2018 Updated Edition FINANCIAL FYSICS

HOW MONEY AND INVESTING REALLY WORK By Don McDonald Dedication

This special edition of “Financial Fysics” is dedicated to a group of passionate financial educators who are willing to speak the truth to fiscal power. Far too many people in the media and even academia have sold their souls to the devil of easy wealth.

Some of the better-known names in this distinguished group are the Wall Street Journal’s Jason Zweig; Ron Lieber from the New York Times; Professors Eugene Fama and Kenneth French; my friends, Dan Solin and Paul Merriman; and my best friend and business partner, Tom Cock. There are many more whom I am sure I neglected to mention, but they, too, have my thanks.

I hope that my work on the behalf of investors and the larger community can come close to matching their efforts.

Finally, my lifelong gratitude to my wife, Debie, who has stuck with me through multiple successes and failures.

i Copyright

© 2010, 2018 Don McDonald and Vestory, LLC

All rights reserved. No part of this publication may be reproduced, distributed, or transmitted in any form or by any means, including photocopying, recording, or other electronic or mechanical methods, without the prior written permission of the publisher, except in the case of brief quotations embodied in critical reviews and certain other noncommercial uses permitted by copyright law. However, I tend to be prefer allowing reproduction with appropriate attribution. Just ask me:

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Interactive edition created using iBooks Author in the good ol’ USA

i Preface

Does the world really need another long, boring, confusing, contradictory book about investing? So, how about a nice, short, easy-to-read, multimedia book instead? There are a lot of investing books out there. I have read many ticularly patient bunch of people (for the most part). I figured of them, and from my less than scientific sample, I would that instead of trying to fight the crowd, why not write invest- guess that at least 90% are utterly worthless. As a matter of ing books that people may want to read? After all, my goal is fact, most of them are downright dangerous—particularly to teach as many people as possible the right way to manage those that deal with trading, timing, flipping, or wealth without and invest their money. Plus, the basic concepts aren’t all that risk. difficult to grasp or put into practice.

There are a few genuinely extraordinary works available from To try to determine the best way to teach financial topics, in a host of thoughtful, intelligent authors. Some of those books book form, I looked to the experts on education: teachers. are relatively easy to read. Others are frustratingly compli- Not surprisingly, we learn in a variety of different ways. cated and/or long-winded. Straight, unadulterated reading tends to be one of the least effective means of imparting valuable information. Most re- When I wrote “Financial Fysics,” back in 2010, I wanted to cre- search has shown that the most effective learning comes from ate something different than the typical, somewhat tedious, a combination of methods. several hundred pages long investing tome. Reading about investing is the last thing most people want to do in their Reading and seeing information is more effective than read- spare time. I would know. I’ve discussed it countless times. Al- ing alone. Reading, viewing, and some type of interactive most to a person, everyone I ask rolls their eyes or cringes at work improves comprehension even more. Adding motion the thought of picking up and reading a 300-page disserta- and sound to the mix further increases our ability to learn. tion on financial matters, no matter how well written it might As I began to contemplate the best way to build a printed be. guide to money and investing, I realized that I had been prac- Like it or not, we are a sound bite listening, drive-thru eating, ticing this multi-pronged approach to teaching for many years YouTube watching, immediate gratification craving, not par- in my investing classes. Combining the words that I spoke

