Investment BS
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Edward Nevraumont
Back in 2016, my friend shared a message from his investment advisor: “your investments are up +14% year-to-date. That’s pretty amazing given the market as a whole is down -11%.” My friend was very impressed with his advisor. “Even better,” he told me, “I don’t pay any fees to him at all. It’s free!”
Everything my friend understood about his finances was wrong.
His advisor was NOT any better than the other advisors out there.
And his advisor certainly wasn’t free.
The financial advisement industry exists to do three things:
Confuse consumers so they feel a need for the advisement industry
“Hold their customers’ hand,” by making clients feel comfortable keeping their investments when the market drops
Sell, sell, sell — build up a roster of customers willing to invest money and pay fees
Notice that none of those things involve actually making money for their clients.
Of the many finance blogs on the internet, the one run by the Collaborative Fund is particularly insightful (and entertaining, too). They once published a list of their “Money Rules.” My two favorites were #9 and #10:
9. Some good advice is simple but made complicated because professionals can’t charge fees for simple stuff.
10. The fact that you can’t charge fees for it is part of what makes it good advice.
To understand why those rules ring true, we can look at them in two different ways: analytically and hypothetically.
Analytically, the research on one investment point is very clear: when money managers beat the market, it is a random phenomenon. Yes, you can find money managers whose returns surpass the market for multiple years in a row, but you can’t predict who those advisors will be beforehand. About half of all advisors will beat the market in any given year, but who those advisors are is impossible to guess. If we calculate the probabilities, 25% of managers will beat the market two years in a row, 12.5% three years in a row, and a mere 0.1% will beat the market 10 years in a row. Those one-in-one-thousand managers that beat the market 10 years in a row might look like financial geniuses, but they are just the lucky ones. If you invest with one of them, there is still only a 50% chance that she or he beats the market the following year.
So even if there IS skill in an investment advisor, it doesn’t really matter — the only data you have on who WAS good and bad doesn’t predict who WILL be good or bad next year. (There is actually a small exception to this. The managers at the very bottom of the performance pool — say the bottom 10% in any given year — are more likely to stay in the bottom 10% than chance would predict. That poor track record, however, isn’t just the managers’ incompetence at picking stocks, but is instead a result of trading more frequently than everyone else — eroding their returns with higher transaction fees, etc.).
The other way to consider the Collaborative Fund’s two ideas is hypothetically. Suppose there really was an investment advisor who consistently beat the market well beyond the level of chance — why would she or he be working with you? The ability to beat the market consistently is an extremely rare skill. Most hedge funds don’t do it. Gigantic funds and trusts — like Harvard’s $38B endowment — allocate significant resources to beat the market. One of those massive firms would quickly scoop up a brilliant person who ensured perennial above-market success — enabling the person to earn vast personal wealth from the management of billion-dollar portfolios. Faced with that opportunity, why would that genius be working with you to invest your $100K or $1MM or even $10MM?
In the conversation about my friend’s financial advisor, I tried to explain the analytical and hypothetical arguments. Nevertheless, my friend continued pointing to the +14% return as evidence of the advisor’s quality. When it comes to life experiences, people regularly ignore contributing factors; instead, humans tend to identify the value, skill, and intention in good outcomes (and lack thereof when the outcome is bad).
My friend also highlighted the fact that his advisor wasn’t charging him the 2% fees I mentioned as fairly common. Without question, the fees are insidious.
“Obviously,” I explained to him, “your advisor is not working for free.” My friend is a bright person and understood that fact; he knew that his advisor was getting kickbacks from the mutual funds he was buying. “But,” he countered, “the mutual fund fees would be the same with or without the advisor. So those fees are just a cost for the mutual funds, not a cost for me.”
“That’s even worse!” I told him. “It means the advisor’s real incentive isn’t to make you money — it’s to sign you up to the mutual funds with the largest kickbacks. And those funds are likely also the funds with the largest fees.”
In essence:
YES, my friend would be paying the same fees if he invested on his own.
BUT, if he was (smartly) investing on his own, he should avoid those mutual funds like the plague.
“So what’s the answer?” my friend asked me. “What should I be doing with my money?”
Here’s my answer to him (and to you). The strategy is actually very easy, which is why the industry needs to spend so much time making it confusing.
Invest in investment vehicles with very low fees. Vanguard Index Funds is one example. Your costs should be on the order of 0.1% of your investment, not 1%. Also: don’t buy and sell anything that causes you to pay transaction fees (which it usually does).
Diversify. Spread your money out as widely as you can, across as many asset classes and geographic regions as possible. Ideally you should allocate your money the same way the global economy is structured. For instance, if the US is 10% of the global economy, you should put 10% of your investments in the US. Diversification provides the best return for any given level of risk.
Find tax advantageous strategies. Max out your 401K or your IRA or any other vehicle the government gives you (education and health in many states). When you hit the highest tax bracket for any reason, sell for capital losses to reduce your tax obligation (but hold capital gains to delay required payments).
That’s it. You can now guarantee yourself a better return on average than any advisor on the planet. If you are really concerned about your fortitude to do the right thing, pay someone $1000 per year to call you whenever the market drops, just to remind you not to sell.
If even the three steps above seem like too much work (and to be fair, diversifying properly and maximizing tax advantages can sometimes be a little difficult), you can use a service like Wealthfront or Betterment (or WealthSimple for Canadians). These firms charge very low fees to handle the diversification (and sometimes tax harvesting) for you.
It turns out personal finance is even easier than marketing.
Keep it simple,
Edward
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Edward Nevraumont is a Senior Advisor with Warburg Pincus. The former CMO of General Assembly and A Place for Mom, Edward previously worked at Expedia and McKinsey & Company. For more information, including details about his latest book, check out Marketing BS.