise, it would have already risen.”


The other half of the equation is your perception of an event.

Consider an event, such as realizing a negative premium over 10 years, a time frame that some investors consider long term. This is not just a hypothetical exercise, because, as shown in Exhibit 2, the cumulative value premium has been negative for the past 10 years in the US, while the market and size premiums were negative in the 10-year periods ending in 2009 and 1999, respectively.

Lengthy periods of underperformance are disappointing, as investors obviously prefer higher rather than lower returns. Nonetheless, disappointment shouldn’t turn into anger or regret if you know in advance that periods like these will occur and recognize you can’t predict them.

Ancient wisdom teaches acceptance, as resistance often fuels anxiety. Instead of resisting periods of underperformance, which might cause you to abandon a well-designed investment plan, try to lean into the outcome. Embrace it by considering that if positive premiums were absolutely certain, even over periods of 10 years or longer, you shouldn’t expect those premiums to materialize going forward. Why is this? Because in a well-functioning capital market, competition would drive down expected returns to the levels of other low-risk investments, such as short-term Treasury bills. Risk and return are related.

The good news is there are sensible and empirically sound ways to increase expected returns. The bad news is there will be periods of underperformance along the way.

Your happiness as an investor depends on how your perception of events stack up against your expectations. Proper expectations alongside the appropriate perception can help you stay the course and may improve your wealth and well-being.

Total Cost of Ownership

Costs matter. Whether you’re buying a car or selecting an investment strategy, the costs you expect to pay are likely to be an important factor in making any major financial decision.

People rely on a lot of different information about costs to help inform these decisions. When you buy a car, for example, the sticker price indicates approximately how much you can expect to pay for the car itself. But the costs of car ownership do not end there. Taxes, insurance, fuel, routine maintenance, and unexpected repairs are also important considerations in the overall cost of a car. Some of these costs are easily observed, while others are more difficult to assess. Similarly, when investing in mutual funds, different variables need to be considered to evaluate how cost‑effective a strategy may be for a particular investor.


Mutual funds have many costs, all of which affect the net return to investors. One easily observable cost is the expense ratio. Like the sticker price of a car, the expense ratio tells you a lot about what you can expect to pay for an investment strategy. Expense ratios strongly influence fund selection for many investors, and it’s easy to see why.

Exhibit 1 illustrates the outperformance rate, or the percentage of funds that beat their category index, for active equity mutual funds over the 15-year period ending December 31, 2017. To see the link between expense ratio and performance, outperformance rates are shown for quartiles of funds sorted by their expense ratio. As the chart shows, while active funds have mostly lagged indices across the board, the outperformance rate has been inversely related to expense ratio. Just 6% of funds in the highest expense ratio quartile beat their index, compared to 25% for the lowest expense ratio group.


This data indicates that a high expense ratio presents a challenging hurdle for funds to overcome, especially over longer time horizons. From the investor’s point of view, an expense ratio of 0.25% vs. 1.25% means savings of $10,000 per year on every $1 million invested. As Exhibit 2 helps to illustrate, those dollars can really add up over time.



The poor track record of mutual funds with high expense ratios has led many investors to select mutual funds based on expense ratio alone. However, as with a car’s sticker price, an expense ratio is not an all‑encompassing measure of the cost of ownership. Take, for example, index funds, which often rank near the bottom of their peers on expense ratio.

Index funds are designed to track or match the components of an index formed by an index provider, such as Russell or MSCI. Important decisions in the investment process, such as which securities to include in the index, are outsourced to an index provider and are not within the fund manager’s discretion. For example, the prescribed reconstitution schedule for an index, which is the process of deleting or adding certain stocks to the index, may cause index funds to buy stocks when buy demand is high and sell stocks when buy demand is low. This price-insensitive buying and selling may be required so that the index fund can stay true to its investment mandate of tracking an underlying index. This can result in sub-optimal transaction prices for the index fund and diminished overall returns. In other words, for a given amount of trading (or turnover), the cost per unit of trading may be higher for such a strictly regimented approach to investing. Moreover, this cost will not appear explicitly to investors assessing such a fund on expense ratio alone. Further, because indices are reconstituted infrequently (typically once per year), funds seeking to track them may also be forced to buy and sell holdings based on stale eligibility criteria. For example, the characteristics of a stock considered value1 as of the last reconstitution date may change over time, but between reconstitution dates, those changes would not affect that stock’s inclusion or weighting in a value index. That means incoming cash flows to a value index fund could actually be used to purchase stocks that currently look more like growth stocks2 and vice versa. Metaphorically, these managers’ attention may be more focused on the rear-view mirror than on the road ahead for investors.

