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5LIESINVESTING

ERIC BALL

- HOW TO AVOID INVESTMENT MYTHS DISGUISED AS TRUTHS -

ABOUT5LIESINVESTING- HOW TO AVOID INVESTMENT MYTHS DISGUISED AS TRUTHS -

TABLE OF CONTENTS

INTRODUCTION ……..………………………….…….......…............... 3

LIE #1: MORE RISK = MORE RETURNS …..……….…….................. 7

LIE # 2: SPECULATING IS BASICALLY THE SAME THING AS INVESTING - JUST BETTER ………..….......... 13

LIE # 3: YOU CAN BUY AT THE BOTTOM AND SELL AT THE TOP ……….………...…………..................... 21

LIE # 4: DIVERSIFICATION IS A GOAL OF INVESTING .......... 27

LIE # 5: MOST INVESTMENT “PROS” MEASURE THEIR SUCCESS BY YOUR RESULTS …….......…....…… 33

INTRODUCTION

4

INTRODUCTION

eptember, 1984 does not seem to be as far away as the calendar indicates. But it was over 30 years ago that I started my career in the investment profession as a securities analyst for a region-

al brokerage firm. It was my dream job, having left the academic world where I had been pursuing a PhD in Finance. I was hoping to participate in something more concrete (and also something that paid a living wage). Over these years, I have had the privilege to work in the brokerage, bank trust department, mutual fund, hedge fund and investment advisory businesses. The companies I worked for allowed me the opportunity to pursue investing, which in turn has enabled me to see the relative strengths and weaknesses that each of these profes-sions bring to this field. I was also able to witness a cast of characters that I will likely never forget. Some taught me important and simple concepts concerning investing; others demonstrated that investing is a discipline which will not be followed by the majority.

In the process of my on-the-job education, I have learned that given the opportunity to exercise the patient path of investing against bet-ting a large portion of one’s retirement money to gain a sizeable, but improbable return, many people will choose to “roll the dice.” And they will do this over and over again—guaranteeing that they will throw good money away.

My complaint is not with them, but rather it is with those invest-ment “professionals” who recycle old lies over and over again to new victims. Their business cards should read: “Anything for a buck,” as I have seen first-hand the results of their greed and clumsiness in the portfolios of far too many people. Widows were encouraged to exchange insurance proceeds for aggressive (and now worthless) secu-rities, retired workers were sold expensive tax-sheltered annuities in their tax-sheltered IRA’s and young professionals were saddled with 5% to 7% “surrender charges” in order to get out of terrible deals that their friend/relative/golf buddy peddled to them. It’s time to expose these lies.

5

5 LIES ABOUT INVESTING

This book describes five lies that are prevalent in the financial indus-try today. In every case these lies are camouflaged as maxims which mainly serve to increase the wealth of investment “professionals” at the expense of their clients. It is my hope that you read this with dis-cernment and make your financial decisions based on wisdom rather than on wishfulness.

IF RISK AND

RETURN WERE

DIRECTLY

RELATED,

CASINOS

WOULD BE

PUT OUT OF

BUSINESS BY

SLOT MACHINE PLAYERS.

““

31M O R E R I S K =MORE RETURNS

LIE #1

8

LIE # 1: MORE RISK = MORE RETURNS

isk is a defining factor of successful investing because the more risk you take, the more likely the returns on your investments will be superlative.”—or so says an award-winning, national-

ly-syndicated columnist, television reporter, best-selling author and radio talk show host who specializes in real estate and personal fi-nance. This doesn’t seem to be an earth-shattering statement; in fact, the vast majority of nationally-syndicated columnists who appear on TV, host their own radio shows, write books and specialize in finance would probably agree wholeheartedly with it. But I don’t. I think it embraces one of the biggest lies told to individuals with money to invest today.

It is a lie told so often, rephrased in so many forms and presented with such sincerity that few stop to question the validity of its argument. And that is a major problem.

Is risk directly related to return?

The conclusion that accepting more risk brings more return is a flawed inference which has only intensified as securities salespeople move from portraying themselves as economists and begin to repre-sent themselves as financial statisticians. They are fond of displaying charts, tables and web presentations which profess to show how this relationship has held among market segments throughout history. Their mantra goes something like this: Over longer time periods, money market returns have been lower than the returns of long-term bonds but have fluctuated less. And, in the aggregate, the perfor-mance of long-term bonds have historically been lower than those of common stocks but have not varied as much.

But they then make an irrational leap by using this data as the basis for prescribing high-risk securities to customers who seek above-average returns. Generally speaking, those portfolios which experi-ence higher returns over long periods of time have experienced greater volatility. However, it is far from true that most portfolios with higher risk have generally earned higher returns. It is entirely more

9


likely that most high risk portfolios have earned low returns.