ii with the words on the screen, the images and videos I showed sion. The title is my tongue-in-cheek name for the basic con- with audience interaction, could actually create a powerful cepts of investing. These simple truths (at least from my per- learning experience. spective), I call the “Laws and Theories of Financial Fysics.” To help you differentiate between these and the real laws of phys- I also discovered that too much information can be counter- ics, I have taken liberties with the spelling of “physics.” productive. If a class exceeded two hours, my audience started to fade away. Mastering these reasonably straightforward concepts should give you a leg up on most people who either claim to be or If all of these things were true for a live class, why wouldn’t it want to be investors. Despite the apparent simplicity of these follow that a short, visual, interactive book would provide a few ideas, they have been gradually developed over the better and more pleasant learning experience than a tradi- course of a couple of decades. For the most part, these ideas tional book? are subject to revision and clarification in the future (for exam- Well, it turns out, that I wasn’t the first person to come to this ple, this 2018 edition). Your input into this ongoing process is realization, as I discovered when I explored my home library. undoubtedly welcome. Anytime the spirit moves you, please The shorter, well-illustrated, how-to books that I owned were drop me an email at [email protected]. the ones from which I gained the most significant knowledge. Since I mentioned Vestory, I should probably tell you that this Take a look at Amazon or Apple’s iBookstore. You will find that book was created in conjunction with my registered invest- many of the best-selling educational books are those that ment advisory firm, Vestory LLC. Yes, for the past decade I teach “visually” or use brief lessons and illustrations to help have been in the business of providing investment advice, provide information on topics for “dummies.” and I’m proud to be doing so. Vestory is a fee-only registered Rather than writing another plain-old investing book, I de- investment advisor (RIA), offering no-load, low-fee funds in cided to combine the best of all of these concepts into a new the form of well-diversified portfolios explicitly designed for kind of investing book. You are reading the results of that deci- the needs and fears of the individual investor. iii That being said, my first, and longest held commitment is to readers and tablet computers before, the iPad® changed the help everyone become a better investor. For some of you, that industry with its unique and user-friendly abilities (yes, I am a is possible without the help of an advisor. For others, the nec- fan of Apple® products). The iBookstore® also shook up the essary direction and required discipline are far too difficult. In electronic publishing industry, particularly by offering free e- those cases, a reasonably priced, fee-only investment advisor book titles. Other outlets discourage free products and make (one who is required to act as a fiduciary, not a salesperson) it very difficult to offer them. will likely help you reach your investing goals. Another iBook® feature that intrigued me was the ability to cre- It has now been eight years since I wrote the first edition of “Fi- ate an interactive, easily updated e-book, using Apple’s nancial Fysics” and, while much has changed in the world, lit- iBooks Author® program. “Financial Fysics” has always been a tle has changed in the realm of real investing. Therefore, the book that aspired to be both interactive and easily updated as contents of this book have changed very little from its printed financial figures change every year. Since the program’s re- edition. lease, I have wanted to turn “Financial Fysics” into a free, inter- active iBook to help the 1 billion users of iPads® and iPhones® The wealth management firm, Vestory, that my friend and busi- become real investors. However, other projects took prece- ness partner, Tom Cock and I created just a few months be- dence. fore writing the original edition of book, is now one of the fast- est growing registered investment advisers in the country. We Six years later, it’s finally arrived, and I hope you enjoy it. have hosted a top-rated talk show on KOMO radio in Seattle for many years which is also one of the more popular invest- ing podcasts at Apple Podcasts®.

The same year that I printed “Financial Fysics,” Apple offered the first iPad to the public. While there had been electronic

iv Other Vestory Educational Resources talkingrealmoney.com

401411.com realinvestingjournal.com

"Investing is too easy to be this hard."

-Me

"A classic is a book that people praise and don’t read."

-Mark Twain

"I’d rather write a book that makes it easy to learn."

-Me

"An investment in knowledge pays the best interest."

-Benjamin Franklin

"Understanding a few basic concepts can save you a fortune."

-Me How to Use the FiFy PDF

This edition of “Financial Fysics” was created using Apple’s iBook Author® program that offers an experience unlike any other e-book.

That means that it can only be viewed in this format using and Apple® like iPad®, iPhone® or Mac® computer. Otherwise, you’ll need to settle for this non-interactive PDF version.

That means that the book is presented in landscape (wide) format. Videos have been removed and interactive features do not work. Plus, the charts currently have a “play” arrow in the middle of them.

Links also may not function and the underlined glossary links are unable to link to the glossary at the end of the file.

If you would like to “Financial Fysics” in all it’s glory, you might want to bor- row someone’s iPad (over 350 million of them have been purchased world- wide).

