The Safe Investor
How to Make Your Money Grow in a Volatile Global Economy
By Timothy F. Mccarthy
Palgrave Macmillan Copyright © 2014 Timothy F. McCarthy,
All rights reserved.
THE DAY I BECAME AN ADULT
How Low Risk Became High Risk
I awoke to my mother screaming, "Oh my God, oh my God!" as she ran down the hallway.
It took a moment for my brain to register her panic.
I had just returned from studying in the Soviet Union. And like many 18-yearolds, I was quite self-absorbed and unprepared to see a parent in such distress. In many ways, I just took my family for granted. That attitude was about to change.
She opened my door and said in almost a whisper, "Your father is dead!"
My father was killed in an auto accident on Sunday morning, October 12, 1969.
The house quickly filled with neighbors and family friends. He was quite a popular figure, and it seemed like everyone we knew came over to help, to console, to just be with us.
Helen, my mother, was in deep shock. I tried to comfort her and my brother as much as I could. I soon began to realize there might be things that needed to be attended to, some perhaps quickly.
The authorities required someone in the family to identify my father's body, so a few of us took the responsibility to go down to the San Jose coroner' office to make sure the body was properly identified. I also wanted to make sure there was nothing in the car that could be possibly used against him.
The weeks following my father's death were emotionally overwhelming for the family. When my mother could finally talk about her finances, we saw she would have just enough for her and my brother to live in modest comfort. I was already making enough money for myself teaching karate, but she was only 48 and having trouble finding a teaching job. And my brother, Danny, was only 13, so their financial nest egg would still have to last for a long time.
We didn't know many people who could give us advice. My uncle and aunt were San Francisco cops. Even the wealthier of my dad's friends did not have much understanding of long-term investing. Indeed, the entire investment industry was quite primitive in the United States, even as recently as the 1960s and early '70s. Most people looked at investing in areas like the stock market as dangerous. Fortunately, one dear old friend of my dad's, Bill O'Farrell, was a controller for the town of San Mateo and was in charge of investing reserves for the city, so he had some experience.
Bill was a good judge of a man's character and he introduced us to a reputable stockbroker. My mom was quite specific in our first meeting with the broker. She wanted conservative investments only, no stocks. She made it clear she could not afford to lose the money, as that was all she had and her new teaching job was not enough to support her and my brother.
After careful consideration and much discussion, the broker put all my mother's money into long-term, fixed-rate, high-quality bonds — mostly governments, utilities, and corporate bonds. It sounded to me like the prudent course of action, but what did I know?
Through the early seventies I was busy studying, teaching karate, and occasionally squeezing in a little time for fun. During this time, my mother and I watched with consternation as interest rates climbed. Later, at its height around 1980, the prime lending rate actually passed 20 percent! Long before then, my mother was panicking. Marked to market, her long-term fixed-rate bonds had fallen to nearly half their value. In general, when interest rates fall, prices of bonds with higher rates rise; when interest rates rise, prices of outstanding bonds with lower rates fall. I shall never forget that look of fear on her face as she exclaimed, "I can't make this money back again. What am I going to do?"
As the seventies progressed many financial industry experts were saying interest rates were going to stay high, maybe go higher, which would mean that my poor mother would lose even more money. She became so emotionally distraught that one day she panicked and sold all her bonds and put the money in money market and bank accounts.
As the eighties wore on, interest rates began to drop. Ironically, had Helen kept the bonds and held them to maturity instead of sticking all the money in the bank, she would have recouped all her principal.
The result? My mother had lost nearly half her financial nest egg. It affected her attitude, how she managed most everything in her life. Helen would often exclaim to her friends, "But who could have told me what to do? Where could I have gone for sound advice?"
A MESSAGE TO THOSE THINKING OF A CAREER ON WALL STREET
Watching my mother so needlessly suffer, and knowing that there were hundreds of thousands of individual investors that were vulnerable to financial markets without sound advice, convinced me that I should build a career in financial services. There had to be a better way for people to grow their money without taking on too much risk. Though today few think this way, I still believe helping people invest is a noble calling, a noble mission for advisors in our industry.
In recent years we have heard much about the greed in our industry — how all brokers, traders, Wall Street execs think about is how much money they can make, often at the expense of the customer. However, being an investment professional can and should be an honorable profession. It is critically important to so many families.