For active approaches like stock picking, both the total amount of trading and the cost per trade may be high. If a manager trades excessively or inefficiently, costs like commissions and price impact from trading can eat away at returns. Viewed through the lens of our car analogy, this impact is like the toll on your vehicle from incessantly jamming the brakes or accelerating quickly. Subjecting the car to such treatment may result in added wear and tear and greater fuel consumption, increasing your total cost of ownership. Similarly, excessive trading can lead to negative tax consequences for a fund, which can increase the cost of ownership for investors holding funds in taxable accounts. Such trading costs can be reduced by avoiding unnecessary turnover and seeking to minimize the cost per trade.

In contrast to both highly regimented indexing and highturnover active strategies, employing a flexible investment approach that reduces the need for immediacy, and thus enables opportunistic execution, is one way to potentially reduce implicit costs. Keeping turnover low, remaining flexible, and transacting only when the potential benefits of a trade outweigh the costs can help keep overall trading costs down and help reduce the total cost of ownership.


The total cost of ownership of a mutual fund can be difficult to assess and requires a thorough understanding of costs beyond what an expense ratio can tell investors on its own. We believe investors should look beyond any one cost metric and instead evaluate the total cost of ownership of an investment solution.

The ABCs of Education Investing

With school back in session in most of the country, many parents are likely thinking about how best to prepare for their children’s future college expenses. Now is a good time to sharpen one’s pencil for a few important lessons before heading back into the investing classroom to tackle the issue.


According to recent data published by the College Board, the annual cost of attending college in the US in 2017–2018 averaged $20,770 at public schools, plus an additional $15,650 if one is attending from out of state. At private schools, tuition and fees averaged $46,950.

pic oneIt is important to note that these figures are averages, meaning actual costs will be higher at certain schools and lower at others. Additionally, these figures do not include the separate cost of books and supplies or the potential benefit of scholarships and other types of financial aid. As a result, actual education costs can vary considerably from family to family.

To complicate matters further, the amount of goods and services $1 can purchase tends to decline over time. This is called inflation. One measure of inflation looks at changes in the price level of a basket of goods and services purchased by households, known as the Consumer Price Index (CPI). Tuition, fees, books, food, and rent are among the goods and services included in the CPI basket. In the US over the past 50 years, inflation measured by this index has averaged around 4% per year.1 With 4% inflation over 18 years, the purchasing power of $1 would decline by about 50%. If inflation were lower, say 3%, the purchasing power of $1 would decline by about 40%. If it were higher, say 5%, it would decline by around 60%.

While we do not know what inflation will be in the future, we should expect that the amount of goods and services $1 can purchase will decline over time. Going forward, we also do not know what the cost of attending college will be. But again, we should expect that education costs will likely be higher in the future than they are today. So, what can parents do to prepare for the costs of a college education? How can they plan for and make progress toward affording those costs?


To help reduce the expected costs of funding future college expenses, parents can invest in assets that are expected to grow their savings at a rate of return that outpaces inflation. By doing this, college expenses may ultimately be funded with fewer dollars saved. Because these higher rates of return come with the risk of capital loss, this approach should make use of a robust risk management framework. Additionally, by using a tax-deferred savings vehicle, such as a 529 plan, parents may not pay taxes on the growth of their savings, which can help lower the cost of funding future college expenses.

While inflation has averaged about 4% annually over the past 50 years, stocks (as measured by the S&P 500 Index) have returned around 10% annually during the same period. Therefore, the “real” (inflation-adjusted) growth rate for stocks has been around 6% per annum. Looked at another way, $10,000 of purchasing power invested at this rate over the course of 18 years would result in over $28,000 of purchasing power later on. We can expect the real rate of return on stocks to grow the purchasing power of an investor’s savings over time. We can also expect that the longer the horizon, the greater the expected growth. By investing in stocks, and by starting to save many years before children are college age, parents can expect to afford more college expenses with fewer savings.

It is important to recognize, however, that investing in stocks also comes with investment risks. Like teenage students, investing can be volatile, full of surprises, and, if one is not careful, expensive. While sometimes easy to forget during periods of increased uncertainty in capital markets, volatility is a normal part of investing. Tuning out short-term noise is often difficult to do, but historically, investors who have maintained a disciplined approach over time have been rewarded for doing so.


Working with a trusted advisor who has a transparent approach based on sound investment principles, consistency, and trust can help investors identify an appropriate risk management strategy. Such an approach can limit unpleasant (and often costly) surprises and ultimately may contribute to better investment outcomes.

