This post was originally published in May of 2012, I've updated it slightly and am re-posting it since I've had a few people asking me about this stuff lately... There was also a great article posted by John Rekenthaler about John Bogle's latest paper (the full paper is available from my friends at the CFA) analysis of actively managed investment funds and the associated costs that an investor bears. This is important to think about as you are thinking through who and what you are investing in. This table is pulled from that article. If you have a "financial planner" who is getting commission to sell you these things that "sales charge" may be a lot higher and they may be getting a cut even though they could have just as easily recommended an investment vehicle that is lower cost. Take the Dow Jones Industrial Average for example - there are really only 12 stocks that makeup over 50% of that index. Is paying all these fees worth it when you could buy just the twelve stocks or buy a motif of the top twelve and get the same results? In the last few months I have been asked way too many times for a referral to or advice on how to pick a stockbroker. My first thought is always that I am glad the people asking realize they just want help managing their investments. It is definitely a good thing to focus on what you are good at and be willing to spend the money for someone to do the things that you are not good at. This is the basic economics that Adam Smith explained. Usually the people asking have looked around on the web already yet have been generally shy to ask their close friends for the same advice. For some reason our culture makes it hard to talk about real money matters with friends and family. Usually that is because those conversations lead to divulging how much is really in the bank or what kind of salary people are earning. I never understood why we were so afraid to have these conversations... sure it means that we end up judging one another, but good family and friends won't make a negative judgement based on a higher or lower than average financial position. Usually people are asking me without having had that conversation with their family though and they are asking about stockbrokers (you know like the ones in the Wolf of Wall Street). They are trying to get validation that going to one of these "financial planners" is a good idea and that they will get help with their money beating the market. They never want to do the investing themselves as they have no clue about the market and think that day traders are the only ones with online investment accounts. This leaves them going to the major advertisers (e.g. the "financial planners" at Morgan Stanley) and then asking me for validation. Occasionally I hear the story about how they read some random walk theory and just want market returns... yet they still want to pay someone to give them market returns. So here goes the basic advice I tell everyone. I will just start referring people to this post and update it if anything changes (doubt it will)...
If you just want to match the average stock market return – you do not need to pay anyone.
Seriously! Make your own little 3x5 card like this one. If you are seriously ok with market returns and want to spend your brain power doing other things like reading great blogs (a.k.a. this one)... Just follow the steps in the card. To expand on the card... Buy the ETFs that track the indexes (S&P 500, NASDAQ, & DJIA) at any online brokerage and you will get market returns. You can also buy Motifs that have the major components of these. These will be good some years and these will be not as good some years. If you want to do a little better than just the US market buy ETFs that represent all of the major indexes around the world. Some online brokers offer these for free, some offer them at little cost. A pretty common place (because it is cheap) that people who want to match the market do this is at Vanguard. Anywhere is fine though. The good part is that you will do just as good as most money managers. This isn’t a joke, if you think it is and you would rather pay someone for market average returns, you need to ask yourself - are you losing money? Remember that most investment professionals are paid to give you exactly the market average return. In fact, I heard the funniest comment this week from a real estate professional who was trying to get interest from people to invest with them. He stated that his investment broker had returned 1% over the market consistently every single year. He said this was amazing. What he failed to mention was that he was likely paying 1% in fees to this same broker and thus getting market returns. Needless to say he didn't attract my investment capital for his real estate fund. You probably think I'm kidding about the financial planner thing.... I too was paying someone 1% to manage my money (after a discount). We would talk once a year and he would tell me how the market was doing. I would argue with him and ultimately get frustrated at his view of the world. He would tell me that buying into these Morgan Stanley managed funds were way better than the indexes. In fact he would convince me to diversify and sell me other Morgan Stanley funds. Most of the time his timing would be WAY OFF. Last summer we talked when I had a 401k to rollover. I told him that I wanted every dollar of my rollover invested because I wanted to catch the coming increase in the market. I could see the business activity in the market and knew it meant improved returns were coming in the market. He said ok…. December rolled around and I called him up very irate, he hadn’t put my rollover into the market and I had already missed part of the move. He said things were about to drop so he saved me. In January I closed all my accounts with him, 1% fees for market returns and complete ignorance to macro economy indicators was ridiculous. Luckily I only had a portion of my money with this broker and had spent the last five years learning how the markets work so capturing the stock market moves we have seen lately wasn’t too tough once I fired my broker. Believe me when I tell you that paying someone 1% to get market returns SUCKS!
