The Worst Investment Advice Ever

When a wise man gives thee better counsel, give me mine again.

Shakespeare, King Lear

I am convinced that 99.9% of reported financial news/analysis is at best a waste of time. Investors tend to be focus upon “noise,” such as a drop in some particular economic indicator, and risk losing sight of the forest through the trees. But once in a while I come across something in the financial media so much more abominable that it warrants special opprobrium.

Let’s travel back in time together nine years, to the halcyon days of early 2000. Ahhh, doesn’t everyone feel better already? Y2K was perhaps the biggest non-event of our lives. Asset prices everywhere were buoyant. Jobs were plentiful. The government actually had a budget surplus, and was thereby reducing the national debt!! Sorry, I am a little dizzy here from the disorientation . . . . Ok, better now.

Of course everyone was happy other than yours truly. My delicate psyche was already troubled by disturbing trends in both personal spending and overall debt levels, as well as what appeared to be unsustainable increases in the stock market. And no sector had experienced greater gains than the tech sector. Now I am just a naïve simpleton; technology largely eludes my ken of understanding. I have to be tutored in the use of Excel. But as an investor, I simply could not see how companies that employed really smart, tech-savvy individuals, yet operated businesses with no track records, tiny customer bases and paltry revenue streams could be valued at billions and billions of dollars.

So while this Chicken Little was warning of the impending sky-earth collision in March 2000, I stumbled across an investment advice column online. In it, the “advisor” recounted the content of a letter he received from a reader seeking guidance. The poor fellow was in a very common situation. He was in his mid-late 50’s and was employed in a lower management position with some company. So here he was in the twilight years of his working life, yet had never gotten around to putting away much money in his retirement account. He had begun to do some back-of-the-napkin calculations one day and realized that his projected financial needs/wants upon retirement would exceed his social security payments. This epiphany suddenly made him a very motivated saver/investor. So he was going to max out his retirement contributions to try and “catch up.” But even at a maximum level, he was concerned about falling short of his retirement needs. He thus asked for this advisor’s portfolio allocation suggestions, both for what relatively small amount he had in his 401(k) at the time, as well as for future contributions.

The advisor began by making some general observations about how in younger years, investors should generally be invested heavily in equities, since stocks have higher long-term returns. These investors can also handle short-term losses given their long investing horizon. Conversely, older investors should start to funnel an increasing amount of their investments into more stable, fixed-income securities, even if they have less up-side. This percentage for someone like the reader might be 40% stocks and 60% bonds if he were an individual with a large sum in his 401(k). Even though I was advising that people have little or no money in the US stock markets at that time, I cannot take issue with the fact that this is good generic advice for any time equity markets are not at bubble levels.

The advisor went on to talk about the reader’s specific situation. Since this investor was way behind in saving for retirement, he would have to take on greater risk with his 401(k) allocation (my eyes began to widen). Specifically, the investor should be putting 80%+ into the stock market (my jaw dropped). And within the stock market he should put most of the money into the tech-laden NASDAQ due to its expected “higher returns” (incredulous, I was in a virtual apoplectic trance)!

This advice was imbecilic and deleterious on three levels. First, if someone has inadequate funds to maintain a desired lifestyle, the most important goal should be capital preservation, not capital appreciation. As such, advising this poor gentleman to place most of his saved income into the riskiest asset class at the time that was not a start up was utterly negligent, and placed the investor in financial harm’s way.

To understand the need to emphasize capital preservation better in this case, let’s imagine that after saving and scrimping all year, this fellow is able to sock away $10,000. Should he make 30%, he banks $3000 and feels good. But in the event his investment goes South 30%, he is now down to only $7000 in savings. But importantly, in order to get back to his initial $10,000 level, he must now obtain returns of 40%+. So volatility to the downside is much worse to his financial health that a commensurate gain is beneficial.

Economic behaviorism is a school of thought to which I adhere. Studies by economic behavioralists have shown that individuals suffer a greater magnitude of displeasure when an investment goes down x% that they receive satisfaction from the investment going up x%. This makes sense intuitively. When you receive something you have not had, you are generally pleased, but not necessarily ecstatic. But when you lose something that you have had, the sting can be very great indeed.

From a pragmatic perspective, it was even more important to prevent significant losses in this man’s retirement account. Assume he wanted to retire at 65 and then take a couple of trips a year with his wife and enjoy life. He figures out how much he needs to have saved to do all that, and then concludes that his investments would have to go up a total of 70% to make that happen. So he eschews bonds and safer equities, and plunks down his hard earned savings in high-flying tech stocks. But instead of gaining 70%, they lose the same amount. The effect? Now it is not an issue of trying to fit in that second trip each year. Rather, he may be unable to make his mortgage payments (more older Americans owe significant amounts on their houses than ever before, so this is not an unrealistic problem). Similarly, the man may conclude that he cannot retire until he is much older.

