The Big Investment Lie: What Your Financial Advisor Doesn't Want You to Know

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This expos of regularized falsehood reveals the unfortunate truth behind the financial advisory industry - that professional investors cannot, and never have been able to, beat market averages. Written by a well-credentialed insider, this book additionally provides detailed insights into where people should really invest their money.

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1 The Beardstown Ladies versus the Professionals

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The Beardstown Ladies would have had it made for good if they hadn’t been so naive and honest.9

In the early 1980s, Mrs. Betty Sinnock, a grandmotherly woman of homespun wisdom, formed an investment club with fifteen other women—also senior citizens—in the town of Beardstown, Illinois, population 6,200. They called their club the Beardstown Business and Professional Women’s Investment Club.

They got together regularly to study public companies and to select some to invest in. They joined the National Association of Investors Corporation (NAIC), an organization of investment clubs. They researched stocks, looking for companies with a solid history of growth. They saved and invested diligently, contributing $4,800 a year to their joint portfolio.

They stuck to companies they knew. When one of them came to a club meeting and announced she had seen a lot of cars parked at Wal-Mart, they bought Wal-Mart. One member brought some Hershey Hugs to a meeting. The members decided they tasted good. They wound up buying Hershey stock.

 

2 The Extraordinarily High Cost of Investment Advice

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Some years ago my cousin Bob, an oral surgeon in a midsized American city, told me someone was trying to sell him investment services. He wanted my thoughts on the matter.

A woman in his city, a local consultant with a large national investment brokerage firm, was calling him regularly to convince him to place his pension fund’s assets in her company’s wealth management program. Bob seemed to be responding to the marketing effort. He was considering entrusting the pension fund assets—about $1 million at the time—to the brokerage firm for advice and management. But he knew I might have a different view, and he wanted to know what I thought. Also, he knew I had a business involvement with her brokerage firm and thought I would be interested to know about the calls.

First, I told Bob never to tell anyone at the brokerage firm that I told him this. At the time, I had a fat contract with the firm. Its consulting division was making heavy and expensive use of a computer system in which I was a 50 percent partner. I had a good relationship with—and liked—the employees at the firm that I did business with, the people running the consulting division. Bob’s suitor presumably worked for that division. Of course, I didn’t want them to know I was working at cross-purposes. But I also didn’t want to give my cousin a bum steer.

 

3 The Outer Limits: Hedge Fund Fees

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Now we come at last to the crowning achievement of the fee-charging business, the pièce de résistance, the masters of the fee-charging universe—hedge funds.

Hedge funds, like mutual funds, are pools of commingled investments shared among multiple investors. The difference between mutual funds and hedge funds is that hedge funds must restrict the type and number of investors that invest in them. Investors must be wealthy enough to bear significant loss (they must own at least a million dollars in investment assets or have income of at least $200,000 a year). As long as a hedge fund adheres to the restrictions on the type and number of investors, it escapes regulations applying to mutual funds. In particular, hedge funds can charge differently structured, higher fees, and they can use “leverage”—they can borrow to invest and use derivative investments mutual funds cannot use. They also don’t need to make their numbers public or have them audited. The principle is that because the investors are wealthy and “sophisticated,” they don’t need the government regulatory structure to protect them.

 

4 Taxes Down the Drain

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In January 1994, I spoke to a small gathering of the superrich at the behest of the Northern Trust Bank of Chicago. I was a speaker at their Family Financial Forum, which was held at an extremely opulent hotel in Dallas.

“Family Financial Forum” sounds like a nice little gathering, perhaps with tea and cakes, that you might have one evening at your local church or community center. But that’s not what this Family Financial Forum was. The average wealth of the families represented at this forum was $400 million. This was not your typical community group.

The wealthy were represented either by family members themselves or by their staff, or both. Most superrich have family foundations managed by hired staff. A few of the people at the conference bore names that would be recognized for their wealth, but most would not be known to the general public.

Northern Trust spared no expense rolling out the red carpet for these, their most well-to-do clients. There were two “name” speakers. One was Dick Cheney. At that time he was known primarily for his understated televised briefings as secretary of defense during the Gulf War in Iraq. He was frequently mentioned as a possible presidential candidate. He seemed, in person as in his television briefings on the Gulf War, understated and modest.

 

5 Why Do We Give Golden Crumbs to Rich People?

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What makes people fall for these high fees? It could be a certain well-documented chink in their good sense.

