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TAKING CHARGE WITH VALUE INVESTING
HOW TO CHOOSE THE BEST INVESTMENTS ACCORDING TO PRICE, PERFORMANCE, AND VALUATION TO BUILD A WINNING PORTFOLIO
By BRIAN NICHOLS The McGraw-Hill Companies, Inc.
Copyright © 2013 Brian Nichols
All rights reserved.
ISBN: 978-0-07-180469-1
Excerpt
CHAPTER 1
Get Prepared
Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway.
—WARREN BUFFETT
If you were to ever decide to handle your own finances, you would find that it just may be the most overly emotional period of your life. Well, hopefully not the most emotional, but no doubt, it would definitely rank in the top five. I use the term overly emotional because there is simply not one single emotion that can accurately describe how someone may feel when he makes a life-changing decision as such. There are a number of different ways you may feel; you may feel joyous, excited, or anxious or possibly scared, fearful, or nervous. Either way, emotions run high because it is one of the most important decisions of your life. It is a decision that very few people actually entertain but something that everyone is capable of doing.
Your emotions will depend on a variety of factors, such as age, financial status, career, children, and so on. A 45-year-old man may view his investments much more differently than a 25-year-old man and is most likely not willing to take the same risks. The factors of age, income, and individual responsibilities will determine your thought process and come together to create the volatility of the financial markets.
The stock market is nothing more than a collection of individual people with various goals that all come together yet react in different ways. This would explain why the market acts without reason and why there is no 100 percent proven way to effectively ensure that you "beat" the market 100 percent of the time. Our market acts without reason because it is a place where emotions are at all-time highs because people are trying to protect and increase one of their most valuable assets—money!
In this book my job is to teach you how to invest in equity markets with a logical state of mind and break free from the grasps of professional money managers so that you can take charge of your own financial future. This book is as much about controlling your emotions and understanding the behavior of the market as it is about fundamental knowledge. Knowing how to research and having the ability to understand a company are great, but they are only half the battle. You must understand the market and its tendencies in order to succeed.
TAKE CONTROL
The first step in taking control of your own financial future may be to free yourself of having others control your money. This is a very difficult task for some because the money manager is often a friend or someone you have known for many years. Your money manager is someone you trust and believe to be particularly knowledgeable about investments. In fact, you may think so highly of your money manager that you are unwilling to sacrifice the relationship for a better financial future.
I personally consider myself to be a story teller, and I like to share personal stories that have affected my life. I think personal experiences are sometimes the best way to describe an event or to truly see the meaning or, in this case, insanity of a situation. Such an example can be seen with my friend Tara, who is much older than myself and a person I consider to be very wise in terms of business. She is the perfect example of a person who let the relationship with her financial advisor cloud her ability to make a rational decision. As a result, she is now suffering great financial loss.
Tara, I would say, lives a comfortable life, but she isn't someone I would consider wealthy. She has run a successful chain of fitness centers and has worked hard her entire life. She has used the same financial advisor since she was in her early twenties. Tara and her advisor have developed a close relationship, so Tara trusts this person completely and has remained loyal despite a large loss. I think to fully understand the complexity of the situation, you would have to know Tara. She is the type of person who does not like change and is quite grounded in her decision making.
In 2010, Tara and I discussed her investments, as well as the investment approach of her advisor, while I was visiting another mutual friend. As it was, Tara had lost a very large sum of her total worth during the recession, thanks to her money manager being overweight on financials. She had lost over 40 percent of her portfolio's value, which indicates a lack of diversification on the part of her advisor. She had wanted to talk to me about her financial advisor's plan, which was to invest heavily into the financial sector with index investing. Her financial money manager's logic was similar to that of a lot of the money managers during that time. They felt that the housing crisis had reached its bottom and would recover, positively affecting the banks. Tara, who was somewhat clueless regarding this subject, reluctantly agreed to maintain the plan that she and her advisor had used for so many years, and she believed that this plan could bring her back to even.
The fact that Tara took the time to ask me about and discuss her options showed that she was not very enthusiastic about the chosen strategy her advisor used with her money. She may not have known a lot about investing, but she did know that she had lost a significant amount of her money by investing in the financial system. As a business owner, she was aware of the risks that were still present within the economy. I advised her to seek the opinion of another advisor, but she would not. I also advised her to question her advisor about investing heavier in bonds and other funds, considering her age. Finally, I urged her to consider opening up her own account and allowing me to help educate her regarding her options and how they could help her to save money. She rejected every possible solution, especially if it meant questioning the opinions of her beloved financial manager.