We have not yet made a static Kindle edition available as Amazon does not offer items permanently free. At some point, we’ll create an inexpensive Kin- dle edition.

vi RULE 1

The Law of Wealth Acquisition: There are just three ways to make money Know How to Grow Your Dough. have been working on this problem for generations, and we’re still stuck with only three. All of the laws and theories of financial “fysics” rest on one bedrock, the Law of Wealth Acquisition. Knowing how we Money Making Means 1: Luck earn money allows us to make intelligent choices about how When you think about making money by way of luck, you to acquire it. Even though there is a massive industry devoted probably imagine a casino, a racetrack, or the lottery. In all to making it seem like there are a variety of confusing means three cases, chance is the primary means by which you obtain to build wealth, they are all constructed on the following three wealth. Most of us know that it isn’t particularly likely that we simple rules of making money. will become wealthy after purchasing a lotto ticket, playing a That’s right—there are only three ways to build wealth! You will hand of blackjack, or picking the underdog to win at a grey- discover that any way you can imagine making a buck falls un- hound race, although we hope for that outcome every time der one (or more) of these three basic money-making princi- we gamble. ples. Gambling is an emotionally driven pursuit. A growing body of There are times when only one of these rules applies to a par- scientific evidence demonstrates a link between gambling ticular approach to building wealth. More often, a portion of and the pleasure centers in our brain. Some studies have two or even all three of these rules will apply. At the end of shown a release of endorphins, in a gambler’s brain, that is this section, we’ll have some fun categorizing the various ways similar to the effects of drugs like cocaine. Some believe that others have made their money by using the three new rules this is why gambling can become addictive. we’re about to learn. Luck is a part of many other moneymaking activities and situa- If you think you have discovered a fourth rule, please let me tions and is often confused with skill or talent. A perfect exam- know. Eternal fame (okay, maybe I’m exaggerating a bit) and a ple is those who “day trade” stocks and other securities. I bunch free financial books will be yours. Don’t count on find- would hazard a guess that the majority of “day traders” con- ing a new one though. Some of the best minds in the world sider themselves to be highly skilled investors, not profes- sional gamblers. However, the recurring reality is that most of

2 those who trade securities end up losing more often than win- wealthy parents. Many other serendipitous circumstances also ning. lead to wealth.

Those who move in and out of securities for quick profits Money Making Means 2: Stealing don’t realize that they are playing the same kind of “zero-sum Despite its distasteful nature, stealing—making money in less game” that takes place in every casino on the planet. For than honorable ways—is used by many. Whether it’s shoving a every winner, there has to be at least one loser. In reality, there gun in someone’s face to collect 100 bucks from the till at a liq- must be even more than one loser to make up for the “house uor store or manipulating the price of your company stock to take” (the transaction costs, commissions, and bid/ask pocket a cool hundred million dollars, it’s all stealing. spreads paid to intermediaries). Every time a short-term trader earns ten times their initial investment, more than ten In the financial world, theft can take many forms. If you are at a people need to lose all of their investment. From my perspec- party and someone feeds you some not yet public informa- tive, this looks a lot like gambling. tion on their company, and you make money on its stock, that’s stealing. Occasionally, a brokerage firm client will pur- Securities market gamblers include those who buy and sell chase a stock expecting it to rise quickly. When it fails to do commodities, like gold. A commodity doesn’t create wealth; it so, they renege on the trade (don’t pay), which is another form merely rises and falls based on changes in either supply or de- of theft. mand. Those who are buying and selling commodities bet on a change in one of those factors to either drive the price There are countless examples of people who have lived the higher or lower, depending on which side of the market they good life by way of Ponzi schemes, mortgage fraud, embezzle- choose. ment, identity theft, etc. Add to that a much larger group of people who have made money by cheating on their income Among the lucky, we can also include those who inherit taxes, lying about their credentials to get a great job, or wealth. These winners of life’s genetic lottery did nothing to merely taking something that didn’t belong to them. earn their money. They were simply fortunate enough to have Of the three ways to make money, this is the one that we should obviously try to avoid. However, because human na- 3 ture is what it is, some kind of dishonest behavior is often par- sonal wealth through their place of employment (unless they tially responsible for a great deal of wealth creation. are compensated through commissions or other incentives). That’s why we invest our earnings with those who grow it. Money Making Means 3: Work The best investors are those who put some effort into the proc- Thankfully, this is the most popular and consistent way to esses. To be a successful investor, you need to understand make money—working for it. By work, I don’t just mean back- how investments work (which you are doing right now). You breaking physical labor. In fact, physical human labor is proba- must create a plan to know what kind of investments you’ll bly one of the least efficient ways to make money. Even the need to make to reach your goals. Then, you must understand earliest civilizations realized that we could get a lot more your emotional makeup and risk tolerance. power for our money with beasts of burden than with human beings. Today, it’s machines that take on most of the brute From there, investors need to create the right portfolio, with a force work, leaving us to more cerebral tasks. proper amount of risk, and develop the discipline to stay in- vested no matter what random chance throws your way. A big The best way to make money is to work for it intelligently. part of a real investor’s behavior requires the ability to regu- Most of the wealthiest businesspeople in the world are peo- larly rebalance your portfolio by selling those securities that ple who worked smart. Yes, they worked hard, but the hard are doing well and buying those that few feel comfortable work is typically done above the neck. While it may have hap- owning at the time. pened, I never once heard of Warren Buffett working up a sweat in physical pursuit of a new company to buy. You don’t Money doesn’t fall from the sky into your lap (that would fall see Apple’s Tim Cook straining over a factory table soldering under category one, luck). There isn’t some money-making se- circuit boards. Yet, it’s hard to deny that either one of these cret that only insiders possess (which can be passed on to you men failed to work for their wealth. legally). If you want to make money the right way, you’ll have to work for it. Building a business is one of the most effective ways to create substantial wealth, but it’s typically hard work. Those who work for a company have less control over the creation of per-

