Chapter 3

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“An investment in knowledge pays the most interest.”

—Benjamin Franklin

In 1963, U.S. television audiences became addicted to a new television game show called "Let's Make a Deal." The show became so popular that it was later syndicated, and it's still being shown in many countries around the globe.

On the show, contestants chosen from the audience were offered the chance to accept an unidentified prize that they knew would be moderately desirable, for example, a TV set or a refrigerator. They didn't know exactly what prize they would get because it was hidden behind a door. To make the game more interesting, the contestants could instead choose an unknown prize concealed behind one of two other doors. One of their choices was something much more desirable such as a new car or a vacation, but the other was something called a "zonk," a losing proposition that might be a roomful of junked furniture or an article of clothing in some ridiculous color or size.

The contestants had to choose between the unknown prize that they probably would like or take a chance of either getting a much better prize or getting something they probably wouldn't like at all.

Because this was television, the contestants were encouraged to behave as if this were among the most important choices they would ever make. It wasn't, but the show seemed to be fun for everybody. Bad guesses didn't have any lasting consequences except perhaps some public embarrassment.

In real life, many of the risks that we take are much more real. Fun isn't guaranteed. This book is about some fundamental choices that are much more important than those on any game show.

Let's Make a Deal

In this chapter, I'm going to ask you to choose one of three doors. The choice has consequences that can last a lifetime. That's the bad news. The good news is that you have one major advantage over the contestants on "Let's Make a Deal"—I'm going to show you what's behind each door.

If you get this choice right, most of the rest of investing will fall into place naturally, and you will be on your way to financial fitness forever. But if you get this choice wrong, no matter what else you do, you will be swimming upstream.

Most likely, you have never thought about this choice. I've read hundreds of books on investing, and I've never seen one that clearly identifies these three doors.

Success in investing, as I mentioned in the Introduction, is not terribly different from success in the rest of life. One of the most important things we do over and over again in our lives is place our trust in people to know what we don't know and to look out for our interests.

Very few of us have the resources, the time, the knowledge, or the patience to discover for ourselves everything we need to know in order to make our money do the most for us. We have to trust that somebody else has figured things out and has found answers that will work for us. The problem is that lots of people claim to know what is best for us, and they supply different answers. Who deserves to have our trust?

Most people and institutions want our trust, but not all of them are equally worthy of it. The brightest people I know are careful about whom they trust. I think it's fair to say that successful people generally make more good choices about this than unsuccessful people do.

In all my years in the investment business, I have found only three basic choices. Because they are so important, I've listed them here and will keep referring to them throughout the book.

  • You can trust Wall Street, which in my mind includes most of the financial media as well as investment banks, insurance companies, brokerage houses, and mutual fund families.
  • You can trust what I call Main Street, meaning your neighbors, friends, relatives, colleagues, and people you may meet casually.
  • You can trust the academic community, which I have labeled University Street.

Imagine that each one of these groups of people is behind a door. Which door do you open for the best source of investment advice? Let's open those doors, which I have labeled Wall Street, Main Street, and University Street, and have a look. I think you'll see some things you didn't know were there.

For starters, it's pretty obvious that there are lots of people who want you to open Door #1, Wall Street, and lots of other people who hope you'll open Door #2, Main Street. Why do you suppose they want you to do that?

Door #1

Behind Door #1, Wall Street has an obvious agenda. Mutual fund companies, brokerage houses, independent advisors, banks, and insurance companies all want our business. In return for our trust (plus some of our assets), they offer assurances and carefully selected past performance data to "prove" they can make our future bright.

However, Wall Street is riddled with conflicts of interest along with hidden and undecipherable fees. Their smiling, friendly people will do virtually anything to attract our assets to their management. This is a path that leads to profits—profits for Wall Street. Wall Street wants us to trust their experts, wants us to try to beat the market—while Wall Street itself seeks opportunities to nibble away at our assets every step of the way.

Door #2

Behind Door #2, Main Street also has an agenda—but it's less obvious. Our friends, neighbors, colleagues, and relatives probably don't want a slice of our assets—at least not enough to come right out and ask for our money. Instead, they want us to respect them and understand how smart and savvy they are.

