Zero Sum

Critical Stuff: The Secret Sauce of most financial advisors is ketchup and mayo–you can make your own

In This Chapter: You can’t time the market. How not to gamble with retirement. Why mutual funds are such a lousy deal. 

Picking individual stocks is just gambling. It’s not a plan for the future. My Dad used to say “If you don’t know who the fool in the game is…  …it’s you.” The worst thing that can happen to you is that you get it right the first time and make a nice wad of money. There will be ups and downs in your stock-picking career after that, but you can be certain of one thing–sooner or later you’ll lose badly. It’s a rare person who can learn from a big loss that their initial luck was a fluke. Most people will keep betting, expecting the game to turn around. You know how that ends. I had a friend whose wife made some money in the stock market. He was impressed and encouraged her. Six months later their entire nest egg of about a million dollars and the kids college funds were gone. She had some losses, got panicked, and kept trying to “fix it” without him knowing. How would you like to explain that to your significant other?

Regression to the Mean–it’s a bitch.

The biggest problem with investing in individual stocks is the uncompensated risk. Any number of events can cause a single company to lose a great deal of value–the talented CEO dies, a drug doesn’t get FDA approval, etc.. Absent some kind of deep insider information, which would make it illegal to trade in the stock, the information about a company will be reflected in the cost of the stock–the market is quite efficient and transparent. Unexpected results can certainly happen, but the most likely outcome is that the increase in value of the stock will track the industry sector it fits. There are fewer events likely to stagger the entire industry, so there’s less risk in owning a little stock in every company in the sector. The underlying principle of diversification is getting the highest reward for the amount of risk you are willing to take. Individual stocks are not a plan, they’re a gamble.

The Market Timing Ratchet

Not only is it foolhardy to try to find individual stocks that are going to make you a lot of money, but it’s equally dangerous to try to buy the general market when it’s low and sell when it’s high. There is plenty of well-documented research and endless charts and graphs (Google all you like) that show the market as a whole grows in fits and starts, driven more by emotion and chaos than anything else. Even people who claim a great deal of market knowledge and understanding get the timing wrong. Generally that means they buy when stocks are going up and sell when they’re going down. Buying when it’s expensive and selling when it’s cheap is the surest way to make your portfolio evaporate, which LOTS of people do.

On either a stock-picking or timing basis the market is a zero-sum game–someone has to lose for you to gain. Why would you think that the wind will blow your way? Perhaps you’re counting on being the smartest, best informed, most decisive, fastest acting, most brilliant investor of the billion people investing. Or having someone who is willing to make you money who has all those attributes. Sorry, if they were that good, they’d be very careful to never tell anyone, and they’d be incredibly wealthy.  That’s not even Warren Buffet–he doesn’t claim to be that fictional character. And if you think it’s you, or that you have access to that talent, then I know who the fool in the game is.

So how do you win in a zero-sum game? The simplest strategy I’ve seen that makes sense to me is to own a little bit of the whole market and benefit from economic growth. In other words, buy the whole market–stocks, bonds, and alternatives, and then pray that economic growth happens. In essence, a strategy called Modern Portfolio Theory which we’ll cover a little later. There are other strategies that look interesting, I’m reading books and digging into websites. They look like a lot more work, but they might be a place to put part of your funds to hedge on the kind of disaster that 2009 delivered to investors. We’ll get to that eventually. Maybe.

That brings us to index investments, which are simply funds of stocks, bonds, or whatever that represent the majority of the value of a given segment. We’ll talk mostly about stock indexes since that’s the most familiar concept, but there are indexes for everything these days.

The notion of an index in this case has been broadened to be more than just all the stocks represented by a popular index, like the Dow, or Standard & Poor. They can include all the major stocks in a segment or geographic market. Buying them feels a lot less like gambling, since you’re betting on the performance of the entire sector represented. But since stocks represent a pretty substantial risk, and the market as a whole rises and falls somewhat in unison, you need other investments that aren’t strongly coupled to market fluctuation–ideally they’d hedge the market, fluctuating in the opposite direction to compensate, or at least not correlating strongly to stocks.

There are indexes for stocks, bonds, and alternative investments. Since the composition of the index fund is established by some algorithm or definition relative to the size or value of the companies comprising it, there’s not much for the fund manager to do. In fact the trade volumes and percentages can be largely automated. That means they can be low cost. But here’s a catch. There’s not going to be some magical gain that’s several times the gain of the general stock market. The recent gain of most index funds is somewhere around 4-5% per year.

The research that supports the theory that buying indexes is the prudent way to invest is substantial. Any broker or financial advisor that starts talking about academic theory of investment is talking about indexes and a concept called Modern Portfolio Theory (MPT), pure and simple. Unfortunately they leave out the crucial part of index investing–the costs need to be kept very low–and many will put you into managed funds that mirror indexes but are supposed to have some kind of secret sauce (like Matson Money, a company that just creates proprietary bundles of DFA funds (DFA is Dimensional Fund Advisors, a company that uses academic research to create index funds). They might cost as much as 2% per year on top of the 1.5% the advisor is charging you to manage your money. At 3-4% cost for a 4-5% gain plus taxes there isn’t anything good that’s going to happen to your money.

Here’s a simple way to find out if your financial adviser is working in your best interest. If they rattle on about index funds and academic investment, but the expense ratio of your funds is more than .5 percent, then there’s something amiss. If it’s more than 1 percent, then either you’re being sold out or your advisor is not very sharp. If it’s more than two percent they’re totally screwing you.

If you have been investing on your own, or most of your investments are through IRA or 401K contributions, you still need to look at the kind of “expense ratios” that the funds you invest in are charging. If you accept the fact that fund managers can’t beat the long term (or even mid term) performance of the market, then the kind of return an index fund provides is probably all you can expect. So what are you paying for? The average expense ratio of mutual funds is about .75 percent, but I suspect that number is fudged. The most popular mutual funds are the ones with strong historic performance, and from what I’ve seen they are a lot higher. You don’t need an advisor to get hosed, you can do it all on your own.

I hesitate to provide this link, because the writing style in NewsMax triggers my bullshit detector, and the “groundbreaking new research” mentioned is hardly new, but it’s right in the wheelhouse of what I’m writing about. The simple fact that the kind of compounded growth you count on to grow your retirement nest egg won’t happen if you give all the gain away in fees. Here’s the link, but keep your bullshit detector turned to eleven and don’t buy anything from these guys.

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The Retirement Trap Copyright © by Bill Babcock and Babcock, William. All Rights Reserved.

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