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Real World Divorce

How to Get Rich

"There are three ways to make money. You can inherit it. You can marry it. You can steal it."

-- conventional wisdom in Italy

Most people who are rich chose their parents wisely. Bill Gates might not have ever figured out 1960s-style computer science but he had the foresight to pick a father who is one of the richest, most prominent lawyers in the state of Washington. And before he and Paul Allen made the deal with IBM that gave them a monopoly on the PC operating system, Bill had the foresight to choose a mother who was personally acquainted with John Opel, CEO of IBM Corporation. None of this would have worked if Bill hadn't been willing to take tremendous personal risks. Should Microsoft have failed, of course, Bill Gates would have had nothing to fall back on but a million dollar trust fund from his mother's parents (bankers) and the resumption of his degree program at Harvard College.

If Donald Trump had taken the millions he inherited from his father and put it all into mutual funds, you'd never have had to suffer through one of his books. But he'd be just as rich or richer today.

For most of the 20th century, common stocks returned an average of 7 percent per year, adjusted for inflation. If you are way smarter, luckier, and less risk-averse than all of the companies in the United States, you may be able to do substantially better. But a return on investment of 200 percent per year is not very exciting when you only have a few hundred dollars in capital. That's why it is so important to pick your parents carefully.

How to Lose it All

Real World Divorce

Common Stocks and the Efficient Market Hypothesis

If you buy into the Efficient Market Hypothesis then you're just as happy to buy a portfolio of stocks selected by throwing darts at the inside pages of the Wall Street Journal. In fact, the WSJ for many years pitted expert wall street analysts against a dartboard portfolio and the darts almost always did better. If you don't have very much money, then a problem with a dartboard portfolio is that you will only be able to buy a few stocks. Your expected return will still be 7 percent per year but the variance will be extremely high because one company going bust could wipe out all of your gains.

Mutual Funds

So you buy into the Chump Fund. Halfway through the year, the Harvard MBAs are tired of their drab offices and Pentium computers. Do they take part of the 2% and move uptown and then buy Pentium Pros? No. They discover all of a sudden that they shouldn't have any General Electric. Westinghouse is really a better investment. And Ford is looking better than Chrysler now too. In fact, the entire $10,000,000 portfolio needs to be traded. Do your mutual fund managers, who've sworn to look out for your best financial interests, execute the trades with the broker who has the lowest commissions? No. After all, the money for trading commissions comes out of your 98% and not their 2% (read the fine print). So why not go to a "full-service" broker with high commissions? That broker will be so grateful that he'll discover he has a whole bunch of office space uptown that he isn't using, already equipped with a bunch of Pentium Pros. He'd be delighted to allow his best customers at the Chump Fund to hang out rent-free.

In your naivete, you might call this a kickback but in the industry it is known as "soft money." Every time the Chump Fund trades with a broker, they accumulate some soft money that they can spend on computers, furniture, data feeds, etc. This comes on top of the opera tickets, broadway shows, limousines, and the rest of the Wall Street lifestyle that is paid for by Mr. and Mrs. Middleamerica.

If the Chump Fund keeps on doing this, eventually their return will be much lower than the S&P 500 and they won't be able to run those nice-looking advertisements anymore. What do they do? Look among the 20,000 tiny little mutual funds out there. Find one that has randomly achieved above-average performance for the past five years. Call it the Chump Growth and Income Fund and run ads showing its past performance. Send letters to all the old Chump Fund customers telling them that the Chump Fund is being closed and, unless they object, their investments will be rolled into the new Chump Growth and Income Fund as of September 1.

An even better strategy for a mutual fund company is to do all of this in-house. If they have 50 mutual funds they can just hang onto the ones that randomly do better than average and flush the ones that do noticeably worse. Then at any time they can show that "45 out of our 50 funds outperform the indices". Now you know why you can't find any mutual funds advertised in the Wall Street Journal that sport worse-than-average performance.

OK, so you expected to get cheated a bit by these Wall Street types. But they're experts so of course they will do a better job picking stocks, won't they? Some will. But with tens of thousands of mutual funds out there, even if they are all choosing stocks at random, you'd expect some to do consistently much better than average and some to do consistently much worse. You'd find, however, that most of them would fall in the middle, forming a Gaussian curve.

