Tip #2: Avoid being Devoured by the Parasites

Light gains make heavy purses - Francis Bacon

Well, as usual my ambition exceeded my accomplishments when it comes to this blog. I had hoped to have posted two or three more entries since Thanksgiving. But the combination of holiday travel, a new fitness/health regimen, trying to keep up with the many developments in the investment world and (admittedly) procrastination have caused me to fall behind schedule. My apologies.

Over the long weekend the financial markets were roiled by what looked to be a massive debt default (well, temporary suspension of payments is how the debtor preferred to characterize it) in Dubai. This seemed to remind investors that, while financial/asset markets have vigorously bounced since last Winter, problems continue to manifest themselves in the real global economy. Over-capacity and slack demand are ongoing issues around the world. Unemployment continues to plague the US, Europe and much of Latin America. While governments across the continents continue to engage in unprecedented deficit spending, the private sector continues to exhibit signs of economic malaise.

As a brief aside, there is a high correlation between coming asset busts and grandiose building projects. Dubai is presently constructing the Burj Dubai, slated to be 162 floors! This will eclipse the height of the current tallest building in the world (the Taipei 101 Tower) by over 1000 feet. Plans for constructing the Taipei 101 Tower in turn occurred prior to the global tech bust of 2000. Up until Taiwan's behemoth building was erected, the Petronas Towers in Kuala Lumpur had been the world's tallest building; it was built in 1998, just in time for the East Asian financial crisis that leveled Malaysia's economy. Indeed, the Empire State Building, the tallest building on earth for over forty years, was finished just as the Great Depression was decimating the US economy and would continue to do so for over a decade. Hence, one may wish to avoid investing in nations which are planning to erect the tallest man-made vista.

At some point the dichotomy between asset markets and the real economy will have to be reconciled. In my opinion, there are only three possible outcomes. First, asset markets could correct down in recognition that structural problems in the global economy will continue to plague us all. Second, the global economy could trend higher, thereby justifying the "forward-looking" asset markets' price levels. Finally, all the stimulus throughout the world could continue unabated, leading to massive inflation, the likes of which have not been seen in decades. In this last environment, non-fixed income financial assets should hold their own, if not increase further (even adjusting for inflation). Most tangible assets should see huge gains in the event of significant inflation. It will be intriguing to see how things unfold to say the least, as the investment implications of the various individual scenarios described above are quite disparate.

But on to other matters. As I mentioned last week, I thought I would try to distill some of the most valuable lessons I have learned as an investor in these series of blogs. The first blog focused on how running with the crowd/lemmings is usually the best way to achieve poor returns, particularly prior to key market inflection points. I would now like to focus on the role financial institutions play in almost inevitably sabotaging your investment returns.

One should never forget that the financial services industry is the equivalent of the "House" in Las Vegas; it always wins in the long-run, and always does so at the expense of its patrons. Since I first published a PDF financial/investment newsletter in the wake of the stock market crash at the beginning of the decade, I have been a merciless critic of Wall Street (see also blogs below). And given what they extract from investors, I think it entirely justified to place them under very close scrutiny, as Americans collectively are charged almost $100 billion in various fees by financial services firms!

Now I do not have a problem with people being paid fairly for providing some value-added service. I will gladly pay money to a mechanic that can fix my theretofore inoperable car. I have no skills in auto mechanics. And as a fan of Adam Smith and David Ricardo, I am a firm believer in specialization of labor. But the problem with the financial services industry is that it collectively not only fails to add value for the unfortunate souls who entrust their hard-earned money to it, but Wall Street actually fails to achieve market returns once their exorbitant fees are considered.

As harsh as it sounds, the vast majority of financial services professionals are imbeciles, twits, scofflaws and/or scoundrels. And let's face it, individuals working as investment professionals would be deriving most of their income from profitable investments as opposed to the fees they collect from managing your money if they could consistently obtain above-market returns. But this is not the case by a long shot.

Now the average investor under-appreciates the way in which his/her returns are savaged by bloated Wall Street fees. Many individuals I talk to have no idea what the expense ratios are for the mutual funds they own in 401(k), IRA and/or brokerage accounts. The fact of the matter is that actively managed mutual funds can charge fees that oftentimes exceed 2%. Now that might not seem like much, but compounded annually over ten years, a 2% expense fee costs an investor almost 22%, which is a significant drag on your returns. This becomes all the more brutal over a decade like the one we have experienced since 1999, where overall returns are almost flat. In that case, you have less than 80 cents left for every dollar invested, despite the market being flat. So what seem like trifling fees actually can make a huge difference in how successful one's investments will be, particularly over very long periods of time.

Accordingly, I am convinced the vast majority of investors would be best served by investing in a properly constructed portfolio of low-cost index funds. Next time - The Myth of Buy and Hold Investing. Likely to be the most iconoclastic blog of this series. My apologies for the unedited nature of this entry; I am late for a poker game.