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"There are three ways to make money. You can inherit it. You can marry it. You can steal it."A young man asked an old rich man how he made his money. The old guy fingered his worsted wool vest and said, "Well, son, it was 1932. The depth of the Great Depression. I was down to my last nickel. I invested that nickel in an apple. I spent the entire day polishing the apple and, at the end of the day, I sold the apple for ten cents. The next morning, I invested those ten cents in two apples. I spent the entire day polishing them and sold them at 5 pm for 20 cents. I continued this system for a month, by the end of which I'd accumulated a fortune of $1.37. Then my wife's father died and left us two million dollars."
-- conventional wisdom in Italy
Most people who are rich chose their parents wisely.Bill Gates might not have ever figured out 1960s-style computer science but he had the foresight to pick a father who is one of the richest, most prominent lawyers in the state of Washington. And before he and Paul Allen made the deal with IBM that gave them a monopoly on the PC operating system, Bill had the foresight to choose a mother who was personally acquainted with John Opel, CEO of IBM Corporation. None of this would have worked if Bill hadn't been willing to take tremendous personal risks. Should Microsoft have failed, of course, Bill Gates would have had nothing to fall back on but a million dollar trust fund from his mother's parents (bankers) and the resumption of his degree program at Harvard College.
If Donald Trump had taken the millions he inherited from his father and put it all into mutual funds, you'd never have had to suffer through one of his books. But he'd be just as rich or richer today.
Common stocks have returned an average of 7 percent per year, adjusted for inflation. If you are way smarter, luckier, and less risk-averse than all of the companies in the United States, you may be able to do substantially better. But a return on investment of 200 percent per year is not very exciting when you only have a few hundred dollars in capital. That's why it is so important to pick your parents carefully.
If you buy into the Efficient Market Hypothesis then you're just as happy to buy a portfolio of stocks selected by throwing darts at the inside pages of the Wall Street Journal. In fact, the WSJ for many years pitted expert wall street analysts against a dartboard portfolio and the darts almost always did better. If you don't have very much money, then a problem with a dartboard portfolio is that you will only be able to buy a few stocks. Your expected return will still be 7 percent per year but the variance will be extremely high because one company going bust could wipe out all of your gains.
So you buy into the Chump Fund. Halfway through the year, the Harvard MBAs are tired of their drab offices and Pentium computers. Do they take part of the 2% and move uptown and then buy Pentium Pros? No. They discover all of a sudden that they shouldn't have any General Electric. Westinghouse is really a better investment. And Ford is looking better than Chrysler now too. In fact, the entire $10,000,000 portfolio needs to be traded. Do your mutual fund managers, who've sworn to look out for your best financial interests, execute the trades with the broker who has the lowest commissions? No. After all, the money for trading commissions comes out of your 98% and not their 2% (read the fine print). So why not go to a "full-service" broker with high commissions? That broker will be so grateful that he'll discover he has a whole bunch of office space uptown that he isn't using, already equipped with a bunch of Pentium Pros. He'd be delighted to allow his best customers at the Chump Fund to hang out rent-free.
In your naivete, you might call this a kickback but in the industry it is known as "soft money." Every time the Chump Fund trades with a broker, they accumulate some soft money that they can spend on computers, furniture, data feeds, etc. This comes on top of the opera tickets, broadway shows, limousines, and the rest of the Wall Street lifestyle that is paid for by Mr. and Mrs. Middleamerica.
If the Chump Fund keeps on doing this, eventually their return will be much lower than the S&P 500 and they won't be able to run those nice-looking advertisements anymore. What do they do? Look among the 20,000 tiny little mutual funds out there. Find one that has randomly achieved above-average performance for the past five years. Call it the Chump Growth and Income Fund and run ads showing its past performance. Send letters to all the old Chump Fund customers telling them that the Chump Fund is being closed and, unless they object, their investments will be rolled into the new Chump Growth and Income Fund as of September 1.
An even better strategy for a mutual fund company is to do all of this in-house. If they have 50 mutual funds they can just hang onto the ones that randomly do better than average and flush the ones that do noticeably worse. Then at any time they can show that "45 out of our 50 funds outperform the indices". Now you know why you can't find any mutual funds advertised in the Wall Street Journal that sport worse-than-average performance.
OK, so you expected to get cheated a bit by these Wall Street types. But they're experts so of course they will do a better job picking stocks, won't they? Some will. But with tens of thousands of mutual funds out there, even if they are all choosing stocks at random, you'd expect some to do consistently much better than average and some to do consistently much worse. You'd find, however, that most of them would fall in the middle, forming a Gaussian curve.
