Millionaire Teacher (18 page)

Most brokers and advisers really are just salespeople, and well-paid salespeople at that. In the U.S., the average broker makes nearly $150,000 a year—putting them in the top five percent of all U.S. wage earners. They make more than the average lawyer, primary care doctor, or professor at an elite university.
6
And if they're recommending actively managed funds, they're a bit like vendors in the guise of nutritionists selling candy, booze, and cigarettes.

The Totem Pole View

Financial advisers and brokers are at the bottom of the totem pole of financial knowledge. At the top, you'll find hedge fund managers, mutual fund managers, and pension fund managers.

Generally earning the highest certification in money management—as chartered financial analysts—pension fund managers have the leeway to buy what they want. These are the folks managing huge sums of government and corporate retirement money. Arguably, they're the best of the best. If your local financial planner applied for the job of managing the pension for Pennsylvania's teachers or New Jersey's state-pension system, he or she would likely get laughed off the table.

Pension fund managers have their pulses on the stock markets and the economy. They can invest where they want. Typically, they don't have to focus on a particular geographic region or type of stock. The world is their oyster. If they want to jump into European stocks, they do it. If they think the new opportunities are in small stocks, they load up on those. If they feel the stock market is going to take a short-term beating, they might sell off some of their stocks, buying more bonds or holding cash instead.

Your typical financial planner isn't as knowledgeable as the average pension fund manager. But most advisers will try and “sell” you on the idea that (like the pension fund manager) they have their pulse on the economy and that they can find you hot mutual funds to buy. They might try telling you that they know when the economy is going to self-destruct, which stock market is going to fly, and whether gold, silver, small stocks, large stocks, oil stocks, or retail stocks are going to do well this quarter, this year, or this decade.

But they are full of hot air.

Pension fund managers are more likely to know oodles more about making money in the markets than financial advisers or brokers.

Knowing that pension fund managers are like the gods of the industry, how do their results stack up against a diversified portfolio of index funds?

Most pension funds have their money in a 60/40 split: 60 percent stocks and 40 percent bonds. They also have advantages that retail investors don't have: large company pension funds pay significantly lower fees than retail investors like you or I would, and they don't have to pay taxes on capital gains that are incurred.

Considering the financial acumen of the average pension fund manager, coupled with the lower cost and tax benefits, you would assume that the average American pension fund would easily beat an indexed portfolio allocated similarly to most pension funds: 60 percent stocks and 40 percent bonds. But that isn't the case.

U.S. consulting firm, FutureMetrics, studied the performance of 192 U.S. major corporate pension plans between 1988 and 2005. Fewer than 30 percent of the pension funds outperformed a portfolio of 60 percent S&P 500 index and 40 percent intermediate corporate bond index.
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If most pension fund managers can't beat an indexed portfolio, what chance does your financial planner have?

The best odds to win

If you told most financial advisers this, they would either begin talking in circles to confuse you, or they would desperately be battling with their ego.

If it's the latter, you might hear this: If it were so easy, why wouldn't every pension fund be indexed?

Pension fund managers are as optimistic as the rest of us. Many of them will try to beat portfolios comprised of a 60 percent stock index and a 40 percent bond index.

But they aren't stupid, and many pension funds maximize their returns by indexing.

According to U.S. financial adviser Bill Schultheis, author of
The New Coffeehouse Investor
, the Washington state pension fund, for example, has 100 percent of its stock market assets in indexes, California has 86 percent indexed, New York has 75 percent indexed, and Connecticut has 84 percent of its stock market money in indexes.
8

The vast majority of regular, everyday investors, however, (about 95 percent of individual investors) buy actively managed mutual funds instead.
9
Unaware of the data, their financial advisers distort realities to keep their gravy trains flowing. It will cost most people more than half of their retirement portfolios—thanks to fees, taxes, and dumb “market timing” mistakes.

Sticking with index funds might be boring. But it beats winding up as shark bait, and it gives you the best odds of eventually growing rich through the stock and bond markets.

Is Government Action Required?

David Swensen, Yale University's endowment fund manager, suggests the U.S. government needs to stop the mutual fund industry's exploitation of individual investors.
10
The U.S. has some of the lowest cost actively managed funds in the world. I wonder what he would think of Canada's costs, Great Britain's costs, or Singapore's costs, all of which are significantly higher.