That's what Burton Malkiel expected to find. He was an economics professor at Princeton who made his life's work the study of investment. When he charted the performance of all the mutual funds, they did indeed form a bell curve. But the center was not the same as the S&P 500. It was shifted slightly to the left. That's right, the average mutual fund was underperforming the blind index by a couple of percentage points. This confused Malkiel until he realized that the discrepancy could be accounted for by the expenses skimmed off the top of the mutual funds and also the commissions they paid to trade the portfolio. [Note: these curves are published in Malkiel's excellent A Random Walk Down Wall Street, an essential book to read before investing.]

Index Funds

poorly programmed Web site: (1) tax forms are offered only in a bizarre Adobe format that cannot be saved, printed, or emailed to an accountant, (2) terrible internal email system that simply throws away your message if you spend too long composing it

customer service that gets worse as you get richer; the folks who answer the phone for the $15,000 IRA crowd are very well informed, can get you the necessary forms or information, and can help you with a transaction; if you get rich enough to be upgraded to Flagship ($1 million+), you get assigned the Vanguard equivalent of a private banker; mine was unable to send email, pick up the phone, send me the right paperwork to get transactions accomplished, keep focus on getting a transaction through. It was dangerous to be a Flagship customer because I thought that someone at Vanguard was going to make something happen when in fact he was just sitting at his desk waiting for me to call him. The solution is to downgrade from Flagship back to Voyager or Voyager Select.

Besides getting a higher average return, there are many other good reasons to invest your money in index funds. The first is psychological. When I had individual stocks, every time a stock went up, I attributed it to luck. Every time a stock went down, I attributed it to idiocy on my part. I felt dumber and dumber with every passing year because I ignored the stocks that went up and focussed on the ones that dived. Some Wall Street types have the opposite psychology: they only remember their winners and hence come to think of themselves as Einsteins after five years. Whatever your psychology, there is a certain inner peace to be achieved by forgetting about your money.

Another reason to index is to free up time to make more money. In every office there is at least one sorry loser checking the market every ten minutes, going home at night to read financial reports, running charts, and buying software to manage his complex portfolio. If he were a managing a $10 billion mutual fund, perhaps this effort would be worth it. But to try to beat the index by 2% with a portfolio of $50,000? That's $1,000 extra/year. Even assuming that he can get that extra 2%, he would have earned far more per hour working the night shift at the local 7-Eleven. Your time is valuable. If you must be greedy, then be greedy and smart and take a consulting job. Or enjoy the extra time with your friends and family. Don't waste it trying to beat the market.

I have oversimplified things a bit here. For example, even if you believe the Efficient Market Hypothesis, there are stocks that are inherently more volatile than others. E.g., a high-tech company will go up more in a market boom and go down more in market bust than will a utility. In some sense, both are "worth their price" but one or the other might be a better buy for you because of your level of risk aversion. If you want to understand this stuff at a deep level, read A Random Walk Down Wall Street and then Principles of Corporate Finance by Brealey and Myers. The latter book is the textbook used in many advanced finance course taken by MBAs. An MBA student will spend the entire term going through the book and doing problems, but if you have a standard MIT freshman math and science background, you can read the whole thing in a night or two.

If I haven't convinced you to stay away from Wall Street esoterica, here are a few things I've learned through bitter personal experience and/or reading the above books...

Shorting

Your broker is holding many shares of Microsoft in "street name" for other customers. So he can very easily find 100 shares of Microsoft to lend you. He lends you these 100 shares, and you sell them immediately. Suppose that the price/share is $10. You get $1000 that you can put into the bank. However, you owe your broker 100 shares of Microsoft Corporation. No problem, you figure. In another year, this company will be near bankruptcy and selling for $0.25/share. You'll buy 100 shares to cover the short for $25, thus making a profit of $975 less commissions.

