Straight Talk: 6 Candid Rules For Individual Investors

by: Donald van Deventer

One of the ironies of the 2007-2010 credit crisis is the bruhaha about conflicts of interest of the rating agencies like Moody's (NYSE:MCO) and the McGraw Hill (MHFI) unit Standard & Poor's. This concern is certainly a valid one, but there is a bigger conflict of interest that hasn't gotten enough attention: nearly every single financial advisor to individual investors on investment strategy has a serious conflict of interest. That's why the rise of and its authors and readers is so important. Something's wrong when the primary source of advice for an individual investor is someone on commission for the sale of financial products. Whether it's Japanese securities firms selling Australian dollar bonds to Japanese housewives, a Dutch bank selling CDO tranches to individual investors, or Goldman Sachs (NYSE:GS) selling investments that the firm doesn't want to retail investors in Honolulu, commission-based advisors have wreaked a lot of havoc. This note is the first of a series on investment strategies for individual investors. Many of the readers of this website will say "Why tell me things I already know?" Another large group of readers will violently disagree with many, if not all, of the points below. All of the comments, however, are based on 35 years of risk management theory and practice and a candid assessment of where the retail investor fits in the Wall Street food chain. In the basement.

First, three disclosure items should be mentioned. Number one: my firm, Kamakura Corporation, does not own or trade securities in conflict of interest with our clients. Kamakura's only investment is a money market fund with Vanguard. Second, my good friend Nick Wallwork at John Wiley & Co., the publishing firm, in Singapore told me that no one wants to listen to advice for individual investors unless CNBC commentator Suze Orman is a co-author. Nick -- I hope you are wrong about that. Finally, as an entrepreneur, it's often hard to follow some of the rules we suggest below. As John Lennon famously said in a song from his 1980 album, Double Fantasy: "Life is what happens to you while you're busy making other plans."

Rule 1: If you are not an entrepreneur, never buy the common stock of your employer or other firms in the same industry as your employer

As employees of Lehman Brothers, Bear Stearns, and Countrywide Financial learned the hard way, owning the stock of your employer is going "double or nothing" with the return on your career. Even before you buy the stock of your employer, your future salary, gains on stock options, and pension cash flows are highly dependent on how your employer and your employer's industry perform. If your employer gets in trouble, your odds of being fired and your odds of not getting your pension skyrocket. One should never increase the size of the very large bet you already have on your employer's well-being. For entrepreneurs, the same advice applies in theory but it's impossible to follow. An entrepreneur, by definition, is someone who is willing to bet 199% of his or her net worth on one stock -- that of the firm that they start up. Even in this case, however, diversifying away from your own company as soon as it is practical is very important. The one caveat to this rule is the possibility of a sharp gain in the company's stock from a merger or buyout, followed by layoffs -- thanks to T. in the Netherlands for his note on this. Even in this scenario, however, one would hope that stock option gains and severance packages make this risk much less significant than the risk that the firm fails, taking your savings with it.

Rule 2: Don't believe the assertion that "In the long run stocks outperform fixed income securities"

This is a common mantra of people who get paid a commission selling common stock. At a convention in Geneva in December 2004, Nobel Laureate Robert C. Merton told a joke that goes something like this: "An equity salesman for a major Wall Street firm called on a very conservative pension fund manager, who had invested 100% of the pension fund's assets in fixed income securities. The equity salesman told him, 'Why don't you shift your portfolio into common stock? In the long run, you'll have a 99% probability of having more money because your time horizon is so long.' The pension fund manager replied, 'Well, if you are right, your firm would find it very inexpensive to provide me with a portfolio insurance policy that will pay me the difference if ever an all equity portfolio was worth less than my fixed income portfolio is worth today. Why don't you price that insurance policy with your colleagues and call me back? If it's as cheap as your argument indicates it should be, I am sure your firm will offer me that insurance policy very cheaply.'" As Merton's audience laughed, he added (of course) that the salesman never called back, because the risk of equity portfolio price declines is huge and such an insurance policy would also be very expensive. Some people just don't believe this, so here's just one example of how big the risk is. The Nikkei 225 stock index traded at almost 39,000 at the end of 1989. Today, 24 years later, the index is at 13,460. One should remember that as recently as 2005, commentators were arguing that home prices in the U.S. could never fall like they did in the collapse of the Japanese bubble.

Rule 3: Don't trade securities when it's not necessary. Follow a buy and hold strategy.

One of my best friends during my years in Los Angeles as a banker was a very funny guy named Robert T. Sussman. He was also a brilliant and practical financial guy. He used to tell me, "My family doesn't buy retail." When you trade securities, you are buying retail. You might be the smartest person in the world, but you're betting against the house. The head of derivatives for Bankers Trust once told me, "I don't have to have a model for that fancy derivative -- all I have to do is balance the buys and sells, and I keep the spread." You should not be giving Wall Street both the commission and the bid-offered spread if you don't have to do it. If you do a million securities trades as a retail investor, your net worth will be zero when you're done.

Rule 4: Taxes matter. Plan your finances in such a way that you take maximum advantage of tax subsidies.

One of the richest men in America told me the only ways to make money these days is "regulatory arbitrage, ratings arbitrage, and tax arbitrage." He's right. If income on an educational savings account is tax free, find a way to take advantage of that. If you are an entrepreneur and the tax rate on a dividend from your firm is less than the tax rate on another dollar of salary, pay yourself a dividend, not a salary. If an IRA contribution moves salary to a non-taxable basis, find a way to do it. A tax attorney may well be the best friend you can have. In the short run, they may appear to be more expensive than a stock broker, but that won't be true in the long run.

Rule 5: Don't borrow on a charge card. Your first investment should be paying that balance down.

When I was considering starting Kamakura Corporation, one of my best clients was Mr. T. at Nippon Shinpan, the big credit card company in Japan. "Don-san," he said, "if you are going to start a new company, here's what you should do. While you're still at that securities firm with a good salary, go out and get a 3 million yen charge card from 30 banks. That way you'll have 90 million yen (almost $1 million at the time) to finance the company, and none of the 30 banks will know you have 29 other cards." The trouble with this advice is that you have to pay the money back. At 29% interest, there is no investment in the world that will return this much with the same degree of certainty that your bank expects you to have with respect to your own payments on the card.

Rule 6: If your employer is in a highly cyclical business, you should own a lot less common stock than an identical person who has a safe government job.

The smartest thing I've ever done from a financial point of view was to quit Lehman Brothers in 1990. The second smartest thing I've done financially was, during the 3 years I worked for Lehman, to have 100% of my savings in money market funds. Less than six months after I started at Lehman, the 500 point drop in the Dow Jones average in the crash of October 1987 devastated Wall Street. My colleagues in New York would call me in Tokyo and cry that (a) they'd lost a ton on their stock portfolio, (b) they were much more likely to be fired, and (c) their year-end bonus was going to be much smaller than expected if they survived at the firm that long. Obviously, the joy of working at Lehman was even less in 2008. For the same kinds of reasons, you shouldn't have a lot in common stocks if you're in the highly cyclical auto business. You shouldn't have a lot of common stocks if you're in the volatile commercial real estate industry. Your employer and the returns on your intellectual property ARE your investment in the market. You don't need to go double or nothing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Kamakura Corporation has business relationships with a number of firms mentioned in this article.