There are alternatives to the ETF strategy and maybe you do a little better than the ETF strategy.
I talked about Betterment, FutureAdvisor, & Wealthfront in my post about how retail investment is changing. These are online based tools that are much lower cost, but also designed to give you around or just above market performance. What I didn’t talk about in that blog post was the emergence of fee based investment professionals. This is similar to the rise in flat fee legal services where you pay an hourly rate to a professional who gives you some tips/tricks on how YOU should change your investments and afterwards steps out (http://www.flatfeeportfolios.com/). Of course in both of these scenarios you are moving away from relying on the fact that the index tracked funds will return exactly that (the same as the indexes they track) and are starting to move towards trusting the person or business you are working with. The flat fee model and the online algorithm model reduce to some extent the need for trust. They only attempt to get just above market returns and risk very little in doing so. They are also not personalized services that require you to believe in the person behind the curtain - they are straight forward and allow minimal interaction.
If you want to be better than average, you have to be willing to accept the risk.
This is hard for most people. If you aren’t doing it yourself you really have to find a way to trust someone or some firm to give you the outlandish returns they are promising. Every time I talk to someone about the returns that they want it is always double digit. When they see the kind of people and firms that can actually deliver double digit returns, they usually say that it is too risky and go with an Ameriprise broker or something. My point is that if you aren’t actually interested in investing with someone who is promising you these returns, don’t waste your time trying. Go back to getting market returns with an ETF. If you want websites look at things like Alphaclone who promise great returns and seem to be delivering. If you want Mutual Funds, those are around as well… or if you really want a person – ask someone you trust if they know a great Registered Investment Advisor (RIA)... RIAs by law, have a fiduciary responsibility to their clients while brokers do not. I guarantee if you ask someone you know and trust that is passionate about success they know at least one great money manager (disclaimer: I know a couple that promise and deliver outlandish returns and am NOT one myself - maybe with enough convincing I'd get setup as one). The point is that if you really want those double digit returns after paying someone else to manage your money, you really are going to have to find someone or a firm that you can trust and usually extending that trust is pretty tough. If you still don't believe me that outperforming the market is possible, read the piece The Myth of the Most Efficient Market by O'Shaughnessy Asset Management - in it, Jim O'Shaughnessy outlines a strategy where actively focusing on a few key financial quality measures, active management always outperforms indexing (due to the fact that the weighting of companies within an index doesn't give preference to the best companies in the index).
If you think back to the snake oil salesman of the past, these people would sell anything to cure the ails of the public. Some would put things in that were bad for you, some would put things in that weren’t good or bad, and occasionally there would be a motivated chemist who would put together a concoction that was truly helpful. The tough part is that they all sounded a little kooky. They all sounded like snake oil salesman. If you walked into a church back then and asked the room for some advice about your cough, they would tell you how they would cure your ailment, point you to the tried and true remedy, or point you to all sorts of snake oil salesmen. What I am saying is no different. If you are asking around for a referral to a stock salesman, the people you are asking can either advise you of their specific remedy, point you to market returns (warning you not to pay too much for them), or point you to their favorite snake oil salesman. Ultimately when you see the salesmen you are pointed to, you will have to make the decision that they are honest or not. There are no laws or regulations that brokers who work for investment banks have to actually return to you this year what they claimed to return last year so it is up to YOU the buyer. The SEC warns of this - http://www.sec.gov/investor/pubs/invadvisers.htm and all the racket in the legislature the last couple weeks around the JOBS bill is centered on this very topic. The fact that anyone can con you as an investor is troublesome to a lot of people; however, there is nothing really preventing the average retail investment broker from conning you into paying them 1% for something that you can get on your own. This means that you need to trust someone or some firm in their ability to provide you with the outlandish claims that they tell you about. Of course determining the difference is the tough part and Mike Alfred seems to forget this fact in his latest Forbes article sucking up to investment advisors.
In the end, my personal recommendations are:
- If you want market returns buy a group of ETFs or funds that track the world's public indexes at any online brokerage – you choose, but it really doesn’t matter.
- If you want a little better than that, use a flat fee RIA or online firm such as betterment, wealthfront, or futureadvisor.
- If you really want to beat the market, ask a trusted friend or family member for a RIA they use because ultimately you will have to trust the outlandish story you are going to hear
- Of course you can always learn to invest yourself, get started reading books like The Intelligent Investor, Margin of Safety, or The Big Secret for the Small Investor - you can also read publications like the GMO Quarterly Newsletter - Jeremy Grantham and then reading Investing Lessons from Venture Capitalist series.