Get Rich or Die Trading: 10 Rules to Live By in the Stock Market
Part 3:
Focus on capital preservation. It’s far more important than capital gains.
Which would you say is more important, making a gain on what you have, or maintaining what you have?
The latter is, by a mile:
If John has $100,000 to invest and he is seeking a safe ROI (return on investment) he has only one real question from the various advisors or products that he’s thinking about purchasing, and that is “what’s your risk tolerance?”
It’s an unfair question that doesn’t take into account the time John can hold, his appetite for risk, his age, the weight of this investment relative to his net worth, or what his objectives on the investment are.
Your Advisor doesn’t lose if you lose, in fact they gain every year, regardless
If you walk into any bank or investment firm in the world and tell them you have $100,000 to invest they’re going to ask if you want a cup of coffee and then present you with 3 boiler plate ‘model portfolios’; here’s the more aggressive one where you can expect a higher rate of return but more volatility and more risk; here’s the middle of the road where you can expect fairly reasonable volatility and a more conservative gain; and here’s a very conservative portfolio where you will expect to get back money-market type rates of return; ie: less than 2% a year, but your risk of loss of capital is pretty well gone with the lethargic return-on-investment.
So in other words, this system is set up to take you for a ride, assuming you can handle it, and keep you at average index returns, somewhere in the neighbourhood of 10 to 12% a year all the way down to GIC type investments where you won’t risk your money, but you also won’t get a return any greater than current inflation rates – ie: a negative return.
Index funds that match the Dow or the S&P for example will yield you about 12%~ per year, but you’ll need to be okay with the wild ups and downs of the equity markets.
Balanced funds that are about half stocks and half bonds will yield you around 5% a year, but with that diminished risk and yield comes about half the volatility and swings.
And money market funds which basically only hold bonds, T-bills and cash, leaving you with little-to-no risk, but paying you the same you’d get in a typical high-interest savings account or GIC.
Those are essentially your three main options in the “investment world” for the masses.
I broke those down to try and easily display the difference between risk and return. This is something that has not changed through the millennia – it may seem obvious that with higher risk, brings higher potential returns, so when choosing something to invest in, the very first question is, “what is your risk tolerance?”
If you have an advisor that does not talk to you about your risk tolerance and comfort level, then you need to fire that advisor immediately.
Fire your Advisor
Most people don’t realize that their friendly financial “advisor” at their local bank branch was a bank teller just years prior. He or she worked their way up from giving out deposit and withdrawal slips behind the counter, to taking a MFDA (Mutual Fund sales) course which can be done in a weekend, in order to be able to advise you and your spouse on your personal finances and life insurance needs. The whole notion is nauseating and scary when you consider that the masses give these people carte blanche with their net worth. Did you ever wonder why mutual fund sales people tend to always have their life insurance license as well? Both are accreditations that can be achieved with a single written test after reading a single text book in any city in North America. The most important financial decisions of your life are being handled by literally the least qualified people, who work on commission, and rely on it to sustain themselves and their employer, downtown, 9-5, at your local bank branch.
A banker is making your life decisions.
Did you realize that your dealings at the bank with financial advisers are with people that have less education in the markets than you could give yourself in a period of a few weeks with a few good books? Do you know that those advisors get paid whether or not they make you money? In fact they get paid very unfairly on your hard earned capital through something called MERs (management expense ratios) and various other commission structures and incentives paid through by the bank and partner fund companies.
So you walk in with the best intentions and you put your $100,000 life savings into a ‘balanced portfolio’, essentially a basket of mutual funds, managed by the bank, which will charge you in the neighbourhood of 2 to 3% per year just for the pleasure of housing your capital.
Let’s be clear, the first $3,000 you make on your $100,000 that you put to work is paid out to the bank, and to the adviser that sold you this product – not you – whether you lose money on that investment that year or not. Not only do some of these products not even see 3% per year in gains, but when you factor in this 3% over the period of 10 or 15 years, you will quickly start to see how you are willingly being robbed blind, by a financial system that is set up to transfer wealth from the sheep to the banking system by way of these “financial advisors”. And all of this because you didn’t pick up a few good books on self-directed investing, or couch potato investing.
