Friday, April 17, 2009

diversification is dead. Farmer and French are Frauds

I like to shop around for advisors. mostly just to keep my advisor on his toes, but also to explore alternative investment strategies and to keep my mind open to new possibilities I might not otherwise have been aware of.

I met with one advisor who seemed to have a fail-proof system. He said he didn't believe in directly investing in the stock market. He argued that when you go to a large financial firm, they give you a list of the dominant companies in the Canadian economy. By owning a firm in the form of common equity, you are essentially taking on all the risks of that company. The same being true for every different holding in an equity portfolio, the actual risks of losing capital is higher than the investor is really aware of.

On the face of it, the logic is clear and the argument is fairly convincing. If i am not qualified to run the business i am defacto part-owner of, I am abdicating my responsibilities to properly manage this company in my role as part-owner, because I only want to invest my money and earn income. In this scenario, the only work the investor is interested in is ascertaining the likelihood of earning money with their investment. Without factoring in the passive role as share holder, leaving the operation of the actual business to other people, there is technically a hidden additional risk to directly purchasing common shares.

his pitch then went on.
Seeing as inflation makes canada savings bonds only a place to store money, lacking the ability to 'grow' money, they are only to be used as a strict way to hold cash for a better opportunity to buy into equities. (this had me puzzled, as he just told me the hidden risk of equities)
No, not equities in any traditional sense. What the advisor was offering was a NEW WAY TO BUY STOCKS! This was a model created by two Harvard economists, that won the Noble Prize in economics.... about 15 years ago.

These genius economists, worked very hard and did the best job ever by any economists to look at what types of stocks go up in price more than other stocks.

(I had to stop there, this was ground-breaking stuff!- No it wasn't and i was just letting him go on hoping it would be short)

So what these two, very hard working, very bright economists did is publish a paper. a wonderful paper. It has a graph, and a spiral thingy. And the best part about this paper and it's graphy and spiral thingy, is that it tells you which stocks to buy so you can make more money than everybody else.

He went on. It wasn't going to be short.

you see, individual money managers may perform well in one year, but it's very difficult for them do so for 2,3,4 or 5 years in a row. Only if you could use academic data for knowing which stocks were good and which stocks were bad, you wouldn't need to rely on those old mutual funds and their archaic way of letting one guy pick all the stocks the fund holds.

Well, these bright, wonderful, Nobel prize-winning economists did develop a formula to buy stocks that will always out-perform the market. They called it the value-growth and asset-value growth system. It's increadible. Here's how it works:

1) you put 75% of all your money in 3 mutual funds right away.
2) you put the other 25% in a long-term canada saving's bond (on the basis that you could sell it if you really need the cash)
3)pay the advisor only .75% of all your assets every year, regardless if you make a positive return of not
4)sorry, forgot to mention, the mutual funds have an additional fee of .75% of all your assets
5)the mutual funds don't let you recieve a distribution, so if you need cash just sell your bond or get a job.

So now the funds go to work, they systematically only choose companies that have a lot of assets, but the stock price is lower than that reflects. They look at small emerging companies and find the ones that have the potential to grow into really big companies.

Wow, what a novel technique. What a revolutionary strategy. It reminds me of a famous Inuit saying about the baby seal skin trade with the Hudson Bay Company. Something like "buy low... sell high". In fact, maybe that mutual fund should see if they can copyright that phrase and maybe a baby seal logo.

This has attempted to be a sarcastic blog.

That advisor, or salesman, showed a chart of what accounts for 'growth' in an equtiy portfolio. he said the evidence shows that 'diversification' is what is responsible for 90% of the growth in any portfolio. If you think about this carefully, it is a hollow description.

My point is, the mutual fund I was being sold was supposed to be the 'next generation of diversification' literally thousands of stocks from all over the globe to be held and traded 24/7, based on some computations from 1996.

The fundamental flaw: all of his charts only went to 2005. I sat down with this salesman in 2009. Why didn't he have more recent data? all of the 1996-2005 data showed the fund consistently beat the average mutual fund by 2-5% every year.

After I met with this salesman, i went to the website of the mutual fund. EVERY SINGLE FUND LOST 60-70% during the past year. Since 1997, the average return of all the different funds was only 3%. that amounts to .25% growth a year. The salesman didn't mention that. He didn't mention that while analysts are in general consensus that small cap growth and asset value companies can routinely outperform general market indexes, they are also much more vulnerable to dramatic and lasting downturns, bankruptcy and buy outs.

He called me later on, hoping i would still open an account. I told him i'm sticking with my bonds. He warned me against inflation. I laughed. Not with a properly laddered investment-grade portfolio. I'm too educated to fall for the sales pitch now. I hope everyone else is as lucky.

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