These amateur statisticians commit a critical and fundamental mistake of logic—merely observing increased volatility in higher-performing portfolios does not mean that each portfolio containing increased risk will outperform a safer portfolio. Volatility is only one characteristic of successful investment portfolios and it is not always necessary. Risk and return are not directly related in securities trans-actions.

Think of it this way, if risk and return were directly related, casinos would be put out of business by slot machine players. But they don’t go bankrupt—even with government-mandated minimum payout percentages, tax payments, compulsory contributions to community foundations, and (one would expect) outrageous electrical bills. In fact it’s just the opposite; the casinos located across the river from my office continue to undergo multi-million dollar expansions. The gambling house holds the better end of the deal in this risk/return relationship (regardless of what your friends may claim).

It follows then that some risks should technically be described as “stupid risks” since they have real costs and aren’t expected to bring real returns to those accepting the risks. Driving without a seat belt, cosigning a loan for a squanderer and buying so-called “penny stocks” all qualify as stupid risks.

Hurry, hurry, step right up…

Also qualifying as stupid risks are the securities of most companies that have limited (or no) operating histories as well as those which have not regularly earned operating profits. The bald fact is that most of these transactions end miserably. Yet it is precisely these types of common stocks that brokers often classify as having the potential for high returns and which are sold to customers who desire growth for their portfolios.

“More risk brings more returns,” begins the pitch of the account

10

LIE # 1: MORE RISK = MORE RETURNS

executive as he or she promotes a new initial public offering or a company where the broker has the “inside scoop.” The proposition is often followed up with snippets of information—a research report, a magazine article, or a press release which reinforces the broker’s asser-tion that buying now will get you in on the ground floor of skyscrap-er-like returns.

These risk plays tend to have the same formula. (1) A premise that a problem exists which could be solved by a product or service yet to be supplied. (2) A conclusion that this specific company (let’s call it SuperCom) will be able to meet that need, and (3) a lack of historical evidence that shows the company to be unsuccessful.

The sleight of hand here makes it difficult to see the error as it occurs. It takes place during points two and three. One conclusion could be that SuperCom will be the only successful business which develops a product to meet the need. Another scenario is that other companies will share the market with SuperCom because of their successes. And yet another conclusion could be that SuperCom will fail in its efforts. The latter two scenarios would certainly reduce the future returns for SuperCom. But because there is no evidence to say that SuperCom has a track record of being unsuccessful (solely because they have a limited operating history), many people will assume that it will be successful. Who’s to say that it won’t?

The more interesting the problem, the more money the company’s idea attracts. There is a great story to tell. For brokers, “story stocks” are easy sales. Most people would like to own the company that develops the cure for Ebola rather than a company which makes bed springs. It’s the difference between trying to sell a sexy sports car versus a frumpy mini van.

I have watched people put hundreds of thousands of dollars into stocks of companies that sold “no-boil” pasta, electric bikes, sugar with a “left-handed” molecular structure (no calories), anti-viral cleaning sprays, saliva collectors (for HIV testing), and time-sharing plans for recreational vehicle camping. Each company had a logi-

11


cal premise which was taken to an illogical conclusion and ended in bankruptcy.

In hindsight, these examples might seem outrageous to you. You can’t imagine anyone doing anything so foolish. I should mention that all these occurred before the dot.com mania made people more “sophisticated” in their search for high risk, high return vehicles. Perhaps these are more familiar—a gas pipeline which wanted to de-liver movies over the internet, a gaggle of companies that buried fiber-optic cable in the ground and staked their futures on the expectation for exponential growth, a variety of assemblers of routers, internet search vehicles, internet retailers, “B2B” companies, “portals,” and internet service providers.

Very few customers were immune from the marketing efforts of their securities salespersons. Most watched their growth-oriented portfoli-os decline precipitously in value. The large returns generated by these high-risk securities were, in fact, large negative returns.

A proper definition of risk

It’s time that we regain the proper definition of risk. In reality, risk is something different from volatility. Risk is the likelihood that a se-curities transaction will incur a loss. When risk is thought of in this manner, investors are more likely to look at the underlying funda-mental characteristics of a securities transaction, rather than towards an overestimated potential result.

Benjamin Graham, the noted investor, once wrote, “Buy stocks the way you buy groceries, not the way you buy perfume.” The enticing aroma of “more risk brings more return” continues to lead people away from evaluating the ingredients of potential investments and towards simply wishing that the promotional hype will come true. Generally speak-ing, being a part-owner of a business (i.e., a shareholder) is an aggressive strategy—you shouldn’t add “stupid risk” on top of it. Think of a com-mon stock as an ownership piece of a business and not as a lottery ticket substitute and you’ll make better decisions.

FOR THE

INVESTOR,

TIME IS A

FRIEND,

NOT AN

ENEMY.

““

LIE #2SPECULATING IS BASICALLY T H E S A M E T H I N G A S INVESTING - JUST BETTER.