You can't wait for government regulation. The best weapon against exploitation is education. You might not have learned this in high school, but you're learning it now.

Among those hearing the call to arms and taking action to educate others is Google's vice president, Jonathan Rosenberg.

In August 2004, Google shares <
www.google.com/intl/en/about/corporate/company
> became available on public stock exchanges and many Google employees (who already held Google shares privately) became overnight millionaires when the stock price soared.

The waves of cascading wealth on Google's employees attracted streams of financial planners from firms such as JPMorgan Chase <
www.jpmorgan.com
>, UBS <
www.ubs.com
>, Morgan Stanley <
www.morganstanley.com
>, and Presidio Financial Partners <
www.thepresidiogroupllc.com
>. Drawn like sharks to blood, they circled Google, wanting to enter the company's headquarters so they could sell actively managed mutual funds to the newly rich employees.

Google's top brass put the financial planners on hold. Employees were then presented with a series of guest lecturers before the financial planners were allowed on company turf.

According to Mark Dowie who wrote about the story for
San Francisco
magazine in 2008, the first to arrive was Stanford University's William Sharpe, the 1990 Nobel laureate economist. He advised the staff to avoid actively managed mutual funds: “Don't try to beat the market. Put your money in some indexed mutual funds.”
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A week later, Burton Malkiel arrived. The professor of economics at Princeton University urged the employees to build portfolios of index funds. He has been studying mutual fund investing since the early 1970s, and he vehemently believes it's not possible to choose actively managed funds that will beat a total stock market index over the long term. Don't believe anyone (a broker, adviser, friend, or magazine) suggesting otherwise.

Next, the staff was fortunate enough to hear John Bogle speak. A champion for the “little guy,” John Bogle is the financial genius who founded the nonprofit investment group, Vanguard. His message was the same: The brokers and financial advisers swimming around Google's massive raft have a single purpose. They're a giant fleecing machine wanting to take your money through high fees—and you may not realize what is happening until it's too late.

When the sharks finally approached the raft, staff members at Google were armed to the teeth, easily fending off the well-dressed, well-spoken, charming advisers.
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I hope that you'll be able to do the same as the crew at Google. But don't forget that for most financial advisers, index funds are pariahs. If you have an adviser today, and you're not invested in index funds, then you already know (based on their absence in your portfolio) that your adviser has a conflict of interest. In that case, asking your adviser how he feels about indexes is going to be a waste of time.

After one of my seminars on index funds, I often hear someone say: “I'm going to ask my adviser about index funds.” That's like asking the owner of a McDonald's restaurant to tell you all about Burger King. They won't want you stepping anywhere near the Whopper.

And they certainly won't want you paying attention to the leader of Harvard University's Endowment Fund, Jack Meyer. When interviewed by William C. Symonds in 2004 for
Bloomberg Businessweek
, he said:

“The investment business is a giant scam. It deletes billions of dollars every year in transaction costs and fees. . . Most people think they can find fund managers who can outperform, but most people are wrong. You should simply hold index funds. No doubt about it”
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Clearly, investing in index funds is a way to statistically ensure the highest odds of investment success. Doing so, however, means that you will need to stand your ground and perhaps take the road less traveled, while most people succumb to the impressive sales rhetoric that leads them toward—at the very least—investment mediocrity with actively managed mutual funds. If you want to grow rich on an average salary, you can't afford to invest in the expensive products sold by most financial advisers.

A huge risk, however, is when investors start looking at options to enhance their investment returns even further than what an indexed portfolio would provide. The following chapter outlines some common mistakes that people make, with a strong message to avoid the same mistakes yourself.

Notes

1.
Sam Mamudi, “Indexing Wins Again,”
The
Wall Street Journal
, April 23, 2009.

2.
An interview with Morningstar research director John Rekenthaler,
In the Vanguard
, Fall 2000, accessed April 18, 2011,
http://www.vanguard.com/pdf/itvautumn2000.pdf
.