That's what Burton Malkiel expected to find. He was an economics professor at Princeton who made his life's work the study of investment. When he charted the performance of all the mutual funds, they did indeed form a bell curve. But the center was not the same as the S&P 500. It was shifted slightly to the left. That's right, the average mutual fund was underperforming the blind index by a couple of percentage points. This confused Malkiel until he realized that the discrepancy could be accounted for by the expenses skimmed off the top of the mutual funds and also the commissions they paid to trade the portfolio. [Note: these curves are published in Malkiel's excellent A Random Walk Down Wall Street, an essential book to read before investing.]
Besides getting a higher average return, there are many other good reasons to invest your money in index funds. The first is psychological. When I had individual stocks, every time a stock went up, I attributed it to luck. Every time a stock went down, I attributed it to idiocy on my part. I felt dumber and dumber with every passing year because I ignored the stocks that went up and focussed on the ones that dived. Some Wall Street types have the opposite psychology: they only remember their winners and hence come to think of themselves as Einsteins after five years. Whatever your psychology, there is a certain inner peace to be achieved by forgetting about your money.
Another reason to index is to free up time to make more money. In every office there is at least one sorry loser checking the market every ten minutes, going home at night to read financial reports, running charts, and buying software to manage his complex portfolio. If he were a managing a $10 billion mutual fund, perhaps this effort would be worth it. But to try to beat the index by 2% with a portfolio of $50,000? That's $1,000 extra/year. Even assuming that he can get that extra 2%, he would have earned far more per hour working the night shift at the local 7-Eleven. Your time is valuable. If you really must be greedy, then be greedy and smart and take a consulting job. Or enjoy the extra time with your friends and family. Don't waste it trying to beat the market.
I have oversimplified things a bit here. For example, even if you believe the Efficient Market Hypothesis, there are stocks that are inherently more volatile than others. E.g., a high-tech company will go up more in a market boom and go down more in market bust than will a utility. In some sense, both are "worth their price" but one or the other might be a better buy for you because of your level of risk aversion. If you really want to understand this stuff at a deep level, read A Random Walk Down Wall Street and then Principles of Corporate Finance by Brealey and Myers. The latter book is the textbook used in many advanced finance course taken by MBAs. An MBA student will spend the entire term going through the book and doing problems, but if you have a standard MIT freshman math and science background, you can read the whole thing in a night or two.
If I haven't convinced you to stay away from Wall Street esoterica, here are a few things I've learned through bitter personal experience and/or reading the above books...
Your broker is holding many shares of Microsoft in "street name" for other customers. So he can very easily find 100 shares of Microsoft to lend you. He lends you these 100 shares and sells them immediately. Suppose that the price/share is $10. You get $1000 that you can put into the bank. However, you owe your broker 100 shares of Microsoft Corporation. No problem, you figure. In another year, this company will be near bankruptcy and selling for $0.25/share. You'll buy 100 shares to cover the short for $25, thus making a profit of $975 less commissions.
Well, in another year, Microsoft is not selling for $0.25/share. In fact, it has gone up to $30/share. You still owe the broker 100 shares, but those 100 shares would cost $3000 to buy. You have a paper loss of $2000 right now. Your broker calls and wants you to put up some assets where he can get at them, either cash or stocks. He doesn't trust you to come up with the cash to cover your Microsoft short unless the cash is physically under his control. You consider cutting your losses by closing your position. Remember that it is 1987, though, and Microsoft hasn't gotten any better at writing software. In fact, they are flailing around trying to copy the Apple Macintosh interface, itself a copy of a Xerox system from the mid-1970s. What a bunch of losers. You put up the extra cash.
By 1996, Microsoft has split a bunch of times and you now owe your broker 1000 shares at $150/share. That's $150,000 to cover the short. You sell your house and say "You know, that potential return of $1000 was not worth ten years of agonized scanning of the stock pages, margin calls, and an ultimate loss of $150,000."
There are many morals to this story. One: stocks go up 7%/year, adjusted for inflation. If you buy stocks randomly you will earn 7%/year. If you short stocks randomly, you will lose 7%/year. Two: you are not smarter than the rest of the world put together and, even if you were, the 24% bias would kill you. Three: if you buy a stock, you can only lose what you put in; if you short, you can lose every dime that you have in the world (and maybe a little bit more depending on how careful your broker is).
You might think my story is biased because I've picked a famous winner like Microsoft. But the fact is even stocks that were nothing but hot air often went up dramatically for years. If a company's book value is $10 million but Wall Street is willing to pay $500 million then there is no reason why Wall Street shouldn't be willing to pay $750 million for the same near-worthless entity. You are perhaps right and eventually the stock will crash down towards the $10 million mark, but it could take many years of sleepless nights.
[Note: I've made one big oversimplification here. You may get to invest the proceeds from a short in other stocks and your broker will invest some of your margin capital in T-bills so your expected return on a short will not be as bad as -7%. Still, the unlimited downside is still present with any short sale.]