14

LIE # 2: SPECULATING IS THE SAME AS INVESTING

old rebounded from the longest slump in almost two years on speculation from investors seeking returns unavailable in the stock and bond markets,” writes a typical financial markets

reporter. I always get a chuckle from updates like this, wonder-ing how a columnist can make such a precise synopsis of the thinking of the average market participant by looking at the sketchy results of six and one-half hours’ worth of trading. But the real gaffe in this reporter’s sentence is the idea that an investor practices speculation.

This mistake is so regularly committed that I expect someday the dictionary will consider the term “speculating” to be a synonym for “investing.” In my estimation, it should be an antonym; a word of opposite meaning.

Defining speculating and investing

So let’s consider these two activities. A person who practices specula-tion buys or sells something expecting to profit from a fluctuation in its price. A speculator’s goal is to discover and take advantage of price volatility occurring during a short time horizon.

An investor, however, commits money in the expectation of earning a share of a financial return. He or she is a part-owner of a firm and as such, the investor’s goal is to discover and buy the stock of a company in order to share in the profits which accrue from its business over the long term.

Defined in these ways, speculation and investing are quite different strategies. The former focuses on making profitable swaps, the latter on acquiring attractive financial assets. One measures success by the trade, the other by the returns generated over longer periods of time.

Who speculates?

Though few people call themselves “speculators,” most people who

15


buy and sell securities have been inducted as full-fledged members—without them even realizing it. And that is probably the biggest prob-lem for market participants today: Most people think they are invest-ing, when in reality they are speculating. They wrongly expect to earn the long-term returns generated from investing while they gamble on trading.

Speculation has many aliases that induce people to practice its strategy. One pseudonym is “momentum investing.” In this version of speculation, the customer is encouraged to buy securities in the expectation that the crowd will soon follow. Often these securities are identified by recent upsurges in price. In other words, a customer is encouraged to buy a stock in which the price has moved up strongly in the hopes that still others will do the same thing later and push the price even higher. Then the customer will sell his or her position at a gain.

“Momentum investing” can also be referred to as “The Greater Fool Theory.” The customer buys something that has jumped up in price in the hopes that he or she can identify an even bigger fool to sell it to at an even higher price. It is not important at all to understand the underlying financial characteristics of a security; what is impor-tant is to accurately comprehend and exploit the behavior of market participants. What is not clear about this strategy is how a customer is expected to know if he or she is taking advantage of the crowd or being taken advantage of by them!

By the way, there are other aliases for speculation. Most strategies which focus on “flipping” initial public offerings or “getting in early” on the securities of start-up businesses are speculations rather than investments. So are tactics which are designed to constantly shift a portfolio in order to keep up with what’s “hot.” These include tactical asset allocation and day-trading as well as many schemes employing newsletters, websites and e-mails to provide timely tips.

16


How do people become speculators?

There are perhaps three major traits that lead most market partici-pants to become “accidental” speculators. The first (as we mentioned above) is a poor understanding of the chasm which exists between speculating and investing. And though some are aware of the concept of investing, they are often encouraged to pursue speculation as a more rewarding approach by those who believe the faulty presupposi-tion that more risk often brings higher returns.

The second characteristic is that most people overestimate their abil-ity to make a good decision when they have only limited information. They rely on their intuition to make up for their lack of research. Even if people feel that they don’t understand the opportunity being presented to them, they often proceed as if they do. They are more willing to use their “gut instincts” to rely on the representations of self-proclaimed “professionals” than they are to ask questions and risk being perceived as naive.

The third attribute that creates accidental speculators is their reliance on faulty scorecards. Most market participants have no true idea regarding their long-term performance but instead rely on their recol-lections of “winners” and “losers.” Like habitual gamblers, they are convinced in their own minds that they are “up.” Some of this is hu-man nature; none of us wish to relive our failures. Another portion of the error is due to sloppy record-keeping. Most people don’t do the work involved to calculate the returns on their entire portfolio (win-ners, losers and idle money). Even worse, many people don’t recognize that low-priced speculative gambles could substantially reduce their overall returns. The fact that a speculator bought a stock for $1.50 which has declined in price by one-half often only means to him that he lost $0.75 per share—not that he lost $20,000 of his $40,000 speculation.

17


How can a person become an investor?

Following the strategy of investing requires discipline and patience, two things that are hard for any of us to practice. An investor focuses on finding good businesses that will generate profits from their operations over long periods of time. The investor’s goal is to become a part-owner of these businesses by buying shares in them at attractive prices and then earning his or her portion of the returns that come from these companies’ profits. Though investors are constantly being offered schemes that appear to offer a quicker path to reward, they ignore these and stick with their original strategy of investing.

