Fees

The commission trap

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So you’re an investor, and you’ve got seemingly unlimited options for your money. Some seem awesome, some look a little suspect, and for the most part, you’re not really sure what’s going to work and what to stay away from. Typically, you’d talk to some type of financial advisor. Or you’d succumb to your own hubris and decide to get online and do this whole investing thing yourself until it becomes clear that you’ve made a huge mistake, then you’d talk to some sort of financial advisor. But now instead of trying to figure out how and where to invest money, you’re trying to figure out how to pick a trustworthy advisor who can help you with the investing part. Well, I’ve got one piece of advice: watch out for the commission trap.

There are several different ways that financial professionals are paid, the two most common are through fees and through commissions. Some advisors only charge one way or the other, some do both.

A fee-based advisor means that if you’ve got money invested, the advisor collects a fee (usually a small percentage) from your investments every year. It’s a pretty simple, pretty common model, and it makes sense because the advisor is invested in your success. It definitely doesn’t mean that the advisor is trustworthy, but you can at least take comfort in the fact that it’s a sensical payment model.
On the other side is the commission trap. There are a few bad things about commissions:

  • It means you’re buying a financial product. Advisors who collect commissions only get paid when a client buys something. Financial products, while veiled as beneficial to the customer, are generally not the best option. They prey on people’s desire for security and charge a hefty premium for it (annuity). What a financial product offers can almost always be had for a fraction of the cost with a much higher ceiling for growth by simply investing in the market. Not every product is always bad, but you definitely shouldn’t be buying lots of financial products.
  • It means the advisor is collecting a large commission. These products, specifically annuities, will pay out massive sums to advisors who can peddle them. Commissions between 5% and 10%, and sometimes even more, are common. That means if you take your $500,000 investment account and buy an annuity, the advisor could be collecting between $25,000 and $50,000. That’s a lot, suspiciously a lot. Brokers will pay advisors these kinds of fees is because the product is extremely lucrative for brokers, which means it’s probably not super beneficial for customers. 
  • It means there’s a conflict of interest for the advisor. They’re stuck with the tough decision (or maybe not so tough) of educating and caring for their client and promoting their best interests or putting food on their own table for their own kids, or taking a super nice vacation, or whatever else you could get excited about buying for $50,000. Unfortunately, the advisor’s interest will likely lean toward the $50k. Better not to put yourself, or the advisor, in a conflicting situation like that. 
  • It means that you’re probably not getting coached. Advisors who sell products aren’t evil (mostly), but they have to function more like salespeople than advisors or coaches in order to survive. Best case, the salespeople are catering to clients, giving them what they want without trying to rip them off. Worst case, the salespeople are manipulating or aggressively pushing bad products to people. Either way, coaching doesn’t enter the equation. There is no correlation between a customer’s desire for or the suitability of a product and the long term success of a client. So instead of coaching and educating clients, financial salespeople end up helping clients orchestrate their own financial purgatory, never making progress towards their goals. 

So keep an eye out for the commission trap when you’re evaluating an advisor.

Robinhood is dangerous

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robinhood-for-webFirst of all, I don’t mean Robinhood the vigilante, the hero. Sure, was a criminal, but at least he was fighting against the bad guys. In an unjust agrarian society, his actions could be seen as defensible, but I digress.
I mean Robinhood the investment app. A few notes on its danger:

