And they certainly won’t want you paying attention to the leader of Harvard University’s Endowment Fund, Jack Meyer. When interviewed by William C. Symonds in 2004 for Bloomberg Businessweek, he said:
The investment business is a giant scam. It deletes billions of dollars every year in transaction costs and fees . . . Most people think they can find fund managers who can outperform, but most people are wrong. You should simply hold index funds. No doubt about it.18
Clearly, investing in index funds is a way to statistically ensure the highest odds of investment success. Doing so, however, means that you’ll need to stand your ground. If you want to grow rich on an average salary, you can’t afford to invest in the expensive products sold by most financial advisers.
Unfortunately, some investors think they can beat a portfolio of indexes with far more exotic methods. Such thinking is costly. The next chapter outlines such mistakes.
Notes
1Sam Mamudi, “Indexing Wins Again,” The Wall Street Journal, April 23, 2009.
2An interview with Morningstar research director John Rekenthaler, In the Vanguard (Fall 2000), www.vanguard.com/pdf/itvautumn2000.pdf.
3Daniel Solin, The Smartest Investment Book You’ll Ever Read: The Proven Way to Beat the “Pros” and Take Control of Your Financial Future (New York: Penguin, 2006), 48.
4William Bernstein, The Four Pillars of Investing, Lessons for Building a Winning Portfolio (New York: McGraw Hill, 2002), 224.
5Investment Funds in Canada Course (IFIC), db2.centennialcollege.ca/ce/coursedetail.php?CourseCode=CCSC-103.
6Daniel Solin, The Smartest Investment Book You’ll Ever Read: The Proven Way to Beat the “Pros” and Take Control of Your Financial Future (New York: Penguin, 2006), 79.
7Sendhil Mullainathan, Markus Noeth, and Antoinette Schoar, The National Bureau of Economic Research, March 2012, www.nber.org/papers/w17929.pdf.
8Goodreads, Upton Sinclair quotes, www.goodreads.com/author/quotes/23510.Upton_Sinclair.
9Kathleen D. Vohs, Nicole L. Mead, and Miranda R. Goode, “The Psychological Consequences of Money,” The American Association for the Advancement of Science, November 17, 2006, http://web.missouri.edu/~segerti/capstone/VohsMoney.pdf.
10Daniel Kahneman, Thinking, Fast and Slow (New York: Farrar, Strauss and Giroux, 2011).
11Larry Swedroe, The Quest For Alpha (Hoboken, NJ: John Wiley & Sons, 2011), 133–134.
12Bill Schultheis, The New Coffeehouse Investor, How to Build Wealth, Ignore Wall Street, and Get On with Your Life (New York: Penguin, 2009), 51–52.
13Paul Farrell, The Lazy Person’s Guide to Investing (New York: Warner Business Books, 2004), xxii.
14Melanie Hicken, “Fidelity Settles Lawsuits Over Its Own 401(k) Plan,” August 18, 2014, http://money.cnn.com/2014/08/18/retirement/fidelity-lawsuits/.
15David F. Swensen, Unconventional Success, a Fundamental Approach to Personal Investment (New York: Free Press, 2005), 1.
16Mark Dowie, “The Best Investment Advice You’ll Never Get,” San Francisco Magazine, December 2006, www.modernluxury.com/san-francisco.
17Ibid.
18William C. Symonds, “Husbanding That $27 Billion (extended),” December 27, 2004, www.bloomberg.com/news/articles/2004–12–26/online-extra-husbanding-that-27-billion-extended.
RULE 9
Avoid Seduction
The trouble with taking charge of your own finances is the risk of falling for some kind of scam. Learning how to beat the vast majority of professional investors is easy: invest in index funds. But some people make the mistake of branching off to experiment with alternative investments.
Others wonder if they can find better index funds––those that promise to beat the market.