Therefore, an investor will research a potential idea before making any decision to proceed. The investor tries to assess this information using a common-sense framework which applies the same principles he or she would use when deciding to buy an existing business—be-cause that is exactly what he or she is doing. When presented with ideas that have only sketchy information or which he or she does not understand, an investor is confident enough in himself or herself to decide not to go any further with this. To do otherwise is to comply with the secondary definition of speculation: “to take to be true on the basis of insufficient evidence.” Warren Buffett says that there are no called strikes in investing. You can and should wait at the plate until a pitch comes along that you feel confident you can hit.

An investor will also evaluate performance over a long enough time period in which to judge whether the business decision was correct. Few would buy a business and then decide a year later to exit it! Yet the average holding time for stocks traded on the New York Stock exchange is less than one year. If a company’s business continues to perform close to the investor’s expectations, he or she will likely continue to hold it. For the investor, time is a friend, not an enemy. Measuring quarterly or yearly increases in the stock’s price is focus-ing on a secondary indicator of a company’s business and creates artificial constraints. Even if a company’s stock price remains flat for a year, a good company will continue to compound its value as its

18


business grows.

Are you an investor or a speculator?

Ask yourself these questions before you make a financial decision: (1) Is my goal to earn the reward that comes from owning the underlying business or is it to profit from a fluctuation in the market price? (2) Am I equipped to understand this business or am I relying on hype? (3) Am I prepared to wait while the business grows or am I motivated to earn returns according to the calendar’s quarters?

You’re an investor only if your motivation is described by the first part of each question.

19


““

IT’S NOT

THAT PEOPLE

NECESSARILY

THINK THAT

THE MAJORITY IS

RIGHT; IT’S THAT

THEY DON’T

WANT TO BE

ALONE IN BEING

WRONG.

LIE #3YOU CAN BUY AT THE BOTTOM AND SELL AT THE TOP.

22

LIE # 3: BUY AT THE BOTTOM, SELL AT THE TOP

sk a typical person why he bought a particular stock and he will often reply, “Because I expect it to go up.” This person is expecting that the stock’s price will move steadily up-

wards. If this does not happen, he will often sell the stock, believing that something went wrong with his original strategy. Both decisions were based on an improbable assumption. Attempt-ing to follow this strategy will usually cause undesirable results.

Trying to lead by following the crowd

For some crazy reason, people overestimate their ability to buy at the bottom and sell at the top. None of us can name anyone else who has done this even half the time, yet people often foolishly think that they will be the one to succeed. Even worse, these people seek affirmation at the same time they try to implement this strategy. They buy the things every one else is buying and sell the things oth-ers don’t like—which ensures their strategy will fail. If many others are buying, they won’t get the cheapest price and they definitely won’t sell at the top if everyone else is selling!

There are numerous studies and articles which show this strategy to be typical. One in The New York Times (“The Peaks of 1999, the Valleys of 2001,”10/7/2001) recounts the experience of inves-tors in the top 10 performing mutual funds of 1999. These funds had spectacular returns for that year—each jumped between 224% and 494%. However, 9 of the 10 subsequently dropped by at least two-thirds over the next 7 quarters (the 10th fund was down by nearly 50%). Even after taking into account the spectacular gains these funds achieved in 1999, overall, investors lost $4.4 billion in these funds over the period (January 1, 1999 to September 30, 2001). How is this possible? It seems that most people jumped in after seeing the strong returns, which only ensured that they were paying a high price for their investments. Looking at the turnover of speculators in these funds, it is easy to imagine that many of them left as returns neared the bottom. Attempting to accomplish the

23


perfect strategy of buying at the bottom and selling at the top, they did just the reverse.

We’d be much better off if we considered buying at the bottom and selling at the top to be an impossible task. We need to focus on a strategy that doesn’t count on perfection in our ability to speculate but instead allows us to take advantage of volatility in a stock’s price.

The big question

In order to see if this other strategy makes sense, we need to first answer an important question: Does a stock’s price necessarily equate to its value? Just looking what happens to stock prices on volatile days should lead most people to understand that prices change quickly in times of worry or when people are overly optimis-tic. Market participants tend to move in crowds. It’s not that people necessarily think that the majority is right; it’s that they don’t want to be alone in being wrong. This can lead to a stock’s price being quite different from its value. Perhaps it would help to think of the house in which you live. Sup-pose someone knocks on your door and offers $30,000 to buy it. Would you sell? It depends on how much you think your home is worth. Most of us have a pretty good idea about the value of our houses and would be unwilling to sell at such a low price.

The same is not true about many people who own stocks. Most have no idea how much the underlying company is worth. When they buy with the assumption that the stock’s price will go up, they are implicitly saying that the market has underpriced the stock (even though they haven’t done any real analysis to test this proposition). The same people turn into motivated sellers when someone gives them a lower offer, believing (for understandable reasons!) that they may have been wrong.

