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May-25-16

A Stock Tip That Went Horribly Wrong

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Of all the misinformation disseminated to investors, the most pernicious supports the belief that some “investment pro” or pundit has the skill to reliably pick outperforming stocks. This myth is perpetuated by endless blogs and television appearances by “gurus” touting their latest and greatest stock selections.

A steady drumbeat

A quick review of what passes for financial news is illustrative. For instance, Jim Cramer is touting “The One Retail Stock Money Managers Want to Own.” Another blog on Yahoo Finance asks: “Why Is SEI Investments (SEIC) a Strong Buy Stock Now?”

Sometimes these recommendations turn out well — especially in a bull market. But it doesn’t seem to matter to those who make them. They take credit for the good calls and have no accountability for the bad ones.

What isn’t disclosed

It’s all an elaborate charade designed to line their pockets with your money. What they don’t tell you is that their track record is no better (and often worse) than what you would expect from random chance. One peer-reviewed study looked at the performance of 2,076 mutual fund managers over a 32-year period. It found 99.4 percent of them (which is statistically indistinguishable from zero) evidenced no stock-picking skill.

The ability to confuse luck with skill is critical to perpetuating the myth that stock gurus have the ability to select “winners.”

The timeline of a bad stock pick

The problem with this myth is that it can have devastating consequences for investors. Here’s a troubling example of a stock tip that went horribly wrong.

On Sept. 30, 2013, The Motley Fool, a very popular financial site, featured an article by Matthew DiLallo. The article was about SandRidge Energy. The stock was then selling at $6 a share and DiLallo discussed whether it was still a good buy at that price. He seems well-qualified. He’s the senior energy and materials specialist at The Motley Fool.

Initially, he noted that SandRidge was a company he knew “inside and out.” After assessing the recent run-up in the stock, DiLallo concluded that “there is a lot of value still left in SandRidge even as its stock has been moving higher.”

He buttressed his views by noting that “hedge fund billionaire” Leon Cooperman estimated that SandRidge could be worth as much as $10 a share. Cooperman had named SandRidge one of his “top 10 stock ideas” earlier in the year and called it a “potential double.” Stock pickers often seek to add credibility to their recommendations by aligning their views with “billionaires.”

DiLallo concluded that the answer to the question of whether or not SandRidge was still a buy near $6 a share was “a resounding yes.” He disclosed that he owned shares of the stock.

On July 18, 2014, DiLallo speculated about the possibility of a merger involving SandRidge. The stock was selling at $6.51 a share. I suspect many investors viewed the prospect of a merger as a bullish sign.

On Oct. 16, 2014, DiLallo revisited SandRidge. The stock had dropped to $4.57 a share. He still owned his shares. DiLallo counseled investors in the stock to watch for SandRidge’s third-quarter earnings, which would tell them how the firm was “managing the plunge in oil prices and what to expect from the company going forward.”

On Feb. 12, 2015, SandRidge was selling at $1.95 a share. DiLallo noted the company needed to “do its best to tread water until the price of oil improves just to control its debt, which has already been a huge weight on the stock.”

On March 24, 2015, with the stock selling at $1.69 a share, DiLallo analyzed the impact of oil prices on SandRidge. He provided reasons both to divest the stock and to hold on, but his takeaway was this: “Because time is on SandRidge’s side, I don’t think now is the time to bail on the company.”

By April 21, 2015, DiLallo’s enthusiasm for SandRidge was starting to wane. The stock price was $1.92 a share. He still owned shares in the company. He cautioned investors that SandRidge had at least three unique risks that could continue “to plague the company if oil and gas prices remain weak.”

On July 14, 2015, with the stock selling at 80 cents a share, DiLallo asked: “Is There Any Hope Left for SandRidge Energy Inc. Investors?” He was still holding on to his shares. He concluded there wasn’t much hope the stock would “ever rebound.” He noted it was down 88 percent over the past year, but that he was keeping his shares because he didn’t “have that much more left to lose.”

On Oct. 8, 2015, with the stock selling for 49 cents a share, DiLallo noted a large debt exchange by SandRidge. The headline of DiLallo’s blog was upbeat: “SandRidge Energy Inc. Takes Another Step Forward.” He was still holding on to shares of the company. While he noted that SandRidge was reducing its legacy debt, he cautioned that “the company still has a lot of work to do as it wasn’t built to handle the current oil price.”

Cramer weighs in

DiLallo was not alone in his enthusiasm for SandRidge. On April 16, 2014, when SandRidge was selling for $6.48 a share, Cramer explained why he viewed the stock as a “speculative buy.” Cramer believed SandRidge had the “potential to double its well count and has up to 20 years of drilling inventory.” He thought the stock could increase to $10 or even $15 a share.