Classical economic theory makes a lot of assumptions about people’s actions when their economic interests are at stake. It assumes, for example, that people act “rationally.”

Some of these rationality assumptions seem a little out of keeping with common sense. At the very least, they are in a strange sort of jargon. For example, suppose someone decides to go to a three-hour baseball game for $20 instead of working overtime for $30 an hour. Economic theory assumes the psychic benefit of attending the baseball game must therefore be worth $110—$20 paid for the ticket plus $90 for the “opportunity cost” of not working. If the overtime option hadn’t been available—assuming rationality—then the person would have been willing to pay $110 to attend the game.

Anyone can see that assumptions like these aren’t going to predict economic behavior very well. People just don’t act like that, for whatever reason. Nonetheless, the assumptions underlying this conclusion are the very backbone of economic theory.

 

6 Why Investment Professionals Can’t Predict Markets

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In previous chapters, I’ve shown what professional investment advice and management costs. Now I’ll show why it doesn’t benefit you—that is, why it doesn’t increase your wealth.

In this chapter, I’ll explain the very sound reasons why professional investment managers should not be expected to beat the market. Then, in the next chapter, I’ll describe the extensive evidence that shows that, indeed, they cannot.

Suppose you were asked which investment manager you would like, one who tries to beat the stock market average or one who is content just to equal it. What would you say?

“Well, it depends on the cost” is the best answer. Is it worth spending more than a minimal amount to try to beat the market?

As I explained earlier, managers of equity investment assets are divided into two main categories. Those who try to beat stock market averages are called active managers. Their practice is called active management. Paid investment advisors typically recommend higher-cost, active managers.

Those who do not try to pick stocks to beat the market averages are called passive managers. Their practice is called passive management.

 

7 The Abject Failure of Professional Advisors and Managers

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If Hayek’s arguments have not convinced you that money managers cannot deduce true prices that are better than the prices set by the dispersed knowledge of the multitudes, the empirical record of active investment management’s dismal failure should convince you.

I will now review that record. I’ll do it first in a simple way, then more extensively with a review of the research studies.

The statistical record of performance of professional investment managers and advisors is voluminous and thoroughly well documented. It has been analyzed dozens of times in academic studies and in private studies by companies in the investment field having their own proprietary databases.

I myself performed studies using the largest then-existing investment performance database for institutional fund managers in the early 1970s, while working at my first job at a brokerage firm.

I performed more studies in the late 1980s and early 1990s when I had access to a large quantity of data on the performance of managed investment accounts, which was input by brokerage firms who subscribed to a computerized investment performance measurement system in which I was a partner.88

 

8 The Market Can Turn on a Dime

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Now I shall explore with you, in an easy-to-under-stand way, the fascinating—and frequently weird—mathematics and chaotic patternlessness of securities markets that occurs when markets are highly competitive and liquid (i.e., easy to trade in).

In the late 1960s, having exhausted my taste for political action as a small part of the early vanguard of student protest against the war in Vietnam, I turned my attention back to my studies. I was a graduate student in pure (theoretical) mathematics at Northwestern University. I had elected to concentrate in probability theory. I had never taken a course in economics or finance or anything faintly resembling those fields. I had no idea what a stock or a bond was. I assumed they were probably different names for the same thing, but I didn’t care anyway. Like virtually all mathematics students and professors at the time—and most students in many fields of study—I was disdainful of business applications.

To begin my studies in the subfield my thesis advisor had designated for me, he gave me a crudely mimeographed set of notes “published” by the Tata Research Institute, a research institution in India funded by the highly successful Tata family business. The notes were written by an obscure Japanese mathematician named Kiyosi Itô. Mathematical symbols like the Greek letter capital sigma for summation and the integral sign were hand drawn, undoubtedly by Itô himself.

 

9 The Claims of Money Managers: “Smoking Our Brand Prevents Cancer”

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Welcome to Fumaria, a vast but little-known country in central Asia.

Fumaria is a land of very heavy smokers. Ninety-nine percent of Fumaria’s eighty million people over the age of twelve smoke an average of four packs of cigarettes a day. As a result, the cigarette and tobacco industries are enormous and highly competitive. The country has more than a hundred major cigarette companies, each offering an average of a hundred brands.

The Fumarian cigarette industry and its advertising are moderately well regulated. Since 1999, when the Fumarian minister of health attended a conference in Washington, DC, organized by a trial lawyers’ association, all cigarette packs have had printed on them in large letters in Woldu, the official national language, “Smoking Kills.” But this warning seems to have had little effect on the level of smoking in Fumaria.