3.
Daniel Solin,
The Smartest Investment Book You'll Ever Read
(New York: Penguin, 2006), 48.

4.
William Bernstein,
The Four Pillars of Investing, Lessons for Building a Winning Portfolio
(New York: McGraw Hill, 2002), 224.

5.
Investment Funds in Canada Course (IFIC), accessed April 15, 2011,
http://db2.centennialcollege.ca/ce/coursedetail.php?CourseCode=CCSC-103
.

6.
Daniel Solin,
The Smartest Investment Book You'll Ever Read
, 79.

7.
Larry Swedroe,
The Quest For Alpha
(Hoboken, New Jersey: John Wiley & Sons, 2011), 133–134.

8.
Bill Schultheis,
The New Coffeehouse Investor, How to Build Wealth, Ignore Wall Street, And Get On With Your Life
(New York: Penguin, 2009), 51–52.

9.
Paul Farrell,
The Lazy Person's Guide to Investing
(New York: Warner Business Books, 2004), xxii.

10.
David F. Swensen,
Unconventional Success, a Fundamental Approach to Personal Investment
, (New York: Free Press, 2005), 1.

11.
Mark Dowie, “The Best Investment Advice You'll Never Get,” San Francisco Magazine Online, accessed November 6, 2010,
http://www.sanfranmag.com/story/best-investment-advice-youll-never-get
.

12.
Ibid.

13.
William C. Symonds, “Husbanding that $27 Billion (extended),” December 27, 2004, accessed April 15, 2011,
http://www.businessweek.com/magazine/content/04_52/b3914474.htm
.

RULE 8

Avoid Seduction

The trouble with taking charge of your own finances is the risk of falling for some kind of scam. Learning how to beat the vast majority of professional investors is easy: invest in index funds. But some people make the mistake of branching off to experiment with alternative investments.

Achieving success with a new financial strategy can be one of the worst things to happen. If something works out over a one-, three- or five-year period, there's going to be a temptation to do it again, to take another risk. But it's important to control the seductive temptation of seemingly easy money. There's a world of hurt out there and rascals keen to separate you from your hard-earned savings. In this chapter, I'll examine some of the seductive strategies used by marketers out for a quick buck. With luck, you'll avoid them.

Confession Time

Perhaps I'm justifying this to feel better about myself, but this is what I believe: Any investor who doesn't have a story relating to a really dumb investment decision is probably a liar. So I'm going to roll up my sleeves and tell you about the dumbest investment decision I ever made. It might prevent you from making a similar, silly mistake.

The dumbest investment I ever made

In 1998, a friend of mine asked me if I would be interested in investing in a company called Insta-Cash Loans. “They pay 54 percent annually in interest,” he whispered. “And I know a few guys who are already invested and collecting interest payments.”

For any half-witted investor, the high interest rate should have raised red flags. Around that time, I was reading about the danger of high-paying corporate bonds issued by companies such as WorldCom, which was yielding 8.3 percent. The gist of the warning was this: If a company is paying 8.3 percent interest on a bond in a climate where four percent is the norm, then there has to be a troublesome fire burning in the basement. Not long after WorldCom issued its bonds, the company declared bankruptcy. It was borrowing money from banks to pay its bond interest.
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The 54 percent annual return that my friend's investment prospect paid was a Mt. Everest of interest compared with Worldcom's speed bump. It rightfully scared me to think of how crazy the investment venture must be, telling my friend as much:

“Look,” I said, “Insta-Cash Loans isn't really paying you 54 percent interest. If you give the company $10,000, and the company pays out $5,400 at the end of the year in ‘interest,' you've only received slightly more than half of your investment back. If that guy disappears into the Malaysian foothills with that $10,000, you get the shaft. You'd lose $4,600.”

It seemed totally crazy. But what's even crazier is that I eventually changed my mind.

After the first year, my friend told me that he had received his 54 percent interest payment. “No you didn't,” I insisted. “Your original money could still vaporize.”

The following year, he received 54 percent in interest again, paid out regularly with 4.5 percent monthly deposits into his bank account.

Although I still thought it was a scam, my conviction was losing steam. It appeared that now he was ahead of the game, receiving more in interest than he had given the company in the first place.

He increased his investment to $80,000 in Insta-Cash Loans, which paid him $43,200 annually in “interest.”