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LIE # 3: BUY AT THE BOTTOM, SELL AT THE TOP

Even worse, people often set up irrational strategies that cause them to sell at a loss. For example, many sell if a stock’s price drops by a specific amount. They think that this limits losses. That’s like saying you wouldn’t sell your house for $30,000 but if someone offers you $25,000, you’re out. You’re not cutting your losses, you’re guaranteeing them.

Using volatility to your advantage

Understanding that a stock’s price may differ from the value of its underlying business, we can implement a strategy designed to take advantage of potential disparities. It involves buying shares of com-panies which you believe to be selling at inexpensive prices versus what their businesses are worth.

This obviously means that research is not optional. You need to know what similar businesses are worth. You can base this valu-ation on earnings, recent takeovers, leveraged buy-outs and com-parable transactions. Often this data is not hard to get. If after analyzing a company, you decide that you like its underlying busi-ness, think its management is proficient (since you don’t get to run the business yourself) and conclude that its current price is attrac-tive, you can buy shares with the expectation that the value of the company should grow over time and that someday its price may equate with its value.

If the stock’s price drops, you can take advantage of this volatility by buying more shares. For an informed investor, these opportunities are similar to finding out about a big sale at your favorite store. You don’t get angry; you pick up more of the items you like at an even more attractive price than before! If, at some point, the stock’s price exceeds what you think the company’s business is worth, you can take advantage of the situation by selling your shares to people more optimistic than you.

25


Be your own judge

Don’t think of the market as being ultimate arbiter of what something is worth; rather consider it as a presenter of opportunities. As in our house example, you don’t have to do anything if you don’t want to. There’s no law that says you have to take people at their offer. In fact, with the stock market, you can do the opposite and take advantage of the offers that exist by exploiting price volatility. It’s impossible to be successful by attempting to buy at the bottom and sell at the top. However, an informed strategy of buying good businesses at attractive prices, taking further advantage of price declines and selling when the market overoptimistically prices the shares allows an investor to buy low and sell high—which isn’t such a bad compromise!

““

THE MOST

IMPORTANT

CHARACTERISTIC

TO THE

CONSULTANT

IS THAT THE

INVESTMENTS

DIFFER—NOT

THAT THEY ARE

GOOD.

LIE #4DIVERSIFICATION I S A G O A L O F I N V E S T I N G .

28

LIE # 4: DIVERSIFICATION IS A GOAL OF INVESTING

y guess is that by the time you saw the title of this chapter, you were ready to nominate me for membership in the Flat Earth Society. Just as in the previous sections, however, I’d ask you to bear with me for a little bit. First, I need to give

a qualifier. I have nothing against ivory-tower academicians. (In fact, at one time I was training to join them.) Ivory-tower academi-cians usually don’t hurt anyone, since they focus their energies on an imaginary world1. In finance, this make-believe land has strict rules to which investment securities always adhere. The financial theo-rists then develop mathematical models which describe the relation-ships among these imaginary securities. It makes for fun reading—if you enjoy statistics, calculus and probabilistic science.

Unfortunately, these models have been hijacked by people who can do real damage to people’s portfolios—“wannabe” academicians who make their living selling securities.

Placing faith in a hypothesis

These salespeople have proclaimed the conclusions of those academ-ic models but have entirely ignored the fact that the models do not accurately describe the real world. Even worse, they feel free to pick and choose the parts of the theories that they follow and the parts they ignore. For instance, a major premise of the “Efficient Market Hypothesis” (EMH), the core of modern portfolio management theory, is that you cannot earn an excess return by using investment strategies based on any historical financial data. Yet securities firms, mutual fund companies and the like often base their strategies on historical data while additionally believing that they can apply the conclusions of this hypothesis to the real world.

Their thinking (fuzzy as it is) goes something like this: Since it is impossible to predict exactly what will happen with a particular security, focus should be directed on the overall portfolio. (So far, I

1A famous and fairly recent exception is the Long Term Capital Management incident, in which some Nobel prize-winning financial theorists lost nearly $5 billion in a few months during 1998 and nearly took down the financial markets system.

29


have no major problem with the logic.) However, the strategy then veers wildly. Investment returns are thought to be governed solely by chance; therefore we should “invest” in as many dissimilar op-portunities as possible.

How do they find these dissimilar securities? It’s simple. They look to see how returns on various securities have differed in the past and then assume that these relationships will hold in the future. So, almost by default, they find it necessary to engage the services of someone who can help them to compile historical information in order to find unrelated (and unusual) investments; they look for a consultant rather than for an investor.

Consultants are often collectively referred to by the pronoun “they,” as in: “They say you ought to have 30% of your portfolio invested in North American stocks, 20% in the stocks of companies located elsewhere, 35% in bonds, 5% in commodities, 5% in real estate and 5% in cash.” Don’t underestimate the power of “they.” It’s hard to argue against such a formidable (and anonymous) brain trust.

