Behavioral Finance 101: Expectations, Reality and the Total Return Swap.

Russell sent me this from the Wall Street Journal and it is quite good. The concept is fairly simple as Jason Zweig illustrates:

David Salem is president of the Investment Fund for Foundations, which manages $8 billion for more than 700 nonprofits. Mr. Salem periodically asks trustees and investment officers of these charities to imagine they can swap all their assets in exchange for a contract that guarantees them a risk-free return for the next 50 years, while also satisfying their current spending needs. Then he asks them what minimal rate of return, after inflation and all fees, they would accept in such a swap.

Does this concept translate to the average Joe saving for retirement? You bet it does as we continue:

Robert Veres, editor of the Inside Information financial-planning newsletter, recently asked his subscribers to estimate long-term future stock returns after inflation, expenses and taxes, what I call a “net-net-net” return. Several dozen leading financial advisers responded. Although some didn’t subtract taxes, the average answer was 6%. A few went as high as 9%.

We all should be so lucky. Historically, inflation has eaten away three percentage points of return a year. Investment expenses and taxes each have cut returns by roughly one to two percentage points a year. All told, those costs reduce annual returns by five to seven points.

So, in order to earn 6% for clients after inflation, fees and taxes, these financial planners will somehow have to pick investments that generate 11% or 13% a year before costs. Where will they find such huge gains? Since 1926, according to Ibbotson Associates, U.S. stocks have earned an annual average of 9.8%. Their long-term, net-net-net return is under 4%.

All other major assets earned even less. If, like most people, you mix in some bonds and cash, your net-net-net is likely to be more like 2%.

The faith in fancifully high returns isn’t just a harmless fairy tale. It leads many people to save too little, in hopes that the markets will bail them out.

The bottom line and implications for financial planners? Easy if one is not blinded by greed:

Meanwhile, I asked Mr. Salem, who says he would swap at 5%, to see if he could get anyone on Wall Street to call his bluff. In exchange for a basket of 51% global stocks, 26% bonds, 13% cash and 5% each in commodities and real estate—much like a portfolio Mr. Salem oversees—the institutional trading desk at one major investment bank was willing to offer a guaranteed rate, after fees and inflation, of 1%.

All this suggests a useful reality check. If your financial planner says he can earn you 6% annually, net-net-net, tell him you’ll take it, right now, upfront. In fact, tell him you’ll take 5% and he can keep the difference. In exchange, you will sell him your entire portfolio at its current market value. You’ve just offered him the functional equivalent of what Wall Street calls a total-return swap.

We’ve covered total return swaps before here on Slabbed. Though the topics are unrelated on its face Nowdy, along with Peter Hunter, nailed it.

We don’t see things as they are, we see them as we are

There is seldom such a thing as an absolute truth. Everything we see and hear causes us to come to a conclusion about what we have seen or heard based upon our own experiences up to that point. A magician will deliberately use our way of perceiving things to suggest that something impossible has just taken place, and therefore entertain us.

Wall Street spends hundreds of millions of dollars in advertising to convince us of a different reality that what I detailed above. One thing that is (almost) an absolute truth are numbers because numbers knoweth not how to lie.

So my question is how much did a total return swap cost in 2007 which guaranteed a 15% return on a portfolio of RMBS yielding 12%? Would a 10% swap on the same 12% paper cost anything to the counterparty back then?