Financial Advisors aren’t evil (mostly)​

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I met a stranger this morning (the beauty of Facebook marketplace). He had looked me up in advance, not to be creepy (he assured me), just to make sure he wasn’t meeting a crazy person. He saw that I’m a financial advisor and wondered if I had ever met his financial advisor, whom he trusts very much. In fact, he trusts his financial advisor so much he recently handed over full discretion, meaning the advisor no longer needs his permission to make trades and move money. It was becoming cumbersome to give the okay every time the advisor wanted to make a trade. I informed him that I had not met his financial advisor, and he assured me that his advisor is a great guy.
Here’s the thing, I’m sure he is a great guy, I’m sure his intentions are (mostly) pure. Many financial advisors are really great, and they really care. But that little discretionary bit he shared with me is alarming. When it becomes cumbersome to approve every trade your advisor wants to make, that’s a problem. According to the data, financial advisors who actively trade routinely underperform the market, even advisors who are really great guys. Don’t work with an advisor only because he or she is a great person. Find an advisor who is a great person, but who also understands how the market works, how to most efficiently capture returns, how to avoid stock picking and market time and trying to beat the market, and most importantly, how to coach you. Your future depends on more than the integrity of your advisor. He may not be evil, but he may also be submarining your retirement.

Human capital

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What’s human capital?
To start, we need a definition. Here’s what Wikipedia has to say: “Human capital is the stock of habits, knowledge, social and personality attributes (including creativity) embodied in the ability to perform labour so as to produce economic value.” A little tricky, but basically human capital is the economic value of a person based on their skills and ability in the workplace.

So who gets paid for human capital?
In a free-market economy, everyone gets paid based on their own human capital. We each own our own skills and abilities and we collect income based on our ability and value when we work. Regardless of whether we work for a company or ourselves, we’re compensated for the value we’re able to provide.

So far so good. Now let’s tie this into investing. Without some understanding of the market, people tend to believe that they can beat the market by picking the right stocks. Consistent success (beating the market) in stock picking is actually impossible, but let’s pretend for a moment that’s not. If the market was beatable, there would naturally be people who were especially endowed with the skills and/or training to beat it. Those people would often become money managers and they would be highly sought after by the general public looking for great returns in their portfolios. But who would collect the premiums for additional returns achieved above-market returns? Stock picking would be a human capitalist skill! The brilliantly skilled money manager would collect some serious fees for his valuable ability, fees almost exactly in line with the amount of return he was able to achieve above the market. The additional return of the portfolio wouldn’t end up in the pockets of investors, it would go to the brilliant manager with the impressive human capital skills.

So here’s the point: the stock market is efficient and so it’s not consistently beatable, but even if it was, investors would not be the beneficiaries. The super-skilled money managers would rightly collect large fees, highly correlated to the additional value they were able to provide based on their human capital skills.

Can investing be stress-free? (Part 3)

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Requirement 3: Coaching. 
Success in investing, just like success in many other things, requires the help of a coach. The stock market is the greatest passive wealth creation tool in existence, but it’s not a cakewalk to navigate. Successful investing requires knowledge of the market and an unwavering dedication to the right investing philosophy. When the market turns downward, which it has and will again, most people freak out and make serious mistakes with their investments. Investor stats from the 2008 crash are astoundingly bad. Billions of dollars fled the market at effectively the worst time to get out (at or near the bottom). It was the second crash the S&P 500 had suffered within the decade and people were understandably scared and pessimistic. This is where a coach helps. A coach will help you gain an understanding of the market (so you won’t have to stress about the downturns), but more importantly will help you maintain your investing discipline (so even when you do feel stressed, you won’t make a big mistake). When most investors are panicking, a coach will keep you on track.

A good coach is the most important facet of stress-free investing. They help by educating clients to an understanding of the market, they help by providing a great portfolio, and they help clients actually obtain the market returns and outcomes they’re looking for. A good coach will allow clients to focus on their purpose instead of stressing about how their money is doing in the market.

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.

Are you track-record investing?

Track record investing is the third and last detrimental investment trap I’ll discuss here. Like stock picking and market timing track record investing is as it sounds, using track records or past history to determine whether or not a money manager or specific fund is a good investment.

Track record investing is tricky because we evaluate track records all the time, they’re a normal part of our lives. I use Apple computers instead of windows computer for a few reasons, not least among them is the track record of Apple devices to outlast their windows counterparts. I buy specific products on Amazon only after reading far too many reviews to determine the track record of said product. Track records are not bad, they’re actually super helpful. But, when it comes to investing, it’s dangerous to rely on the same mechanism we use to evaluate Amazon products to decide whether or not a money manager or mutual fund is a good investment. Here are a few reasons why:

The number one disclaimer in the world of investing is “past performance is not indicative of future results.” Why is that phrase posted everywhere? Well, first, because it’s the law. But more importantly, it’s because we so badly want to use track records to determine which mutual funds to invest in, and it doesn’t work. Like we learned about stock picking, people can’t consistently predict the market. If a mutual fund manager does well one year it does not indicate that the manager has figured something out, it means he or she got lucky. People can make guesses about the future, and they do, but no one knows the future, and the market will move based on things that will happen in the future.

A fun example of this past performance issue is Morningstar’s famous five star rating system. Morningstar has long rated funds year after year with one to five star ratings, and it’s a big deal to earn the coveted five stars. However, since 2010 Morningstar has stated that the cost of a fund is a better predictor of its future success than Morningstar’s star rating, essentially admitting that the rating system is useless for evaluating future performance. Track records cannot help when it comes to choosing specific investments.

Another issue with this past performance stuff has to do with the data consumers actually see. Investment companies are notorious for practicing something called selection bias. Selection bias means that if a mutual fund does really poorly, the investment company will kill it and expunge its data from their records so that it has no effect on the overall statistics consumers see. Unfortunately those dead mutual funds often have a drastic effect on returns for real people. The worst 200 funds that were killed between 1923 and 2016 averaged a cumulative return total of -81%. Not only does past performance have nothing to do with future results, but the data consumers see only muddies the water.

So should we shun all data when it comes to investing? Definitely not. It’s important to make a distinction between past performance data, which relates to specific funds or managers or even whole firms, and long term market data, which teaches us about how investing works and where returns come from. I use historical market data all the time, not as if those are returns my firm has achieved since the 1920’s, but to help people understand what to expect from the market, and to show them why diversification is so important. So just remember, past performance really isn’t indicative of future results. Look for an advisor who understands the academics of investing, not one who shovels you past performance data.