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Smart Advice for the HuffPost Investor

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What is the greatest risk that investors face in these troubled times?

Soaring energy prices?

The threat of terrorism?

The housing crises?

The state of the economy?

The answer is none of the above.

I deal with an issue that is decimating the assets of investors every day in this week's column -- bad advice from your broker or advisor.

I appreciate your questions. Please add them as comments to this blog and I will do my best to answer as many as I can.

Question From Halsey:

Dan,

You're a smart guy..your advice is...I'll leave it at decent..but, again, I take offense at:

"My concern is not shared by most "investment professionals" licensed to sell you stocks and bonds. Predicting where the market is headed is the daily grist for their mill."

As an (sic) dirty rotten investment professional..I fight daily..tooth and nail..to GET clients to take profits..and go to cash equivalents...

I got lucky (no crystal ball..just...educated myself) with Google..Apple, and boring old Deere....and on a day the market fell over 100 pts..boring Deere was up 5 pts..and is splitting..raising their dividend.. I have to talk people OUT of buying (bottom fishing) Citigroup (sym. C)..yes.nice dividend..but will it hold...me thinks not.. I am very willing to make less money in order to save client's "nesteggs"...

so...continue to educate...but please...give some of us credit...I do invest my clients in low fee ETF's..for global exposure.. We buy Germany, Sweden, South Africa...and I don't make much on these trades...but sleep at night.

Halsey,

My comment was that many "investment professionals" try to predict the direction of market. What's worse, their clients often rely on their predictions. My point was that market timing is a zero sum game and Smart Investors should not rely on it -- or on those brokers and advisors who profess to have this skill.

When you indicate that you advise clients to "...take profits...and go to cash equivalents", you are engaging in market timing.

You may be right or you may be wrong, but you are not relying on any data that would provide a basis for your advice that now is a good time to cash out and sit on the sidelines.

The studies in my column demonstrate that a small number of trading days account for a large percentage of yearly returns. Your "now is the time to cash out and take profits" advice ignores this data.

The stock picking advice you give your clients also has no data to support it. Initially, you indicate that your stock picks were "lucky." If that statement is not just false modesty, it is troubling.

How would you feel if your doctor made an important diagnosis, or a structural engineer calculated the load capacity of a bridge, based on "luck" and not on hard, irrefutable evidence?

If you are relying on luck, your clients should know that you are gambling with their assets. Don't they have a right to expect more from their investment advisor?

Let's assume that your good stock picks were the result of careful research. Should your clients rely on your stock picking skills?

Burton Malkiel is one of the outstanding financial minds of our time. He is the Chemical Bank Chairman's Professor of Economics at Princeton University.

While he is best known for his classic investment book, A Random Walk Down Wall Street, he is also the author of many other books and scholarly articles.

In a television interview, Professor Malkiel was asked: "To beat that average [of the stock markets], should an investor listen to the Wall Street professionals?"

His response was to the point:

No, all the information an analyst can learn about a company, from balance sheets to marketing material, is already built into the stock price, because all of the other thousands of analysts have the same information. What they don't have is the knowledge that will move the stock, knowledge such as a news event, which is unpredictable and impossible to forecast.

Your stock picking is also contrary to the views of a number of Nobel Laureates in Economics (Daniel Kahneman, Merton Miller, Myron S. Scholes, Paul A. Samuelson, Robert C. Merton and William F. Sharpe), and countless academic studies.

One study looked at the performance of 10,000 discount brokerage accounts. I am sure that the holders of these accounts thought they had the ability to pick "winners" and that many of them did careful research on their stock picks.

How did they do?

The study found that trading costs ate up profits and the stocks that these investors purchased underperformed the ones they sold.

You noted that you had picked three "winners": Google, Apple and Deere. All have done well for your clients -- to date.

How will you know when to advise your clients to sell them?

One study looked at stock "winners" for the period 1980-1996. Stocks that had average returns for three years of 130 percent, fell in the next three years to average returns of 6.6 percent.

Do your clients understand the risk of holding these stocks? Are they aware that they could obtain the same expected return, at a significantly reduced risk, by holding an index that covers the same asset class as these stocks?

You do not discuss risk in your comment. Have you computed the standard deviation of your clients' portfolios? Do your clients fully understand the risk inherent in relying on your market timing and stock picking skills?

Here is what Nobel Laureate William F. Sharpe had to say on this subject in a magazine interview:

What if your advisor talks only about returns, not risk? ...It's his job to take risk into account by telling you the range of possible outcomes you face. If he won't, go to a new planner, someone who will get real.

You indicate that you use ETFs to "...buy Germany, Sweden, South Africa." You noted that these ETFs gave your clients "global exposure."

They don't. These ETFs give your clients exposure to the markets in those three countries. To give them "global exposure," they would have to invest in the markets of approximately 50 countries.

There is no data indicating that you, or anyone else, can select foreign countries that will outperform the markets of other countries. You would have to be "lucky" if the ETFs you selected outperform a fund like the Vanguard Total International Index, which will always capture the returns of the MSCI AC World Index (excluding the USA), less transaction fees. This fund does give its investors "global exposure."

Your selection of ETFs for just three countries may also expose them to greater risk than holding an index fund that captures the MSCI AC World Index. For example, the standard deviation of the Vanguard Total International Index (VGTSX) is 11.20%. Its year-to-date return is 23.88 percent.

The standard deviation of iShares MSCI South Africa Index (EZA) is 23.88 percent . Its year-to-date return is 14.98 percent.

Do your clients understand the significance of this meaningful difference in volatility?

I do not believe that brokers are bad people. I subscribe to the views of Bill Bernstein who famously stated, in his excellent book, The Intelligent Asset Allocator:

There are two kinds of investors -- those who don't know where the market is headed, and those who don't know that they don't know. Then again, there is a third type -- the investment professional, who indeed knows that he or she doesn't know, but whose livelihood depends upon appearing to know.

I believe your desire to provide sound advice to your clients is sincere and well-intentioned. You think you know, but you don't know, and your livelihood depends upon your ability to appear to know.

It is my opinion that the stock picking, market timing, manager picking segment of the securities industry represents the single greatest threat to the wealth of investors.

If you want to act in the best interest of your clients, and are willing to sacrifice fees and commissions to do so, you should focus on their asset allocation and advise them to invest in a globally diversified portfolio of low cost index funds.

Then you can really "sleep at night."

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