If you are wealthy, on your way to becoming wealthy, or working hard to accumulate net worth – you may have sought investment advice at some point. Not because investment success is difficult, but because doing it well is time-consuming; it requires knowledge of finance and accounting; and because the future is uncertain.
The investment advice industry has many different types of firms: stockbrokers, trust companies, fund of funds, family offices, private client groups, consultants, insurance agents, financial planners, wealth managers, independent advisers – just to name a few. Their pitches are all different and it’s difficult to determine who is right. Despite there being many bright and caring people in the advice-giving industry, the competitiveness and incentives can cause actions and reactions that do not always favor clients. It is important to be aware of them.
Investing is about making money and minimizing the risk of a permanent loss. Period. It is not done to beat a benchmark, to avoid taxes, to minimize costs, or to express a political belief. This is not to say that costs, taxes and being a good citizen aren’t important. They are. But the purpose of making an investment is to grow your net worth and improve your standard of living. That’s it. Yet the investment advice industry makes it about something else.
To distract you from the true purpose of investing, to deflect accountability, and to avoid hard work … the investment advice industry commits one or more of the following seven sins:
1) GIVES CONFLICTED ADVICE, OR ADVICE FOR SALES PURPOSES – Stockbrokers, insurance agents, and private client groups represent companies that are not required to put your interests first. They get paid for placement…in other words, they are paid to raise money. The advice they give may be terrible for you, but it may sound good. These advice-givers often do not highlight that they are allowed to act in their own interests first. They let you figure that out by giving you a prospectus written in legalese.
2) OVERDIVERSIFICATION – Your adviser may give you a little bit of everything, so as to never be too wrong. Often, it will invest you in funds with various strategies, or recommend so-called “best of breed” managers. This means that it will invest you in various actively managed strategies through investment “products,” i.e., hedge funds, managed futures, or separately managed accounts. Some will be fine, and some will not. In the end you get an average-to-poor return.
“Best of breed” means a third-party consultant was hired to figure out who is the “best” within a certain style. The purpose of hiring a third party is to deflect responsibility for choosing bad managers (blame the consultant). The consultants torture statistics on a manager’s past returns (even though past returns do not predict future returns) to try to figure out the “best”. But these predictions don’t work: Janus Funds was a “best of breed” manager in 1999-2000, which did not help its investors for the next 10 years.
3) CONVINCING YOU THAT IT HAS A BETTER MOUSETRAP – Some providers in the advice industry will try to convince you that they have investment markets figured out or a superior process. Or they have access to something special and rare. They don’t. The only thing that is rare is the hard work of properly vetting a prospective investment on its merits – reading the disclosures, figuring out the economics of the issuing business, looking into risks, estimating a value of the stock, making a decision, and being patient. Ninety-nine percent of investors do not do this.
4) CLOSET BENCHMARKING OR, EVEN WORSE, TRYING TO BEAT A BENCHMARK – Closet benchmarking is done to never “underperform.” It means the adviser will buy stocks similar to some benchmark (such as the S&P 500) so that it performs similarly. The problem with hiring an adviser that closet benchmarks is that the benchmark return is available for free. It makes no sense to pay an investment adviser 1.0% per year unless it is performing many other services such as tracking a financial plan, vetting private equity deals, paying bills, preparing taxes, advising on your estate, etc.
A bigger problem with an adviser that closet benchmarks is that there are times, such as the present, when indexes are not a truly diversified portfolio. And you don’t want to track it. The S&P 500 currently has 20% of its return driven by the top 5 positions, and 60% of its return comes from the top 50 companies. And even more important, indexes can sometimes be wildly expensive, such as today. When you adjust the S&P 500’s P/E ratio by market-cap weighting the earnings number instead of using a simple average (as widely quoted sources use), you see that it now trades at 29X forward earnings. You probably want nothing to do with the S&P 500 right now for long term positioning.
Even worse than an investment adviser that closet benchmarks is one that actively tries to beat a benchmark. This reflects a poor investment process; way too much risk (adviser not paying attention to downside) and a self-serving intent. Self-serving because beating a benchmark brings in assets.
