Millionaire Teacher

by Andrew Hallam

  So if Morningstar can’t pick the top mutual funds of the future, what odds does your financial planner have—especially when trying to dazzle you with a fund’s historical track record?

  If you’re the kind of person who enjoys winding people up, try this comeback the next time an adviser tries selling you (or one of your friends) on a bunch of funds that he claims have beaten the index over the past 15 years.

  Hey, that’s great. They all beat the index over the past 15 years. Now show me your personal investment account statements from 15 years ago. If you can show me that you owned all of these funds back then, I’ll invest every penny I have with you.

  Okay—maybe that’s a bit mean. You aren’t likely to see any of those funds in his 15-year-old portfolio reports. You won’t likely see them in any of his five-year-old portfolio reports either.

  If the salesperson deserves an “A” for tenacity, you’ll get this as the next response:

  But I’m a professional. I can bounce your money around from fund to fund, taking advantage of global economic swings and hot fund manager streaks and easily beat a portfolio of diversified indexes.

  Just thinking about that kind of love gives me goose bumps. Many advisers will lead you to believe that they have their pulse on the economy—that they can foresee opportunities and pending disasters. Their sagacity, they will suggest, will enable you to beat a portfolio of indexes.

  But in terms of financial acumen, brokers and financial advisers are at the bottom of the totem pole. At the top, you have pension fund managers, mutual fund managers, and hedge fund managers. Most financial advisers, as US personal finance commentator Suze Orman points out, are “just pin-striped suited salespeople.”

  Your financial planner could have just a two-week course under her belt. At best, a certified financial planner needs just one year of sales experience at a brokerage firm and fewer than six months of full-time academic training (on investment products, insurance, and financial planning) before receiving his or her certification. With some regular nightly reading, it wouldn’t take long before you knew more about personal finance than most financial planners. They have to sell. They have to build trust. They have to make you feel good about yourself. These skills are the biggest part of their jobs.

  When arbitration lawyer Daniel Solin was writing his book, Does Your Broker Owe You Money?, a broker told him:

  Training for a new broker goes something like this: study and take the Series 7, 63, 65, and insurance exams. I spent three weeks learning to sell. If a broker wants to learn about (asset allocation and diversification) it has to be done on the broker’s own time.3

  This might explain why it’s often common to find investors of all ages without any bonds in their portfolios. Predominantly trained as salespeople, it’s possible that many financial representatives aren’t schooled in the practice of diversifying investment accounts with stocks and bonds.

  Noted US finance writer William Bernstein echoes the gaps in most financial adviser training, suggesting in his superb 2002 book, The Four Pillars of Investing, that anyone who invests money should read the two classic texts:

  A Random Walk Down Wall Street by Burton Malkiel

  Common Sense on Mutual Funds by John Bogle

  “After you’re finished with these two books, you will know more about finance than 99 percent of all stockbrokers and most other finance professionals,” he said.4

  From what I’ve seen, he’s right.

  When my good friend Dave Alfawicki and I went into a bank in White Rock, British Columbia, in 2004, we met a young woman selling mutual funds. Dave wanted to set up an indexed account, and I went along for the ride. The adviser’s knowledge gaps were extraordinary, so I asked the question: What kinds of certification do you have and how long did it take? She received her license to sell mutual funds through a course called Investment Funds in Canada (IFIC). It’s supposed to take three weeks of full-time studying to complete the course, but she and her classmates finished it in just two intensive weeks.5 Before the two-week course, she knew nothing about investing.

  A year later, I went into another Canadian bank with my mom to help her open an investment account. We wanted the account to have roughly 50 percent in a stock index and 50 percent in a bond index. Of course, the adviser, as usual, tried to talk us out of it.

  But once the adviser recognized that I knew more about investing than she did, she came clean. To paraphrase the discussion, she shocked us with this:

  First, we get a feel for the client. The bank suggests that if the client doesn’t know much about investing, we should put them in a fund of funds, for example, a mutual fund that would have a series of funds within it. It tends to be a bit more expensive than regular mutual funds. This sales job only works with investors who really don’t know what they’re doing.

  If the investor seems a little smarter, we offer them, individually, our in-house brand of actively managed mutual funds. We don’t make as much money with these, so we push for the other products first.

  Under no circumstances do we offer the bank’s index funds to clients. If an investor requests them and we can’t talk them out of the indexes, only then will we buy them for the client.

  I appreciated her candor. By the end of the conversation, the adviser was asking me for book suggestions about indexed investing and she gratefully wrote down a number of titles. At least she was willing to take care of her own money.

  Three years later, a different representative from the same bank phoned my mom. “Your account is too risky,” he said. “Come on down to the bank so we can move some things around for you.”

  Thankfully, my mom was able to stand her ground. With 50 percent of her investment in bond indexes, the account wasn’t risky at all—but it wasn’t profitable for the bank.

  If you notice a financial adviser has a university degree in finance, commerce, or business, hang tight for a moment. Find someone else with one of these degrees and ask this: During your studies at university, did you study mutual funds, index funds, or learn how to build a personal investment portfolio for wealth building or retirement? The answer will be no. So don’t be fooled by an additional, irrelevant title.

