I do know that my promised purpose in the first blog was to dive deeper into the ten fundamental questions we raised about in immediate next blog sequences. Yet, I digress from this task for a simple, yet extraordinary reason. While chatting with a very good friend of mine over lunch recently, the discussion drifted towards investment routines. Now, this good buddy is a super smart, intelligent, rational person and is very well respected for her professional exploits in a complex field of engineering. She is a great colleague with microscopic attention to detail. There is every reason to believe that math is fundamentally ingrained in every decision taken by this person, conscious and subconscious. Right from choosing the best route compromise between home and office every day for speed and driving efficiency to select the optimum size of the bread at Walmart to maximize $$ spent per oz, while minimizing the risk of running into the expiry date. The cavalier answer she came up with when the conversation drifted towards investment routines, therefore, surprised me. She claimed to be working with an investment advisor, who charged her about 1.5% of the total portfolio as a fee. She was so happy with the performance of this advisor that I had to ask the question. Dear, what sort of returns have you been getting? Oh! The reports that my advisor sends me in December are very professionally written. These people really know their stuff. She said. I am putting in money into this account every month and the portfolio size keeps going up. It was not clear to her though that if the portfolio was going up as a result of her adding money to it, month after month, or her advisor had a great knack of picking right stocks or doing index investing. The illusion of expertise is dangerous in your investment advisor, especially when it is based in the quality of the paper on which the annual report is printed on and the number of words and beautiful, lovely pictures and graphs and stories in it.
Everyone owes it to themselves and their families to invest wisely. We owe it to our future selves, to our children that we keep track of our investments and create a responsible portfolio. This is especially true for the kind of investment this friend of mine has been making. All of us put a considerable portion of our hard-earned moolah into the stock market, month after month, or at least I hope you do. This has to be the single largest investment for most of the Americans, therefore pay attention people to how this is done.
I am not remotely suggesting that all the investment advisors are bad investors. I am just hypothesizing that a lot of them are. These kind are far better at charging you 1% or more of your portfolio. They route your investments into funds and brokers that give them a greater cut of your money and of course never forget to send that glossy report once or twice a year. The returns generated by an average investment advisor’s stock selection choices do not beat the market over long term. Let me clarify that I am not a believer in the theory proposed by physicist Alessandro Pluchino and economist Alessio Biondo either. These good theorists claimed in one of theirwell-written studies that a chimp making random stock picking decisions by throwing darts performs at least in the stock market as good as some quant algorithms. I do see a fallacy when I read this study a bit deeper. You would too. The chimp succeeds in this carefully chosen example because authors compare the poor (but intelligent than most advisers) creature’s performance to some strange quant decision algorithms. These methods were so simple in nature that any quant worth their salt would hardly agree to these being called a “stock selection strategy”. The second problem with the study was how a selected stock was decided a “winner”. Suppose quant strategy X generated a buy signal today due to some simple parameters lining up in a particular way. The study would consider this selection a “win” if the price of the selected stock on the next day closed higher than the price of the stock today. This is such a short term view of the market that it is bound to be inherently random. Therefore while the intention of such theorists may be noble in trying to discredit using quant strategies for the ultra-short term, high-frequency traders, the arguments that they have built to justify their lofty theories are mathematically unsound.
So, we can see that the illusion of expertise and grandiose theories affects both sides of the argument, The investment advisor who sends you the glossy reports and the expert theorist who has probably never invested a dime of his own money in the market, yet claims that stock picking is a chimps’ business. The reality would lie somewhere in the middle. As an individual investor, you have to be responsible for curating the financial future of your loved ones. So, if you are working with an investment advisor, do it by all means. Just don’t be impressed by the quality of the glossy paper used in the report. Ask few very simple questions on Dec 31st of every year -
- What was the value of my portfolio on the first day of the year?
- How much money did I deposit into my portfolio during the last 12 months?
- What is the value of my portfolio on the last day of the year?
- Not considering the money I deposited into my account this year, is percentage change in the portfolio from the first day to last (a) more, (b) less, (c) similar to the change in S&P500
- Not considering the money I deposited into my account this year, is my portfolio drawdown from the first day to last (a) more, (b) less, (c) similar to the drawdown in S&P500. In case you are wondering what drawdown is – It is a very simple formula and can be calculated as the “difference b/w the highest value of your portfolio and the lowest value”, divided by the “highest value”. Higher drawdowns indicate higher risk to your portfolio.
If the answers to question 4 and 5 are not favorable and reasonable, your investment advisor is not earning his commission. It is time for you to fire him.
Additional disclosure: Profit Monk is the trademark pen name for profitmonk.com. We are in the business to let retail investors and hedge funds balance their portfolios through smart leverage.