3 Pieces of Investing Advice from AWM

1. There is always a correlation between risk and return - a high expected return always means that there is a greater possibility of a loss.
Generally, when you hear of an investment return that is better than yours it is because that investment is riskier. Never compare your returns in a vacuum.
So, the next time your neighbor is bragging about some great investment return, ask them if they know the amount of risk they are taking. In fact, ask them if the return relative to the risk is efficient.
I often have people show me a "great" return, but when evaluated relative to the risk it is not that great.
An investors return should only be compared to the risk they are taking.

2. Portfolios are commodities. That means most advisers, banks, mutual fund families, brokers who recommend a certain allocation are all very similar. That is because they are all using similar software - "Portfolio optimization" software which allows somebody to enter into a computer the historic risk/return statistics of different stock/bond classes and find what combination gave the best risk/return outcome. Outcomes differ a little based on the data entered, but generally the Principle's 60% stock portfolio is similar to the Merrill Lynch 60% which is similar to the Smith Barney 60% etc.
I have created my own portfolios and my 60% is close to everyone else's.
which leads to point 3.

3. What are you paying? Especially if the adviser is charging you fee's of 1%. Calculate the hourly rate on 1%. If you have a retirement portfolio of $500,000 and some adviser is charging 1% (a common fee),  that is $5,000/year. If that adviser spends 10 hours/year really focusing on your portfolio you are paying $500/hour. Nice. Even nicer when all the academic evidence says that your adviser has almost no chance to outperform an index portfolio over time. If they do outperform whatever benchmark, then they either are lucky or taking more risk than the benchmark.

An adviser should:

1. Know what your investment needs are and what your tolerance for risk is.
2. Help you allocate into a suitable portfolio.
3. Help minimize your costs.
4. Hold your hand and keep you from doing irrational things when the markets are bad.

"The Big Investment Lie"

This is a blog post copied from one of my favorite blogs: 

http://whitecoatinvestor.com/

Don’t Invest in Hedge Funds (until you’ve read this book)

Posted on February 1, 2012 by White Coat Investor

Michael Edesess’s book The Big Investment Lie is now 5 years old.  I’m afraid that far too few investors have read it.  At this time of so much discontent with Wall Street, it’s time to pull it down off the shelf for another look.  Mr. Edesess provides an insider’s look at Wall Street and its huge disconnect with Main Street.  With a brand-new PhD  in mathematics in hand, he was hired by a brokerage firm.  Due to this degree, he was able to rub shoulders with the financial academics and see the evidence of what worked in finance and what didn’t first hand. Then, he realized The Big Investment Lie.  Here’s his explanation:

    Within a few short months I realized something was askew.  The academic findings were clear and undeniable, but the firm–and the whole industry–paid no real attention to them.  It was as if theoretical physicists knew the laws of thermodynamics, but engineers spent their time trying to construct perpetual motion machines–and were paid very handsomely for it….The message of this book is not new.  It has been written many times before–though, it seems, not forcefully enough.  If the book is imbued with a sense of outrage, it is because nothing else has worked.  The lie perpetrated by the investment world to sell its services at exorbitantly high prices still works all too well.

So, what is the lie?  It is this:

Most professional investment help, no matter how seemingly respectable, is in truth hazardous to your financial health.

Michael Edesess

He then divides the book into three appropriately titled sections- How Much You Pay, How Little You Get, and How You Are Sold.  He goes far above and beyond even Jack Bogle’s criticisms of the industry.  You see the usual skewering of active mutual fund managers, but you also get well-written chapters on hedge funds, derivatives, business ethics, and on how institutional investors get fooled too.  He also gets in to behavior finance and discusses how investors delude themselves with “The Lie”.

The discussion of hedge funds throughout the book is particularly good.  I quote again:

Now we come at last to the crowning achievement of the fee-charging business, the piece de resistance, the masters of the fee-charging universe-hedge funds….In 2004, those fees totaled $70 billion on an estimated $1 trillion in hedge fund assets–an average fee rate of 7 percent.  While not all hedge funds have large ups and downs, the ones that acquire the big names, essentially carrying the whole hedge fund business in the public mystique, do experience large ups and downs.  They get famous for the ups and draw huge amounts of investment capital and then are usually not noticed so much for the downs.  But the hedge fund managers make out very well on them.

Where are the investors’ yachts?  Indeed, where are the investors’ flotillas?  Hedge fund management is not just a license to steal; it is a license to steal literally billions.  The hedge fund management business has created more billionaires than you can shake a stick at.  In 2004, according to Alpha magazine, a magazine published by Institutional Investor, the average cash take-home pay for each of the top twenty-five hedge fund managers was $251 million.  Yes, you read that right.  It doesn’t take long to become a billionaire at that rate.  And where does the money come from?  It comes literally straight out of the investors’ accounts.

He does a great analysis of perhaps the best known hedge fund manager, George Soros.  His Quantum Fund grew from $6 Million in 1969 to $5.5 Billion in 1999 when he closed it.  Much of that, of course, is new capital contributed by investors seeking great returns.  So how much did Soros get for that work?  His personal fortune was estimated at $7.2 billion, not including the $4 billion he’s given away.  So $11 Billion for the manager on a fund that was only $5 Billion at its largest!  Keep in mind there are 10,000 other hedge funds out there that have come and gone.  If this is how the most well-known/successful hedge fund did, how are the unlucky ones doing?

This book makes Jack Bogle’s tirades against Wall Street seem tame by comparison.  But if you enjoyed Bogle’s revelations from the inside of the industry, you’ll love The Big Investment Lie.  He concludes the book with the Ten New Commandments for Smart Investing, which shouldn’t be big news to regular followers of this blog:

Ten New Commandments for Smart Investing

1. Follow a wealth-building strategy, not a gambling strategy.
2. Stop searching for the Holy Grail: Give up the futile quest to beat the market
3. Stop believing that past investment performance predicts future performance
4. Don’t be duped by the false claims of investment managers and advisors
5. Fire managers and advisors who charge more than barebones fees
6. Don’t pay anyone to pick stocks for you; There’s no reward for the cost and risk
7. Avoid hedge funds like the plague
8. Know the risks of investing; Take only the risk you are comfortable with
9. Keep fees and taxes as low as possible; They can swamp your investment returns
10. Invest only in true low-cost index funds

There you have it, straight from the horse’s mouth.  If you’d like to read more, pick up a copy of The Big Investment Lie at Amazon or your local library