Couch Potato Investing
Did you know 85% of the money managers on earth continue to underperform the stock market index year after year? 85%. Can you imagine the trillions in fees paid out on those assets to the Banks to miss the mark? Paying money to lose money. That sounds like Government.
Did you know that less than 1% of the high-paid Mutual Fund Managers ever invest even $1 into the funds that they manage despite being allowed to do so?
The S&P 500 has netted out an average return of about 10-11% per year, going back 100 years. The average mutual fund on the other hand, has averaged out 4-5% per year. So with Mutual Funds you get to pay 3% to a Fund Manager, who doesn’t invest in his own fund and makes money even when you lose it, in order to underperform the general market with your life savings.
Because you didn’t read the books. You don’t know yet that cash is a position – cash is choices. And just because you have choices doesn’t mean you need to make decisions now.
There are some incredibly eye opening books out there that get into this in great detail, and I would suggest “Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns” by John C. Bogle as a great place to start. I promise you that you’ll feel both nauseous and empowered once you expose yourself to Index Investing opposed to Mutual Fund investing through a bank or advisor. You’ll make more money, too.
Stock brokers
Stock Brokers, who are an essential component of the capital markets, who serve as the human order takers to put in buy and sell orders for those who don’t do it digitally, are also called “Investment Advisors”. This title also causes a lot of confusion out there.
While having, or having access to a good stock broker can be make or break – especially for penny stock ‘investors’, the full-service stock brokerage model is slowly decaying for their digital counterparts while more and more ‘advised’ people are turning to online discount brokerage accounts and taking control of their own stock trading – for better or for worse.
Much like your MFDA Mutual Fund Investment Advisor at your bank, your IIROC Stock Market Investment Advisor at your brokerage firm also carries an accreditation that takes mere days to study for and pass. A securities license in North America has one of the lowest barriers to entry and takes less time than it does to drive a forklift or get your Level-1 First Aid. The people that advise one of the most important decisions you can make, have the least amount of education and qualification. Go figure.
Most advisors know nothing about asset allocation, economics, behavioural finance, or geopolitical risk and yet they are making your asset weighting decisions for you. This is dangerous and needs to be addressed. There is a saying that your broker is ‘broker’ than you, otherwise they’d be investing their own money, not yours. Most advisors – again, I generalize, are fantastic people doing a very hard job, but as soon as they figure out ‘how it actually works’ they immediately start doing something different, and then often bring in juniors to do the sales for them. I’m positive that the life cycle of an Advisor is extremely short relative to other vocations, purely based on the fact that most new advisors don’t know anything about what they’re selling.
I will emphasize again; I have had many incredible advisors, and still do, but I always ask them the hard questions and I have a tendency to ask them questions that make them think, research, discover and get back to me on things they never knew. I gently remind them which side of the desk they’re on.
Think of it this way; you can either pick up the phone, hope to get your broker on the line, have to hear him chewing his lunch and give his completely unqualified economic forecast for the day while you tell him to please buy 100 shares of XYZ stock. He continues to crunch on his tuna sandwich on the phone while you sit and patiently wait for him to say “okay, you own it”.
And you paid $100 on average for the pleasure of that transaction. Costly, rude, inefficient and utterly unnecessary in a digital age. Again; on the deal side, brokers serve a very important function, and for those that don’t want to trade themselves, brokers serve another important function, but the argument of recent years is that if you’re smart enough to enter the order verbally, you better be smart enough to understand how to do it digitally yourself.
Alternatively; you can open the app on your phone of your online broker with a single click, enter in XYZ stock, get a real-time quote on the price, for free, enter ‘100’ in the amount, enter in your buy price under ‘limit’, click confirm, and presto, you own the same shares for about $5 and the whole thing took you less than 15 seconds.
Of course there are always exceptions to the rule, and much like cops, teachers or any other vocation, most of them mean well and genuinely want to help others – but at the end of the day, these people are clipping a fee off your money, and getting paid – whether or not you make money on the trade or investment. They have no capital at risk, and they get paid. You carry all the risk and get paid second often due to their neglect or ignorance.