The second way in which this ranks as the worst investment advice I have seen in the financial media is that this counsel was provided on the eve of the great tech implosion of 2000. Now many financial advisors/professionals at the time claimed that they could not be blamed for being caught unawares, as most of their colleagues we similarly blind-sided by the precipitous fall in stock prices. Rubbish! The same reason the current housing crash should not have surprised people who claim to be real estate experts applies to tech crash of 2000: anytime there is an unprecedented increase in the magnitude of returns for a particular asset class, investors (as opposed to speculators) should generally run for the hills.

Stocks are like any other asset. There is some notion of intrinsic value that applies to companies. Those of us who invest based upon fundamentals look at a variety of metrics to determine how attractive stocks are priced. This method can be applied to individual companies, or markets as a whole. And while its application is far from scientific or fool-proof, it can give one a general idea of whether the stocks in question are investment worthy. When applying these analytical tools to the NASDAQ in the early part of 2000, it was apparent that the market was over-valued to an extent never seen before. So for this advisor to justify his recommendation of tech stocks based upon very recent, ephemeral and unsustainable gains in the NASDAQ was appalling by any standard of responsible financial advising. But this was not unique. I talked to dozens of people that were getting similar advice from their financial professionals as well.

Finally, the advisor made the mistake of treating stock market returns like an actuarial table. Sure, if one charts out the last 80 years or so, average returns in the stock market look pretty impressive (although a lot less impressive than they did back in 2000!) And in 2000, even ten year returns for tech stocks looked remarkable. But this is like driving by looking at nothing else but the rear-view mirror. Generally when one sees such complacency in the markets, danger is lurking around the corner. Of course even being able to see the corner and adjust one’s direction assumes that one is looking at the road. In this case, investors and their advisors en masse drove right through the barrier and off a cliff. One should never forget that asset markets make very quick and violent reversals. Expected returns can be dashed in the process.

I periodically think of the poor gentleman and the terrible advice he received from the investment "professional." I hope he got a second opinion that was remotely sensible given his situation. You see, the 70%+ loss scenario I outlined above was not arbitrary. In the nine years since March of 2000, that is the magnitude of losses in the NASDAQ index. It would have been far better advice to have told the reader to go to a roulette table once a year and put his entire annual savings on black. The total expected losses would have been much less than buying tech stocks in early 2000.

This topic came to mind due to the fact that I have had numerous inquiries from friends who are trying to assist their parents, many of whom have suffered huge losses in retirement funds, manage the money that is left. Since many older individuals rely upon these accounts for a stream of income, the relevant question is usually whether they should cut their losses in stocks and get out, or stick it out expecting some imminent rebound. However, without doing a painstaking analysis of someone’s entire finances, it is impossible to proffer general advice on this topic responsibly.

But it is possible for me to implore folks, whether you are managing your own personal finances, or those of your parents, to determine what level of income is needed to support a minimally accepted lifestyle. Frankly we in this country are blessed, as no one will ever be in a position of starving, and few will be unable to find long-term shelter. Social security and other state programs alone address these needs. But once the investor determines one's future acceptable standard of living, the savings that will support that level should be in very secure investments. Generally this would be something like Treasury Inflation Protected Securities, short-term fixed income instruments, and possibly certain investment grade corporate bonds.

Reader Appreciation

I began this enterprise in a rather sputtering manner last July. While always having a passion for assisting people who might not be otherwise financially inclined make smart decisions concerning their money (or at least avoid making poor ones), I am not by nature a self-promoter. However, after a close friend told me that a “blog unread is simply a diary,” I realized I hate diaries and needed to do something about that. Accordingly, I started to let people know this personal endeavor exists, mostly through contacting Facebook friends.

In the month that I have spread the word, this is now the most tracked blog dealing with either investing or personal finance that is networked through Facebook, with 100 individuals who have signed on as followers. It is also the most followed blog under the topic of “ranting.” I am not sure how I should feel about that.

Since letting folks know about this blog, I have received excellent and supportive comments, as well as ideas to make it better. All of the input is greatly appreciated, and please keep it coming.

I would encourage any of you that are reading this to pass along my blog link to friends who may also find it of interest or use. The more people who follow this, the less likely I am to feel like these entries are akin to those of a 13 year-old girl.