My Comments: There is a distinction between dumb and ignorant. The second you can fix with mental effort, but the first just happens. Sometimes I wonder if people are born this way or whether they have to work at it.
These five ‘bets’ happen often. Many times it’s because someone has “sold” them the idea, whether on TV or in person. Either way, the outcome can be avoided if you are willing to exercise some mental effort on your own behalf. Like reading this article by Allan Roth.
by Allan S. Roth JUN 15, 2015
When I look at professionally designed investment portfolios other advisors have assembled for clients or prospects, I nearly always find something that concerns me. Maybe it’s because of fees, or because they’re choosing active rather than passive strategies. I can even debate the validity of “core and explore.”
But roughly 80% of the time, I see one or more of these five really dumb investment strategies.
Absolutely none make sense. And they have virtually no chance of working for the client. Admittedly, many advisors don’t actually know that they are executing any of these five strategies, though that won’t console clients much.
Here are the five strategies I suggest you avoid.
1. GAMBLE IT AWAY
Clearly, it would be illegal to siphon off some of our clients’ money and gamble it away in Las Vegas. Anybody would see the obvious folly; after all, every Las Vegas game (from blackjack to craps) is staked in favor of the house.
Clients understand that an advisor needs to take some risk to get returns, but they want advisors to invest money in vehicles that at least have some expectation
To be fair, I’ve never actually seen advisors literally take their clients’ money to Vegas. But that’s essentially what they are doing when they invest in certain alternative
For example, managed futures and options are zero-sum games — not a penny has ever been made with these strategies, in the aggregate, before costs. I’d even go as far as to say that, after the costs (both the funds’ and the advisor fee), the odds at the tables in Vegas look attractive by comparison.
Only slightly better are market-neutral funds, which have an expected return of the risk-free rate, which is currently about 0.01% — close to zero, for all practical
The typical response from advisors is that they are making one of these investments because they are uncorrelated with the stock market. Well, taking a chunk of your clients’ money to Las Vegas isn’t correlated with the market either — but that doesn’t make it any less dumb.
Only 31% of financial advisors felt they understood alternative funds “very well,” according to a survey by Natixis Global Asset Management, yet 89% of them used alternatives. That’s not just dumb, but
2. BET ON BOTH SIDES
If gambling away clients’ money in Vegas is dumb, the concept I’m going to describe is dumber. If you’d bet half of a client’s money on Seattle in this year’s Super Bowl and the other half on New England, you would have been sure to lose by paying the bookie twice.
No advisor would suggest that, of course. And yet planners do something equivalent when they buy an inverse or levered inverse market fund, which bets against the broader equity market (and in the case of the levered version, the fund borrows to bet against the market).
It might only be a strategy I disagree with if they didn’t also have the client long in stocks; often the advisor will have both a levered inverse S&P 500 fund and an S&P 500 fund.
Typically, advisors claim the inverse position is a hedge against the possibility of a declining market. They often say something like, “You’ll be glad you own the inverse fund if markets plunge.” OK, but why pay a management fee to be in on both an up and a down market?
You can’t win by having both a short and long S&P 500 fund. Wouldn’t it be far more cost-effective to hedge by keeping some cash on the sidelines? This is especially true now that cash can earn an FDIC-insured return of 1% annually, if you do a little research.
One might assume, at least, that one of the two bets must be right, since you can’t lose on both sides of a bet — but one would be wrong. In 2011, for instance, both the ProShares UltraPro S&P 500 (UPRO), a triple levered long fund, and the ProShares UltraPro Short S&P 500 (SPXU) lost double digits.
3. BORROW AT 4%, LEND AT 2%
This is pretty much the opposite of how a bank makes money. It’s a common mistake, and there is an enormous amount of money at stake when people get it wrong.
This error typically surfaces when a client comes to me with a mortgage at 4% and bonds paying 2%. Advisors typically argue that the mortgage is only costing the client 3% after taxes and that clients can get higher expected returns on their overall portfolio. When interest rates go up, they say, clients will be glad they have this cheap money.
Unfortunately, it’s still just as dumb for the client to be borrowing money at twice the rate they are earning on a comparable low-risk investment that also happens to be taxable. If rates do go up (and the top economists have a great track record of calling that wrong), then the clients’ bonds and bond funds go down. The client can’t win.
As far as taxes go, one must remember that the goal is not to pay less in taxes, but rather to make more money after taxes. As a CPA, I know that taxes matter — and in roughly 75% of the cases I’ve looked at, the tax argument makes it even more compelling to pay off the mortgage.
That’s because the clients either aren’t getting the full value of the mortgage interest deduction (due to phase-downs or part going to meet the standard deduction), or are getting hit with the extra 3.8% Medicare passive income tax on the investment income they have from not paying off the mortgage.
I’ve had more than a few advisors tell me how wrong I am on this point, but I’ve given everyone a chance to prove it by lending me money at 2% and borrowing it back from me at 4%. To date, no one has taken me up on this offer.
4. GUARANTEE A LAG
I’m not one to say that active management can’t ever beat the low-cost index equivalent — although research suggests that active funds do tend to lag the broader market.
I am, however, willing to go out on a limb and say that a high-cost index fund can’t beat the lower-cost one. For example, take the Rydex S&P 500 C fund (RYSYX) — which has an expense ratio of 2.32%, or more than 46 times the 0.05% expense ratio of the Vanguard S&P 500 Admiral (VFIAX). One would expect it to underperform by the differential of 2.27% annually — although, according to Morningstar, the five-year shortfall was actually a bit higher, at 2.74% annually as of the end of May.
I used the most extreme example I could find, but in general, when it comes to index funds, you actually get more by paying less. The larger, lower-cost funds tend to be far better at indexing, as smaller funds must buy more expensive derivatives.
In the true confessions category, I’m actually guilty of this mistake myself: I own the Dreyfus S&P 500 Index fund (PEOPX), which carries a 0.50% expense ratio — not as egregious as the Rydex, but well above the Vanguard option. Dumb as it is, the tax consequences of moving to a lower-cost fund are just too huge to make the switch.
5. LEAVE CASH UNINSURED
I have clients that come to me with as much as tens of millions of dollars earning 0.01% annually, which I round to nothing — although, in truth, that money will double in value in a mere 6,932 years.
In some cases, the advisor is even charging an AUM fee — so the money is actually losing value. And the money isn’t even federally insured.
If the client is going to keep cash, at least get it federally insured and earning 1% interest; as of early June, that was still possible with FDIC-insured savings accounts at banks such as Synchrony or Barclays. It’s fairly easy to get
millions of dollars in FDIC insurance by titling the accounts correctly.
Taking on more risk for a fraction of the return is just dumb. Really smart people sometimes do really dumb things. Sometimes what drives us is ignorance, while other times it’s the financial incentives.
For example, advisors who get compensated by a percentage of assets under management may be loath to tell clients to reduce those assets by paying down the mortgage or keeping cash outside the advisors’ custodian.
But being a fiduciary means advisors must constantly examine what they are doing for clients. That means taking a step back and looking at what admittedly might be some unpleasant facts.
If you find yourself using some of these strategies, at least examine the arguments being presented here. Then think of how you will answer your clients if they come to you with logic that’s similar to what I’ve presented.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for The Wall Street Journal and AARP the Magazine, and has taught investing at three universities. Follow him on Twitter at @Dull_Investing.