Recently, the range of these consultants has expanded to include web-based services offered by discount securities firms and financial advisors. The popular descriptive term for these is “Robo-advisor.” Often, these services are sold as being inexpensive and more accu-rate.

Putting their beliefs to work in your portfolio

The salesperson/consultant/robo-advisor then takes your retire-ment money and buys securities based on how the firm’s “market strategist” is currently tweaking their “asset allocation model” in an attempt to achieve better than average results. Somehow they overlook that EMH says that this, too, is an impossible task.

The customer is left with a portfolio that contains securities from “a” to “z” as well as selected letters from the alphabets of several other languages. Obviously, this will include a number of securities that

30

LIE # 4: DIVERSIFICATION IS A GOAL OF INVESTING

he or she knows nothing about. Conveniently, this increases the importance of the securities salesperson who can point to the firm’s “expertise” in following and trading such esoteric securities.

Of course, when a person’s portfolio is diversified in this way, the scorecard of how much was earned on the portfolio in a three to five year period is often considered to be much too crude to be of any help. The service provider would rather speak of returns relative to representative indices such as the EAFE, GSCI, and Barra Growth measures. (Again, it helps them that these are unfamiliar measures to the vast majority of people). Simply put, the consultant’s goal in investing is to create a broadly-diversified portfolio. How it actually performs is only a secondary consideration at best. (An additional bonus for the consultant is that with such a wide array of securities, his or her chances of pointing to something that performed well certainly increases.)

Think about what would happen if a farmer in Nebraska followed this strategy. Instead of growing crops that do well in that climate and soil condition—winter wheat, corn and soybeans—let’s say the farmer plants an acre of cotton, an acre of tobacco, an acre of ruta-bagas, and so on. He does this because he can’t know with certainty what the weather is going to be like or what his harvest will earn. Therefore, he hopes that following a strategy of planting a little bit of everything will at least give him the same results as the “average” farmer. Does this kind of crazy diversification make any sense?

But it seems that this is exactly the strategy that investment consul-tants preach. They do not focus on the quality or the attractiveness of the underlying investments—and they poke fun at the people who think that these characteristics are important, as if we were relics of some bygone era. In essence, they would tell the farmer to ignore the fundamentals and spread out his risk.

In fact, if a client possessed a portfolio solely comprised of stocks of good quality companies selling at attractive prices, the consultant would insist that he or she sell some of these and invest in stocks that do not meet these qualifications in order to “diversify.” Obvi-

31


ously, they wouldn’t put it so crassly—they would speak instead us-ing phrases such as utilizing “asset allocation” to gain “exposure” to the “microcap,” “emerging markets,” and “commodity” asset classes. The effect, however, is the same. The most important characteristic to the consultant is that the investments differ—not that they are good. (What somehow gets overlooked are the investment results of the consultants themselves. As far as I know, they don’t tout their own track records.)

A return to common sense

Investors, however, believe that the goal of investing is to preserve and grow capital. They focus on each underlying investment, paying attention to price, risk and fundamental characteristics since they think that these are directly related to future returns. Therefore, an investor will have a good understanding of each security owned in a portfolio, which tends to limit the number of securities he or she invests in.

Investors also understand that diversification can be used to reduce overall portfolio risk but they don’t practice diversification for diversification’s sake. If an investor doesn’t understand a security after studying it, he or she won’t get involved with it. Investors do not share the consultant’s belief that buying it would lower the risk of a portfolio. In fact, they would argue that buying things they don’t understand would probably increase portfolio risk and reduce expected returns. They believe it is possible to spread a portfolio so wide that they di-worse-ify instead of diversify. An investor wants to own his or her best ideas, not all the ideas that exist.

All of which leads us to the final point. Since investors are focused on growing their capital over the long term, they measure success by the absolute returns of a portfolio over an intermediate (three to five year) time period. They look for positive returns and a handsome increase in capital so that they can use this for their needs later.

In the real world, few of us can afford to think like a consultant. We need to take good care of what we already have and we want it

““

THE

MEASURE

OF AN

INVESTMENT

“PRO” IS THE

COMMISSION

REVENUE

HE OR SHE

PRODUCES.

LIE #5MOST INVESTMENT “PROS” MEASURE THEIR SUCCESS B Y Y O U R R E S U L T S .

34

LIE # 5: “PROS” CARE ABOUT YOUR RESULTS

mentioned in my introduction that I began my career as a securi-ties analyst for a regional brokerage firm. The firm is no longer in existence. It had been managed by people who could best be described as “old-timers” and it was sold several years ago for

a mere fraction of what other similarly-sized firms were worth—mostly because it hadn’t generated similarly-sized revenues. That’s one reason I consider it to have been a reputable firm. Management wasn’t fixated on inventing new ways to separate its customers from their money.