These people are happy to share their successes, their hot tips, their newest insights. Trouble is, they are amateurs who rarely if ever show us proof of their claims. Did your neighbor who bragged about his or her stock market prowess ever show you annual trading statements or personal tax returns? Probably not, and this means you really have no way to judge the validity of what you're being told.

Door #3

Behind Door #3, University Street has the most interesting agenda, one that doesn't actually involve us. Professors and graduate students want their peers to realize how brilliant they are to have figured out the intricacies of investing. They want their research to be published, with all the attendant opportunities that can result, including tenure, acclaim, and even the Nobel Prize.

The academics on University Street don't have much reason to care whether or not we know about them or follow their teachings. They aren't trying to impress us or make a profit from us. They're most interested in finding out what works and what doesn't—and where the holes are in Wall Street's sales pitches.

So it boils down to three choices: We can trust institutions that want us to help them make profits. We can trust people who want to impress us. Or we can trust people who don't care what we think about them—who just want to get it right. In my mind, the choice is clear. I'll take Door #3, and I think you should do the same.

In the rest of this chapter, I'll explain why.

Wall Street

I'm going to paint a picture of Wall Street that may seem very negative. It's certainly quite different from the impression you're likely to get from the upbeat ads and commercials for brokers, mutual funds, and insurance companies.

I want to emphasize a point here. My criticism is not directed at the individuals who work on Wall Street. My beef is with the system. Obviously, the financial world as we know it could not operate without brokers, buyers, sellers, traders, and all sorts of systems for gathering and disseminating information.

As investors, we need some version of Wall Street. But we need a better Wall Street. We need a Wall Street that's aligned with the interests of the investors whose money is at stake, whose futures are at stake. Until we get that better Wall Street, we have to be on our guard.

Most of us deal with brokers in one form or another. In the simplest terms, a broker is somebody who takes our buy orders and our sell orders and sees that they are executed. But brokers do much more than that. They sell products, often in the guise of giving advice.

When we walk into an automobile showroom, we understand that the salesperson who greets us is not there to be a transportation consultant. We know that salesperson's job is to persuade us to buy a car—and ideally to sign the papers before the day is done. In car sales, this is easy to figure out. Yet many investors never seem to figure out that the same thing is true of brokers. They are there to sell.

If you have a broker, you probably like him and trust him. (I use the male pronoun for writing convenience only; I know that many brokers are women.) And the chances are good that he deserves your trust. This may surprise you, so let me repeat it. Most brokers deserve your trust, at least as individuals.

The problem is that brokers don't work for themselves. They work for companies designed to generate profits. And we investors are the source of those profits. The danger to you is much more likely to be the broker's boss, the branch manager. And the boss's boss, perhaps a district manager too, and so on up the line including the CEO, board of directors, and shareholders. Up and down this long chain, do you know who really cares about you as a person? The answer is probably nobody except your broker. And your broker is the person with the least status and power in this system.

If your broker loses your trust and business, he probably won't lose his job. However, if your broker loses the trust of the people he reports to, he could find himself on the street. You can be sure your broker understands this. In a pinch, the company and its interests must prevail.

The company's interests are served when revenue is generated, most often from sales commissions.


Commissions often seem minor, a convenient way for you to pay for expert advice. But commissions can cause well-meaning sales professionals to recommend one product instead of another just because of the size of the commission.

Naturally, salespeople would rather earn larger commissions instead of smaller ones. And that's where the conflict of interest begins. Wall Street pays the highest commissions on the products that are hardest to sell. And those are the very things that people are most reluctant to buy because such products carry the highest risks.


Here's the point I want you to take away from this: Your broker has more financial incentives to persuade you to buy expensive and risky financial products than he does to get you to buy cheaper, safer ones. Here are two stories to illustrate.

Some years ago I was invited to speak at a conference of agents who had been outstanding producers for a particular insurance company. At a cocktail party after a fabulous day in a location that could only be described as paradise, I got to chatting with one of the agents and asked how he and the others had qualified for the lavish honors and treatment they had received.

He was an independent agent and told me he had sold large amounts of one of the insurance company's products. He liked this product and found it was easy to sell and beneficial to his clients.