4 "Good luck is a lazy man’s estimate of a worker’s success." "The law does not pretend to punish everything that is dishonest. That would seriously interfere with business." -Unknown -Clarence Darrow "I’m a great believer in luck, and I find the harder I work the more I have of it." "Opportunity is missed by most people because it is dressed in overalls -Thomas Jefferson and looks like work." "Diligence is the mother of good luck." -Thomas Edison

How did he primarily make his bil- How did he primarily make his bil- How did he primarily make his bil- lions? lions? lions?

Bernie Madoff (Madoff Securi- Jeff Bezos (Amazon founder) Rob Walton (son of Walmart ties founder) founder, Sam Walton)

A. Luck A. Luck A. Luck B. Stealing B. Stealing B. Stealing C. Work C. Work C. Work

Check Answer Check Answer Check Answer RULE 2

Supply & Demand: What is anything actually worth? Economics 101 What is the real worth of your house? As with any other asset, the actual value of a home is what someone else is willing to Supply and demand is the key to almost everything financial. pay for it. In the 2000s, when demand was high, home values It’s a pretty simple concept: if the demand for something is rose. As demand plummeted, so did prices. Thus, just be- higher than the supply, then the price will typically rise. When cause your house was worth $500,000 in 2007, didn’t mean it demand falls, and supply remains high, prices fall. was still “worth” that in 2009.

The real estate markets of a few years provide a perfect illus- Day-to-day, year-to-year prices for almost everything fluctuate tration. In the 2000s, thousands of people bought real estate based on how much of the product exists and how many peo- in hopes of making big money. It only took a few success sto- ple want it. Take gold, for example; what is the intrinsic value ries, particularly in high growth markets like Arizona and Flor- of an ounce of gold? Today, gold sells for well over $1,000 ida’s, for potential real estate investors to start lining up to per ounce, but what is it actually worth? Could it possibly be buy—what they perceived to be—a limited supply of homes. worth $2,000 an ounce (as some “gold bugs” claim) or is it only worth $500 an ounce or less (as was the case in 2005)? In some cases, people bought the right to move closer to the The correct answer is elusive. It is worth what someone is will- front of the line in order to pay prices unheard of in the his- ing to pay. tory of real estate. In some markets, plain-vanilla, suburban tract houses were selling for $500 per square foot.

It wasn’t long before the pool of potential buyers dried up. There was no “greater fool” available to pay the new higher prices. The neophyte “investors,” who had no intention of own- ing properties for an extended period, quietly walked away from their mortgages. In some markets (notably Florida, Ari- zona, and Nevada’s), home prices quickly plummeted.

This extreme pricing volatility left a lot of homeowners con- fused about the real value of their properties.

7 Supply and demand is the primary driver behind most short- It’s all about supply and demand. When interest rates on new term price movements. An intraday increase in the price of bonds rise, due to lower bond demand or higher supply, old the stock is usually due to a flood of buyers without a com- bond prices fall. When interest rates on new bonds fall, as sup- mensurate increase in the number of sellers. The same forces ply decreases or demand increases, the value of older bonds drive bond markets. increases.

