Investment is Easy

Last night a friend told me how his investment advisor called him up to tell him his investments were up +14% year-to-date. That’s pretty amazing given the market as a whole is down -11%. He was understandably very impressed with his advisor. “Even better,” he told me, “I don’t pay any fees to him at all. It’s free!”

Everything he understood about what was happening with 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 they need the advisement industry
  • “Hold your customer’s hand” – Make people feel comfortable so they don’t pull their money out of the market when it drops
  • Sell sell sell – build up a book of business of customers who are willing to invest their money and pay their fees

Notice none of those things involve actually making money for their clients.

To understand why we can look at it in two different ways: Analytically and hypothetically.

 

Analytically the data is very clear that when money managers beat the market it is random. Yes you can find money managers that beat the market multiple years in a row, but you can’t predict who those advisors will be beforehand. About half of the advisors will beat the market in any given year, but who those advisors are is random. So 25% will beat the market two years in a row, 12.5% three years in a row, and 0.1% will beat the market 10 years in a row. Those one-in-one-thousand 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 those guys there is still only a 50% chance he beats the market next year (one in two thousand beat the market 11 years in a row).

So even if there IS skill in an investment advisor it doesn’t matter. Because the only data you have on who is good and bad doesn’t predict who will be good or bad next year.

(There is actually a small exception to this. The guys at the very bottom of the performance pool – the guys in the bottom 10% in any given year, are more likely to stay in the bottom 10% than chance would predict. But even for those guys it’s not because they are worse at picking stocks. It’s just that they trade more frequently than everyone else so their performance drops due to transaction fees.)

 

The other way to think about it is hypothetically. If there really was an investment advisor who was able to consistently beat the market well beyond the level of chance – why would he be working with you? The ability to beat the market consistently is an extremely rare skill. Most hedge funds don’t do it. Pension funds and trusts like Harvard’s are doing everything they can to beat the market. If there was someone who could do that, they could take a role with one of those companies in a second and be paid a small share of the billions of dollars those funds invest. Why would that genius be working with you to invest your $100K or $1MM or $10MM?

 

I tried to explain this to my friend but we was still pointing to the +14%. It doesn’t matter what the input is, it is very difficult for humans not to see value, skill and intention in good outputs (and lack thereof when the output is bad). He also pointed out that it didn’t cost him the 2% in fees number I was throwing around.

The fees are insidious. “Obviously,” I explained to him, “your advisor is not working for free.”

He said he understood that. He knew his advisor was getting kickbacks from the mutual funds he was buying. “But,” he said, “The mutual fund fees would be the same with or without the advisor. So it’s just a cost for the mutual funds, not a cost for me.”

That’s even worse I told him. It means the advisors real incentive isn’t to make you money. The advisors incentive is to sign you up to mutual funds with the largest kickbacks. And those funds are likely also the funds with the largest fees. So he would be paying the same fees if he was investing on his own, but if he was investing smart on his own he would be avoiding those mutual funds like the plague.

 

“So what’s the answer?” He asked me, “What should I be doing with my money?”

 

Here’s my answer to him (and to you). It’s actually very easy, which is why the industry needs to spend so much time making it confusing.

 

  1. 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 included here: Don’t buy and sell stuff if it causes you to pay transaction fees (which it usually does)
  2. Diversify. Spread your money out as widely as you can across as many asset classes and geographies as you can. Ideally you spread your money the same way the global economy is spread (If the US is 10% of the global economy, you should put 10% of your investments in the US).This gets you the best return for any given level of risk.
  3. 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 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). They charge very low fees to handle the diversification (and sometimes tax harvesting) for you.

It turns out personal finance is even easier than marketing.

 

The returns made by investment advisors are an example of how easy it is to identify “good enough” but how it is impossible to identify in advance “excellence”. This pattern repeats itself in many many fields – not just investment advisors. It is the thesis of the book I am writing. To read more about “Good Enough” check out this teaser, and then sign-up to get weekly emails with new unique not-seen-on-the-blog content here.

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