That was the good news. The bad news was that in order to win the trip to this conference, he had to sell an equal amount of one of the insurance company's other products. He did not believe this other product was in his clients' best interests. He sold that other product anyway in order to put money in his own pocket and take care of his family—and to win the trip to paradise.

I see a naked conflict of interest here. You want someone who will direct you to the products that will meet your needs in the best and most efficient way. But Wall Street wants to sell you high-commission products. When Wall Street gets its way, a little less of your money is working for you, and at the same time you are taking more risk—likely without ever really understanding it.

Some fixed-income funds that charge above-average management fees try to overcome that disadvantage by investing in riskier bonds with higher potential returns. But this additional risk can backfire, and you as the shareholder are the one who pays the price.

For five years from 2006 through 2010, the Oppenheimer Champion Fixed Income Fund (1.25 percent expense ratio) lost more than 20 percent annually. In that same five years, Vanguard's high-yield bond fund (0.28 percent expense ratio), which didn't invest in such risky securities, had a positive annual return of 6.3 percent. Which one of these operated in Wall Street's interests? Which operated in the shareholders' interests?

My second story involves sales goals that Wall Street imposes on brokers. Not long ago I met a young advisor who had just quit his job at one of the biggest investment firms in the country. He had thrown in the towel after deciding he was uncomfortable with the ethics of his firm. He had taken a job in the firm's Seattle branch office along with nine other greenhorns. When he finally left, he was the only one of his 10-person training group who was still there. No one in his class survived.

This young fellow was very open with me. He said that in order to remain on the payroll after the training period, he was required to produce commissions of at least $120,000 a year, or $10,000 a month. Even though the company knew he was only learning the ropes, he was encouraged to solicit business from his friends and family members. This is standard practice in the industry, and a young broker's friends and family may be his greatest asset to the company, since they are new prospects. Once he has obtained all the business he can from that source, he is less valuable unless he can excel at making successful cold calls.

To meet his production quota, this broker decided to focus on professional couples in their 30s and 40s who could save money for retirement in 401(k) accounts, individual retirement accounts (IRAs), and 529 college savings plans for their children. He immediately ran into two problems. First, he could not make any money if these professionals contributed to 401(k) plans because there was no commission. Second, if he could persuade them to invest in IRAs instead of their company retirement plans, the only products he could sell were load mutual funds and variable annuities.

This young broker didn't believe that his clients' best interests were served with either load funds or variable annuities. In addition, those products paid only about 5 percent in gross commissions. If he persuaded a couple to save $500 a month, his gross commission was $25. To generate $10,000 in commissions that way, he'd need at least 400 clients who were each adding $500 a month to their funds or annuities. That could take years, and he was under pressure to produce commissions now.

Then his company showed him a better way to meet his quota. It was better for him and better for his employer. But was this better for the investors? I'll tell you the facts and let you be the judge.

The company taught him how to sell variable universal life insurance and to pitch it as superior to 401(k) and IRA investments. He was taught how to explain the policy's tax-free growth of principal and the benefit in later years of being able to take money out tax free by borrowing from the policy, even before reaching age 591/2.

He started making this sales pitch to clients, but he didn't fully disclose his motivation for his recommendation. Instead of making $25 on each month's $500 investment, his firm made 10 times that much because during the first year the insurance company paid the brokerage house $250 each month. That's right, a full 50 percent of the insurance premium.

Now our young broker could stay on the payroll by finding only 40 active clients instead of 400. Even better, if he could find investors who could write big checks immediately, for example $10,000 in a lump sum instead of paying monthly, the broker could make his quota by opening only a few accounts per month.

Over our third cup of coffee, he admitted that although the variable universal life insurance is a terrible solution for most clients, it's a wonderful solution for a young salesperson.

This chapter is about trust. If this man had been your broker, you would have liked him. I certainly did. You might easily have trusted him, as I did (of course without following any of his investment recommendations).

