Funny story: about a two and half years back, my mother-in-law’s financial advisor suggested to her that she could edge up a point or two of interest income by investing some of her money in Puerto Rican municipal bonds. This was the late spring of 2006. In May of 2006, Puerto Rico went bankrupt, and its bonds were downgraded to Baa3 – effectively, one step above junk bonds. Interestingly, a look at Moody’s ratings suggests that PR bonds had been consistently downgraded in spring 2006. So it was not a shock that the slightly higher premium paid to PR bonds were due to risk of default. He just didn’t disclose that to my mother-in-law. She took a pass on the opportunity, by the way.
I didn’t say anything at the time, and I still don’t make a big deal out of it, because to do so would throw into question whether my mother-in-law can trust her financial advisor. But this person – who, incidentally, wins prizes for being one of the best financial advisors in the state of Hawaii – is a bad man. And his advice was, and is, morally reprehensible. Or rather, it’s not the man, it’s the structural position of being a financial advisor for a large financial services firm. Because I can guess what really happened back in 2006. His firm – Merril Lynch – owned a bunch of Puerto Rican municipal bonds, and a call went out to salespeople to offload these losers to their customers. PR munis have high tax-exempt status, which gives them a great selling point, especially when you can obfuscate the rest.
Why do I relate this story? Let me be as clear as possible: the interests of Wall Street are not your interests. Let me say it again: the interests of Wall Street are not your interests. The main interest of Wall Street is to use your bank account to enlarge their own. There are, quite simply, no exceptions to this rule, no nice guys who are different and have your interests at heart. Puerto Rican munis. Puerto-Rican-frickin-munis.
So what’s a person to do? Here’s what I think:
1) You can’t beat the market. Theoretical discussions of the Efficient Markets Hypothesis aside, you don’t have the technology, time, and tools to beat the market. Your cognitive biases and lack of experience make you likely to trade too much, to herd, to fail to take gains, and to fail to minimize losses. Believe this in your heart. You can beat the market like you can win at poker. Someone can win at poker, but it ain’t you.
1a) They have access that you don’t. The reason why investment banks and hedge funds can beat the market is less due to their brilliance – though they are sometimes brilliant – and more due to the availability of opportunities they have that you don’t. You’ve heard of private equity. Notice that this is not public equity. Private equity is the purchase, sale, investment in, privately held firms. My brother runs a legal loan sharking business. Investment in his business will yield you 15-20% returns. But you can’t get it. Investment banks have a better shot at getting stuff like this. It’s not the same as saying that they are better stock traders than you are.**
2) Fees kill. Buy a passively managed fund, because active funds = more involvement by a fund manager = more opportunity for you to get hosed by a moron with an MBA (or a PhD!). But even relatively passively managed funds have variation. These are two mutual funds, vanilla investment vehicles, both directed towards mimicking the broadest market:
JP Morgan’s Institutional US Equity Fund (JMUEX) has fees of .64% (1-year expenses of $56.65 on $10,000). And over the course of 10 years, for a minimum of $3M and $225,000 in fees. Their performance over 10 years was 3.42% compared with 3.06% for the S&P as a whole.
The Vanguard Total Stock Index fund (VTSMX) has fees of .19% (1-year expenses of $16.74 on $10,000). Over the course of 10 years, with a $3M investment – though their minimum is $3000 – you pay $70,000 in fees. Their performance over 10 years was 3.92% compared with 3.06% for the S&P as a whole.
And these are both passively managed index funds. A hedge fund can have fees of 2 and 20 – 2% of assets and 20% of gross profits (performance fee). Woot! When someone tells you ‘2 and 20 is standard’, point and laugh at them. Or write them a check. Or better yet, write me a check! When they offer to show you track records, ask that management fees and performance fees be included in a bar graph. Besides, none of their derivatives obligations are on the books, so you likely won’t really know how to interpret their track record anyhow.
2a) Transaction fees are fees. Your financial advisor wants to move money, since they make money when money moves. Repeat this over and over. Your financial advisor is not your friend. S/he is your adversary. S/he wants your money.
3) Stocks, bonds, cash. 40% bonds, 40% total US stock market, 20% international stock market. When stocks go down, bonds go up, and vice versa. By ‘bonds’ I mean ‘total bond market’ or ‘treasuries’ – not crazy-ass multi-tiered mortgage swaps. Think the dollar sucks? Berkshire Hathaway has been betting against the dollar for years, go ahead and buy a share of Class B – it’s like buying a slightly riskier mutual fund with high fees, run by Buffett (though he won’t live forever). Or buy a materials (i.e. gold) fund. Again, higher fees, more volatility. If you are more risk averse, 80% bonds, 15% stock market, 5% international. The point is, invest in lazy funds.
4) Stuff I don’t know but I know. It’s better to forgo 1-2% investment income and reduce spending by 1-2%. Less risky by a lot.
It is often good to own a house – we don’t but we live in NYC. I have no idea if this suggestion holds up under current housing market conditions.
Volatility means that randomness can be ascribed to real market movement, but that movement can also just be randomness. That is, check your portfolio once every month or two or six, not every day. If the volatility is making you crazy, move most of your money to cash or treasury bills. And get some sleep, I hear that it is more important that we think.
5) People versus positions. I know a number of people in financial services, and I’ve studied them as well. Wicked smart, not necessarily nice but certainly not moral reprobates. The problem is, the rules are tilted. It’s not about whether Steve, or Jenny, or Chet is trying to steal from you. But it is a system that benefits you and benefits financial firms more. There was a time in history when I would defend high finance; I might still. But it seems ripe for a New Deal-type re-visioning.
**When my uncle went to college, my grandmother sent him an allowance for food, clothing, books, spending money. She arrived at a figure by asking his roommate’s mother if she sent an allowance, and if so, how much. She matched that figure. Of course, the roommate’s mother sent the allowance, and also paid for food, clothing, books. Even with a job, my uncle went through school relatively poor, and with my grandma’s unshakable belief that since he never had enough cash, he must have been spending it all on drugs. Investment banks are like the roommate – they may look like you, but they have resources behind the scenes that you don’t have.