Cigarette companies and their brands compete fiercely in advertising campaigns. Most of the ads focus on claims of reduced cancer risk.

Although the vast majority of the population smokes, the cancer rate in the nonsmoking population has been determined from the eight hundred thousand nonsmokers. The companies’ advertising implies they are able to beat this benchmark. Cigarette companies compete in claims that their flagship brands can reduce cancer rates below the nonsmoking level. The implication is that smoking their brand prevents cancer.116

 

10 Idle, Greedy Hands and Too Much Data Do the Devil’s Work

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Given the abundant evidence that trying to beat the stock market is a waste of time and effort, I have often wondered how smart people can do so much of it. Those who are professionals in the business do it, of course, because they are paid very handsomely to at least pretend to try. Thousands upon thousands of people are engaged one way or another in the effort.

When I was a child, I would look out on the roadway and see all the cars going to and fro. I would wonder where each and every one of them was going. Now I wonder what each and every one of those would-be market beaters is doing, day after day after day. Of course, I have been involved in the investment business in one way or another for most of my career, so I have some idea what they are doing.

But I have never been so close to a group of people in a corporate environment who were determinedly trying to beat the stock market as I was a short time before starting to write this book, in the fall of 2004. The experience was, in fact, what provoked me to write it.

 

11 The Simple Rules of Nobel Prize Winners

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In this chapter and the next, I will explain the Nobel Prize–winning theories that are supposed to form the basis for the advice given to customers of investment advisors and managers.

As we shall see, however, these theories underpin Strategy 1—the simple, low-cost strategy—not Strategy 2, the expensive addition that consultants, advisors, and managers tack on so that they can charge high fees.

When Harry Markowitz started thinking about investments in the late 1940s, he was a student at the University of Chicago selecting an area in which to write his dissertation. He started to think about applying mathematics to the stock market (a novel idea at the time); his advisor agreed it was a reasonable idea.

Much later, in his Nobel autobiography, Markowitz described how he came up with the seeds of his breakthrough idea—portfolio theory—while reading in the university library:

The basic concepts of portfolio theory came to me one afternoon in the library while reading John Burr Williams’s Theory of Investment Value. Williams proposed that the value of a stock should equal the present value of its future dividends. Since future dividends are uncertain, I interpreted Williams’s proposal to be to value a stock by its expected future dividends.1 (emphasis added)142

 

12 There’s No Such Thing as a Free Lunch

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I begin this chapter by changing everything I said so far. I said you couldn’t beat the market, except by chance—especially after the fees charged by investment managers and advisors.

Now I say, “You want to beat the market? OK, you can.” Not only can you beat the market, but it’s very easy to do. Here’s how. Go out and borrow some money. If you want to beat the market by a lot, borrow a lot of money. Invest it in the stock market.

Consider an example (see Exhibit 12.1 on page 150). Suppose your investment portfolio is $200,000. If you invest that in the stock market, let’s say you can expect, in the long run, about an 8 percent return annually. Let’s say you invest it for two years in the stock market for a return of 16 percent.

Now assume you can borrow $50,000 at 4 percent interest. Invest that in stocks on top of the $200,000. Your investment portfolio is still worth $200,000—that hasn’t changed, because you’ve got $250,000 invested in the stock market, but you have to subtract $50,000 for the debt you owe.

 

13 Investment Genius or the Thousandth Coin?

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Whenever anyone says that beating the stock market is purely a matter of luck, not skill, it always seems to produce the same response. It’s as if people had been scripted to say it.

“Then how do you explain Peter Lynch and Warren Buffett?”

Because of this almost universal script reading, it verges on heresy to suggest that Warren Buffett and Peter Lynch might have been merely lucky. It would be like saying that Abraham Lincoln, without really having any idea what he was doing, sacrificed six hundred thousand American soldiers to grisly deaths by refusing to grant the southern states their request to secede from the Union. Luckily for Abe, it turned out OK in the end.

Once someone is lionized and firmly enshrined in the public legend, it is simply not allowed to say anything that could erode that legend. There is a simple difference, though, between Abraham Lincoln, on the one hand, and Peter Lynch and Warren Buffett, on the other. We can’t measure statistically how effective Lincoln was. We can’t measure his performance against what might have happened without him or against any benchmarks. We only know the positive results—that slavery in the United States was summarily ended and that the reunified nation grew to become one of the most prosperous and democratic in the world.