Well, in another year, Microsoft is not selling for $0.25/share. In fact, it has gone up to $30/share. You still owe the broker 100 shares, but those 100 shares would cost $3000 to buy. You have a paper loss of $2000 right now. Your broker calls and wants you to put up some assets where he can get at them, either cash or stocks. He doesn't trust you to come up with the cash to cover your Microsoft short unless the cash is physically under his control. You consider cutting your losses by closing your position. Remember that it is 1987, though, and Microsoft hasn't gotten any better at writing software. In fact, they are flailing around trying to copy the Apple Macintosh interface, itself a copy of a Xerox system from the mid-1970s. What a bunch of losers. You put up the extra cash.

By 1996, Microsoft has split a bunch of times and you now owe your broker 1000 shares at $150/share. That's $150,000 to cover the short. You sell your house and say "You know, that potential return of $1000 was not worth ten years of agonized scanning of the stock pages, margin calls, and an ultimate loss of $150,000."

There are many morals to this story. One: stocks go up 7%/year, adjusted for inflation. If you buy stocks randomly you will earn 7%/year. If you short stocks randomly, you will lose 7%/year. Two: you are not smarter than the rest of the world put together and, even if you were, the 14% bias would kill you. Three: if you buy a stock, you can only lose what you put in; if you short, you can lose every dime that you have in the world (and maybe a little bit more depending on how careful your broker is).

You might think my story is biased because I've picked a famous winner like Microsoft. But the fact is even stocks that were nothing but hot air often went up dramatically for years. If a company's book value is $10 million but Wall Street is willing to pay $500 million then there is no reason why Wall Street shouldn't be willing to pay $750 million for the same near-worthless entity. You are perhaps right and eventually the stock will crash down towards the $10 million mark, but it could take many years of sleepless nights.

[Note: I've made one big oversimplification here. You may get to invest the proceeds from a short in other stocks and your broker will invest some of your margin capital in T-bills so your expected return on a short will not be as bad as -7%. Still, the unlimited downside is still present with any short sale.]

Options

If it sounds like Vegas to you then you've already figured out the worst thing about options: they appeal to people who like gambling and therefore tend to be overpriced. They are best used when you know something that almost nobody else does and when that something will affect a company on a specific date.

Note: there are "Call Options" as well. These give you the right to buy a specific stock on a specific date at a specific price. They are used when you expect a stock to go way up.

The Fly in the Ointment

Making matters worse is the fact that corporate managers and accounting firms have been fraudulently overstating earnings. The published P/E ratios are based on the lies that CEOs and CFOs tell investors, not the actual cash coming into companies' bank accounts.

A deeper problem than fraudulent reporting is managerial theft. Investors have accounting firms and the SEC to protect them but the top managers have their hands on the company checkbook and their friends on the Board of Directors. In the old days if a company did well the managers would send a letter to shareholders: "The economy was booming last year and Blatzco prospered; your dividend is being doubled." In the 1980s and 1990s a more typical response to a boom year was management saying "Blatzco did well because we're such geniuses; we are going to take home all of the improved profit in the form of bonuses and stock options." Jack Welch in Straight from the Gut proudly states that during his 20 years as General Electric CEO the "employees", by which he means himself and some other top managers, went from 0% to 31% ownership of GE. Rephrased, Jack and his golf partners stole 31% of GE from the investors who owned the company in 1980. What's more, thanks to accounting rules that enable unlimited stock option grants without any charge to earnings, none of this had to be reported in financial statements. My cousin used to be an animator at Walt Disney. In the old days of Hollywood a boom and bust cycle of profits was to be expected. It is tough to predict whether a movie will be a hit. But after Michael Eisner joined the company in 1984 successes were attributed to superior management rather than luck. Eisner helped himself to more than $1 billion of the shareholders' money over the years. Thus when Disney ran into a string of flops the company didn't have enough cash to hang on until the next boom. Disney shut down its Los Angeles animation group and will use contract labor in Eastern Europe for future animated features.

It is tough to see how historically high rates of return on common stocks can be maintained in a world where managers steal most of the fruits that stem from the investors' capital.

Note that the 1980s and 1990s CEOs stealing from their investors are not innovators. Leland Stanford and his partners in the Central Pacific Railroad managed to steal a fabulous sum of money from their British investors by contracting the construction of the railroad to a company that they owned personally. It was a very similar scam as that pulled off by the managers of Enron except that Stanford did it in the 1860s.