Devastating losses

So what’s the big deal? Sometimes the forecasts that stock pickers make are right and sometimes they’re wrong. Everyone has a right to express their opinion, right?

Here’s the problem. When pundits hold themselves out as having an expertise that a wealth of evidence indicates doesn’t really exist, they are misleading gullible investors who can be harmed by their advice. These losses, in aggregate, can be devastating.

According to an analysis published just this month by economists Brian Henderson and Craig McCann, both of whom hold Ph.D.s, SandRidge’s stock price declined by 99 percent since 2014, erasing more than $4 billion of market capitalization. In addition, investors lost billions of dollars in SandRidge notes. The authors calculated losses of approximately $3.3 billion across all outstanding notes. Total losses to investors in SandRidge have been well over $7 billion.

SandRidge closed at 2 cents a share on May 16.

Reforms needed

It’s not fair to blame DiLallo and Cramer for these losses. Investors have to take responsibility for their own conduct. However, there’s an obvious need for regulation of those making stock predictions. They should be required to prominently disclose the accuracy rate of their predictions and to highlight research indicating that stock picking is a highly speculative activity in which few have demonstrated any expertise (as contrasted with luck).

These mandated disclosures would inform investors that a monkey throwing darts is likely to compile as good a track record as investment “pros.” It would limit the carnage by giving investors a dose of reality when evaluating stock-picking advice.

 

A Stock Tip That Went Horribly Wrong blog was originally posted on The Huffington Post website.

 

2014-04-01-Hiresfrontbookcover.jpgDan Solin is a New York Times bestselling author of the Smartest series of books, including The Smartest Investment Book You’ll Ever Read, The Smartest Retirement Book You’ll Ever Read and his latest, The Smartest Sales Book You’ll Ever Read. He is a wealth advisor with Buckingham and Director of Investor Advocacy for The BAM ALLIANCE.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

 

 

By: Dan Solin | 0 comments
May-20-16

The Three Biggest Investing Anomalies

There are many anomalies in investing. It wasn’t easy to isolate the three biggest ones, but here are my choices:

1. You love Warren Buffett, but ignore his advice.

Warren Buffett has rightfully been called “the greatest investor of his generation, or ever.” Given his cult-like status, you’d think investors would hang on his every word.

For many years, Buffett has been a proponent of index-based investing. Here’s what he said in Berkshire Hathaway’s 1996 letter to shareholders:

“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”

This advice was largely ignored.

At this year’s annual meeting of Berkshire Hathaway shareholders, Buffett upped the ante. According to The Wall Street Journal, he stated that market-beating investment consultants were usually a “huge minus” for those following their advice. He noted that passive investors will likely outperform “hyperactive” investments recommended by consultants and fund managers.

His advice wasn’t limited to individual investors. It applied with equal force to pension funds and endowments that pay high fees to consultants in the mistaken belief they can achieve market-beating returns. He accurately noted that “no consultant in the world is going to tell you ‘just buy an S&P index fund and sit for the next 50 years.’”

In 2006, I used the term “hyperactive” to describe the conduct of stock-picking brokers when I wrote The Smartest Investment Book You’ll Ever Read. I urged investors to dump their brokers and invest in low-management-fee index funds instead.

Maybe this latest, forceful effort from Buffett will be the tipping point. It would be gratifying to stop the transfer of wealth from those who earn it to those who “manage” it. The securities industry needs to be exposed for its greed and self-interest.

2. You keep doing business with companies that abuse your trust.

MetLife is no better or worse than many others in the securities industry. That’s precisely the problem.

On May 3, the Financial Industry Regulatory Authority announced a sanction of $25 million against MetLife for negligent misrepresentations and omissions in connection with variable annuity replacements.

FINRA found that from 2009 through 2014, MetLife Securities misrepresented or omitted at least one material fact relating to the cost and guarantees of its customers’ existing variable annuity contracts in 72 percent of the 35,500 replacement applications the firm approved.

These misrepresentations weren’t minor. They included telling customers the replacement annuity was less expensive than the current one when it was actually more expensive, understating the value of existing death benefits and failing to inform their customers the replacement annuity would “reduce or eliminate” important features in their existing annuity.

As is the custom when industry players get caught with their hand in the cookie jar, MetLife “neither admitted nor denied the charges, but consented to the entry of FINRA’s findings.”

The list of settlements involving household names (and others) in the securities industry, for a variety of unethical and illegal behavior toward their customers, is a long one. Misconduct relating to the financial crisis alone was so extensive the SEC maintains a separate compilation of its enforcement actions. Almost every major brokerage firm is on this list.