 

14 Effective Pitches to Sell the Big Lie

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When I was a teenager, I had an experience that was very valuable even though I would never dream of doing anything like it again.

I was a door-to-door salesman. I sold magazine subscriptions. Almost everyone has had a magazine subscription salesperson come to the door. It’s often a young person, someone in high school or college. It was hard work, but educational and financially rewarding. In one of my summers of magazine sales, I contributed from my earnings about $1,800 in today’s dollars to my college education. I was proud of it.

But it was a very strange experience. It was not, I think, a good way to cultivate respect for one’s fellow man.

The team was composed of two tiers of salespeople: the managers and the crew. Typically the crew consisted of high school kids, while the managers were college students or at least boys or men older than high school age. Two middle-aged men back at the office assigned us the neighborhood we would work in. Sometimes they gave us a car to use, and they paid us if we made sales.

 

15 How Investors Delude Themselves

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Investors are alarmingly prone to self-delusion, and most investment advisors and managers are only too happy to take advantage of that fact. It might just be part of our makeup.

In the near future, brain researchers will discover that the urge to get rich quickly originates in the same region of the cerebral cortex as the urge to have an orgasm. The same behavior patterns accompany both, the same attitudinal changes: a tendency to have less concern with speaking the truth; a tendency to overlook or forgive others’ disregard for the truth; a marked increase in the level of gullibility; a decrease in the capacity to notice flaws; a singleness of purpose, accompanied by diminishment of the ability or will to think rationally.

I have seen people in this condition more times than I can count. Sometimes they came to me seeking objective comment or knowledgeable counsel. But it often turned out that—though they appeared to seek it—neither objectivity nor wise counsel was what they really wanted. They wanted someone to ratify their urge to go for it.

 

16 How Hedge Funds Operate and Are Sold

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A few years ago, I was the chairman of the investment subcommittee of the board of an important and creative nonprofit organization near Aspen, Colorado. The investment subcommittee was part of the finance committee, so it often met as part of a finance committee meeting.

As chairman of the investment subcommittee and the person most knowledgeable about investments, I recommended a fairly high allocation to stocks for the nonprofit’s small endowment of about $8 million (since it would be invested for the long run). I recommended passive funds—that is, indexes—for the actual investments. After some discussion, we agreed on a stock allocation, and the others agreed to the index recommendation. We chose for part of our index investment a broadly diversified, low-cost, indexlike “socially responsible” mutual fund.

I sent the committee a write-up with the usual caveats about the stock market. The caveats said that the stock market will almost surely produce a good return in the long run, but it will experience unpredictable declines along the way, some quite steep.

 

17 How Consultants and Money Managers Sell to Institutional Investors

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Let’s look at how it typically works in the institutional investor market—the large employee benefit, endowment, and foundation funds.

Big institutional investment funds (their assets can be in the tens of billions of dollars or more) almost always retain a consulting company. The consulting companies, which specialize in the institutional investment consulting business, can be large and extremely profitable. For example, the president of the consulting company Wilshire Associates (with whom I once debated at a University of Chicago conference) had in his youth worked on computer programming for the U.S. space program. At the age of sixty—perhaps feeling nostalgic for space projects—he reportedly spent $20 million to buy himself a ride on the Soviet Mir space station. His institutional investment consulting business must not have done too badly!

Consulting firms perform various research studies for their clients, such as—for example—running asset–liability models, which project the future assets of a pension fund compared with its liabilities. (A pension plan’s liabilities are what it will cost later to make the promised payments to retirees.) These models can help the fund’s managers determine how likely it is they’ll have enough to cover benefits and how much they might need to add to the fund in the future.

 

18 Derivatives: The Good, the Bad, and the Ugly

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I will talk about derivatives because there actually can be a place in some people’s—and some institutions’—portfolios for certain kinds of derivatives, especially if they are almost paranoically concerned about the possibility of losses. But as most of the public is at least vaguely aware, some uses and forms of derivatives can also be quite dangerous. In this chapter, I will explain the beneficial uses as well as the bad uses.

In the last thirty years, a segment of the financial market that was once very small has come to account for a large portion of the trades. Derivative products called options and futures, which are derived either from individual stocks or from stock indexes, or from commodities like oil, have proliferated and are traded very actively.

Most of these contracts are more like insurance contracts than investments. (Of course, for those who offer the insurance, it is an investment.) They are called derivatives because their values depend on the value of some other indicator—such as the price of a stock, a stock index, or a commodity.

 

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