Bonds

What brought bonds back into fashion was the realization that corporate top management was stealing on a grand scale. If a company had a bad year, the CEO somehow had to manage on his $1.2 million cash salary. If a company had a good year, the CEO would steal any profits by exercising stock options that he and his buddies on the board had previously issued to themselves. With bonds the company borrows $1 and has to pay back that $1 plus interest. If in the meantime the managers have stolen everything that they can from the shareholders that shouldn't affect the bondholders.

Taxes

The Future

philg@mit.edu

Reader's Comments

After working for a few years there (albeit as a lowly programmer), I feel somewhat qualified to comment on the casino known as Wall Street. I like your somewhat accurate description of "soft money", but don't totally agree with your conclusions on investing philosophy. I've read the Random Walk book, and I've also read Warren Buffett's book on "value" investing. Most people are probably better off following your advice and sticking with an index fund, but do you realize what would happen if everyone did that? Think about it.... Warren's recommendations are very interesting. Those who are interested in learning more about Wall Street are encouraged to read "Liar's Poker" and "Nightmare on Wall Street", which both happen to be about Salomon Brothers.



-- Guru --, December 20, 1996

Hey, it's great to see someone exposing mutual funds. Very few beat the index. There is an alternative, a clever way of investing directly. Read about the Motley Fool (www.fool.com). This web site will give you the confidence and information to invest successfully.



-- Dennis Rose, June 24, 1997

Wish I'd read your page before I spent all that money on an MBA . . . Good commentary, and good advice for most investors. But a lot of people like to pick stocks. Buy and hold index investing doesn't sound exciting at a cocktail party! Much better to talk about your triumphs, and to ignore your defeats.



-- Robert Budding, March 12, 1998

You are right about Oppenheimer being a bunch of sharks. Back in my youth about four years ago I decided it would be responsible to invest my money rather than having it simply stagnate in my checking account. I figured (being an idiot) the way to do this was to visit a securities firm and ask for advice. The guy I spoke to seemed decent enough, asked a bunch of questions, and recommended I invest in five different Oppenheimer mutual funds. I did so and let the whole thing aside. Then about a year ago I landed up reading a copy of Andrew Tobias' _The Only Investment Guide You'll Ever Need_. Fired up with enthusiasm, I looked at my Oppenheimer statements to learn that, in the greatest bull market in history, these people had made me maybe 4% return in 3 years. (And the reason for this sort of thing is as Phil says---kickbacks, huge "management fees", huge advertising budgets, a constant impulse to churn stocks simply to create the illusion of business etc). There are a few morals here. One is that Oppenheimer suck. A more general one is almost everyone in the finance business is out to screw you, and just because they have nice offices and call themselves financial consultants does not mean that they care about you, or that they have any idea what they are doing. The most general message is, before investing a cent, READ A BOOK. If you are going to read only one book, IMHO read the Tobias book I mentioned above. If you refuse to read even one book, invest in a Vanguard fund; unlike Oppenheimer and friends they will try to do good by you. The Vanguard prospectuses are a joy to read, written in clear English, their web site does the job, their funds stick to what they claim in the prospectus, they constantly try to cut costs etc.



-- Maynard Handley, June 30, 1999

About shorting stock. I haven't run across a broker that would allow a client to invest the procedes from a short. Generally they want to hold it in a segregated account (where they can invest it) and pay you nothing. For large shorts (>$100,000) or good customers they will negotiate some fixed return (a low fixed rate) on the funds. If you know a broker that offers a decent return on short procedes (or lets you invest them!) I'd like to know...



-- Matthew Rochlin, September 5, 1999

I keep two quotes prominently displayed above my desk to help me out when I am stricken with a bout of "Materialism": (1) "If you would make a man happy, study not to augment his goods; but to diminish his wants."--Orestes Brownson, 1864. (2) "Being frustrated is disagreeable, but the real disasters in life begin when you get what you want."--Irving Kristol, 1983.