As a retiree, he was able to travel all over the world on these interest payments. He went to Argentina, Thailand, Laos, and Hawaii—all on the back of this fabulous investment.

After about five years, he convinced me to meet the head of this company, Daryl Klein (and yes, that's his real name). How was Insta-Cash Loans able to pay out 54 percent in interest every year to each of its investors? I wanted to know how the business worked.

I drove to the company's headquarters in Nanaimo, British Columbia, with a friend who was also intrigued.

Pulling alongside the curb in front of Daryl's office, I was skeptical. Daryl was standing on the sidewalk in a creased shirt with his sleeves rolled up, a cigarette in hand.

We settled into Daryl's office and he explained the business. Initially, he had intended to open a pawn brokerage but changed his mind when he caught on to the far-more lucrative business of loaning money and taking cars as collateral. As a result, Insta-Cash Loans was created.

In a narrative recreation, this is what he said:

I loan small amounts of short-term money to people who wouldn't ordinarily be able to get loans. For example, if a real estate agent sells a house and knows he has a big commission coming and he wants to buy a new stereo right away, he can come to me if his credit cards are maxed out and if he doesn't have the cash for the stereo.

“How does that work?” I wanted to know.

Well, if he owns a car outright, and he turns the ownership over to me, I'll loan him the money. The car is just collateral. He can keep driving it, but I own it. I charge him a high-interest rate, plus a pawn fee, and if he defaults on the loan, I can legally take the car. When he repays the loan, I give the car's ownership back.

“What if they just take off with the car?” I asked.

I have some great retired ladies working for me who are fabulous at tracking down these cars. One guy drove straight across the country when he defaulted on the loan. One of these ladies found out that he was in Ontario (about a six-hour flight from Daryl's office in British Columbia) and before the guy even knew it, we had that car on the next train for British Columbia. In the end, we handed him the bill for the loan interest, plus the freight cost for his car.

It sounded like a pretty efficient operation to me. But I wanted to know if the guy had a heart. “Hey Daryl,” I asked, “have you ever forgiven anyone who didn't pay up?”

Leaning back in his chair with a self-satisfied smile, Daryl told the story of a woman who borrowed money from him, using the family motor home as collateral. She defaulted on the loan, but she didn't think it was fair that Daryl should be able to keep the motor home. Her husband had not known about the loan. He came into Daryl's office with a lawyer, but the contract was legally airtight; there was nothing the lawyer could do about it.

But, as Daryl explained, he took pity on the woman and gave the motor-home ownership back to the couple.

It sounded like an amazing operation.

However, nobody can guarantee you 54 percent on your money—ever. Bernie Madoff, the currently incarcerated Ponzi-scheming money manager in the U.S. promised a minimum return of 10 percent annually and he sucked scores of intelligent people into his self-servicing vacuum cleaner—absconding with $65 billion in the process.
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He claimed to be making money for his clients by investing their cash mostly in the stock market, but he just paid them “interest” with new investors' deposits. The account balances that his clients saw weren't real. When an investor wanted to withdraw money, Madoff took the proceeds from fresh money that was deposited by other investors.

When the floor finally fell out from underneath Madoff during the 2008 financial crisis, investors lost everything. His victims included actors Kevin Bacon, his wife Kyra Sedgwick, and director Steven Spielberg, among the many others who lost millions with Madoff.
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Yet the percentages paid by Madoff were chicken feed compared with the 54 percent caviar reaped by Daryl Klein's investors.

Despite the solid-sounding story Daryl told me back in 2001, I still wouldn't invest money with the guy.

But my friend kept receiving his interest payments, which now exceeded $100,000.

By 2003, I had seen enough. My friend had been making money off this guy for years and my “spidey senses” were tickled more by greed than danger. I met with Daryl again, and I invested $7,000. Then I convinced an investment club that I was in to dip a toe in the water. So we did, investing $5,000. The monthly 4.5 percent interest checks were making us feel pretty smart. After a year, the investment club added another $20,000.

Other friends were also tempted by the easy money. One friend took out a loan for $50,000 and plunked it down on Insta-Cash Loans, and he began receiving $2,250 a month in interest from the company.

