Stock Market Rules To Live By: Part 3

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 - let me tell you why:

If John has $100,000 to invest and he is seeking a safe ROI (return on investment), he has only one real question for the various advisors or products he’s considering purchasing: “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 his actual investment objectives.

If you walk into any bank or investment firm in the world and tell them you have $100,000 to invest, they're likely to offer you three boilerplate 'model portfolios': the more aggressive one with higher potential returns but also more volatility and risk, the middle-of-the-road option with moderate volatility and conservative gains, and the very conservative portfolio with money-market type returns of less than 6% per year but minimal risk of capital loss.

So, in essence, this system is designed to offer you three options, assuming you can handle the risk, and keep you within average index returns, ranging from about 10 to 12% a year down to GIC-type investments where your money is safe but you won't see returns greater than current inflation rates, resulting in essentially a negative return.

• Index funds that track the Dow or the S&P, for example, typically yield about 12% per year, but investors need to be comfortable with the volatile nature of the equity markets.

• Balanced funds, which typically comprise about half stocks and half bonds, typically yield around 5% a year. However, this lower risk and yield also come with about half the volatility and fluctuations.

• Money market funds primarily hold bonds, T-bills, and cash, offering little-to-no risk but paying returns similar to those of a typical high-interest savings account or GIC.

Those are essentially the three main options in the investment world for the masses.

I break these down to easily illustrate the difference between risk and return. This fundamental principle has remained unchanged through the millennia: higher risk typically corresponds to higher potential returns. Therefore, when considering an investment, the very first question asked is, "What is your risk tolerance?"

If you have an advisor that does not talk to you about your risk tolerance, goals, timeline and overall comfort level, then you need to fire that advisor immediately.

Most people don't realize that their friendly financial "advisor" at their local bank branch was a bank teller just a few years prior. They likely worked their way up from handling deposit and withdrawal slips behind the counter to taking a CIRO (Former MFDA) (Mutual Fund Dealers Association) course, which can be completed in a weekend, in order to advise clients on personal finances and life insurance needs. This reality can be unsettling and concerning, considering that many entrust these individuals with their entire net worth. Have you ever wondered why mutual fund salespeople often hold life insurance licenses as well? Both are credentials that can be obtained with a single written test after reading a single textbook in any city in North America. The most critical financial decisions of people's lives are often handled by some of the least qualified individuals, who work on commission and rely on it to sustain themselves and their employer, typically in a downtown, 9-to-5, at your local bank branch.

A former bank teller is making your life decisions?

Did you realize that the financial advisers you deal with at the bank often have less education in the markets than you could give yourself in just a few weeks with a few good books? Furthermore, these advisers typically get paid whether or not they make you money. In fact, they earn compensation through various means such as MERs (management expense ratios) and other commission structures and incentives paid by the bank and partner fund companies (deducted from your portfolio).

So, you walk in with the best intentions and entrust your $100,000 life savings to a "balanced portfolio", essentially a basket of mutual funds managed by the bank. However, you soon realize that you're being charged in the neighbourhood of 2 to 3% per year just for the privilege of having your capital housed there, all while underperforming the broader market.

Let's be clear: the first $3,000 you make on your $100,000 investment is paid out to the bank and the adviser who sold you the product - not you - regardless of whether you make money or not on that investment that year. Some of these products don't even yield 3% per year in gains. When you factor in this 3% over a period of 10 or 15 years, you'll quickly realize how you are willingly being exploited by a financial system designed to transfer wealth from the masses to the banking system through a sales network known as "financial advisors". And all of this because you didn’t pick up a few good books on self-directed investing or couch potato investing.

Did you know that 85% of money managers on earth continue to underperform the stock market indexes year after year? 85%. Can you imagine the trillions in fees paid out on those assets to the banks for missing the mark? Paying money to lose money sounds worse than government.

Did you know that less than 1% of high-paid mutual fund managers ever invest even $1 into the funds they manage, despite being allowed to do so?

