Index Issues (part 1)

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Passive index investing has seen significant growth over the last 30 years as an alternative to active (stock picking) investing. Studies surrounding active investing have shown that on the whole, active investors underperform the market significantly, for two main reasons: high fees and poor stock selecting. As people come to grips with the problems inherent to active investing they naturally turn towards index funds, which seems to solve both of the problems listed above. Index funds are typically very cheap to own (solves the fee problem), and instead of actively picking stocks, they simply own sections of the market (solves the poor stock picking problem). Sounds pretty good, right?
Well, it’s definitely better than an active investment strategy but index funds are not without their problems, and they’re certainly not the best way to invest your money. Here are a few issues:

  1. An index is arbitrary. The S&P 500 Index (the most popular index out there) was created more as a measurement than an investment vehicle. It’s simply a list of 500 of the largest companies in the U.S., there’s no magic to the number 500. But that’s the thing, indexes were not created to maximize investor returns or diversify into asset classes in the most strategic way, they’re just arbitrary measurements.
  2. Index funds are almost all cap-weighted. This is an important thing to note. What this means is the larger the company, the larger percent of the index it takes up. In the S&P 500, the largest 10 companies take up 20% or more of the entire index while the bottom 10 companies take up less than 0.2%. In any index, most of your money is going into the most valuable several companies instead of being evenly diversified. A total U.S. market index fund, while seemingly offering lots of diversification, is almost entirely loaded up in the largest companies because of its cap weighting.
  3. Index fund investing often puts your finger on the trigger. Many index fund investors do their investing on their own since you can own an index fund yourself for a fraction of the cost you could pay an advisor to put you in the exact same fund. I’ve made this point in the past, but when it’s as easy as the click of a button to pull money out of an investment account, people tend to make mistakes. The S&P 500 for instance, has averaged about a 10% return per year for almost 100 years, which is fine, not great, but fine. However, from 2000 to 2009, it averaged a -1% return per year. It doesn’t matter how low the fees were or how well it compared to the stock-picking accounts, precious few of us would have stuck around for those returns over 10 years if we could move the money with the click of a button. Successful investing requires good coaching. Good coaching should include a better portfolio than a bunch of cheap mutual funds.

So what’s the alternative? Stay tuned for part 2.

5 ways your investing app is ruining your retirement

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In the last five years, we’ve seen the explosion of alternative investment avenues, especially through apps. While technological advances (computers, algorithms, the internet, you get it) certainly make investing a better and easier experience than it’s ever been, they’ve also promoted some troubling trends in popular consumer investing apps.

Here are a few ways your investing app is ruining your retirement:

  1. Investing apps are built for active trading which loses money compared to the market. In order for investing apps to be interesting, they promote active trading. No one wants or needs an app to help them buy and hold and never make trades. Unfortunately, active trading is a recipe for disaster. Even professionals lose to the market when they actively trade stocks, not because of any inherent flaws in themselves, but because it’s literally impossible to consistently beat the market.
  2. No great offerings. Because they’re designed to encourage active investing, investing apps don’t offer many great investing options. Even if you could ignore all the crap, the best funds aren’t in there. Sure, you can find some cheap ETF and index funds, which aren’t the worst options in the world, but they’re definitely not the best. And investing apps know you might try them out, but ultimately you’re going to be moving money around.
  3. Your earliest years are the most important years and you’re wasting them. Investing apps appeal unilaterally to younger people. The great thing about investing when you’re young is that money invested early will compound far more significantly over time than money invested later. Unfortunately, many young people fall prey to these investment apps which do the opposite of maximizing investment dollars.
  4. Mis-education, worthless news. In order to make active investing seem legitimate, investing apps often share news and information regarding the market. Unfortunately, the news is not helpful for investing. Instead of learning about how the market works and how to prudently invest money over time, these excerpts simply validate terrible investing strategies.
  5. Encourage bad behavior. This is the biggest problem. Instead of educating investors, investing apps take advantage of them. Active investing feels right, it seems legitimate, and investing apps only encourage that feeling. Unfortunately, the feelings of investors have no correlation with successful investing, if anything they’re negatively correlated.

So dump the investment app. Learn about important investing concepts like Efficient Market Hypothesis, Modern Portfolio Theory, the Three-Factor Model. Get a good advisor who will get you into the best funds and help you remain disciplined through scary markets. Take your purpose seriously, it’s probably something worth more than speculating and gambling with your investments.