Some people seem to have difficulty understanding the fluc- The same rules apply to gold or any other commodity. A sig- tuation that occurs in fixed income securities. Why do bond nificant new gold discovery will increase supply and drive prices fall when interest rates rise and vice versa? What it prices down. A significant new employer opening near your comes down to is fundamentally an issue of supply and de- house should increase demand and cause your home to be- mand. come more valuable.

Assume, for a minute, that the government issued a billion dol- Supply and demand is also the primary driver of stock prices. lars’ worth of 10-year notes paying 3% per year. All of these If a company is doing well, demand for the existing, finite sup- bonds were sold and are now in the hands of investors. The ply of stock in the firm will drive prices higher. A poorly run next year, the government decides that it needs some extra business will lead shareholders to sell, adding to the supply. money and plans to issue $2 billion worth of new ten-year More supply means that sellers are forced to ask less for their notes. However, they discover that there aren’t enough inves- shares to move them. In essence, putting them on sale. tors interested in that much paper. So, to sell the debt, the When a company decides to raise capital by issuing stock, government must make the notes more attractive by reducing they increase the supply, and often depress the price of exist- the price so that the total annual return (yield to maturity) rises ing shares. This process is known as “dilution.” to the equivalent of 4% per year. Day-to-day, supply and demand changes cause the prices of Should one of the investors who purchased a 3% note (for securities to swing wildly. Inevitably, for companies whose which they paid full price), the year before, want to sell it, they earnings are growing, the dollars leaving poor performing will also need to reduce the price to give the new investor the firms will find their way into their stock, increasing demand same effective 4% yield to maturity that brand-new 10-year and pushing prices higher. notes are delivering.

8 Trying to assign a value to something arbitrarily is futile. Seven of the craziest bubbles of all time: Things, whether they’re stocks or houses, are only worth what someone else is willing to pay. The more buyers competing to DUTCH TULIP MANIA- 1634-1638 purchase, the higher the price can rise. Fewer buyers and in- A young, growing capitalist economy led to speculation in a new import from creased supply will push prices down. the Ottoman Empire to Holland, tulip bulbs.

SOUTH SEA COMPANY BUBBLE - 1711-1720

A perception that the South Sea Company had a monopoly on “New World” trade (and great PR) helped this “low risk” investment spread across England.

“Teach a parrot the words ‘supply and demand’ and you’ve CALIFORNIA GOLD RUSH - 1848-1855 got an economist.” News of vast riches with no effort ignited “gold fever” and tens of thousands sold everything to seek out or invest in gold mining ventures. -Thomas Carlyle RAILROAD FRENZY - 1860-1873

"A nickel ain’t worth a dime anymore." Perceived “boundless” growth in the American West led to euphoria over rail- road investment opportunities. -Yogi Berra STOCK MARKET MARGIN MANIA -1927-1929 "Supply always comes on the heels of demand." Easy credit and post-war economic growth drove stock demand and prices.

-Robert Collier DOT COM BUBBLE - 1997-2000

Technology and a “new market paradigm” propelled tech stocks. "Advice is the only commodity where the supply always ex- ceeds the demand." REAL ESTATE MADNESS - 2003-2007 Real estate rose on relaxed credit standards and low rates, plus a bit of fraud. -Unknown CRYPTO CURRENCY CRAZE - 2017-?

Digital currencies went from a niche transaction tool to a perceived “invest- ment.” The wild ride is ongoing as of this edition.

9 RULE 3

Financial Fluctuation: What goes up, goes down, goes up, goes... Those Squiggly Lines Over the past 40 years, the standard deviation for one year bonds has been approximately 2%. On the other hand, over You see them all the time: charts of various securities or securi- that same period the Standard & Poor’s 500 index experi- ties markets. They move up, down, up, down, and then, up enced a 16% standard deviation. To help make investing more again. This behavior is known as “volatility.” Almost every in- vestment is volatile to one degree or another.

The more risky the investment, the greater its volatility will tend to be. This is the price you pay for the return you receive. Investors must be able to accept volatility in their portfolio.

There are ways to make volatility more palatable. In fact, stud- ies over many decades have shown that volatility can actually be reduced by implementing some relatively simple strate- gies.