I haven't spoken with Tara for about two years now because my family and I relocated. But if she did not take my advice, which I believe she did not, and she remained quiet, then her portfolio, which was almost all in financials, most likely has declined another 10 percent while the Standard and Poor's 500 Index (S&P 500) has increased over 20 percent within the same time period. Of course, I have no idea what Tara ultimately decided, but I have a strong suspicion that the connection she felt with her advisor blinded her from making rational decisions that must be evaluated when your financial future is at stake.
MONEY MANAGERS ARE LIKE CAR SALESMEN
Tara's dilemma is all too common for a large number of people who let the "professionals" control their portfolio. Some people are very hesitant to confront their advisors about any issues related to their decisions. I have talked with people who are afraid of asking their financial money managers to sell stock because every time they needed money, their advisors would make them feel bad, saying that taking money from the portfolio was a big mistake. Therefore, I have tried to teach people to change their perceptions of their advisors by comparing them with car salesmen.
When I think of a car salesman, I don't think of a friend; I think of someone whose first job is to sell me a car. I also have a mental image of a guy with a wrinkled shirt and a clip-on tie who is asking me for a credit report before I can close the door of my vehicle. I understand that his job is to sell me a car, and any questions or concerns all revolve around the main goal of selling the vehicle so that he, the salesman, will get a commission check. Whether my notion of a car salesman is right or wrong, I view the experience of buying a new car as similar to that of a financial manager, one seeking to cash his commission check using your money.
When a person thinks of a money manager, she sees someone who is wise, interesting, and charming and someone who has your best interest at heart. We don't think of money managers as self-driven, but rather driven by the return they can provide for their clients. We think of our money managers as people who want to help others, but in reality, their goal is to earn their check the same way a car salesman earns his, by selling you his service. If you have ever used a money manager, then you may have noticed that a money manager's goals and your goals do not always align. A money manager's goal is to have as many assets under management as possible. If you are someone like my friend Tara, who has excess of $500,000 in assets with a money manager, then chances are your relationship will be good with the advisor. I am not suggesting that money managers are bad people, but I am implying that people allow emotions to get in the way while making decisions about handling their own finances or even whether or not to even shop for another firm to handle their finances. As stated previously, if you are going to trust someone with your money, it would have to be a special kind of person. Think about it, how many people in your life would you trust with all your money? My guess is not many, yet we allow ourselves to give full control to money management firms, who are people we really don't even know.
If you buy a car at a dealership, you are most likely going to pay a higher price because you are letting the professionals sell it to you. Likewise, when you buy a security with a money manager, you are paying a much higher premium than if you bought the security yourself through an online brokerage firm because you are letting the professionals buy the security. The only difference is that anyone can buy a security, but you can't create a car and finance it from thin air. Therefore, the car salesman provides more value. In both professions, the number one goal is to sell as much of the product or service as possible. The goal is to convince prospective clients that they are getting the best deal, brand, or service that cannot be provided anywhere else.
It is your personal obligation to view the person handling your money the same way you would any other business transaction or any other person hired to perform a service. If you are dissatisfied or feel as though you are getting a poor deal, it is merely common sense that you should walk away and not worry about hard feelings. Trust me, if your money were to run out, or if you were to take your business elsewhere, there would be very few small-talk conversations or days on the golf course between you and your current money manager. Once again, it's the same concept as when a car salesman spends hours with you to get the best possible sale. The only difference is that money managers must continue to work with you so that they can keep your business.
Now that we have discussed the thought process of both money managers and clients, let's take a look at the performance of money managers. The key to deciding on whether or not you will handle your own finances should be determined by your level of satisfaction with your portfolio. Therefore, let's look at the areas that your money manager may not discuss with you as a client and allow me to explain why managing finances is the only industry in the world where a loss can be measured as a success.
MEASURE OF SUCCESS (FOR YOUR MONEY MANAGER)
Did you know that the majority of money managers have either performed with or underperformed the S&P 500 over the last 12 years? If you incorporate the number of money managers who barely beat the market, then you are looking at nearly all the money managers throughout the country. Most are either underperforming or barely performing with the S&P 500, and yet they are marketing it as a success.