  Most brokers and advisers really are just salespeople, and well-paid salespeople at that. In the United States, the average broker makes nearly $150,000 a year—putting them in the top five percent of all US wage earners. They make more than the average lawyer, primary care doctor, or professor at an elite university.6 And if they’re recommending actively managed funds, they’re a bit like vendors in the guise of nutritionists selling candy, booze, and cigarettes.

  Why Your Financial Adviser Might Lie

  Harvard economist Sendhil Mullainathan, Markus Noeth of the University of Hamburg, and Antoinette Schoar of the MIT Sloan School of Management published a study, The Market For Financial Advice.7

  They hired actors to approach financial advisers with a fictitious $500,000 portfolio. In some cases, the portfolios were made with low-cost index funds. The researchers wanted to see what kind of advice the advisers would give. Over a five-month period, the actors made nearly 300 visits to financial advisers in the Boston area.

  When shown a portfolio of index funds, most turned up their noses. Eighty-five percent said actively managed funds were better. As Upton Sinclair said long ago, “It is difficult to get a man to understand something when his salary depends on his not understanding it.”8

  But what makes them lie?

  In 2006, Kathleen D. Vohs, Nicole L. Mead, and Miranda R. Goode published a study called The Psychological Consequences of Money.9 It showed that money makes us selfish. Subjects played the board game Monopoly with an experimenter who posed as a subject. When the game was over, the board was put away. In some cases, a large stack of Monopoly money was left on the table. In other cases, a small stack or no money remained.

  At this point, somebody walked into the room and dropped a box of pencils. It was a staged experiment to see if the s
ubjects would help to pick them up. The subjects with a large sum of Monopoly money on the table picked up the fewest number of pencils.

  During another test, an experimenter pretended to have a tough time with a problem. Those whose minds were imprinted by money beforehand weren’t very helpful. It was the opposite for those who weren’t primed by money.

  According to Nobel Prize winner Daniel Kahneman in his book Thinking, Fast and Slow, “The psychologist who has done this research, Kathleen Vohs, has been laudably restrained in discussing the implications of her findings.”10

  Ask an adviser to build you a portfolio of index funds. The implications of the experiment will become obvious.

  The Totem Pole View

  Financial advisers and brokers are at the bottom of the totem pole of financial knowledge. At the top, you’ll find hedge fund managers, mutual fund managers, and pension fund managers.

  Generally earning the highest certification in money management—as chartered financial analysts—pension fund managers have the leeway to buy what they want. These are the folks managing huge sums of government and corporate retirement money. Arguably, they’re the best of the best. If your local financial planner applied for the job of managing the pension for Pennsylvania’s teachers or New Jersey’s state-pension system, he or she would likely get laughed off the table.

  Pension fund managers have their pulses on the stock markets and the economy. They can invest where they want. Typically, they don’t have to focus on a particular geographic region or type of stock. The world is their oyster. If they want to jump into European stocks, they do it. If they think the new opportunities are in small stocks, they load up on those. If they feel the stock market is going to take a short-term beating, they might sell some of their stocks, buying more bonds or holding cash instead.

  Your typical financial planner isn’t as knowledgeable as the average pension fund manager. But most advisers will try to “sell” you on the idea that (like the pension fund manager) they have their pulse on the economy and that they can find you hot mutual funds to buy. They might try telling you that they know when the economy is going to self-destruct, which stock market is going to fly, and whether gold, silver, small stocks, large stocks, oil stocks, or retail stocks are going to do well this quarter, this year, or this decade.

  But they are full of hot air.

  Pension fund managers are more likely to know oodles more about making money in the markets than financial advisers or brokers.

  Knowing that pension fund managers are like the gods of the industry, how do their results stack up against a diversified portfolio of index funds?

  Most pension funds have their money in a 60/40 split: 60 percent stocks and 40 percent bonds. They also have advantages that retail investors don’t have: large company pension funds pay significantly lower fees than retail investors like you or I would, and they don’t have to pay taxes on incurred capital gains.

  Considering the financial acumen of the average pension fund manager, coupled with the lower cost and tax benefits, you would assume that the average American pension fund would easily beat an indexed portfolio allocated similarly to most pension funds: 60 percent stocks and 40 percent bonds. But that isn’t the case.

  US consulting firm FutureMetrics studied the performance of 192 US major corporate pension plans between 1988 and 2005. Fewer than 30 percent of the pension funds outperformed a portfolio of 60 percent S&P 500 index and 40 percent intermediate corporate bond index.11

  If most pension fund managers can’t beat an indexed portfolio, what chance does your financial planner have?

  The Best Odds to Win

  If you told most financial advisers this, they would either begin talking in circles to confuse you or they would be battling with their ego.

  If it’s the latter, you might hear this: If it were so easy, why wouldn’t every pension fund be indexed?