If this resonates, do yourself a favour, educate yourself on the mechanics of starting a DYI couch potato, low-fee index fund portfolio and eliminate the risk of human error. It’s cheaper, safer, more efficient, and you’ll never have to listen to anyone eat their tuna sandwich on the phone again.
The rich get richer
Of course they do – and why wouldn’t they? They must be more educated, smart and effective if they’re more rich, right?
Wrong.
While the masses have to walk into the bank to see Sandra the Advisor for a 3% MER mutual fund, the wealthy can participate in hedge funds bearing 30%+ a year and play in things like private placements, where the real juice is, often bearing the coveted “10 baggers” if you “know a guy” that can get you in.
What’s the difference?
Accredited Investors
If you’re not familiar with the concept of being an “accredited investor”, I strongly suggest you do so. It varies by region, but typically means you have at least $250k a year in income and a million or more in liquid assets. Once you do – congratulations, you can now invest in the actual investments that are out there that usually bear upwards of 20-30% per year. Oh and the fees are smaller too – of course.
While Sandra the financial advisor at BMO is telling you what to do with your RRSP and TFSA, her high-net worth clients are leaving in droves to subscribe to hot private placement offerings below market price and getting into hedge funds that are taking in new capital. Even private capital opens up to you if you have a million to invest – sometimes the barrier to invest is as low as $100,000. But you have to be “accredited”!
In my personal experience, The majority of accredited investors didn’t start that way and they fudged the numbers on their initial opportunity in order to become accredited. While I would never suggest fraud or breaking the law, I do strongly suggest that you find an actual fee-based financial advisor, who won’t take your money, but will rather charge you hundreds per hour to give you actual sound financial advice – non biased, non-commission based advice. Ie: an actual advisor. How do you find these people? Go find a rich person and ask them who they go to for their financial advice. You’ll be surprised to hear more often than not that “books” is their answer, but they should be able to point you in the right direction. Wealthy people are educated people – no not in school, in actual financial education and literacy which comes in the form of personal journeys and wanting to learn how the system works from those who are just a bit ahead of you.
Wealthy people don’t invest with the bank, they invest “in the bank”, by way of owning the bank’s common shares so that when poor-minded people come in and invest, those MERs – fees from the common-folk, translate to profits for the bank, which translates to higher stock prices; which translates to the rich getting richer.
It’s time we started calling fees what they really are; fines. Because fines are an avoidable tax on the poor.
Example
Most people remember September of 2008 well. Not because Lehman Brothers collapsed, or because the entire US housing system melted down, but because they lost more than half of their net worth, on paper during the month of September 2008.
I remember it well because my first son was born that month, and while I was holding him in the hospital, listening to financial news live on my phone, I didn’t lose half of my net worth; I lost it all – and then some – thanks to a commission-based advisor and a little thing called leverage.
Leveraged Investing
In the summer of 2008, I met a friendly Mutual Fund salesman who said everything I wanted to hear about starting to build my wealth, by way of a leveraged, albeit ‘balanced portfolio’.
I was 23 years old, I had a 1-year-old daughter, a son on the way, I was newly married, I made less than $60,000 a year managing a Harley-Davidson dealership in Chilliwack, BC and I had managed to save up $40,000 to start actually investing for retirement, outside of my penny-stock trading and speculation. It was all the money I had in the world and I got it through teaching myself to trade penny stocks from 2004 when I was first old enough to open a brokerage account, to that summer of 2008. I was very proud of my hard earned market gains and I wanted to lock it into a nice blue-chip portfolio for my new family. My first real “investment portfolio” outside of real estate and junior miners.
The ups and downs that came with speculating on gold exploration penny stocks had taken a toll on me, and I wanted to finally start a portfolio I could leave alone. To start Investing for the long term.
So I did what I thought was right at the time, I found the right “Investment Advisor”.
We’ll call him Mark, since after all – he only did his job and this story is not about him. It’s about being naive, ignorant to how the system works, and not respecting money.
I later learned that money will always “flee inhospitable environments”, and this is a perfect example of treating $40k the way you’d treat a haircut decision.
Mark was a friendly advisor at a local firm, he was trusted and liked by his colleagues, he was consistent as a rock and always quoted Warren Buffett – what more could you hope for.
