Question: Do you believe it’s important to diversify a portfolio? Of those who have advisors, 94 percent said yes; of DIY investors, only 22 percent answered yes.
That alarms me. It tells me that many investors are more interested in having easy investments than safe investments.
Apparently, advisors are teaching clients valuable lessons, including the value of diversification.
Investing may seem simple: Buy low, sell high. What else do you need to know? Plenty, actually. Tax implications, asset allocation and risk analysis are all essential ingredients. Yet it is very rare for me to encounter an investor who understands them and can properly apply them.
I believe that most investors need investment advisors. Unfortunately, of those who recognize this, far too many wind up with brokers. Brokers often call themselves advisors, hoping for respectability that they might not have if they were known as securities salespersons.
If you learn only one thing from this article, let it be this: Brokers are not advisors, any more than car salespeople are transportation consultants. Brokers are salespeople.
Brokers are trained, motivated and evaluated as salespeople. Ultimately they keep or lose their jobs entirely by their own performance in meeting sales targets and bringing in revenue. If their clients do well, or if their clients do poorly, that is essentially irrelevant from a business perspective.
A major West Coast brokerage house combed through its clients’ investment records over a 10-year period and found that investors who took the advice of the firm’s brokers wound up with lower returns than if they had invested in certificates of deposit!
You won’t be surprised to know that this study, conducted over a period that was mostly a bull market, was never released to the public. (I learned of it from a friend who was an executive of that firm.)
Just as brokers are not advisors, neither are they analysts. Relatively few brokers are trained to analyze securities or economics. They are trained to pass tests required for licensing, and then to meet sales objectives.
It’s not that brokers are bad people. Usually they’re easy to like and eager to please. But brokers work under pressures that make it very hard to put their clients’ interests first.
Like individual investors, brokers tend to over-estimate their own abilities. Every so often a study is done that shows a large majority of investors believe they will outperform the markets. In reality, only a small minority do so over any length of time. (Take a second look at the answers to the first question on Page 1. Can nearly everybody beat the market?)
If all these pressures weren’t enough, every broker has a sales manager breathing down his or her neck. The sales manager’s message: Produce. (That doesn’t mean produce gains for clients; it means produce sales.)
Some brokers understand the markets quite well. But many have only superficial knowledge. Next time you talk to a broker, ask for an explanation of R-square (a statistic that tells how closely any investment typically follows some reference, often the Standard & Poor's 500 Index) or standard deviation (a statistical measure of risk).
These are things that every DIY investor needs to know. But investors aren’t likely to learn about them from brokers.
Unfortunately, most of the DIY investors who recognize that they need help wind up working with brokers who are motivated to tell clients whatever the brokers think those clients want to hear. And brokers know that hope and optimism are much more popular than patience, moderation and caution.
Here’s a true story: Last year we began working for a new client who split his money half and half. We got to manage $1 million, and he placed an equal amount with a well-known national advisor whose name is familiar to many investors. (We’re not naming names here because the point of this story is about common practices, not just this particular advisor.)
This client was just entering retirement and had a relatively low tolerance for risk. We concluded – and he agreed – that his primary need was to preserve his capital instead of trying to make it grow. Our prescription: moderate growth from a buy-and-hold portfolio of Dimensional Fund Advisors funds, half in equities, half in bonds.
The other advisor, for whatever reasons, had a different prescription: aggressive growth through individual stocks.
By the end of 2002, this new retiree had lost about 30 percent of the $1 million he invested in stocks. While he didn’t make money in the DFA portfolio we manage for him, his losses last year were less than 2 percent.
When we reviewed these results with our client in January, he told us the other advisor was predicting a 40 percent upturn in the stock market this year, urging clients not to abandon their stocks.
We got a chance to look at the 30-page market forecast that this advisor sent to our client. “We expect a stunning 2003 … one of the best years ever for equity investors,” the report said on its first page.
The report elaborated by saying this advisory firm thinks the evidence “points to the prospect of a coming massive wall of increased securities demand” to be created “as global central banks bolster expansionary monetary policy” while inflation remains in check.
Even if this advisor’s wildly enthusiastic forecast were right and this client’s stocks participated fully in a 40 percent rally, look where he’d be at the end of 2003: still down 2 percent. ($1 million that loses 30 percent turns into $700,000. When that gains by 40 percent, it grows to $980,000.)
For comparison’s sake, assume the equity part of his DFA portfolio participated in a 40 percent rally while the fixed-income side just broke even. The client’s initial $1 million would be up 17.6 percent to nearly $1.18 million.
With a much more likely 10 percent stock market gain this year, his stock portfolio would be worth $770,000 and his DFA portfolio would be worth $1.03 million.
A less likely scenario, but still quite possible, would be a repeat of last year: He loses 30 percent in his stock portfolio and 2 percent in his DFA funds. Result: His stocks are worth $490,000 (requiring a gain of more than 100 percent to break even) and his DFA funds are worth $960,400.
Lesson #1: Hope and optimism are very different from real results.
Lesson #2: Be careful how you choose an advisor.
It’s easy to find someone you are comfortable with. But when your money and your financial future are at stake, there are things much more important than comfort.
Most important, find somebody who does not have a conflict of interest with you. You want an advisor who has no financial incentive to put you into some specific investment in order to make a commission, please the boss or win a “top producer” award that comes with a free cruise or a week in Hawaii.
You want an advisor who is free to conclude, if it’s true, that the best place for your money is in a money-market fund or Treasury bills. Any commissioned salesperson who regularly did such a thing would soon be out of a job.
And look for an advisor who’s able and eager to talk to you about risk, and how much of it you should take on.
At its core, investing is about taking calculated, smart risks. If you manage your risks and manage your emotions, the rest will take care of itself. Look for somebody who understands that and who will help you manage those things.
Finally, next time you are tempted by optimistic predictions and feel desperate about making money in the market, remember the fable of the tortoise and the hare. The hare will win some short races. But as our client’s $700,000 stock portfolio demonstrates, the hare may also spend quite a bit of time exhausted on the sidelines.
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