I recently met with a wealthy client. We manage half his assets. The balance is handled by a broker who picks stocks. I asked him why he believes the broker can pick stocks that will outperform the market. He told me the broker spends all of his time studying the market and this kind of commitment is likely to be fruitful.
I hear that a lot. Here's the question I always ask: What is he looking for? No one has ever given me an intelligent response. The standard retort is that you should carefully research companies and invest only in those you know and understand. Since wealthy people don't have the time to do this, they entrust this task to brokers. Brokers do nothing to disabuse them of this flawed belief in their expertise.
In my experience, the primary difference between middle class and wealthy investors is that wealthy investors lose more money in the markets, because they have more to lose.
In 1995, Eastman Kodak (NYSE: EK) was a stellar performer. According to an article in the New York Times on October 18, 1995 (available by searching the New York Times database online) things were looking up for the iconic camera manufacturer. Earnings for the quarter were $338 million, up 33 percent from operating earnings a year earlier. The consummate insiders -- the Board of Directors of Kodak --authorized the purchase of 2.5 percent of its stock in the next six to nine months, at a cost of nearly $1 billion. The analysts were enthused. Goldman Sachs called the balance sheet "a success story." Kodak stock was approaching $60.
I have no doubt that many investors knew Kodak well. Families had worked there for generations. They were "comfortable" with the company. They felt they could count on it.
This pattern of a stellar company falling on hard times is not unique to Kodak. Here are other examples: Lehman Brothers, Washington Mutual, WorldCom, General Motors, CIT Group, Enron, Conseco and many other companies were all once highly touted by the most sophisticated analysts on Wall Street.
Here's the takeaway:
- Good companies don't always make good investments;
- Taking the time to learn about a company is no guarantee of achieving stellar returns;
- The risk of owning any individual stock is considerably higher than the risk of owning the index to which it belongs, but the expected return is no greater.
I don't care how much time your broker (or you) spend studying the markets. You are unlikely to learn anything that will help you improve your returns. Instead of engaging in an exercise likely to enrich your broker at your expense, consider this admonition from Nobel Laureate, Paul A. Samuelson: "... most [stock pickers and market timers] should go out of business -- take up plumbing, teach Greek... "
Dan Solin is a Senior Vice President of Index Funds Advisors (ifa.com). He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, was released in September, 2011.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. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.