The S&P 500 has netted an average return of about 10-11% per year over the past 100 years. In contrast, the average mutual fund has averaged about 4-5% per year. So with mutual funds, you pay 3% to a fund manager who doesn't invest in their own fund, and they still make money even when you lose it, all while underperforming 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 delve into this topic in great detail, and I would suggest starting with "The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns" by John C. Bogle. I promise you that you'll feel both nauseous and empowered once you expose yourself to index investing as opposed to mutual fund investing through a bank or advisor. Plus, you'll likely make more money in the process.

Stock brokers

Stock brokers, who are an essential component of the capital markets, serve as the human order takers to execute buy and sell orders for those who don't do it digitally. They are also commonly referred to as "investment advisors," a title that can cause confusion among investors, as they rarely provide any sort of advisory services.

While having a good stock broker, or access to one, can be crucial - especially for penny stock investors - the traditional full-service stock brokerage model is gradually being replaced by digital counterparts. Increasingly, ‘advised’ individuals are turning to online discount brokerage accounts and taking control of their own stock trading, for better or for worse.

Stock market investment advisors at brokerage firms hold accreditations with low barriers to entry, similar to mutual fund investment advisors at banks. Obtaining a securities license in North America requires very minimal study time compared to other professions. Go figure; individuals advising you on critical investment decisions often possess very limited education and qualifications.

Many investment advisors lack any real understanding of asset allocation, economics, behavioural finance, and geopolitical risk, yet they make crucial asset weighting decisions for clients. This situation poses significant risks and warrants attention. There's a common belief that brokers would invest their own money if they were financially successful themselves. While many advisors are dedicated professionals, some may deviate from best practices once they understand the system, potentially delegating sales duties to juniors. As a result, the turnover rate for advisors may be higher relative to other professions due to the lack of comprehensive knowledge among new entrants.

I want to reiterate that I've had the privilege of working with many outstanding advisors, both in the past and presently. However, I make it a point to ask challenging questions and encourage them to delve into topics that may be unfamiliar. By doing so, I remind them of the importance of their role and encourage continuous learning and growth. It's essential to keep in mind which side of the desk they're on and ensure that they're equipped to provide informed guidance.

Consider this scenario: you dial your broker's number, hoping to reach them, only to hear the sound of them munching on their lunch. Amidst the chewing, they offer their unqualified economic forecast for the day as you request the purchase of 100 shares of XYZ stock. Meanwhile, you're left waiting patiently for them to confirm the transaction with a casual "okay, you own it.

And for this service, you typically pay an average of $100 per transaction. It's a costly, rude, inefficient, and ultimately unnecessary process in today's digital age. While brokers play a crucial role in facilitating deals, for those who prefer not to trade independently, they serve another essential purpose. However, the prevailing argument in recent years is that if you're capable enough to place an order verbally, you should also be capable enough to do it digitally yourself.

Alternatively, you can open the app on your phone from your online broker with a single click, enter XYZ stock, receive a real-time quote on the price for free, input '100' in the amount, set your buy price under 'limit', click confirm, and voila, you own the same shares for about $5, and the entire process takes 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. Worse yet, they need to churn your funds over constantly in order to generate more fees, and a high rate of churning is precisely how to lose money over time.

If this resonates with you, do yourself a favor and educate yourself on the mechanics of starting a DIY couch potato, low-fee index fund portfolio. By doing so, you can eliminate the risk of human error and learn to manage your portfolio from your laptop. It's cheaper, safer, more efficient, and you'll never have to listen to anyone eat their tuna sandwich on the phone again.

Of course they do - and why wouldn’t they? They must be more educated, smart, and effective if they’re richer, 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 yielding 30%+ a year and engage in opportunities like private placements - where the real potential lies - often resulting in the coveted "10 baggers" if you know someone who can get you in.

The difference lies in access and accreditation. It's about being "in the room, in the deal," so to speak.