If it sounds like Vegas to you then you've already figured out the worst thing about options: they appeal to people who like gambling and therefore tend to be overpriced. They are best used when you know something that almost nobody else does and when that something will affect a company on a specific date.
Note: there are "Call Options" as well. These give you the right to buy a specific stock on a specific date at a specific price. They are used when you expect a stock to go way up.
Making matters worse is the fact that corporate managers and accounting firms have been fraudulently overstating earnings. The published P/E ratios are based on the lies that CEOs and CFOs tell investors, not the actual cash coming into companies' bank accounts.
A deeper problem than fraudulent reporting is managerial theft. Investors have accounting firms and the SEC to protect them but the top managers have their hands on the company checkbook and their friends on the Board of Directors. In the old days if a company did well the managers would send a letter to shareholders: "The economy was booming last year and Blatzco prospered; your dividend is being doubled." In the 1980s and 1990s a more typical response to a boom year was management saying "Blatzco did well because we're such geniuses; we are going to take home all of the improved profit in the form of bonuses and stock options." Jack Welch in Straight from the Gut proudly states that during his 20 years as General Electric CEO the "employees", by which he means himself and some other top managers, went from 0% to 31% ownership of GE. Rephrased, Jack and his golf partners stole 31% of GE from the investors who owned the company in 1980. What's more, thanks to accounting rules that enable unlimited stock option grants without any charge to earnings, none of this had to be reported in financial statements. My cousin used to be an animator at Walt Disney. In the old days of Hollywood a boom and bust cycle of profits was to be expected. It is tough to predict whether a movie will be a hit. But after Michael Eisner joined the company in 1984 successes were attributed to superior management rather than luck. Eisner helped himself to more than $1 billion of the shareholders' money over the years. Thus when Disney ran into a string of flops the company didn't have enough cash to hang on until the next boom. Disney shut down its Los Angeles animation group and will use contract labor in Eastern Europe for future animated features.
It is tough to see how historically high rates of return on common stocks can be maintained in a world where managers steal most of the fruits that stem from the investors' capital.
Note that the 1980s and 1990s CEOs stealing from their investors are not innovators. Leland Stanford and his partners in the Central Pacific Railroad managed to steal a fabulous sum of money from their British investors by contracting the construction of the railroad to a company that they owned personally. It was a very similar scam as that pulled off by the managers of Enron except that Stanford did it in the 1860s.
What brought bonds back into fashion was the realization that corporate top management was stealing on a grand scale. If a company had a bad year, the CEO somehow had to manage on his $1.2 million cash salary. If a company had a good year, the CEO would steal any profits by exercising stock options that he and his buddies on the board had previously issued to themselves. With bonds the company borrows $1 and has to pay back that $1 plus interest. If in the meantime the managers have stolen everything that they can from the shareholders that shouldn't affect the bondholders.
A couple of weeks later, I got a trade confirmation from Oppenheimer showing that 600 shares had been traded on my behalf. I called up Michelle Bach and said "Hey, I thought I bought 2,000 shares. What's this piece of paper with 600 on it? Are you sure that I got 2,000 shares?" She confirmed that I'd bought 2,000 shares and said that the trade report I'd seen was sent in error. She asked me to wait for my next statement, which would show that I'd gotten the paid-for 2,000 shares.
On January 13, 1999 I received a monthly statement from CIBC Oppenheimer showing ownership of 600 shares of ABOV and $18,200 in a money market fund. I called Michelle Bach and she denied ever having told me that I was going to get or had gotten 2,000 shares. She said that if I had any complaints, I should FAX them to her boss, Dave Carey. After receiving my FAX, which outlined the situation, Mr. Carey phoned back to say that Oppenheimer would not deliver the promised 2,000 shares. Between the time Michelle Bach confirmed that I had my 2,000 shares and January 13th, ABOV had gone up approximately 13 points. So I'd lost $18,000 due to Oppenheimer's negligence. Carey said that they did not record phone conversations and the written record showed that I only had 600 shares. If I didn't like it, I was welcome to go to arbitration but that he was very experienced with arbitration and opined that I had only "a slim chance of prevailing." He noted that my costs to pursue the arbitration would be excessive.
What I learned from this is that you're much better off with a discount or Internet broker than with a traditional full-commission broker like CIBC Oppenheimer. The discount brokers tape record phone conversations and therefore can't simply lie to cover up their mistakes. Second, you're much better off trusting computer-generated statements than human stock brokers. Computers will make mistakes, but they won't lie to cover them up. Nor will they pretend to check your account when they've actually not done so. This is another powerful argument in favor of using an Internet-based brokerage. You can check your account status online at any time; you won't have to wait for a month to find out that one of the Michelle Bachs of the world gave you the wrong info. Finally, since it is obvious that computers don't have a sense of honor and obligation to clients, you won't mistakenly rely on them to do the honorable thing.
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