5) CHASING POPULAR INVESTMENTS – This is done to leverage people’s fear of missing out. Many advisers simply invest in what is “working” and what is popular because it is easy to do and attracts assets. But this is not an investment process at all. It is super-important for you to know that most advisers believe that it is OK to be wrong with the crowd, but not OK to be wrong alone. Being wrong alone gets you fired, and investment advice businesses never want to lose clients. So, many own the same popular stocks until they stop “working.” Then they all exit at the same time, and if there are very few buyers at that point, huge price declines can happen.
What is popular makes for a good story and appeals to your sense of wanting. Everybody wants to be with a winning team. But the problem with this is that these investors are unknowingly taking on much risk of a permanent loss of capital because “popular” generally means overvalued. Investments come in two types: expensive/popular investments that have had good news, and cheap/unpopular investments that have had bad news. For a long-term investor, buying expensive stocks is a recipe for disaster. The best investments are the cheap ones, where you have a well-performing business that has hit a rough patch that will not last forever. The most money is made when situations are less bad than everybody’s already-pessimistic view, rather than in expensive stocks where things are even better than an already-optimistic view. There is significantly less risk to invest this way.
6) INCOMPETENCE – While there are plenty of competent people in the advice industry, the business also has its share of ineptitude: People with little (or inappropriate) experience, and/or the background to understand financial statements and prospectuses. Their job is simply to represent the interests of their brokerage or insurance company employers.
To minimize the risk of dealing with incompetents, hire people as though you would hire them for your high-stakes family business. Look for education, professional credentials, appropriate experience, reputation, advocacy and a conservative approach. Check their record and history. Ask them questions and be careful. Work with those that operate as fiduciaries and are independent. Your advisory relationship should be long-lived and your adviser should be your advocate, not a salesperson. On the credential front, there are literally hundreds. The only one I trust is the CFA (Chartered Financial Analyst) credential because of its rigor, breadth of knowledge, advocacy, and code of ethics. People with securities representative licenses (Series 6,7, 66, etc.) or insurance licenses will not help you.
7) OVERCHARGING – Many advice-giving businesses make it extremely difficult to figure out the amount of fees you pay them. Often, they are embedded in the “products” in which you are invested. Or there are multiple layers in the case of funds of funds, or with wealth managers. I have seen variable annuities that charge 5% - 6% per annum where the client had no idea because it wasn’t disclosed by their “adviser” and they didn’t know where to look. Closet benchmarkers overcharge by definition because a benchmark return is free. Overcharging can also come in other forms: What is the cost of receiving conflicted advice, for example, given for the purposes of a sale? Costs don’t just come in the form of dollars.
So, what to do?
Be aware of the five big wealth destroyers: 1) Inflation; 2) Taxes; 3) Misbehavior; 4) Malinvestment; and 5) Theft or catastrophic loss. One can easily minimize these, so why do so many people instead fixate on “beating the S&P” or chasing the latest fad or trend – to their peril? Answer: Because the advice industry encourages it and enables it.
Inflation risk can be minimized with inflation hedges. Taxes can be minimized with low trading. Misbehavior involves paying excessive fees, overtrading, market-timing or overspending – don’t do those things. Malinvestments means chasing returns, overpaying for stock, taking on bankruptcy risk and not being thorough in your investment process – don’t do those things either. Theft or catastrophic loss can be avoided with security protocols and insurance.
If you don’t have the time or inclination to manage these things yourself, consider hiring an independent adviser that operates as a fiduciary. Ideally its staff has CFA credentials, the decisions are made by someone with at least 20 years of experience (has managed through 2008), and it charges low fees. On the investment side, it doesn’t chase popular stocks, doesn’t trade much, knows your situation, ignores benchmarks and cares only about earning high average returns with low risk of permanent losses. Ideally, it’s a firm that allows you to speak with a decision-maker, and it doesn’t have too many clients that drain the firm’s resources.
The investment advice industry exists mostly to deliver what it thinks will sell well. It does a poor job delivering sound advice. It appeals to you through storytelling, schmoozing, and promises of status and security. But none of these things deliver to you the goal of investing. What is under the hood, the culture and incentives of the firm you work with and how it invests are what matter most.
Advisers that earn the highest average returns do so by being down less in down markets, rather than by being up more in up markets. This is why over the long run, those that focus on value have much higher risk-adjusted returns. Hopefully, knowing this, as well as how the advice industry operates, will equip you to find the right adviser, take the stress out of investing, and give you a superior experience.