I first sat down with him in June of 2008 – the peak of the market, as so often is the case, something I will get into later – and I made that critical error in saying to him:
“Mark, I want to start investing in the markets – not just trade it – and I have $40,000 saved up – what would you do if you were me?”
An innocent question; but one that I later learned was the demise of every doe-eyed retail investor walking in off the street to be culled by a “Licensed Advisor”.
Keep in mind that my $40,000 was not enough for him, he needed far more than that if I were to make myself worthwhile to him from a fee-based perspective. You see; 3% a year will only generate about $1,200 per year in fees for Mark. That’s not even enough to make me worth the paperwork involved in a new account with the “Know your client” forms (KYC) requirement that Advisors are required to adhere to.
What Mark needed was some leverage; some juice to make me more worthy of his time and his sage, albeit regurgitated, cliche and dated advice.
You see – if he could convince me to just take out a loan with him at the firm, and “leverage” that $40k, I could conceivably invest $80k! $100k! Why not even $120k!
Fuck it, let’s borrow $120k against my $40k and we’ll have a $160k mutual fund sale; generating more like $4,800 in commissions that year alone. Now we’re talking! Now this 23-year-old with a sub-$100k net worth, a young family, and no clue what a leverage loan even was, was worth his time – for sure. I’m now half of his Family vacation to Mexico that year. Perfect.
So he did exactly that. He convinced me that I was young, which I was, that I had time, which I did, and that this was a long term investment – which it was – so why not borrow to invest and that way I can make 3 or 4 times the annual rate of return on my $40k, even after the interest on the loan was factored in! Brilliant. It makes so much sense. After all, it’s all the same to me, and now I will be generating rates of return equal to a $160k balanced portfolio instead of a $40k portfolio. A “no-brainer” he told me. “This is what I would do if I were you – this is what I do for all my clients and for myself” is what he told me.
Sold.
He wasn’t lying. In fact, he had somehow taken something like $2 or $3 million in investable assets in our little town, and turned it into a fee-generating machine of over $10 million invested thanks to a little known term in the markets at the time; ‘leverage loans’ which were being handed out to anyone with 10-20% down.
Until September of 2008.
You see, what Mark failed to mention, was the worst case scenario, which literally happened, a mere 90 days later.
My portfolio of mostly US large-cap equities of $160,000 in July, had bottomed out to about a $70,000 portfolio of banged-up US large-cap equities by mid-September.
The best part? My $40k was long gone in the blink of an eye, yet the manager had already made $4,800 on the transaction that year alone.
But it gets better! Not only was the $40k that I saved up over 4 years was gone, but I now owed $120,000 on a portfolio valued at $70,000. And this is with no end in sight of this new “financial crisis”. It wasn’t until March of 2009 that the indexes bottomed out, and at the time of this writing, my ‘balanced portfolio’ still – to this day – has not even come close to returning to its glory days of $160k. Of course I left the account open, and guess what; I never heard back from Mark. Yep – he didn’t want to face the music and as a result of his and some others actions, the rules and regulations on margin requirements and leverage loans was changed globally in 2009 because of exact cases like my own. It was in fact, the very reason that Lehman Brothers collapsed. Over-leverage. Bad debt to equity ratios. Borrowing more than you should. Not understanding what you’re borrowing against. Not factoring in September 2008 or March 2000 type scenarios and how they would effect the 10 year plan.
In summary I took $40,000 and I didn’t respect it. I gave it to an advisor who didn’t care about it as much as I did.
He leveraged it to generate more fees for himself. He didn’t ask me risk tolerances nor did he tell me what could happen if the market were to correct in any significant manner.
I did this at a perfect market top, the market crashed right after and I was left holding a $120,000 bag, which was worth $70,000.
A $90,000 loss on paper in 90 days, for being lazy and trusting a commission-based ‘advisor’ with my hard earned money.
Perhaps if his business card read “Mutual Fund Salesperson” I would have sought out a second opinion before signing for the loan in his office.
Mark has since retired.
Protect your capital. Focus on Capital Preservation. Always remember that keeping what you have is far more important than what gain you might miss out on. And never forget that the answers and the solutions to your money questions are out there, but they don’t sit with commission based financial advisors who could very well be brand new to finance.