Achieving success with a new financial strategy can be one of the worst things to happen. If something works out over a one-, three- or five-year period, you’ll be tempted to try it again, to take another risk. But it’s important to control the seductive temptation of seemingly easy money. There’s a world of hurt out there and rascals keen to separate you from your hard-earned savings. In this chapter, I’ll examine some of the seductive strategies used by marketers who are out for a quick buck. With luck, you’ll avoid them.
Confession Time
Any investor who doesn’t have a story relating to a really dumb investment decision is probably a liar. So I’m going to roll up my sleeves and tell you about the dumbest investment decision I ever made. It might prevent you from making a similar, silly mistake.
The Dumbest Investment I Ever Made
In 1998, a friend of mine asked me if I would be interested in investing in a company called Insta-Cash Loans. “They pay 54 percent annually in interest,” he whispered. “And I know a few guys who are already invested and collecting interest payments.”
The high interest rate should have raised red flags. Around that time, I was reading about the danger of high-paying corporate bonds issued by companies such as WorldCom. They were yielding 8.3 percent. The gist of the warning was this: if a company is paying 8.3 percent interest on a bond in a climate where 4 percent is the norm, then there has to be a troublesome fire burning in the basement. Not long after WorldCom issued its bonds, the company declared bankruptcy. It was borrowing money from banks to pay its bond interest.1
The 54 percent annual return that my friend’s investment prospect paid was a Mt. Everest of interest compared with Worldcom’s speed bump. That’s why it scared me.
“Look,” I said, “Insta-Cash Loans isn’t really paying you 54 percent interest. If you give the company $10,000, and the company pays out $5,400 at the end of the year in ‘interest,’ you’ve only received slightly more than half of your investment back. If that guy disappears into the Malaysian foothills with that $10,000, you get the shaft. You’d lose $4,600.”
It seemed totally crazy. It’s even crazier that I eventually changed my mind.
After the first year, my friend told me that he had received his 54 percent interest payment. “No you didn’t,” I insisted. “Your original money could still vaporize.”
The following year, he received 54 percent in interest again, paid out regularly with 4.5 percent monthly deposits into his bank account.
Although I still thought it was a scam, my conviction was losing steam. He was now ahead of the game. He had received more money in interest than he had given the company in the first place.
He increased his investment to $80,000 in Insta-Cash Loans. It paid him $43,200 annually in “interest.”
As a retiree, he was able to travel all over the world on these interest payments. He went to Argentina, Thailand, Laos, and Hawaii—all on the back of this fabulous investment.
After about five years, he convinced me to meet the head of this company, Daryl Klein (and yes, that’s his real name). How was Insta-Cash Loans able to pay 54 percent in interest every year to each of its investors? I wanted to know how the business worked.
I drove to the company’s headquarters in Nanaimo, British Columbia, with a friend who was also intrigued.
Pulling alongside the curb in front of Daryl’s office, I was skeptical. Daryl was standing on the sidewalk in a creased shirt with his sleeves rolled up, a cigarette in hand.
We settled into Daryl’s office and he explained the business. Initially, he had intended to open a pawn brokerage. But he changed his mind when he caught on to the far more lucrative business of loaning money and taking cars as collateral. As a result, Insta-Cash Loans was created.
In a narrative recreation, this is what he said:
I loan small amounts of short-term money to people who wouldn’t ordinarily be able to get loans. For example, if a real estate agent sells a house and knows he has a big commission coming and he wants to buy a new stereo right away, he can come to me if his credit cards are maxed out and if he doesn’t have the cash for the stereo.
“How does that work?” I wanted to know.
Well, if he owns a car outright, and he turns the ow
nership over to me, I’ll loan him the money. The car is just collateral. He can keep driving it, but I own it. I charge him a high-interest rate, plus a pawn fee, and if he defaults on the loan, I can legally take the car. When he repays the loan, I give the car’s ownership back.
“What if they just take off with the car?” I asked.
I have some retired ladies working for me who are fabulous at tracking down these cars. One guy drove straight across the country when he defaulted on the loan. One of these ladies found out that he was in Ontario (about a six-hour flight from Daryl’s office in British Columbia) and before the guy even knew it, we had that car on the next train for British Columbia. In the end, we handed him the bill for the loan interest, plus the freight cost for his car.