It’s a stunning anomaly that you continue to entrust your retirement savings to those with this extensive track record of abusing your trust.

3. You continue to search for patterns where none exist.

The holy grail of investing is to identify a predictive pattern and take advantage of it to trade profitably. Many in the financial media exploit this fantasy because it encourages you to trade. Trading increases the revenue earned by the brokerage industry, which in turn supports the media through massive advertising expenditures.

Jim Cramer shamelessly leads this effort with columns like this one: “Cramer: Yikes! Scariest pattern in the charts.” As usual, Cramer references no peer-reviewed data supporting his reliance on patterns, which is not surprising. It has long been my view that Cramer and others in the financial media who purport to be able to spot predictive patterns, pick outperforming stocks, select outperforming mutual funds and predict the direction of the markets are emperors with no clothes. They do incalculable harm to gullible investors.

There is ample evidence these “gurus” have no expertise that can’t be explained by random chance. Cramer’s track record is actually worse than a coin flipper would have compiled.

The securities industry adds to the myth that predictive patterns exist. One major firm advertises software that will help you “read charts, recognize price patterns, add indicators, and detect market reversals.”

It doesn’t caution that this is a fool’s errand.

The reality is that stock prices are independent of each other. As Burton Malkiel established in his seminal book, A Random Walk Down Wall Street, the history of stock prices tells you nothing about future prices, just like a coin toss tells you nothing about the probability of the outcome of a future coin toss.

The first step to becoming an intelligent and responsible investor is recognizing these anomalies and refusing to buy into them.

 

The Three Biggest Investing Anomalies blog was originally posted on The Huffington Post website.

 

2014-04-01-Hiresfrontbookcover.jpgDan Solin is a New York Times bestselling author of the Smartest series of books, including The Smartest Investment Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read and his latest, The Smartest Sales Book You'll Ever Read.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

 

 

By: Dan Solin | 0 comments
May-16-16

Complexity Is the Investing Devil

What do the following investments have in common?

  • Options
  • Covered calls
  • Collateralized mortgage obligations
  • Non-traded REITs
  • Master limited partnerships
  • Variable annuities
  • Equity-indexed annuities
  • Hedge funds
  • Principal protected notes
  • Private equity

Here’s the answer: They are all complex investments. As a result, assessing the risks involved with owning these investments can be challenging. They also generate meaningful commissions for the brokers who sell them so enthusiastically.

Brokers benefit from complexity

Brokers love complex investments. They give them the opportunity to demonstrate their “superior” knowledge. They also reinforce the message that you need them to guide you through the intricate world of investing.

Few investors understand complex investments. The securities industry wants to keep it that way. One study concluded that “producers of retail financial products create ignorance by making their prices more complex, thereby gaining market power and the ability to preserve industry profits.” The same study found investors “often make purchases without knowing exactly what they are getting or how much they are paying. In fact, they may also be unaware that they are indeed over-paying.”

The lack of knowledge about complex investments is shrewdly exploited by the securities industry. For instance, some experts believe structured products are almost never suitable for retail investors.

Opt for simplicity

Intelligent, responsible investing does not have to be complicated. Market returns are yours for the taking (less low management fees). Here’s an example. I’m not suggesting it’s suitable for everyone.

What if you invested all your retirement and non-retirement assets in Vanguard’s LifeStrategy Moderate Growth Fund (VSMGX)? This fund holds 60 percent of its assets in stocks, a portion of which is allocated to international stocks, and 40 percent in bonds. It’s broadly (and globally) diversified. It rebalances automatically, so your risk profile never changes. It has a very low expense ratio (management fee) of 0.14 percent.

Since its inception on Sept. 30, 1994, the fund’s average annual return has been 7.49 percent.

Think about that data. Your account statement would consist of one line item. You could easily determine your return for every quarter and over various periods of time using Vanguard’s website.

There are, of course, other options available for investors who want to customize their portfolio and still keep it simple and understandable. The three index fund portfolio I recommended in The Smartest Investment Book You’ll Ever Read has withstood the test of time. I summarized those recommendations in this blog.

Dealing with pushback

You need to be prepared for pushback from your broker when you discuss the benefits of simplifying your investment life. Remember that brokers thrive on opacity. The less you know, the better it is for them.

