The Passive Investment Problem

Buy it, hold it and forget it is the idea behind robo-advisors and is the reason that robo-advisors are detrimental to your financial health and well-being.  The hype behind robo-advisors comes from the advisors themselves who are determined to get your money out of the bank and onto their platforms.  When the market turns down, robos are going to have a lot of unhappy customers.

I spent more than 25 years representing investors who had been ripped off in the financial markets. In most cases they knew just enough about investing to get themselves into trouble.

One of the reasons that I write this blog is my desire to point out foolish investments and investment advice.  Much of that advice, because it is repeated over and over by an industry with a massive advertising budget, becomes “common knowledge” even though it is without a solid basis in fact.

Most professional investors use what is called fundamental securities analysis to make a determination of what stocks to buy and at what price they are willing to buy them.  Fundamental analysis was developed by Prof. Benjamin Graham in the late 1940s and his textbook is still used in business schools all over the world.

Fundamental investors analyze a company’s income statements and balance sheet. They look at its management, products, competitors and prospects for the future. The question they are faced with is the same question all investors face: if I buy this stock today, will the price go up in the future?

It is important to understand that this analysis is not an exact science.  What is more, markets are as often as not driven by irrational forces, fear and greed, as anything else.  Even some of the basic macro-economic factors that drive the markets such as interest rates and oil prices are political decisions, not rational ones determined by supply and demand.

But that is not a reason to give up on a rational, analytical approach to investing or stock selection.

The idea of passive investing has gained some traction of late for the wrong reasons.  Passive investing is the idea that you “buy and hold” a stock or a fund no matter what happens.  The theory, at least for investors with a long time horizon, is that the investment will be worth more when you need it, years in the future.

It should not take you long to realize that no one can predict what the market price of any stock will be years in the future. Fundamental analysis looks out a year or so and even that is difficult.

That “no one can predict the future” is one of the reasons that people advocate passive investing.  But their “buy, hold and it will be worth more when you need it” strategy does just that.

Advocates of passive investing will point to a number of academic studies, most from the 1990s that suggest that mutual funds, which are actively managed, failed to beat the market indexes over the long term.  These studies exist but are flawed for a number of reasons.

In the first place, beating the market index should never be the goal of any small investor.  To beat an index means that you will need to take risks that are higher than the index and those risks will often come back to bite you.  That is one of the reasons that mutual funds, the active investors that these academic studies are looking at, do not, on average, perform as well as an index.

The other reason is that mutual funds are not efficient. They are constrained by law, their own advertising and the ebb and flow of funds in and out.  Mutual funds are also subject to advertising costs, sales charges and management fees.  They should always yield less than a theoretical index that is not subject to these charges.

Notwithstanding, the passive investors are quick to repeat that the average investment advisor cannot beat an index.  I do not know why anyone would hire an “average “advisor or why any investment advisor would bother trying to beat an index.

Your goal should always be to have more money in your portfolio this year than last year and more again next year.  The way to accomplish this is to do the one thing those passive investors will never do, sell your positions when the market starts to go down.

How can you know when the markets are starting to go down? Fundamental analysis works both ways; it tells you what to buy and at what price and what to sell and when to sell it. Even if your analysis is wrong, there are ways to protect your portfolio against losses with stop-loss orders that get you out before you have given back all of the profits that you have made.

No one can predict when the market will peak. People can get greedy and fearful that if they get out now, they might miss another year of profits.  Of course, even if the market does go up for another year, two years from now it may be at levels below where it is today.  That means that you will have less money and be two years closer to retirement.

Investing is difficult. Fundamental analysis is a skill that takes time to learn and is time consuming for anyone.  If all you had to do to make money in the stock market was to buy an index ETF and leave it alone, everyone would do it.

Passive investing in general and robos in particular are for people who do not know enough about investing to do it well.  If you consider yourself to be in this group, either hire a competent advisor to do it for you or leave your money in the bank.  Anything else is foolish.


Founders Dating Discussions

Innovation and entrepreneurship are very much a part of the American culture.  In many respects this may be the best time in history to start a new business. In many industries barriers to entry have never been lower. Globalization has reduced the costs of production and opened new markets. The new media has provided inexpensive ways to reach new customers.