  • The Robinhood app is gorgeous. It’s so pretty it’s hard not to look at it. The graphs and charts are perfect, the animations and gestures are seamless, the design is minimal, it’s about as well designed as apps come. The old mantra ‘beauty is only skin deep’ applies here. The beauty draws you in but also masks some sordid parts.
    The beauty of Robinhood masks the fact that it’s essentially a place to gamble. Sure, you could call it sophisticated gambling, at least you’re not sitting in the smoky haze with eyes glazed over at a shiny slot machine, but it’s still gambling. The little news tidbits aren’t going to help you beat the market, nor will the pretty charts. The truth is that even professionals don’t beat the market. The beauty and ease just make it more tempting.
    Robinhood will you trade options, which is an even riskier way to invest, and even more likely to lose you more money. An option is just a leveraged bet on the market, like putting your money on 13 at the roulette table. It’s a terrible idea.
  • Robinhood offers free trades, perhaps its most alluring selling point. Purchasing stocks always involves fees, brokerage fees, trade commissions, transaction fees, etc. Brokers who conduct trades charge fees, usually per transaction. Robinhood is one of the few places where consumers can purchase shares without transaction fees. So it’s beautiful and free? Who says no to that?
    It’s not entirely free. There are regulatory fees on every trade which Robinhood does pass on to customers. These fees are typically fractions of pennies, and Robinhood rounds them up to the nearest penny, pocketing the round-up of course.
    Robinhood also generates substantial income from a practice called ‘payment for order flow,’ a controversial industry practice interestingly invented by Bernie Madoff. It basically means Robinhood sells the right to execute customer trades to third-party market makers who pay a small fee. Those small fees add up, and Robinhood relies on their high-frequency traders to make it work. Regulators don’t love it, in fact, other brokers and market makers have faced lawsuits over the issue. Robinhood’s dependence on this income could spell its downfall in the coming years.
  • Robinhood only allows you to buy entire shares, which are often pricey. At the time of this writeup Apple is trading at around $200/share, SPY (a very popular ETF that tracks with the S&P 500 index) is trading at about $300/share, Tesla is at $220, you get the idea. Not all shares are that expensive, but it’s tough to deposit a small amount and get trading, you need more money to buy full shares.
    It’s not like Robinhood couldn’t offer partial shares, other platforms do it. Robinhood doesn’t because this is another one of the ways they make money. Offering full shares exclusively means that you will usually have some leftover change in your account, and Robinhood earns interest on those leftover funds. It also encourages you to invest larger chunks of money, which means you’re likely to lose more money.

I’m not saying you’ll die young or retire destitute if you invest some money in Robinhood. But just be aware of what you’re doing. You’re gambling. For the most part, it’s best to stay away.

Are you stock picking?

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Stock picking is the art of choosing stocks that you believe will outperform (in which case you’d buy) or underperform (in which case you’d sell) the rest of the market, at least for a period of time. Whether you decide based on some special analytics or just follow your gut, it doesn’t really matter, you buy stocks you think will do well or dump stocks you think won’t. To put it another way, you’re looking for inefficiencies in the stock market. You believe that the stocks you plan to buy are underpriced; if everyone else knew or believed what you do the stock price would already be higher. Or you plan to sell stocks you believe are overpriced; again, if everyone knew or believed what you do, the stock price would already be lower. Naturally, once you’ve made your move, you expect the rest market to catch up and the stock prices to move accordingly.

Stock picking is a normal practice throughout the investing industry, even the prevailing practice. Professionals have been engaging with it since the inception of the stock market, and, with the advances in technology, more non-professionals than ever also have access through convenient investing apps and websites. Stocking picking is everywhere. In fact, most people think stock picking is investing, that they’re one and the same. The above definition of stock picking sounds like investing, doesn’t it? Here are a few reasons why that’s a problem:

1) Stock picking is built on the premise that the market is not efficient, that smart people can find deals and make money buying and selling the right stocks at the right time. The problem is that’s a false premise, the stock market is actually efficient. An efficient market means that stocks are never overpriced or underpriced, there are no deals, there is no right or wrong time to buy. Stock prices move based on future news and information (no one knows the future) and they react to the new news and information very quickly. If you purchase a stock based on an intuition about the future, that’s just guessing. If you purchase a stock because you believe it’s poised for growth based on a new report you read, the stock price has already adjusted to the report’s information, the price has already moved. With improving technology and additional regulation the market is more efficient now than ever before. News is disseminated immediately and trades can be placed instantaneously. There are differing beliefs as to the level or scale to which the market is efficient, but research continually supports the Efficient Market Hypothesis. Since the market is efficient, stock picking doesn’t work by definition.

2) Research into the results of stock picking has been impressively depressing. Study after study shows that no one, not even professionals, has consistent success picking stocks over time. People will outperform the broader market occasionally, maybe even for a few years in a row, but because of the number of people trying that’s a statistical probability, it’s not based on any skill. Professor Russ Wermers stated in a 2008 mutual fund study, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, that “the number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives.” He’s basically saying that there are so few active stock pickers who have outperformed the market that they were more likely a product of luck than skill. And that’s the professionals. Stock picking doesn’t work because it’s built on a false premise and the research agrees.

3) Research into the costs associated with stock picking is also grim. William Harding, an analyst with Morningstar, said that the average turnover ratio for managed domestic stock funds is 130% (Apr 23, 2018). That’s a terrifying number. It means that through the course of a year the fund will replace all of the stocks it owns, and then re-replace another 30%. It means that the average stock is held for only 281 days. There is a lot of trading going on here. One of the reasons stock picking fails is because of the additional expenses it incurs for all of these trades. Active funds charge an expense ratio, which is normal (although active funds typically charge higher expense ratios than passive funds because of the additional work it takes to actively trade), but they also incur significant trading costs, which is unique to active funds. The expense ratios are published but the trading costs often aren’t. A 2013 study, Shedding Light on ‘Invisible’ Costs: Trading Costs and Mutual Fund Performance, discovered that the average trading costs of mutual funds amounts to 1.44%, that’s in addition to the already higher expense ratio. Even worse, funds owning higher performing long term asset classes (see Three Factor Model) have even higher trading costs, 3.17% on average for small cap funds. These additional trading fees are debilitating to fund returns.

