Post #10 – First Rule of Investment Planning
Based on what I see in the media concerning stocks and other investments, it’s not surprising that some who have an interest in investing for retirement may get so bewildered that they just want to give up. I sympathize with these people. All the media outlets offering confusing and conflicting investment advice can be daunting, and no doubt cause a lot of anxiety for the average retail investor. But I have the solution for you. My first rule of investment planning is to ignore all the financial media outlets. In fact, ignore everything that comes out of Wall Street.
I know it is not a news flash that Wall Street does not have your interest at heart. Wall Street is only concerned with its own bottom line. When I say this, I do not mean to be a Wall Street basher. I am only saying that Wall Street firms are like every other corporation; their goal is to maximize the bottom line in the interest of their shareholders. They do this by offering a product or service that they think their customers will find valuable and be willing to pay for. For the retail investor the only problem with this arrangement is you are not Wall Street’s customer. The customers of Wall Street firms are other banks, insurance companies, and corporations. Although some big Wall Street firms such as Citigroup and Bank of America offer retail consumer services, most Wall Street firms make the majority of their earnings from services they sell to other corporations (i.e., through their investment banking divisions). So, as far as the retail investor is concerned, there is a built-in conflict of interest in regard to the information that comes out of Wall Street.
Let’s take stock investing as an example. The securities research division within a Wall Street firm does the research and analysis on a corporation and then publishes its recommendation of whether to ”buy, hold, or sell” that corporation’s stock. This is supposed to be an unbiased assessment of the stock’s investment value because the research division in a Wall Street firm is independent of the firm’s investment banking division which handles new stock offerings. But in reality there is no independence between these two divisions, and oftentimes the stock assessments are not unbiased.
One of the most egregious examples of this conflict of interest was illustrated in the late 1990s. Remember back during the technology bubble when almost every technology stock was rated a “Buy” or a “Strong Buy?” I remember at the time thinking how could this be? Some of these firms had little or no earnings and had Price/Earning (PE) ratios approaching triple digits. I know people invest based on a company’s anticipated future prospects, but this was ridiculous and represented a huge risk for stock investors. Needless to say I stayed away from these overvalued technology stocks. The reason for these ridiculous “Buy” ratings is the built in conflict of interest within the Wall Street firms.
As previously mentioned Wall Street firms do not make a lot of money from their securities research departments; they make the majority of their money from their investment banking divisions which handle new stock or bond offerings. In other words, in the late 1990s, if a Wall Street firm wanted to have a chance of handling a new technology company’s stock IPO, that firm would not rate that corporation’s stock a “Sell” or even a “Hold”. If the firm did, it would have virtually no chance of getting that company’s IPO business. So the stock assessments by Wall Street were routinely biased toward a better rating. The retail investor who may have been depending on these biased ratings when investing was badly hurt.
The recent financial crisis is another example of the conflict of interest that exists on Wall Street. But in this case the conflict of interest actually hurt other big institutions, such as pension funds, as well as the retail investor.
Another big source of income for Wall Street is underwriting new bond issues for large institutions or corporations. A Wall Street firm’s securities research department is reticent to assess any potential client’s finances as shaky because this will cause the client’s bond rating to be lowered. A lowered bond rating would lead to a higher interest rate on their bond which is not good for any business. If a Wall Street firm wants to obtain the bond underwriting business, it must provide a financial strength rating that is very high. As such their assessment of the organization was usually biased indicating the organization’s finances were stronger than an objective assessment might indicate.
What about the bond rating agencies such as Moody’s, Standard & Poors, etc.? Aren’t they there to protect the bond buyers? Yes, theoretically, they are, but in reality they do not. The major bond rating agencies also have a conflict of interest. To understand this conflict, you have to go no further than to understand how they get paid. The bond rating agencies get paid by the same organizations whose bonds they are rating. Although these rating agencies do review the organization’s books to make their financial strength assessment, do you really think you’re getting an unbiased assessment? I have wondered for years when the bond rating agencies’ conflict of interest would be exposed. It took the credit crisis for that to happen.
Unfortunately this Wall Street conflict of interest was not resolved with the recent financial reform bill passed by Congress. This bill does some good things, but it does not end the basic business model which Wall Street firms operate under. The conflict of interest of Wall Street firms I have described in this blog post still exists today. So ignore everything that comes out of Wall Street.
You need to be careful even if your stock broker is employed by an investment firm that does not underwrite stock and bond offerings. Stock brokerage firms make money from the fees they charge investors for owning shares of their mutual funds. The fees charged by their stock mutual funds are generally much higher than their bond or money market mutual funds. I believe this fact is one reason why the investment advisory arms of brokerage firms recommend much higher stock allocations for the average portfolio than they did 30 years ago. They make more money from their stock mutual fund fees. And, in the process, the average investor is taking on more risk than they otherwise might. Believe it or not, mutual fund fees can greatly impact your investment results over time, therefore assessing the management fees when choosing a fund is important. I will cover this topic in a subsequent post.
The previous discussion does not mean you shouldn’t invest in stocks, bonds, or mutual funds. What it does mean is, just like buying a car; you need to know the value of the product you are buying (and whether the product is even right for you). Some time ago I read a statement by investor Phil Fisher that I think was emblematic of the late 1990s, “The stock market is filled with individuals who know the price of everything, but the value of nothing.” I think this is still true today. Some of it may be due to laziness, but some of it is likely due to biased information put out by Wall Street. Knowing the value of your investments is one of the most important concepts in investing. If done right, it can turbo-charge your investment returns.
You may be wondering, “If everything is so biased, what am I supposed to do?” There are unbiased investment sources available. But, in order for them to be unbiased, you must pay for them (e.g., paying an investment advisor or buying a newsletter subscription). By paying for your investment advice you become the customer, and not just a cog in the wheel of someone else’s agenda. But paying for investment advice reduces your investment returns just as mutual fund fees do, so you need to be careful how much you pay for advice and whether you believe it is worth the cost. As I will discuss in future posts, I don’t think the average investor needs to pay for investment advice or even do a lot of investment analysis beyond keeping abreast of long term trends. But, if you are interested in attaining more specific investment advice, check back. I will be posting my thoughts about how and where to get cost-effective unbiased information.
To end this post the two most important traits of a good investor, in my opinion, are discipline and patience. These two traits along with an understanding of some basic investment concepts will be all you need to be a successful investor. In the next few blog posts I will talk about these investment concepts. Some of the subjects may be familiar. A preview:
- The single most important factor in investment returns
- The importance of investment risk
- Avoid the big losses
- Pay attention to valuations
- The importance of income investments
“We don’t have to be smarter than the rest. We have to be more disciplined than the rest.” -Warren Buffett
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