Accredited Investors

If you're not familiar with the concept of being an "accredited investor," I strongly suggest you become acquainted with it. 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 opportunities that often yield upwards of 20-30% per year. Oh, and the fees are smaller too, of course.

While Sandra, the financial advisor at BMO, is advising you on what to do with your RRSP and TFSA, her high-net-worth clients are flocking to subscribe to hot private placement offerings below market price and gaining access to hedge funds that are accepting new capital. Even private capital opportunities become available if you have a million to invest - sometimes the barrier to entry is as low as $100,000. But, you have to be "accredited"!

In my personal experience, the majority of accredited investors didn't start out that way; many of them adjusted their financial circumstances to meet the criteria for accreditation. While I would never endorse fraud or illegal activity, I strongly recommend seeking out a bona fide financial advisor—someone you pay for their time, rather than earning commissions on your capital. These advisors provide unbiased, non-commission-based advice. How do you find them? Seek recommendations from affluent individuals, who often rely on books for financial education, or turn to trusted professionals who have helped them navigate the complexities of wealth management. Wealthy individuals tend to be financially literate, drawing from their personal journeys and insights to guide their decisions.

Wealthy individuals often don't invest their money with banks; instead, they invest "in the bank" by owning preferred and common shares. When less financially savvy individuals invest through the bank, the management expense ratios (MERs) and fees they pay contribute to the bank's profits, ultimately driving up stock prices. This cycle benefits the wealthy, enabling them to accumulate even more wealth.

Wealthy people avoid fees at all cost, viewing them as unnecessary expenses that erode their returns. They consider them an idiot tax. They take their capital where it is preserved, not pillaged.

It's time we started calling fees what they really are: fines. Because, like taxes, fines are prevalent for the poor and almost entirely avoided by the rich.

Most people remember September of 2008 well. Not just 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 that month.

I remember it well because my first son, Shane, was born on the 25th day of that September. While I was holding him in the hospital, listening to financial news live on my phone, I didn’t just lose half of my net worth; I lost it all, and then some. This was thanks to a commission-based advisor and a potent and deadly little tool called leverage. It's a financial weapon famously avoided by people like Warren Buffett and Charlie Munger; one that guarantees to blow your hair back, both on the way up and on the way down.

In the summer of 2008, at 23 years old, while managing a Harley-Davidson dealership in British Columbia, I encountered a persuasive Mutual Fund salesman. His promises of building wealth through a leveraged yet 'balanced portfolio' resonated with my aspirations. Despite my modest income of less than $70,000 annually, a growing family (with a 1-year-old daughter and another child on the way), and a recent marriage, I had diligently saved $40,000. This represented the entirety of my savings, earned through self-taught penny-stock trading since 2004. Eager to transition from speculative trading, I sought to secure my hard-earned gains in a stable blue-chip portfolio - an inaugural step into genuine investment beyond real estate and junior miners.

The rollercoaster of highs and lows in speculating on gold exploration penny stocks had worn me down, motivating me to establish a stable, hands-off portfolio for long-term investing. Intent on making the right choice, I sought out what I believed to be the ideal "Investment Advisor."

Let's call him Mark, as ultimately, he merely performed his job and this narrative is not centered on him. Instead, it revolves around my own naivety, ignorance of the system's intricacies, and a lack of experience.

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, an amiable advisor at a local firm, enjoyed trust and popularity among colleagues. His steadfast nature and frequent reference to "Value Investing" made him an ideal choice. What more could one ask 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 of 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 spelled 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” (KYC) forms 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, cliché, 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 $3 million in investable assets in our little town, and turned it into a fee-generating machine of over $20 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’ on the portfolio, 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, greedy bankers and brokers. Bad debt to equity ratios. uneducated retail investors borrowing more than they 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.

Always model what would happen to you in a dot-com-crash type event, or Lehman scenario. Know your worst case scenario - and be okay with it before you commit.

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, at interest, which was only 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.

-B