Brokers face constant pressure not only to sell but to sell high-profit products, which often turn out to be more risky. A friend of mine who is a broker told me his manager stopped by his cubicle one day to ask why he hadn't sold his allotment of a new security the firm was pushing. This broker, always direct and to the point, told the boss, "Because I think it's a piece of s___!" The manager replied, "You will either sell it to your clients or you will buy it in your own account."

You can certainly put your trust in Wall Street, and you'll be rewarded by the smiling faces and glitzy marketing materials designed to make you comfortable. But sooner or later, you will run smack into a conflict of interest. And in that conflict, Wall Street will win.

Main Street

Painting a picture of Main Street is more difficult, and that's just the problem. On Main Street, there are no reliable data, and you can't prove anything.

Informal contacts between individuals happen everywhere, all the time, in just about every conceivable manner. Short of organizations such as investment clubs (in which individuals share the work of doing research on individual stocks and then make group decisions to buy and sell), the communications on Main Street take place one interaction at a time. You sit next to somebody on an airplane. A neighbor remarks that she made $10,000 in the stock market last week; your brother-inlaw claims to have special insights about some company or industry.

Main Street is a wonderful way to find out about restaurants, hotels, shops, dry cleaners, and hundreds of other products and services. People helping people really works in these realms, and the rise of review sites on the Internet has become a vast source of useful knowledge that reflects the experiences of real people.

But when it comes to investing, I don't think this works. When I choose a hotel or a restaurant, the stakes are relatively small. If I make a serious mistake, my evening or my vacation might be ruined, but not my financial future. On the other hand, when I decide how to invest my life savings, the stakes are very high. Casual just doesn't cut it.

Here are my main concerns. I don't know if somebody is telling me the truth. I don't know whether the success I'm hearing about was pure luck, or something else. I don't know how much risk this person is willing to take, or how much risk he or she actually took. I don't know whether this person's great success involved an entire portfolio or only a sliver of it. I don't know how much he or she knows about alternative choices that are available to me. I don't know how much, if anything, the person knows or cares about taxes, expenses, index funds, conflicts of interest, liquidity, and diversification. I don't know whether somebody with a huge portfolio acquired it by successful investing or by a big inheritance.

There's one thing I do know, however. It is very likely that I won't get the whole truth with documentation to let me confirm it.

I have talked to many investors who say they count on advice from friends and relatives whom they regard as more trustworthy than securities salespeople. Often, these investors turn to Main Street feeling very vulnerable after having lost money at the hands of a broker, who in fact may have been a clueless greenhorn or may have found this particular investor an "easy sale" for products that the company was eager to sell.

If you are following a guide from Main Street, you should know the answers to a few questions.

  • Is my Main Street source telling me the truth—and the whole truth?
  • Does he know how much risk I am willing to take and should take?
  • Does he encourage me to practice smart diversification?
  • Does he show me documentation to back up his stories of success?
  • If he is indeed successful, why? Was it skill? Was it luck? Was it inside information?
  • Does he have securities training or licenses?
  • Does he have a long-term strategy that he can explain so I understand it?
  • Does he have any legal obligation to me?

I don't think you are likely to get the whole truth from a friend or relative. Study after study has shown that most investors don't even know themselves exactly how their portfolios have performed. The human mind is very good at selective memory. We feel good when we remember our gains, and we find it quite convenient to forget our losses. I have a friend who likes to tell me of his market success. If I take him at his word, he has never had a losing trade. With a record like that, he should be managing billions of dollars for a mutual fund company!

Your neighbor may tell you how successful he is, but he won't tell you how much risk he's taken. Maybe that neighbor can afford to lose 50 percent of his investment portfolio. But when he actually sustains losses of that magnitude, does he regard it as a "normal" event to be expected? Will he tell you over the fence that he just lost half his money? Will he tell you he bailed out in panic after a big loss?

If you could see your neighbor's complete investment statements for 2008 and 2009, you'd have a pretty good idea. But I doubt you'll ever get that opportunity. And even if your neighbor can easily tolerate a huge loss like that, is that right for you?

If you listen carefully to what you hear on Main Street, you'll almost always find that the bragging is about short-term results, not those that span decades. Often, people ask me what I think the market is going to do this month or this year. A common question is some variation of: Where should my money be right now? I don't know the short-term prognosis for any investment. People who are focused on the short term are unlikely to succeed in the long term because they keep changing course instead of letting a good strategy work for many years.

