A Tale of Two Investors: A Moral You Should Heed

Falling markets don't tell the whole story. You need to understand the real world consequences of the way you invest. Otherwise, you are bound to repeat the problem. The only change will be the name of culprits.

Here is the tale of two investors. Both are true. The names have been changed to protect their privacy.

Fred is the only child of immigrants who came to this country with no money and a strong work ethic. He built up his business through twenty years of hard work and sold it to a large corporation. He is in his mid-forties. When he cashed the last check from the buyer, he retired, secure in the knowledge that he would never have to work again.

Fred had no need to take risks. His business was eagerly solicited by all the large firms. He was wined and dined, given tickets to sports events, trips in private jets, and generally treated like a rock star. He settled on one well known firm. The broker there became his new best friend, attentive to his every need.

On their advice, he invested a portion of his portfolio in Auction Rate securities. He was told they were "as good as cash."

One of these bonds recently defaulted. Fred called his broker and asked the firm to buy back the bond. In that instant, the relationship with his former "friend" changed dramatically. The broker told him that he was a wealthy and sophisticated investor who knew exactly what he was buying and that "hell would freeze over" before the firm would take him out of his position.

He retained counsel who made a demand on the firm and filed complaints with regulatory authorities.

A cold wave must have hit hell because the firm caved.

Fred pulled his account.

Bill and Marianne are wealthier than Fred. They sold their real estate business for over $100 million. They invested with another well known broker. They thought they were in a conservative portfolio. They lost over $40 million in the last year.

An examination of their portfolios indicated excessive trading (called "churning"), risky securities and an asset allocation inconsistent with their investment objectives.

They hired a firm that specializes in securities arbitrations. The firm suggested mediation, which is a process in which an independent expert attempts to settle cases.

At the mediation, the law firm representing the broker pulled out a copy of a study on mandatory arbitration which I co-authored. The firm correctly noted that our study demonstrated that investors in these arbitrations are unlikely to recover any meaningful portion of their losses. The industry has basically gamed the system against investors. The firm offered to settle for pennies on the dollar.

The lawyer for Bill and Marianne told them the data in our study was consistent with his experiences. He also advised them that brokers know that wealthy investors are unlikely to have any effective redress so they are "fair game."

Bill and Marianne rejected the settlement offer and decided to proceed with arbitration. I don't like their chances.

Here's the moral, in case you have not already gleaned it:

Rich or not-so-rich, the securities industry views you as sheep waiting to be shorn. The industry is premised on a demonstrably false set of assumptions. They cannot pick stocks or mutual funds that will outperform their benchmarks over the long term. Investors who use them are likely to underperform those who don't, according to many independent studies.

This system, relied upon by most investors, is geared to separate them from their money, and not to build their wealth.

Investors need to fundamentally change the way they invest and to think differently about the information they rely on to make investment decisions.

Your broker may be a "great guy" (or woman), but his agenda is in direct conflict with yours.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.

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Comments

[torrrep]

This mentality of "money for nothing" that this society has embraced over the last few decades is exactly why this country is falling apart. Why would someone who worked so hard to make $100 million dollars throw it away by trusting a stranger? Did they not realize that simply placing the money in a low bearing savings account paying 3% annually would make them 3 million per year? They could have lived off the interest for the rest of their lives and never touched the original balance. Greed is what destroys us. Not just the rich, who invest poorly. But also the poor who think it is ok to "buy now and pay later". You don't have to be rich to be responsible. Go to school. Get an education. Get a good job. Save your money. Then start a family. Too many people try to it backwards. And they wonder why they can't succeed. And they expect government to solve all of their problems. It's common sense people. Really, it is. Unfortunately most people these days don't have any.

[robinhood2]

People who know little or nothing about the securities markets have no business investing in stocks or long term bonds, directly or through mutual funds. They should stick to FDIC insured CDs or short term US Treasury bonds. October 2008 will probably go down in history as one of the stock market's worst months on record. It is a time when even knowledgeable investors are experiencing significant losses. Investors who thought they were reducing their risk and improving their returns by investing in international stocks or funds are finding that this strategy is not working in 2008. Vanguard's Total International Stock Index Fund is down over 44% through yesterday (Oct. 21). Its 500 Index fund is down over 34%. Funds bought through brokers with loads or high annual fees have done even worse. The Legg Mason Value Trust is down over 49%. While the S&P/Toronto Stock Exchange Composite Index has outperformed the Dow Jones Index year to date, the decline in the C$ has more than offset the stock gain. Nearly 19 years after the Tokyo Stock Exchange's Nikkie 225 peaked out at close to 39,000, it remains down over 77%. Bear markets can last a long time. One of the best performing asset classes in 2008 has probably been short term US Treasury bonds. But how many brokers would recommend them? You can buy them commission free at Treasury auctions. There's no money in that for brokers.

[francoise]

What I don't get in this story is that Fred, Bill, and Marianne, made money with their real concrete business or real estate.

Then when they get the cash, earned thanks to work, they decide to make money out of money, which is not their job to begin with.

Then they trust a complete stranger who can't obviously be as careful as they could be. After all, it's not even his money, and they're not family.

It's like asking a stranger to gamble in Vegas with your money.

How could these otherwise reasonable people behave in such an irrational manner ?

[johnsopinion]

The "Wall Street Casino's" are open for business and awaiting
your call.

(ever hear the phrase "the odds are stacked in favor of the house?"
That's why casino's stay in business.)

It's really that simple.

Really.

[ReasonIsMyReligion]

Churn, baby, churn....
Disco inferno.
etc.

The boogie nights are over, if indeed they were ever really here; time to let the Nobel laureates be your guide.

[nclwtk]

You cant be a sheep ready to be shorn if you refuse to act like a sheep. People who in thier other lives would never let any detail go by without scrutinizing it, seem so calm about allowing supposed experts to fool around with their money. Really, if you feel insecure about your knowledge of how to invest there are far better ways than losing it to get an education. The more sophisticated the product is not necessary a better product, the less you understand how you are invested the more likely you are to lose money. Most important is that one should have an early warning system in place to indicate when things are going bad, and that is not your monthly statement. Brokers should have to earn their money keeping you informed and educating you as to the risk reward tradeoffs you are making.

[nezumi]

Because of the herding instinct (my neighbor has this great broker that made millions for him in no time) and greed (I also want to make millions in no time), this advice, as sound as it is, is always unheaded in boom times. Only when the &%$ finally hits the fan, suddenly it sounds ingenious.

I tried to warn my friends and relatives, twice (this and the dotcom bubble). Now they are complaining but they would commit exactly the same mistake again the next time, if they have any money left.

So, this advice is not ingenious. Realizing that 99% of the people cannot deal rationally with money would be.

[cylindar]

Good advice!