A key part of maintaining this discipline throughout the investing process is starting with a well-defined investment goal. This allows for investment instruments to be selected that can reduce uncertainty with respect to that goal. When saving for college, risk management assets (e.g., bonds) can help reduce the uncertainty of the level of college expenses a portfolio can support by enrollment time. These types of investments can help one tune out short‑term noise and bring more clarity to the overall investment process. As kids get closer to college age, the right balance of assets is likely to shift from high expected return growth assets to risk management assets.

Diversification is also a key part of an overall risk management strategy for education planning. Nobel laureate Merton Miller used to say, “Diversification is your buddy.” Combined with a long-term approach, broad diversification is essential for risk management. By diversifying an investment portfolio, investors can help reduce the impact of any one company or market segment negatively impacting their wealth. Additionally, diversification helps take the guesswork out of investing. Trying to pick the best performing investment every year is a guessing game. We believe that by holding a broadly diversified portfolio, investors are better positioned to capture returns wherever those returns occur.


Higher education may come with a high and increasing price tag, so it makes sense to plan well in advance. There are many unknowns involved in education planning, and no “one-size-fits-all” approach can solve the problem. By having a disciplined approach toward saving and investing, however, parents can remove some of the uncertainty from the process. A trusted advisor can help parents craft a plan to address their family’s higher education goals.

What is a MEP?

MEP’s have been all the rage recently.  President Trump recently signed an executive order asking regulators to make it easier on small businesses to sponsor retirement plans.  There is a lot to unpack in this executive order.  For those who are near age 70 1/2, the order is asking for a review of RMD (required minimum distribution) amounts.  With Americans living longer, this makes some sense.

The downside is it will also cost the government money so a bi-partisan approach will need to be taken.  The big piece for the retirement plan advisory world is the possible expansion of MEP’s.  A MEP is a multiple employer plan.  The idea is that by bundling employers together it will be easier and less expensive to offer a plan (more on  that later).  In the past, there had to be a common bond among those employers (ex. American Bar Association members).

There also was a one bad apple issue.  If one employer failed in their duties, everybody failed.  The industry has been arguing to get rid of this rule.  For start up plans, open MEP’s hold significant promise.  They can limit the set-up costs of a plan and offer a basic vanilla plan to an employer without excessive costs.  There is one tax filing and one audit per MEP versus each employer having to do their own.  For large plans over 100 employees with low account balances, MEPs can be a great solution.

But what about those groups who have mature plans with healthy account balances?  The issue with most MEPs pricing is that the large members of the MEP significantly subsidize the costs of those smaller or start-up plans in the MEP.  This costs them and their employees money.  While the regulatory language has a good ways to go, it would be helpful to have open MEPs available to the public.  That being said, each employer should critically evaluate the positives and negatives before jumping in blindly.  #401k #403b #fiduciary

Fidelity no-fee funds

If you pay attention to the investment news, you may have heard about Fidelity’s no-fee index funds.  Fidelity No Fee Funds  These funds are made up of proprietary indexes that Fidelity has created in-house.  There is no expense ratio on these funds.  They also are not available on their 401K platform or outside vendors recordkeeping platforms.

Normally if it sounds too good to be true, it is.  In this case, the answer is maybe.  If you just want broad based market coverage for your retail brokerage accounts, then this could be a good avenue to pursue.  Now one might ask the question, Isn’t Fidelity a for profit company?  The last time we checked the answer was still yes.  The Johnson family has done quite well for themselves in the investment management space.  The main issue was that Fidelity was bleeding assets to competitor Vanguard.  This is the definition of a “loss leader”.

Fidelity will forgo tens of millions of dollars in index management fees with the hopes that they can bring more accounts on their platform and eventually cross sell higher margin products.  So if you have money sitting in money market, Fidelity makes money off that.  If you go with a NTF (non-transaction fee fund) for some of your assets outside of the core allocation to the free index funds, Fidelity will make money off that.

For Vanguard to make a comparable move would cost them in the hundreds of millions of dollars.  They are a much larger provider of index offerings.  They also have to pay the manufacturer of those indexes (vs. Fidelity’s approach of crafting their own).  At the end of the day, this competition is good for consumers.  After the race to the bottom in fees, firms are going to have to differentiate themselves on value.  #401k #403b #fiduciary

Part 5: An understanding the advice is individualized and based on the needs of the retirement investor

Maybe it is easier to explain when advice might not be individualized to the retirement investor.  What if the vendor puts out a proposed fund line-up (NO)?  What if the broker dealer puts together a preferred list of funds or stocks (NO)?  Now what if the advisor took that preferred broker dealer list and narrowed it down to picks for that individual plan sponsor (Probably)?