  Pension fund managers are as optimistic as the rest of us. Many of them will try to beat portfolios comprised of a 60 percent stock index and a 40 percent bond index.

  But they aren’t stupid, and many pension funds maximize their returns by indexing.

  According to US financial adviser Bill Schultheis, author of The New Coffeehouse Investor, the Washington state pension fund, for example, has 100 percent of its stock market assets in indexes, California has 86 percent indexed, New York has 75 percent indexed, and Connecticut has 84 percent of its stock market money in indexes.12

  The vast majority of regular, everyday investors, however, buy actively managed mutual funds instead.13 Unaware of the data, their financial advisers distort realities to keep their gravy trains flowing. It will cost most people more than half of their retirement portfolios—thanks to fees, taxes, and dumb “market timing” mistakes.

  Sticking with index funds might be boring. But it beats winding up as shark bait, and it gives you the best odds of eventually growing rich through the stock and bond markets.

  Why Did Fidelity’s Employees Sue Fidelity?

  Fidelity is one of the world’s largest mutual fund companies. Most of their funds are actively managed. But they offer index funds, too. In 2012, I helped my friend Patti Smaldone build a portfolio with Fidelity’s low-cost indexes. Three years later, a representative from Fidelity contacted Patti. “He said we should move the investments into some actively managed funds,” says Patti. “He said they would perform better.”

  Ironically, Patti’s portfolio had performed very well. But if you want an example of a conflict of interest, this one is a doozy.

  Fidelity’s employees prefer to invest in index funds. But the company’s 401(k) fund options were full of actively managed funds. In 2013, Fidelity’s employees put Fidelity to task for that. A group of Fidelity’s employees sued Fidelity for trying to profit at its employees’ expense.

  At the time, company spokesperson Vincent Loporchio said, “We believe the lawsuit is totally without merit, and we intend to defend vigorously against it. Fidelity has a very generous benefits package that provides significant contributions to our employee’s retirement planning.”

  But Fidelity lost that war. In August 2014, CNN reported that “Fidelity agreed to pay $12 million to settle the class-action suits, which alleged that the firm was profiting at the expense of its workers by offering high-cost fund options and charging excessive fees for a plan of its size.”14

  As for the Fidelity representative who contacted my friend Patti? I wonder how well he sleeps.

  Is Government Action Required?

  David Swensen, Yale University’s endowment fund manager, suggests the US government needs to stop the mutual fund industry’s exploitation of individual investors.15 The United States has some of the lowest cost actively managed funds in the world. I wonder what he would think of Canada’s, Great Britain’s, Australia’s, or Singapore’s costs, all of which are higher.

  You can’t wait for government regulation. The best weapon against exploitation is education. You might not have learned this in high school. But you’re learning it now.

  Among those hearing the call to arms and taking action to educate others is Google’s vice president, Jonathan Rosenberg.

  In August 2004, Google shares became available on public stock exchanges and many Google employees (who already held Google shares privately) became overnight millionaires when the stock price soared.

  The waves of cascading wealth on Google’s employees attracted streams of financial planners from firms such as JPMorgan Chase, UBS, Morgan Stanley, and Presidio Financial Partners. Drawn like sharks to blood, they circled Google. They wanted to enter the company’s headquarters so they could sell actively managed mutual funds to the newly rich employees.

  Google’s top brass put the financial planners on hold. Employees were then presented with a series of guest lecturers before the financial planners were allowed on company turf.

  According to Mark Dowie who wrote about the story for San Francisco magazine in 2008, the first to ar
rive was Stanford University’s William Sharpe, the 1990 Nobel laureate economist. He advised the staff to avoid actively managed mutual funds: “Don’t try to beat the market. Put your money in some indexed mutual funds.”16

  A week later, Burton Malkiel arrived. The professor of economics at Princeton University urged the employees to build portfolios of index funds. He has been studying mutual fund investing since the early 1970s, and he vehemently believes it’s not possible to choose actively managed funds that will beat a total stock market index over the long term. Don’t believe anyone (a broker, adviser, friend, or magazine) who suggests otherwise.

  Next, the staff was fortunate enough to hear John Bogle speak. A champion for the “little guy,” John Bogle is the financial genius who founded the nonprofit investment group, Vanguard. His message was the same: the brokers and financial advisers swimming around Google’s massive raft have a single purpose. They’re a giant fleecing machine wanting to take your money through high fees—and you may not realize what is happening until it’s too late.

  When the sharks finally approached the raft, staff members at Google were armed to the teeth, easily fending off the well-dressed, well-spoken, charming advisers.17

  I hope that you can do the same as the crew at Google. Always remember that for most financial advisers, index funds are pariahs. If you have an adviser today, and you’re not invested in index funds, then you already know (based on their absence in your portfolio) that your adviser has a conflict of interest. In that case, asking your adviser how he feels about indexes is going to be a waste of time.

  After one of my seminars on index funds, I often hear someone say: “I’m going to ask my adviser about index funds.” That’s like asking the owner of a McDonald’s restaurant to sell you on Burger King. They won’t want you stepping anywhere near the Whopper.