During my second year (of three) that I worked there, someone decided that I should take time each Friday afternoon to discuss the concepts of investing with new brokers. I was glad to do this and the meetings were well attended. After a couple of months, though, I noticed that a few of the newer brokers had never joined the group. I made it a point to discuss this with the brokerage’s office manager.

Investment pros are judged by their “production”

I asked the manager, who was responsible for supervising the firm’s “investment executives” (sometimes called advisors, consultants or brokers) what I could do to encourage them to participate in our training sessions. He smiled and walked me out of his office to-wards a large poster hanging in the midst of the brokers’ cubicles. Then he asked me to look at the display. It was a bar chart showing commissions generated by each of the firm’s brokers against a goal—an amount which guaranteed them the right to go on a group trip to Mexico. He said, “Every minute they spend with you is a minute in which they’re guaranteed not to earn a commission. You might think that you’re helping them in their careers, but really, prospect-ing for new customers is what helps them the most.”

I went back to my desk embarrassed. I hadn’t recognized that my sessions were costing my fellow workers real money. But then I remembered that my emphasis had been on helping the firm’s customers reach their goals. I felt that if our clients would achieve

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strong returns in their portfolios, their brokers would also benefit. Some of them (as well as their supervisor) did not agree and prob-ably for good reason: Brokers are not evaluated (or compensated) by the investment performance of their clients; they are measured solely by the amount of commissions that they generate. This was true even at our old-line firm. The primary role of any investment executive was to produce revenue for the firm. In fact, the best brokers earned the title “big producers.”

What it takes to become an investment “pro”

Skeptics may think that the answer to what it takes to become an investment professional is an EKG that shows a heartbeat. That’s not entirely true. First, you need a brokerage firm to sponsor you so that you can get licensed.

It is impossible to obtain a license to sell securities without one of these firms sponsoring you. Brokerages have created an industry trade group (usually described as a self-regulatory organization) called the Financial Industry Regulatory Authority (FINRA and formerly called the National Association of Securities Dealers). The US Securities and Exchange Commission allows this trade group to set the standards for licensing. And the SEC requires that an individual have some sort of securities license before he or she deals in securities with the public.

When I arrived at the brokerage firm, my first assignment was to obtain my General Securities Representative (Series 7) license. I was told to register for the test which was to be given two weeks later.

I had never worked for a brokerage firm before, let alone walked into one. I had no clue as to what the rules and regulations were—and if you had asked me about such crazy things as margin limits and ex-dividend dates for stock splits, I wouldn’t have known how to answer. But I was given an already-used workbook to study and told that all I needed to do was to score 70% in order to pass the test. I

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got some encouragement from the fact that a 70% was the lowest grade eligible for a “D” at my college and I figured that I had at least a chance to achieve that score. Two weeks later, I took the test and scored in the 90’s. I asked our human resource officer for informa-tion on the state licensing (Series 63) test and she assured me that I did not need to study for it at all. She was right; I passed it on my first try.

I don’t say this to boast, I say this because I have never met anyone who has not (at least eventually) passed these tests. In fact, the only person I ever heard not to pass was a former professional athlete who figured in a humorous chapter of the firm’s folklore.

But what I’m not saying is that just anyone can get a securities license. In order to be sponsored by a firm to take the test, you need to get hired. In order to get hired, the firm wants to ensure that you will “produce.” A securities firm will generally make a prospective broker take a psychological profile test in order to determine the candidate’s suitability for sales. In reality, this is the most difficult test to pass in order to become an investment pro. If you pass, the firm will likely send you to an exam preparation school in order to train for your licensing exams. (Since analysts aren’t producers, I didn’t get the same treatment).

It’s safe to assume that the same values hold in the annuity, life insurance and mutual fund businesses. The measure of an invest-ment “pro” is the commission revenue he or she produces; it is not the portfolio returns earned by his or her clients. In fact, you might be tempted to say that the “pro” in “investment pro” stands for “pro-ducer.”

Modern variations of investment “pros”

What about financial planners? They often describe themselves as being “fee based.” I find this term to be extremely misleading as well as offensive because it means something opposite to what many

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people think. It means that the planner charges a fee for his or her services and also receives commissions on the products he or she rec-ommends. Basically, the planner is a broker who tacks on another fee. Many of these planners go into business for themselves so that they can keep more of the commissions they generate. They are big producers for themselves.

You can often tell if a financial planner is also a broker by looking to see if his or her advertisement has a sentence that begins with “Securities offered by…” That’s a sure tip-off that the planner has contracted with a firm who specializes in working with independent brokers interested in maximizing their own commission revenue. Often the planner can keep as much as 75% of the commissions earned on stock transactions and 90% of the fees earned on annuity and mutual fund sales. Brokers who work for traditional firms often keep less than 35% of commissions earned. Combine the higher payouts (percentage of the commission kept by the broker) with a planning fee and you can see why this is such an attractive route for many brokers.