The fact that money managers mostly perform at or underperform the market does not mean that these people are not superintelligent individuals. There are several reasons that average returns have fallen as of late. First, we endured a recession, and a large number of money managers were invested heavily in the financial sector, which crashed during the housing crisis. Second, the market has traded flat over the last 12 years, which led to more desperate moves to keep unsatisfied clients happy. Lastly, most money managers are goal-oriented by certain benchmarks, which means that a loss can be positive in the eyes of the money manager. This may sound ludicrous to you, but being a successful money manager is sometimes measured by performance against an index, not an overall return. If the manager outperforms the index by only a fraction, it is great for his or her marketing campaign and is measured as a success.
A DIFFERENCE IN GOALS
A money manager's goal is simple: She must get as many assets under management as possible. There is a theory among the general public that fund managers only get paid if you make money. In fact, money managers typically make money on initial and closing fees or get higher percentages based on the total amount managed. A money manager may charge you an annual amount based on the size of your portfolio, or she may charge you a fee for every "buy and sell" of a security. Therefore, she gets paid regardless of performance and benefits from a larger number of assets under management.
What if I told you that the so-called "professionals" underperformed their benchmark on a pre-tax basis by about 1.8 percent per year. Would you still be so optimistic and supportive of your money manager? In The Quest for Alpha, Larry Swedroe begins his book by discussing a study performed by Mark Carhart and three colleagues where they analyzed 2,071 equity funds for a period of 33 years and found that the average fund underperformed its "benchmark" by this 1.8 percent margin. To many this won't make sense because these are the professionals who are supposed to be the "wizards" of the market. However, because of large fees and "index chasing" you can be more successful than the high-profile fund managers, although I am certain that you will want bigger returns for you and your family.
The key with this study is the word "benchmark," which is a focus for a particular fund. A fund will typically trade certain stocks in their investment strategy, or fund, such as small caps, large caps, energy or financial stocks. As a result, at the end of the year the firm will compare their performance to the performance of an index, or the industry of companies that is being monitored by their fund. I know it sounds confusing, but this is how much of Wall Street works. The most popular strategy is to track the S&P 500, therefore no matter what, the firm will perform closely with the S&P 500 on a yearly basis, but will always be behind because of large fees. As a result some firms will add other investments to try and close the gap, but based on the study above, it's rare. However, when a firm does outperform their benchmark it is a cause for celebration and is a great marketing tool to grow the fund larger. Because at the end of the day, the goal is to grow the fund larger to collect larger fees and put more money in their pocket.
A money manager who outperforms a benchmark can market herself as having great returns because money managers measure their success against a particular index or class of stocks. So even though the market has lost or traded flat, a money manager can market herself as a wizard who has outperformed the market even if the gain is only 1 percent, which underperforms all other investments. For example, if a money manager was overweight (invested heavily) in financials during the recession or had a large-cap financial fund that outperformed the performance of the S&P 500 financial sector, that firm could correctly advertise themselves as outperforming the sector, even if you and everyone else who invests with the firm lost 15 percent of their worth. This is important, so I'll say it again: It doesn't matter if the index loses 5, 10, 15, or even 20 percent; as long as the firm does a little better (even if it's a loss) than the index, it is a win on Wall Street, and for the firm.
It is important that all investors come to the realization that your goals and a money manager's goals more than likely do not align. I am not saying that money managers don't want great returns or that there aren't any great money managers because there are some who will spend much time doing research and are worth every penny. The majority, however, care only about outperforming the S&P 500, even if the index is trading with a 10 percent loss. As long as the manager loses only 5 percent, she has performed 100 percent better than the market, and that is a very marketable fact to people who don't fully understand the measure of success on Wall Street. As a result, the money manager makes more money by attracting new clients and still takes commission costs from you while sometimes losing your money and calling it a success.
A MORE INTELLIGENT FORM OF INVESTING
Let's say that you have $100,000, and you want a money manager to invest the money. We have already discussed money managers being driven by the performance of various indexes. Therefore, the money manager may purchase a fund that mirrors the S&P 500, which is most commonly referred to as "SPY." Now, if the money manager purchases SPY, he could very well charge you north of $2,000 just to buy the security. If you open up an online brokerage account, it could cost you less than $100 to invest the same amount while diversifying the money yourself.
(Continues...)
Excerpted from TAKING CHARGE WITH VALUE INVESTING by BRIAN NICHOLS. Copyright © 2013 by Brian Nichols. Excerpted by permission of The McGraw-Hill Companies, Inc..
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