My message to young people coming into the industry is to always remember your number-one job is to help people grow their money more than savings, but with less risk than trading. If you keep that motto as a constant reminder, you can make a difference in this world, much like a doctor or a minister — but only if you genuinely care about your mission. Once you qualify as an advisor, you will have the opportunity over the decades to help at least a thousand families ensure financial comfort in their later years. Above all else, anyone who works on Wall Street has to ask himself each day, "Would I sell this product to my mother?"
THE LESSONS I LEARNED FROM MY MOTHER'S MISFORTUNE
1. There is no such thing as a no-risk investment. All investments, even cash, have elements of risk. An investor has to understand those risks, especially the subtle or indirect risks. In the case of the bonds my mother bought, the credit quality was fine. Indeed, all the bond issuers at maturity paid back the principal and interest. It was the interest rate fluctuation that contained the risk. As you shall see in other examples, like my mother's portfolio, one of the greatest ironies about investing is that a concentrated portfolio of only low-risk investments can be actually riskier than a broad, multifaceted package of investments.
2. Don't put all your eggs in one basket. If my mother had only broadened her investment instruments by investing in bonds with different maturities, and invested broadly in the stock market even a little, she never would have lost so much money. I know — many of the experienced investors and advisors are saying, "Of course, you have to diversify!" However, I tell this story first because lack of diversification remains among the biggest mistakes I still see being made by even the "sophisticated" investors. The idea of diversification may be easy to understand, but too many times I have observed it is not easy for people to follow, even when they have been properly instructed. And as you shall also see in subsequent chapters, getting the mix right in your portfolio can be more difficult than you think.
3. Keep your emotions under control. Be patient. If my mother had not panicked, and instead simply held those bonds until maturity, she would not have lost half her money. No one was there to tell her to wait it out and hold the bonds through maturity, so she followed her emotions. I still meet investors who have made the same mistake as she did. But what others can learn from my mother's experience, and what I learned, is that understanding one's true, long-term horizon and sticking to a basic plan are critical to growing your assets safely.
DIAGNOSES FOR MY DOCTOR
Diversifying Can Be Tricky
One of my closest friends is a heart surgeon in Silicon Valley. And like many successful folks in 2000 to 2001, he often told anyone who would listen about his investing prowess. He had done so well with his investing over the past decade that he planned on retiring soon. I asked him if he was diversified, and he replied that his equity portfolio was quite diversified by industry, size of companies, and individual stocks and mutual funds. He had one-third of his portfolio in stocks he chose, with the balance divided among a variety of four highly rated stock funds and the Standard & Poor's index fund. He put most of his money in equities, as he was impressed by his own stock-picking ability over the previous five years.
Soon afterward, I moved back overseas, mainly to buy a brokerage firm in South Korea, and I didn't see him for a few years. Upon returning to the United States, we got together for dinner. He complained he would now have to work another five years due to his poor investment performance. After the dot.com bubble burst in 2001 and 2002, causing most of the technology and internet-oriented stock prices to collapse, he lost nearly half his money. He asked me to help him figure out what went so wrong with his portfolio. After all, the Dow had only declined around 15 percent in the same time frame. In the 2000–2002 price plunge, the technology-heavy NASDAQ lost a whopping 66 percent.
In studying the details of his portfolio, it became crystal clear that he had been lulled into a false sense of safe diversification. Indeed, he was correct that all his money was not in one investment portfolio, but instead was mixed up with other fund managers and some in indexing funds as well. So, what was his mistake? Why had his portfolio dropped so much more than the blue-chip market?
First off, his personal stock-picking portfolio was concentrated in large high-tech and internet stocks, many of which were naturally connected with Silicon Valley. During the OTC market crash, these stocks were crushed the most — many dropping as much as 90 percent. They were often valued in excess of 100 times annual earnings, so they had a lot of room to fall.
Second, the funds he chose were the top-rated performing funds of the previous five years. By definition, since the major high-tech stocks were the best performers in the late nineties, most of those funds were exposed to the very same stocks he bought in his own portfolio. Buying many of the highest-rated or multiple "stars" funds doubled his concentration risk rather than helping him to diversify. I was able to see firsthand how fund ratings can be quite misleading and should be evaluated very carefully to avoid overconcentration.
Third, the major index fund, the Standard and Poor's or S&P 500, like many index funds and ETFs (exchange traded funds), are "cap weighted," i.e., the amount of shares bought for each stock is determined by the value of the company relative to the total market. So during the late nineties, though many people thought an index fund does not follow an investment strategy, it turns out that if you bought most index funds, they would be weighted or concentrated in the blue-chip momentum growth stocks. After all, it is this group of stocks that will have the highest market values. Naturally, during the late nineties the large or blue-chip high-tech and internet stocks were indeed large-cap momentum growth stocks. So, my poor doctor friend ended up being triple concentrated — the index fund also had large concentrations of the same stocks he was buying and his funds were buying.