If you think that my view is jaundiced, you need to keep reading.

One of the more successful financial planners in my area advertises that his firm offers a “personalized approach to wealth planning, accumulation and preservation.” It would appear that he is very customer-focused. Yet the very same planner operates a sales train-ing company whose stated goal “is to empower financial advisors to achieve the business and quality of life they desire by offering proven tools and innovative programs that ignite their burning desire to succeed!” In the company’s literature, he is described as a “multi-million dollar practicing producer.” (In fact, his bio claims that he makes over $7 million a year.)

This planner also is a member of a speaker’s bureau. For a stated fee of $10,000 to $15,000, he will speak on “The Secrets to Becoming a Million Dollar Success,” where he reveals to other financial planners the recipe that helped to make him a multi-million dollar producer

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so that they, too, can increase their income.

I believe that this planner truly has achieved success as an “invest-ment pro.” He began his career selling insurance and annuities and became very successful when he adopted the “fee based” financial planner model. For many years, he has been the top broker of one of the “securities offered by…” firms. It certainly has worked for him. He boasts of taking one week off a month and spending as much time as possible working at home and playing golf.

I’m not sure, however, that being his client would be so comfort-able—especially since this man’s clients are the source of his multi-million dollar earnings.

The more things change…

Fred Schwed recounted a story of a visitor who “was being shown the wonders of the New York financial district” over a century ago. “When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said, ‘Look, those are the bankers’ and the brokers’ yachts.’ ‘Where are the customers’ yachts?’ asked the naïve visitor.’” The implied punch line, of course, is that there weren’t any.

The truth has always been that too many investment pros measure their success by the size of their take.

“Pro”active steps

Since you, however, are interested in growing your portfolio, you need to take preemptive action before you work with an investment “pro.” First, ask how he or she is compensated. Does the agent receive commissions? Does the agent receive payments or bonuses when a security transaction is made? Does he or she participate in

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contests that reward the agent for the number and/or size of trans-actions? How are fees calculated? Does the firm send a bill that shows an accounting of these fees before they are paid? Similarly, ask for an explanation of all the fees and commissions you will be responsible to pay. In order for an advisor to place trades, commis-sions will have to be paid to someone—check to see if the advisor will use a discount broker which can save much in transactions fees. What you’re looking for is a firm whose interests are best aligned with yours, or at least one whose financial motivation does not en-courage the agent to act as a speculator rather than an investor.

Secondly, ask who the primary regulator is of the firm’s business. Brokers will be primarily regulated by the Financial Industry Regu-latory Authory (FINRA). Insurance firms are regulated by the state insurance authorities. Firms and brokers who are subject to FINRA regulation or to state insurance authorities are often not subject to the same fiduciary standards as investment advisors.

Small investment advisers (less than $100 million of client assets) are regulated by state investment or banking departments and larger ones are regulated by the Securities and Exchange Commission. These advisors are called a “Registered Investment Adviser,” and must adhere to a fiduciary standard of care laid out in the US Invest-ment Advisers Act of 1940.

In each case, ask to see the firm’s disclosure document, which will show information required by the regulator and possibly any nega-tive issues they might have with the firm.

Finally, ask the representative to describe the firm’s investment philosophy. It should be a simple and to the point description of the process of investing. Remember that most people are not investors, but are speculators. If he or she does not clearly describe a philoso-phy of investing, you need to look elsewhere.

ABOUT THE AUTHOREric Ball has served as the Chief Executive Officer of Amer-ica First Investment Advisors, LLC since 2002 and has been with the company since 1997. Eric holds the Chartered Fi-nancial Analyst designation and is a member of the CFA Institute. Previously in his career, Eric served as Manager of Equity Strategy in the trust department of a regional bank, as Chief Operating Officer of a registered investment advi-sory firm, was a securities analyst for a brokerage firm and also was employed by a value-oriented mutual fund firm.

Eric is a past president of the Omaha-Lincoln Society of Financial Analysts. He is married to Denise and has three grandchildren.

ABOUT THE FIRMAmerica First Investment Advisors, is an investment man-ager from the Old School. We put our clients’ interests first and consider ourselves stewards of the assets placed in our care. We don’t sell investment products and don’t charge commissions. Our only compensation is a quarterly management fee.

Building long-term relationships with clients is important to us. We listen, offer our best advice, and act as a partner and ally. Our personal service means we stay in touch.

We use a disciplined approach to stock and bond invest-ing, one that features independent research and judgement. We read a lot, ask questions, and carefully consider the merits of potential investments. Our concern with own-ing the right kind of investments at the right price means we’re willing to be out of step with the market. We think this rational approach offers the best opportunity to build wealth over time.

America First Investment Advisors LLC is an independent investment advisor registered with the Securities & Ex-change Commission (SEC). For more information, including our investment brochure filed with the SEC, please visit our website at www.am1st.com.

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