Why would the average plan sponsor allow for advice that wasn’t regular, with a contract, for compensation, a primary basis, and individualized?  The main reason we see is plan sponsor confusion.  The delivery and sales process for retirement plan advisors can be confusing.  Everyone says they are a fiduciary, everyone promotes similar services, and everyone appears to be an expert.  What is the average plan sponsor to do?

Ask a lot of questions.  How much of the advisors business comes from qualified retirement plans?  Can you see a sample client contract?  Can you speak to some of their retirement plan clients?  And most importantly, are they dually registered?  If they have a broker/dealer affiliation, it is very difficult to tell what side of their business you are working with.  If you are working with a firm that is registered solely with the Securities Exchange Commission (or state for smaller firms), at least you will know that you are working with a fiduciary.  Then the question becomes, are they any good?

Part 4: The recommendation should be a primary basis for investment decisions

This one seems like a no brainer.  Who hires an investment advisor only to not follow their recommendations?  We have seen this happen where a plan sponsor is just looking for validation of their prior thoughts on the marketplace.  Since the retirement plan advisor is providing advice on much more than just investments (think plan design, vendor compatibility, product structure, etc.), they are typically meeting this requirement of the five part test and exceeding it in other areas.

We can’t think of too many scenarios where an advisors recommendations don’t serve as the primary basis for decisions but in the case of outsourced ERISA 3(21) or ERISA 3(38) investment managers that are not the advisor, this could still be the case.  The advisor could say they have simply provided a list of options and it was the plan sponsor who made the decisions.  If it wasn’t even the advisor who formulated the options (think Morningstar, Mesirow, etc.), then the advisor could avoid becoming a fiduciary.

Part 3: A mutual understanding, arrangement or agreement, between the investor and the advisor

We are shocked when we meet with plan sponsors and in our review of their advisor we find that they have no written agreement with regard to what the fee is and what services they will be providing.  Most professional services industries have some sort of basic contract that outlines the project and what will be provided for the cost of the contract.

Under the old and now new five part test, we are back to the wild west of what constitutes and agreement.  We would advise every plan sponsor to have a contract with their advisor or his/her firm.  If they do not have one for your plan, we would recommend finding a new advisor.  How can a plan sponsor satisfy the prudent man rule without a basic contract that outlines the price & services?  How do you evaluate whether your arrangement is reasonable without any explicit idea regarding the services rendered?

Even though it stands to reason that you would have a contract for a service that probably costs thousands of dollars, it is shocking to find out how few 401K plan sponsors miss this simple step.  They are inundated during a plan conversion with TPA contracts, recordkeeper contracts, and investment contracts for stable value investments that they forget the one contract that really matters most and that is the one from the person they think is their fiduciary.

Part 2: Provide the advice on a regular basis

Many commission based sales people are simply completing a transaction.  This is an area where many investors are rightfully confused.  If your advisor is dually eligible to both receive commissions and provide investment advice, which are they doing for you?  If they are simply selling a product/platform and relying on the vendor to do all of the reviews and heavy lifting, then it is possible they are just serving in an arms length capacity.

For 401K, 403B & 457B plans, most retirement plan advisors are serving in a fiduciary capacity.  There are some still in the small end of the marketplace that do not but it is difficult to justify your services if you are not providing independent advice.  If your advisor is providing quarterly reports, assisting with the construction and amending of your investment policy statement, and continually providing guidance and advice to your trustees, then they are likely serving in a fiduciary capacity.

If they are showing up with the plan vendor and sitting on their hands while the vendor provides the evaluation and review piece, then you probably need to start looking for a new advisor.  This is part 2 of the five part test and just about every retirement plan advisor worth a nickel is checking this second part of the test.

Part 1: Make investment or insurance recommendations for compensation

This should be the easy one.  Does the person you rely on for your investment advice receive compensation?  Unless you are talking to your Father who isn’t charging you anything, then you are likely paying something.  Whether that something is agreed to in a contract, is invoiced directly to you, or is paid by the product you purchased, then part one of the five part test is met.

Just about every advisor providing advice for a fee would meet part one of the five part test.  Unfortunately there are a number of “advisors” who aren’t really investment advisors at all.  When in doubt, take a look at Investment Advisor Public Disclosure site to read up on your advisor.  How long have they been in the field?  Who have they worked for?  Have they had any complaints against them?  This will be useful information that anyone with an internet connection can access.