Take Sun Microsystems. It was a great company in the nineties with a high market value versus other companies. It had a major position in the doctor's personal portfolio, as well as in most of his funds due to its good performance, and had a large weighting naturally in the index portfolio. During the early 2000s crash, Sun fell around 85 percent from its peak and, for the most part, did not fully recover. No wonder my friend lost nearly half his money. All his different investments contained large portions of companies like Sun, but he did not realize he was so inadvertently concentrated.
Of course, the good doctor was not the only one who lost a lot of money at the beginning of this century. Over the years, I have met many smart and capable doctors as well as business professionals who were extremely successful in their careers, and yet lost fortunes due to their investing decisions. Indeed, even many full-time investment professionals have made serious mistakes in their own portfolios. It is not so easy to beat the market, and often, in trying to outperform, you can put your portfolio at risk.
THE LESSONS I LEARNED THROUGH MY DOCTOR FRIEND
1. Diversifying can be much trickier than you think. Just like the doctor, you may think you are diversified because the investments are with different managers, or in different parts of the world, or even in different asset classes. But unless you and/or your advisor are regularly checking the details about how similar the underlying investments are, or how an event can affect all the exposures you have in your overall portfolio, don't be surprised if you get surprised and are more concentrated than you think.
2. Selecting a fund just by its rating doesn't ensure success. Simply taking a rating on a fund, or looking at the last one-, three-, or even five-year performance of a fund or a manager often doesn't help you much in selecting the right fund. In many cases the funds that had the highest ratings throughout the late nineties — had the best performance, were the highest in evaluations by experts — crashed the hardest by the end of 2002.
If that's the case, how then does one make the right choices?
DIETING AND INVESTING
A Broad Range of Ingredients Keeps Your Portfolio Healthy
There are a lot of people whose eyes glaze over every time they even think about investing. All those numbers and terms and graphs ... they neither have an interest nor perhaps an ability to grasp abstract concepts easily. I recall learning from a colleague in education that something like 85 percent of people have difficulty thinking conceptually. After all, investments are not something you can smell or touch or kick. To many people using numbers to symbolize anything is like taking high school algebra all over again.
In the finance and investment industry, however, there is a concentration of people who relish thinking in numbers or thinking conceptually. When people in our industry explain financial terms and concepts, they don't realize many of their clients actually don't like being there, having to listen to something they think is boring. I remember once working at Tyndall, a major investments company in Sydney, Australia that takes a lot of care in investor education. One of the novice investors said to me, "When I walk into a broker or a bank, to me, it is like going to the dentist to get a tooth drilled, or worse, going to a proctologist!" But since we in the industry don't share that feeling, we often overlook the idea that our lectures don't help many people.
Perhaps it was best said to me by a great manager in a local Asian bank: "Just give me a product where none of the explanations have even as much as one detailed graph in it. My clients hate it and complicated graphs even scare a lot of my staff." It was a revelatory moment for me as I realized just how much more work we need to do in the area of communication with investors. Otherwise, no matter how brilliant our strategies, the average investor won't benefit from the basic tools of investing if they can't easily identify with them.
Fortunately, there are excellent examples outside of investing that can help people get more comfortable with our basic concepts. For instance, many of the principles of a good diet, surprisingly, turn out to be the same principles needed for a good investment portfolio.
Over the last decade, diet experts and food scientists have discovered much about what our bodies need. The human body and brain do much better when we have a very broad diet — much broader than was realized before. As many people now know, it turns out that a natural mixture of "old-fashioned" meals our grandmothers made often deliver the broad diet that is so good for our health. For instance, when one takes a vitamin E tablet once a day, it is too narrow or too focused in only one subtype of vitamin E. A broad diet, however, inherently gives us a nearly infinite variety of vitamin E subtypes. It's the same story with chia, which is high in omega-3, notably valuable for our brain health. Yet we only need to eat a small amount of chia seeds throughout the year to capture this form of omega-3 without adding a lot of extra food to our diet. (Continues...)
Excerpted from The Safe Investor by Timothy F. Mccarthy. Copyright © 2014 Timothy F. McCarthy,. Excerpted by permission of Palgrave Macmillan.
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