On REITs

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REITs (Real Estate Investment Trust) are a hot topic in 2019. Real estate is popular, it’s tangible, it’s easy to understand the profits and costs involved, and many of us already own some ourselves. REITs offer the allure of owning income-producing real estate without ever having to take a call from a grumpy tenant or running over to fix a leaky toilet in the middle of the night. It’s real estate investing without all the hassle! Well, that’s not exactly true, here a few reasons to look elsewhere for investing returns:

  1. A REIT is not like investing in real estate the way most of us think about real estate investing (owning rental properties). Traditional real estate investing is a great way to make money, but it’s not passive. Ask anyone who owns rental properties and they’ll tell you it’s a job, maybe a part-time job, maybe a worthwhile job, but a job none-the-less. It takes work and time and good business sense. A REIT is like a mutual fund that only owns income-producing real estate (at least 75% of the income within a REIT must come from rental income or something similar), which sounds similar to traditional investing, but a REIT is completely passive. The expected earnings on the two types of investments are very different because they’re very different types of investments.
  2. Investing in REITs is redundant. If you’re invested in the stock market you already own real estate. In fact, you already own the same exact companies and properties that are also in the REIT you’re thinking about purchasing. You could theoretically double down on real estate, own it both in your investment account and in a REIT, but why would you do that? There are three essential market factors that drive returns: stocks (which outperform bonds over time), small companies (which outperform large companies over time), and value companies (which outperform growth companies over time); real estate doesn’t make the cut. There’s no additional benefit to increasing your exposure to real estate, no additional returns, no additional diversification benefits, nothing. You could buy into a REIT if you have a hunch that real estate as a market sector is going to do well in the next few years but that would be market timing, a proven great way to lose money.

REITs sometimes sound exciting, especially when they’re doing well, but keep the big-picture perspective. No one knows when REITs will do well or for how long, we just know that over time they won’t beat a well-diversified portfolio, which already owns a lot of real estate anyways.

Robinhood is dangerous

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.

3 Questions to Ask your Financial Advisor

Your investment advisor is a very important person. You rely on this person to help you navigate your lifelong financial journey, and hopefully guide you to a successful outcome. There are obvious characteristics we want in an advisor: integrity, honesty, diligence, etc., all good things. But there are other, almost equally important things most of take for granted in an advisor: What’s their investment strategy? What’s their view on the market? How do they expect to help you capture returns? These are questions we don’t tend to ask, after all, they’re the professionals, but the answers to these questions will have a profound impact on your future.

  1. Do you think the market is efficient or not?

This is a simple question with massive implications. Basically, you’re asking whether or not your advisor thinks he/she can consistently get you better returns than the market by actively buying and selling stocks (stock picking), moving in and out of different market sectors (market timing), and using funds with the best recent return history (track-record investing). If the market is not efficient then these are valid exercises. An inefficient market means that stock prices could be underpriced or overpriced and assumes that smart advisors should be able to figure out which stocks are which and pick the ones that will outperform all of the others. Unfortunately, advisors don’t consistently beat the market, they can’t consistently pick the winners. The results of choosing stocks and timing the market have been overwhelmingly negative and research has resoundingly supported the assertion that the market is actually efficient (Efficient Market Hypothesis). An efficient market means a stock is never overpriced or underpriced, its current price is always the best indication of its current value. If the market is efficient, that means it’s impossible for anyone to consistently predict or beat it, in fact, attempts to do so are more like gambling than investing. Instead of trying to outperform the market, the goal should be to own the whole of it as efficiently as possible. This brings us to the next question.

2. What Asset Classes Do I Own?

In order to efficiently own the market, you need broad diversification. That means you want to own many companies, but more importantly, you want to own many companies in many different asset classes (large companies, small companies, value companies, international companies, etc.). When you ask, most advisors are going to tell you that the large majority of your money is in Large US Growth companies (S&P 500), which is unfortunate because the Large US Growth company asset class is one of the lowest returning asset classes in history. That’s not to say the asset class is a bad investment, it’s great for diversification, but it’s certainly not where you want most of your money. Small and Value asset classes return better over time, so you want to ensure you’re broadly and significantly invested in those asset classes.

3. How will you help me capture returns?

There are three important components to successfully capturing returns: 1) diversify, 2) rebalance, 3) remain disciplined. Diversification (1) means you’ll have ownership in companies of all different shapes and sizes all over the world. Good diversification does two things for an investor: it reduces risk/volatility and increases return. Since we don’t know which sectors or stocks will do best this year, we own all of them, and then we rebalance, which brings us to point 2. The goal in rebalancing (2) is to keep an ideal percentage of each of the different asset classes in your portfolio. Since stocks and asset classes don’t all move the same way every year when one asset class is up and another is down your portfolio percentages get out of whack. That’s where rebalancing comes in. In order to rebalance your portfolio, your advisor will sell some of the asset class that went up and buy some of the asset class that went down, bringing the percentages back into alignment. This must happen systematically, for example, it could be every quarter, in order for it to be effective. The end result is that you’re automatically selling high and buying low. There’s no gut instinct, no guessing, no market timing, it’s committed disciplined rebalancing, which brings us to point 3. Discipline (3) isn’t something that comes naturally to most of us, but it’s extremely important in capturing returns and planning for your future. There’s a behavior element that all of this hinges on, if an investor doesn’t have the discipline to ride out the ups and downs in the market they can’t be a successful investor. The average investor switches advisors and funds and strategies every 3.5 years, that’s a losing game. So how will your investor help you stay disciplined and on track to capture those returns and achieve your goals?

Since I’m writing this and I’m an advisor, you probably assume I’ve got answers to these questions, your assumption is correct. But this isn’t just a sales pitch, good answers to these questions are critical for successful investing, and far too many people simply have no idea what their advisor is doing for them, whether good or bad. So ask a few questions!