-- Ken O'Brien, September 7, 1999

As a guy who manages a pile of money for others (paid by clients, not commissions), Phil's overall view of the process is quite accurate and his approach is mostly correct. One exception however is the common oversight of confusing indexing with buying the S&P 500 index. There are lots of other indexes out there such as EAFE, the S&P Mid Cap 400 and the Russell 2000 that, when combined with the S&P 500 can actually serve to both increase the chances of better returns over time and reduce short term volatility (our nice way of saying "losing money"). There is an old Wall Street saying "don't confuse genius with a bull market." Frank the day trader should take note.



-- Bill Middleton, August 8, 2000

Phil neglects to mention rebalancing in his article. It is not a good idea to manage your own money if you don't rebalance your portfolio on a regular basis.



-- Yi-Lun Ding, October 29, 2002

My favorite mutual fund site right now is FundAlarm . Check in and see if your fund is up to any sleazy business; the discussion board is lively with up-to-the-minute comments and links to articles.



-- W Sanders, December 2, 2003

I don't agree with you idea that to progress in life you must have rich parents. My grandfather quarreled his father and abandoned the home when he was nearly 18 (in 1918) without studies and money and with the only capability of drawing acceptabily well. He went to the war in Africa in 1921 and came back to Spain where he married and began to work a jewel company making 3D pictures on silver (using his gift for drawing). Soon he found himself with 4 children and not much income, so he employed his savings in buying some sheep. He would keep on working for others and the 2 or 3 sheep would be under the care of a shepperd. This shepperd would collect a comission when the animal were sold. 3 sheep made 6, 6 made 12, 12 made 24, 24, made 48, and so on. Reached this point my grandfather left his job and settled as farmer and shepperd. After he began with pigs and cows. Apart from meat, he sold milk, and employed many other workers to take care of the cattle. When the 60's reached and the economy got better, he began buying buildings: 2 buildings made 4, 4 made 8, 8 made 16, etc.... So when he died in 1986 he owned almost one whole neighbourhood of Madrid and gave many flats and buildings in inheritance to each one of his 7 children.



-- Peccata Minuta, September 19, 2006

Two additional items you might have mentioned: 1. Taxes & Inflation. Long term ownership of individual stocks has a significant tax advantage over mutual fund ownership, due to tax-free compounding of capital gains. Most mutual funds distribute capital gains, as they frequently turnover portfolio holdings. This applies to index funds too. Seperately, inflation has a greater effect on eventual return than you suggest. Because stock prices rise with inflation over the long term, investors pay capital gains taxes on grossly inflated, empty profits. This is big. 2. Responsiblity for CEO's stealing from shareholders. Since management reports to the board of directors, and the BOD represents shareholders, how do they get away with it? Answer: Most shareholders use mutual funds. Mutual funds do not allow their clients to vote the shares in the funds, even though the clients own the shares. Instead, fund managers vote the shares. Guess who recently played golf with the fund manager? If you want fundamental reform of corporate management, outlaw the practice of funds voting shares. Better yet, outlaw funds altogether (fat chance).



-- Jack Neally, November 30, 2006

Regarding Michelle Bach (no 's'), a quick Google search indicates that this is where she is now: http://www.hadley-reynolds.com/michelle.htm Readers might want to direct any current Hadley-Reynolds clients they know to Philip's above story.



-- Curtis Wayne, May 11, 2007

I think the article is pretty good and comprehensive considering that it was written in 1996. But I recommend adding some newer information, specifically: (1) Vanguard's Total Stock Market tracing Wilshire 5000 is frequently preferable to S&P500, because it is more diversified and it does not buy/sell as frequently as stocks move in and out of the index. (2) Exchange Traded Funds (ETF) are a good alternative to index mutual funds for those who do not dollar-cost-average into it. (3) Treasury Inflation Protection Securities (TIPS) are worth considering, especially by retirees. (4) Single Premium Immediate Annuities (SPIA) may offer a better way not to outlive one's money than a frequently recommended Safe Withdrawal Rate (SWR) scheme. (Note that these are different from variable annuities that generate huge profits to insurance agents and less value to their customers.) These and many other topics are discussed at the Bogleheads Forum which I linked below.



-- Victoria Fineberg, July 13, 2008

I am certain. My prayers are for improvement of your financial situation. If and when I have more funds I will come and visit. I can't wait to snow ski there. In may a very small way I can help your situation.http://www.bayut.com



-- dubai property, October 6, 2010