So stock picking is built on a false premise, it doesn’t work by definition, and it charges a premium for its lackluster results. On top of all of that, there’s a massive cost of lost opportunity when your portfolio is stuck stock picking. While your funds are engaged in the losing strategy the rest of the market is consistently earning great returns over time, returns that can be captured simply with diversification, rebalancing, and discipline. Unfortunately, large swaths of the investing industry still promote the active stock picking strategy, in fact, you’ve more than likely got stock picking funds in your 401k portfolio. There’s a better way to invest.

Your Investment Philosophy is Important

Joshua VanDyke

First things first, what’s an investment philosophy? What I mean by investment philosophy is this: where you believe investment returns come from, and the strategy you employ to capture those returns.

When you put money in your company 401k, or write a check to put some money away in your IRA, or make an electronic transfer within your investing app of choice, you should know how the money will be invested and why. You should even have an expectation for the amount of return you’ll earn on those investments long term. These things all play into your investment philosophy.

Here’s the thing, for most people I run into, when I mention their investment philosophy I get blank stares. Frighteningly, I sometimes even get those blank stares from other financial advisors. Since most people haven’t ever thought about their investment philosophy and they have no idea where to expect returns to come from, their investing strategy devolves into a fee game. Fees are easy to track, easy to understand, and they feel more like they’re in our control than the scary market with its ups and downs. So, find a fund with low fees, maybe a little diversification (whatever that means) and you’ll be all set. Advisors who don’t have an investment philosophy tend the same way, they pick out a couple of low fee funds because they ‘care about the customer’ and make an easy sale. Turns out low fees are easy to sell.

This is a problem. Low fees are not bad, but they’re distracting. Returns don’t come from low fees, and looking for funds with low fees does not count as an investment strategy. There are two significant problems if you play the low fee game:

  1. You’ll only invest in low fee funds. On the surface that doesn’t sound like a problem, but there’s a reason that some funds have low fees. US large companies (S&P 500) are among the easiest stocks to trade the world so the transaction fees are very low. That’s what low-cost funds are almost always made up of, S&P 500 index funds are incredibly cheap to own. Smaller and international companies are more expensive to trade because they simply require more work. However, over long periods of time, small and international asset classes outperform the large US asset class. Not only that, the small and international asset classes are essential to the structure of a balanced, diversified, efficient portfolio. If you’re in low fee funds only, you’re missing out on significant returns and reduced volatility, things that far outweigh their additional cost.
  2. You’ll be tempted to invest without an advisor because advisors charge fees. Today it’s easier than ever for individuals to invest on their own. Within a few taps on the screen in your pocket, you can be up and running in a super cheap large US index fund with no additional advisor fees. Again, that seems like a good thing on the surface, but data has overwhelmingly shown that investors do not match market returns, even the lower returns of the S&P 500, over time. A major reason for this is the lack of a disciplined advisor sticking to a good investment philosophy and coaching clients all along the way. It can be really tough to stick with the market during down years, especially when retirement is just around the corner and the media is freaking out and your friends are getting out. Our natural tendency is to bow out of the market during turbulence and wait until it seems safe again or retreat into something ‘guaranteed’ like a fixed annuity. That’s exactly what we do, routinely. A good advisor thwarts all the fear and insecurity, they help investors stay focused and disciplined, and vastly out-earn their fee. In fact, the advisor fee is one of the most inconsequential pieces of all this.

So an investment philosophy is very important. It will keep you from low-fee only investing. It will keep you grounded when the market hits turbulence. Ultimately, it will be a deciding factor on how and when you can retire, what you can do for your dependents, even the legacy you leave. It’s worth spending some time on.

At Cornerstone Wealth Partners we’ve spent a lot of time formulating our investment philosophy and we think it’s the best one out there. We know that returns come from owning the market, not trying to beat it (with constant trading and hedging); we know that strategic diversification offers the most return for the least risk; and we know that small and value companies outperform large companies over time (even though they’re more expensive to own). Most importantly, we know that staying disciplined in the market is tough, and having the help of a good advisor can make all the difference.

Our goal is to share our philosophy with as many people as possible and to help our clients become abundantly successful investors.