It sounded like an efficient operation. But I wanted to know if the guy had a heart. “Hey Daryl,” I asked, “Have you ever forgiven anyone who didn’t pay up?”
Leaning back in his chair with a self-satisfied smile, Daryl told the story of a woman who borrowed money from him. She had used the family motor home as collateral. She defaulted on the loan, but she didn’t think it was fair that Daryl should be able to keep the motor home. Her husband didn’t know about the loan. He came into Daryl’s office with a lawyer, but the contract was legally airtight; there was nothing the lawyer could do about it.
But, as Daryl explained, he took pity on the woman and gave the motor home ownership back to the couple.
It sounded like an amazing company.
However, nobody can guarantee you 54 percent on your money—ever. Bernie Madoff, the currently incarcerated Ponzi-scheming money manager, promised a minimum return of 10 percent annually and he sucked scores of intelligent people into his self-servicing vacuum cleaner—absconding with $65 billion in the process.2 He claimed to be making money for his clients by investing their cash mostly in the stock market. But he was paying them “interest” with new investors’ deposits. The account balances that his clients saw weren’t real. When an investor wanted to withdraw money, Madoff took the proceeds from fresh money that other investors deposited.
When Madoff’s floor caved in during the 2008 financial crisis, investors lost everything. His victims included actors Kevin Bacon and his wife Kyra Sedgwick, and director Steven Spielberg, among the many others who lost millions with Madoff.3
Yet the percentages paid by Madoff were chicken feed compared with the 54 percent caviar reaped by Daryl Klein’s investors.
Daryl’s story sounded solid, when we first met back in 2001. But still, I wasn’t prepared to invest my money.
Meanwhile, my friend kept receiving his interest payments, which now exceeded $100,000.
By 2003, I had seen enough. My friend had been making money off this guy for years and my “spidey senses” were tickled more by greed than danger. I met with Daryl again, and I invested $7,000. Then I convinced an investment club that I was in to dip a toe in the water. So we did, investing $5,000. The monthly 4.5 percent interest checks were making us feel pretty smart. After a year, the investment club added another $20,000.
The easy money tempted some of my other friends, too. One of my friends borrowed $50,000 and plunked it down on Insta-Cash Loans. He began to receive $2,250 a month in interest from the company.
Another friend deposited more than $100,000 into the business; he was paid $54,000 in yearly interest. But Alice’s Wonderland was more real than our fool’s paradise.
As in the case of Bernie Madoff (who was caught after Daryl), the party eventually ended in 2006. The carnage was everywhere. We never found out whether Daryl intended for his business to be a Ponzi scheme from the beginning (he was clearly paying interest to investors from the deposits of other investors) or whether his business slowly unraveled after a well-intentioned but ineffective business plan went wrong.
Klein was eventually convicted of breaching the provincial securities act, preventing him from engaging in investor-relations activities until 2026.4
The fact that he was slapped on the wrist, however, was small consolation for his investors. A few had even remortgaged their homes to get in on the action.
Our investment club, after collecting interest for just a few months, lost the balance of our $25,000 investment. My $7,000 personal investment also evaporated. Many investors in the company lost everything. My friend, who borrowed $50,000 to invest, collected interest for 10 months (which he had to pay taxes on) before seeing his investment balance disappear when Insta-Cash Loans went bankrupt in 2006.
It’s an important lesson for investors to learn. At some point in your life, someone is going to make you a lucrative promise. Give it a miss. In all likelihood, it’s going to cause nothing but headaches.