Next time someone tells you about his great results, ask him to explain his long-term strategy and the assumptions that underlie it. You'll probably find him quickly changing the subject.

Most Main Street mavens don't believe much in diversification. After all, if you're super smart, you don't need to hedge your bets; instead, you'll tend to put everything on the winner. Many people will tell you quite confidently that there's no need to own more than 10 to 20 stocks in a portfolio. Their attitude is that diversification is for people who don't understand the market.

But in my view, the lack of diversification is for people who don't understand the market and for people who don't understand numbers, especially statistical probabilities.

This is one of the major differences between Main Street and University Street. Every piece of serious research I am aware of has concluded that investors need 100 or more stocks in every asset class to mitigate the risk of unexpected company failures. (Remember Enron, once highly respected and the seventh-largest public corporation in the United States.)

This means that if you invest in 10 great asset classes, as I recommend later in this book, you should have a thousand or more stocks. Does your Main Street guide tell you to do this? I'm guessing not.

Luck, Good and Bad

I've always been interested in the role that pure, dumb luck plays in investing. I remember a retiree who came into my office one day wanting my help in bailing herself out of a disastrous situation. Her first lucky day came in 1986, the year Microsoft stock went public. She bought 200 shares for about $11,000 and then hung on to them during Microsoft's glory days in the late 1980s and 1990s. The stock did so well, splitting time after time, that she stopped saving money. Microsoft was all she needed. Or so she believed.

This woman's second lucky day came in 1999, just a few months before the peak of the technology boom, when she sold all her Microsoft stock for about the same price per share she had paid originally, a bit more than $50. However, after eight splits, she owned more than 51,000 shares and had a capital gain of more than $2.6 million.

Lots of her friends naturally thought this woman was extremely smart and wanted to follow her next move, whatever it was. Some of them urged her to keep her winning streak going, and that certainly reflected the conventional wisdom in 1999.

But this woman had educated herself about investing, and she had heard one basic message loud and clear: diversify. That's what Bill Gates, Microsoft's founder and then the wealthiest man in the world, was doing. So she decided to diversify too.

Normally, diversification reduces risk. However, she had become addicted to winning, and she wanted to taste that grand success one more time. So she "diversified" by buying stock in 10 young, hardcharging technology companies that she knew were revolutionizing the world. Each one was another potential Microsoft. Surely she would strike it rich at least once more.

Remember what I said earlier about owning 10 asset classes and 100 or more stocks in each one? This woman believed that she was diversifying by owning only 10 stocks in a single asset class. By the end of 2002, all of her companies had shrunk to mere shadows of the promise they once held out to eager investors.

When she came to see us, this woman's portfolio was worth much less than the capital gains taxes she had paid on her Microsoft stock. Unfortunately, she and her family paid a huge price for the fact that she didn't understand proper diversification. Instead of living with a portfolio that could have supported them very comfortably forever, they had to live with the risk of running out of money and starting over.

Among investors who choose to place their trust in Main Street, this woman would be a star, somebody who was smart enough to turn $11,000 into more than $2.6 million with only two well-timed decisions. But anybody who had followed her lead in 1999 would have lost almost everything, as she did. You have no doubt heard that past performance does not indicate future performance, and as this story shows, Main Street is no exception.

Before you conclude that Main Street is trustworthy, remember there are a million reasons investors do what they do. Even when somebody else is successful, that doesn't mean his or her winning strategy is right for you. I know some investors who have tons of money and, therefore, look very successful. But if you look at their investment statements, you may find that they have extremely poor returns.

For some of them, that's just fine because they inherited more money than they'll ever need. Their net worth is wonderful, but it doesn't make their advice worthwhile. When I think of them I remember an old saying, sometimes told as a riddle, that packs a lot of truth into a few words: It is easy to make a small fortune; start with a large fortune.

Despite the success stories they will tell you, very few of the "experts" along Main Street have any formal understanding of how investing really works. This should not be surprising. Many very bright, hardworking people spend most of their time and much of their lives trying to figure out the markets. Some of them wind up on Wall Street, and others reside on University Street. That's where I would like to go next.