Start-ups have access to incubators, accelerators and many other support systems that did not exist a generation ago.  There are more books, classes, conferences, coaches and success stories to emulate than ever before.  Unfortunately many offer conflicting and sometimes foolish advice.

Start-ups also have access to far more capital than ever before. There is more money in venture capital and angel investor funds. There are government programs like the SBA which will guarantee loans and other programs that provide grants for new ventures.

This convergence of knowledge and capital is important because both are needed for any business to succeed.  A good business without capital is likely to go nowhere. What I find amazing is the need to explain this to a great many people who want to be entrepreneurs.

I frequently speak with two or three entrepreneurs a week.  I meet many through Founders Dating.  Founders Dating is a website where entrepreneurs can ask each other questions that are relevant to the start-up experience.

Conceptually, Founders Dating is an excellent idea. Entrepreneurs frequently face similar problems and unfamiliar situations. There are many seasoned executives who are willing to offer them advice.  However, some of the questions and many of the answers highlight substantial problems.

Some of the questions reveal that some of the entrepreneurs do not have a clue about the real world.  Many of the answers are shallow and reflect a “gut response” to complicated issues.

On more than one occasion, someone has asked for the best book to read to help make them a successful businessperson or to teach them how to successfully market their product.  There seems to be an attitude, especially among the younger entrepreneurs, that they can learn all they need to learn without a business school education or any practical experience.

As it should be, many of the entrepreneurs are younger millennials and many of the advisors are older baby-boomers, like me.  I am surprised how many times that the advice offered by these older executives is “pooh-poohed”.  There is an obvious attitude that baby-boomers do not understand technology or the “new” financial markets.  Nothing could be more foolish.

Baby-boomers after all created both Apple and Microsoft, were the first users of their products and invested in their IPOs.  Similarly, when Genentech did its IPO in the mid-1980s baby-boomers did not have much difficulty understanding “genetically engineered pharmaceuticals” even though they were a cutting edge concept at the time.

At the same time the idea that the financial markets have fundamentally changed is just wrong. If you are looking for funding for your start-up you are probably not going to ask millennials for money because they do not seem to have a lot of it.  Baby-boomers, on the other hand, poured billions into tech stocks in the 1990s and still do.

There are actually a few angel investors on Founders Dating who are happy to tell entrepreneurs what they are looking for in a start-up and how they think a start-up should structure its pitch to investors.    You would think that the entrepreneurs who are looking for funds would value the advice of people with money to invest, but it is not apparent that they do.

Again, there are people who have read one or two books on the subject who claim to know better.  They are telling the entrepreneurs what they want to hear, not what they need to know.

Many inquirers seek specific advice about legal or tax issues.  I always advise them to seek their own legal counsel.  General answers to general legal questions rarely apply in all cases. In many cases questioners are referred to forms or templates which may or may not get the job done.

In one case, a questioner asked about the tax ramifications of using independent contractors as opposed to employees.  It was not a foolish question but it elicited a foolish and dangerous response.

I am not a tax specialist but I do know that the IRS has a specific guideline for determining who is an employee and who is an independent contractor. The guideline contains a list of about 20 things the IRS considers and will apply should you get audited.  I told the questioner to consult his accountant and follow the IRS guideline.

Almost immediately, another person chimed in to tell me that I was an idiot to follow the IRS guidelines or to recommend that anyone should. That person had apparently done so, hired a slew of independent contractors and the IRS penalized him anyway.

My first thought, of course, was that he had not followed the guideline correctly or that there was more to the story than he was telling.  Whatever the truth, he was adamant in his advice to the questioner that following the IRS guideline was useless.  He was so adamant and made such a compelling argument that I called a tax attorney I know to ask if the IRS had changed its mind or if my advice to follow the guideline was misplaced.  He assured me that any competent tax professional would have given the advice that I did. But how would the person who asked the question know that?

I look at Founders Dating as way of doing pro-bono work. When I am speaking with an entrepreneur I give the same advice for free that I would give to a large established company that was paying my normal hourly rate.

One of the hazards of the information age is that there is so much bad information out there.  Founders Dating is a good idea, but it needs some mechanism to filter the good information from the bad or the recipients of the information will get nothing of value.