Investment Newsletters and Their Track Records
In 1999, the same investment club mentioned earlier was trying to get an edge on its stock picking. We purchased an investment newsletter subscription called the Gilder Technology Report, published by a guy named George Gilder. He might still be in business. A quick online search in 2011 revealed a website boasting of his stock picks. It claims his picks have returned 155 percent during the past three years, and that if you buy now, you’ll pay just $199 for the 12-month online subscription to his newsletter. By 2016, the website was unchanged. It said the exact same thing.5
Back in 1999, we were convinced that George Gilder held the keys to the kingdom of wealth. Unfortunately for us, he was the king of pain. Today, if George Gilder reported his long-term track record online (instead of trying to tempt investors with an unaudited three-year historical return) he would have a stampede of exiters. His stock picks have been abysmal for his followers.
We bought the George Gilder technology report in 1999, and we put real money down on his suggestions. I’m just hoping my investment club buddies don’t read this book and learn that George Gilder could still be hawking promises of wealth. They’d probably want to send him down a river in a barrel.
Back in Chapter 4, I showed you a chart of technology companies and how far their share prices fell from 2000 to 2002.
In 2000, whose investment report recommended purchasing Nortel Networks, Lucent Technologies, JDS Uniphase, and Cisco Systems? You guessed it: George Gilder’s.
Table 9.1 puts the reality in perspective. If you had a total of $40,000 invested in the above four “Gilder-touted” businesses in 2000, it would have dropped to $1,140 by 2002.
Table 9.1 Prices of Technology Stocks Plummet (2000–2002)
High Value in 2000
Low Value in 2002
Amazon.com $10,000
$700
Cisco Systems $10,000
$990
Corning Inc. $10,000
$100
JDS Uniphase $10,000
$50
Lucent Technologies $10,000
$70
Nortel Networks $10,000
$30
Priceline.com $10,000
$60
Yahoo! $10,000
$360
Source: Morningstar and Burton Malkiel’s, A Random Walk Guide to Investing
And how much would your investment have to gain to get back to $40,000?
In percentage terms, it would need to grow 3,400 percent.
Wow—wouldn’t that be a headline for the Gilder Technology Report today?
“Since 2002, Our Stock Picks Have Made 3,400 Percent”
If that really happened, George Gilder might be advertising those numbers on his site.
Just for fun, let’s assume that Gilder’s original stock picks from 2000 did make 3,400 percent from 2002 to 2016. That might impress a lot of people. But it wouldn’t impress me. After the losses that Gilder’s followers experienced from 2000 to 2002, a gain of 3,400 percent would have his long-term subscribers barely breaking even on their original investment after a decade—and that’s if you didn’t include the ravages of inflation.
If there are any long-term subscribers, they’re nowhere near their break-even point. Can you hea
r his followers scrambling in the Grand Canyon’s lowest rings? I wonder if they’re thirsty.
Where There Is a Buck to Be Taken
We already know that the odds of beating a diversified portfolio of index funds, after taxes and fees, are slim. But what about investment newsletters? They’re about as common as people in a Tokyo subway. They selectively boast returns (like Gilder), creating mouthwatering temptations for inexperienced investors:
With our special strategy, we’ve made 300 percent over the past 12 months in the stock market, and now, for just $9.99 a month, we’ll share this new wealth-building formula with you!
Think about it. If somebody really could compound money 10 times faster than Warren Buffett, wouldn’t she be at the top of the Forbes 400 list? And if she did have the stock market in the palm of her hand, why would she want to spend so much time banging away at her computer keyboard so she could sell $9.99 subscriptions to you?
Let’s look at the real numbers, shall we?
Most newsletters are like dragonflies. They look pretty, they buzz about, but sadly, they don’t live very long. In a 12-year study from June 1980 to December 1992, professors John Graham at the University of Utah and Campbell Harvey at Duke University tracked more than 15,000 stock market newsletters. In their findings, 94 percent went out of business sometime between 1980 and 1992.6
If you have the Midas touch as a stock picker who spreads pearls of financial wisdom in a newsletter, you’re probably not going to go out of business. If you can deliver on the promise of high annual returns, you’ll build a newsletter empire. If no one, however, wants to read what you have to say (because your results are terrible) the newsletter follows the demise of the woolly mammoth.
Millionaire Teacher Page 22