University Street

You might have an image of University Street as an ivory tower, removed from real life. There's probably some truth in this. Academics are not trying to make money from us and don't care very much what we think of them. In my mind, that makes them more trustworthy, not less. They are looking for the real truth, and that's what we investors should want. They have nothing to gain from us, hence no conflict of interest with us.

The national financial media certainly pay attention to the academic community. Morningstar, a heavily used and highly respected online publisher of information on stocks, funds, and exchange-traded funds (ETFs), was shaken up a few years ago when academic studies showed that its fund categories were relatively meaningless.

Equity funds, for example, used to be grouped in categories like capital appreciation, growth and income, and aggressive growth. But University Street found little correlation between those groupings and differences in performance. For example, two mutual funds that are being managed in hopes of achieving "aggressive growth" may hold very different portfolios. This plays right into one of the most important findings of the academic community. The overwhelming majority of any portfolio's performance can be accounted for by the types of assets in it.

Now Morningstar's nine-segment style box groups equity funds by the percentages of the portfolio in small-company (small-cap) stocks, large-company (large-cap) stocks, value stocks, and growth stocks. This information makes it easier for investors to put funds together into portfolios that take advantage of the valid research. And at the same time it removes some of the mystique of vague labels. (Quick: Do you know the difference between a growth fund and a capital appreciation fund?)

This is a good example of how solid research can move the investing process from intuitive to scientific. Academic studies cannot predict the future, but they can quantify the past in a way that's useful for identifying the sources of return and the sources of risk. If you want to be a successful long-term investor, you should want this type of analysis much more than the smiling faces in Wall Street ads and the unsubstantiated boasts you will find on Main Street.

Fortunately, you and I don't have to comprehend all the details of academic research in order to put it to work. Two famous professors, Eugene Fama and Kenneth French, demonstrated that three measurable factors can explain more than 90 percent of the difference between the return of any equity portfolio and the overall market. (Those factors are the size of the companies, the book-to-market ratio of the companies, and the volatility, or beta, of the stocks in the portfolio.)

You may wonder who keeps the academics honest. Unlike Wall Street, they aren't regulated by the government, and they aren't subject to the discipline of the marketplace. They don't have much reason to care whether or not we scoff at them or admire them.

What they are concerned about is the opinion of their peers. Peer review is a process in which professors evaluate the work of their colleagues, maintain standards, and try to protect credibility. Most academic papers are reviewed by experts in the subject matter before they are published. Papers that fall short may be critiqued in print or even denied publication.

This process isn't perfect, but it strongly discourages authors from making statements they cannot back up. To my mind, this is a comforting source of credibility.

Here's another important difference between Wall Street and University Street. Although most people have no interest in reading academic papers, those papers are available to anybody who wants to dig into them. On Wall Street, each firm acts as if it has a "secret sauce" or formula for getting results—and does its best to keep this sauce away from the competition. On Wall Street, if you share your firm's trade secrets, you are not only likely to be out of a job, you might even be taken to court. On University Street, you are rewarded for sharing what you know and having it critiqued by your peers.

Think of Wall Street as filled with know-it-all investors and managers who like to boast they have the best research, the best analysts, the best funds, the best resources of all kinds. Main Street is filled with people whose egos want us to believe they know it all, even though (as I have shown) it is pretty easy to find the limits of their knowledge and understanding.

Ironically, University Street is probably the smartest and best educated of these groups, yet academics make no pretense of knowing it all. For example, they recommend index funds that hold thousands of stocks, and they don't even try to pick ones that will be the winners.

When we're thinking about a recommendation of what to do with our life savings, we should ask: Where's the beef? Where's the evidence? Wall Street cleverly selects the evidence it will show us. Main Street almost never shows us the evidence. University Street is all about showing us that evidence.

This is why I think our trust should go to University Street. That's the door you should choose. Most of the rest of this book is about how we can apply the lessons of the academic community to become better investors.

In the next chapter we'll look into a basic issue that, in my own observations, trips up more investors than any other—the sometimes irresistible desire of investors and managers to beat the market.