Another friend deposited more than $100,000 into the business; he was paid $54,000 in yearly interest. But Alice's Wonderland was more real than our fool's paradise.

Like Bernie Madoff (who was caught after Daryl) the party eventually ended in 2006 and the carnage was everywhere. We never found out whether Daryl intended for his business to be a Ponzi scheme from the beginning (he was clearly paying interest to investors from the deposits of other investors) or whether his business slowly unraveled after a well-intentioned but ineffective business plan went awry.

Klein was eventually convicted of breaching the provincial securities act, preventing him from engaging in investor-relations activities until 2026.
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The fact that he was slapped on the wrist, however, was small consolation for his investors. A few had even remortgaged their homes to get in on the action.

Our investment club, after collecting interest for just a few months, lost the balance of our $25,000 investment. My $7,000 personal investment also evaporated. Many investors in the company lost everything. My friend who borrowed $50,000 to invest, collected interest for 10 months (which he had to pay taxes on) before seeing his investment balance disappear when Insta-Cash Loans went bankrupt in 2006.

It's an important lesson for investors to learn. At some point in your life, someone is going to make you a lucrative promise. Give it a miss. In all likelihood, it's going to cause nothing but headaches—not to mention a potential black hole in your bank account.

Investment Newsletters and Their Track Records

In 1999, the same investment club mentioned earlier was trying to get an edge on its stock picking. We purchased an investment newsletter subscription called the
Gilder Technology Report
, <
www.gildertech.com/
> published by a guy named George Gilder. Unbelievably, he is still in business. A quick online search today reveals a website that exhorts his stock picks, claiming his portfolio returned 155 percent during the past three years, and that if you buy now, you'll pay just $199 for the 12-month online subscription to his newsletter. If you're falling for that promotional garbage, I have a story for you.
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Back in 1999, we were convinced that George Guilder held the keys to the kingdom of wealth. Unfortunately for us, he was the king of pain. Today, if George Gilder reported his 11-year track record online (instead of trying to tempt investors with an unaudited three-year historical return) he would have a stampede of exiters. His stock picks have been abysmal for his followers.

We bought the George Gilder technology report in 1999 and we put real money down on his suggestions. I'm just hoping my investment club buddies don't read this book and learn that George Gilder is still hawking his promises of wealth. They'd probably want to send him down a river in a barrel.

Back in Chapter 4, I showed you a chart of technology companies and how far their share prices fell from 2000 to 2002.

In 2000, whose investment report recommended purchasing Nortel Networks <
www.nortel.com
>, Lucent Technologies <
www.alcatel-lucent.com/wps/portal?COUNTRY_CODE=US&COOKIE_SET=false
>, JDS Uniphase <
www.jdsu.com/en-us/Pages/Home.aspx
> and Cisco Systems <
www.cisco.com/
>? You guessed it: George Gilder's.

Table 8.1
puts the reality in perspective. If you had a total of $40,000 invested in the above four “Gilder-touted” businesses in 2000, it would have dropped to $1,140 by 2002.

Table 8.1
Prices of Technology Stocks Plummet (2000–2002)

Source:
Morningstar and Burton Malkiel's
A Random Walk Guide to Investing

And how much would your investment have to gain to get back to $40,000?

In percentage terms, it would need to grow 3,400 percent.

Wow—wouldn't that be a headline for the
Gilder Technology Report
today?

“Since 2002, our stock picks have made 3,400 percent”

If that really happened, George Gilder would be advertising those numbers on his site rather than showcasing a measly return of 155 percent over the past three years.

George Gilder's stock picks have tossed investors into the Grand Canyon and he's bragging that his investors have scaled back about 50 feet. He could tell the truth about his real stock-picking prowess, but then he couldn't fool newsletter subscribers looking for keys to easy wealth. There are no keys to easy wealth—so don't be fooled by advertised claims.

Just for fun, let's assume that Gilder's original stock picks from 2000 did make 3,400 percent from 2002 to 2011. That might impress a lot of people. But it wouldn't impress me. After the losses that Gilder's followers experienced from 2000 to 2002, a gain of 3,400 percent would have his long-term subscribers barely breaking even on their original investment after a decade—and that's if you didn't include the ravages of inflation.