Few investors understand their brokerage statements. I believe in some cases they are intentionally formatted to make it difficult or impossible to elicit critical information. Here are some questions to ask your broker:

  1. Since the beginning of my relationship with you, what has been my annualized return, net of commissions and other fees?
  2. How much risk am I taking in my portfolio?
  3. How much have you earned from my portfolio since you started managing it?
  4. Because I can easily and inexpensively capture the returns of the global marketplace using low-cost index funds, shouldn’t you be compensated only if my risk-adjusted returns are in excess of those returns?

You are unlikely to get straight answers.

In investing, complexity is the devil.

 

Complexity Is the Investing Devil blog was originally posted on The Huffington Post website.

 

2014-04-01-Hiresfrontbookcover.jpgDan Solin is a New York Times bestselling author of the Smartest series of books, including The Smartest Investment Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read and his latest, The Smartest Sales Book You'll Ever Read.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

 

 

By: Dan Solin | 0 comments
May-09-16

A Simple Strategy Your Broker Hopes You Won’t Learn

The data is irrefutable. There’s a direct correlation between low fees and higher expected returns. Two recent studies from Morningstar bring this point home in a powerful way.

The significance of low fees

In the first study, Morningstar found that asset-weighted expense ratios (the management fees charged by mutual funds) continue to decline. Investors are taking note. The study found that, over the past decade, 95 percent of all fund flows have gone into funds in the lowest-cost quintile. Because index funds are very low cost, they have benefited “disproportionately.”

However, the study also found the big winner during the past decade was the mutual fund industry and not fund shareholders. Assets went up by a far greater percentage than fees went down.

How you can be the winner

In the second study, Morningstar measured the performance of actively managed funds against the “net of fee” performance of passive funds. This is a more valid evaluation than comparing actively managed funds directly to indexes, because investors can’t buy the index. They need to buy a fund that tracks the index and pay the management fee charged by that fund.

The study found actively managed funds “generally underperformed their passive counterparts, especially over longer time horizons.” Significantly, it determined that this underperformance was positively correlated with higher fees. Lower-cost funds “were likelier to survive and enjoyed greater odds of success.”

The conclusion of this study should be posted as a sticky note on your computer and serve as a major guide to investment decisions: “Fees matter. They are one of the only reliable predictors of success.”

A winning strategy

It seems so simplistic. Once you have decided on your asset allocation, your globally diversified portfolio should consist exclusively of the lowest-cost mutual funds you can find. These funds typically will be index funds. The lowest-cost provider of index funds historically has been Vanguard.

If more investors followed this route, the securities industry would be in trouble. It’s in the business of selling you expensive, actively managed funds. It claims to possess the ability to tell you when to dump some of your mutual fund holdings and buy others that (so it says) are poised to outperform. Could it be that this sales pitch is just hot air?

The dismal track record of consultants

A fascinating study published in 2014 provides an answer to this question. Your broker probably has many clients similar to you (individuals with various levels of assets to invest). What if, instead of relying on your broker, you had access to consultants who normally work with pension plans, endowments and foundations? These consultants advise more than $25 trillion in assets. They are the best, brightest and probably most highly compensated investment advisors in the world.

The study looked at survey data from investment consultants with a combined share of around 90 percent of the consulting market. It focused on recommendations of actively managed U.S. stock funds for the period from 1999 through 2011.

The conclusion of the study is stunning and unambiguous: “We find no evidence that consultants’ recommendations add value to plan sponsors.”

How could this be? Part of the reason, as found in the Morningstar studies, is cost. The institutional funds studied charged, on average, 65 basis points a year, which is much more than the fees of comparable index funds.

The study also found that consultants often recommended bouncing in and out of funds more frequently than plans that followed an index strategy. Finally, the study concluded: “Consultants face a conflict of interest, as arguably they have a vested interest in complexity.”

Now think about the actively managed fund recommendations made by your broker. They are probably more expensive than comparable index funds. Also, your broker likely periodically suggests that you sell some funds and buy others, which increases your transaction costs (and reduces your returns). Lastly, your broker — like a consultant — has “a vested interest in complexity” as well.

The takeaway

The securities industry relies on your lack of knowledge and gullibility. Now that you understand the findings in these studies, it’s time for you to become an evidence-based investor. The first step is to fire your broker. Then, buy index funds on your own or seek the services of a registered investment advisor who understands the data and will assist you both with implementing your new plan and with the balance of your comprehensive financial planning needs.

 

A Simple Strategy Your Broker Hopes You Won’t Learn blog was originally posted on The Huffington Post website.

 

2014-04-01-Hiresfrontbookcover.jpgDan Solin is a New York Times bestselling author of the Smartest series of books, including The Smartest Investment Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read and his latest, The Smartest Sales Book You'll Ever Read.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

 

 

By: Dan Solin | 0 comments