Before we delve into those, we should first find a common lan- guage of volatility. One of the most widely used measures of comfortable, we need to find a way to reduce the volatility of it is called “standard deviation.” This is a number that reflects your portfolio. One way to do that is to accept far lower re- the level of fluctuation in a percentage figure. turns on your investments.

The lower the number, the less an investment value changes. There is another way to reduce volatility while maintaining rea- For example, a security with a standard deviation of zero sonable returns. What we need to do is invest in markets and would never rise or fall. asset classes that don’t always move in the same direction over extended periods of time. In other words, you want to in-

11 vest in markets that don’t always exactly correlate with each times, the timing of the changes are not identical and the mag- other. nitude of the fluctuations can vary wildly which can trigger an extreme emotional response. However, if you owned all of A good example of markets that failed to match performance these asset classes, the degree of volatility would have been can be seen in movement of U.S. and Japanese markets in the reduced (the wide yellow line) keeping greed and fear in 1990s. Throughout that decade, the US stock market grew dra- check. matically, while the Japanese stock market was steadily falling. Those who owned assets in both markets enjoyed reduced Investing in assets that don’t always move in exactly the same volatility in their portfolios over that decade - albeit with direction can allow an investor to add positions with inher- smaller overall returns. ently greater risk and yet reduce the overall volatility of the portfolio to an acceptable level, as illustrated in the chart on In the next chart, you can see the movement of various equity page 23. asset classes. While the may move up and down at similar Here we see a typical balanced portfolio of 60% stock (S&P 500) and 40% in the Goldman Corporate/Government bond index compared to a portfolio with 40% of the assets in a re- duced volatility, shorter-term government bond portfolio. The 60% of the portfolio devoted to equities is split evenly be- tween the U.S. and foreign markets. It is further divided into small and large companies; and between growth and value stocks.

Over 40 years, the more diversified portfolio would have turned a $10,000 investment into $16,600 more with slightly

12 less volatility. Plus, the massively diversified portfolio spread the risk among about 15,000 different stocks around the world, compared with just 500 stocks un the United States.

Of course, there is no way to know if something that worked “It will fluctuate.” in the past will do so again. We have been running this same -J.P. Morgan When asked what the stock market would do. hypothetical portfolio exercise for over 15 years and the re- "October: This is one of the peculiarly dangerous months to sults have always favored the globally diversified portfolio. Of speculate in stocks in. The other are July, January, Septem- course, past performance tells you nothing about the future ber, April, November, May, March, June, December, August, and a hypothetical portfolio is just that. and February.."

However, you can be reasonably confident that diversifying -Mark Twain will often reduce the perception of risk. This alone should "Look at market fluctuations as your friend rather than your help keep you investing in riskier assets for the additional re- enemy; profit from folly rather than participate in it." turn they have historically provided. -Warren Buffet The key to successful long-term investing lies in finding a way to build a well-diversified portfolio designed for your per- “By the late 1980s people realized that houses did not al- sonal risk/volatility tolerance and ignoring the market’s inher- ways appreciate and that they could fluctuate like any other ent volatility. market commodity” -Ron Chernow You can even take advantage of the fact that markets move un- predictably by regularly rebalancing your portfolio (in a highly disciplined fashion). This forces you to do what all investors should do; buy low and sell high. 13 14 The Market Rises More 1949 20.2 1951 20.7 Chart Of The Annual Returns Of The 1963 21.0 US Stock Market From 1926-2017 1993 11.1 1982 21.0 1970 0.0 2014 11.6 2017 21.1

1953 0.7 2004 12.0 1996 21.4 Take the quiz on the next two pages. 2011 0.8 1959 12.7 1944 21.5 1960 1.2 1952 13.4 1983 22.0 1987 1.7 2016 13.6 1979 22.6 1997 31.4

1948 2.1 1968 14.1 1998 24.3 2003 31.6

1939 2.8 1965 14.5 1955 25.2 1985 32.2

1966 -8.7 1947 3.6 2006 15.5 1999 25.2 1936 32.3 1973 -18.1 1932 -8.6 1934 4.1 1942 16.1 1976 26.8 1980 32.8

1929 -15.2 1940 -7.1 1984 4.5 1964 16.1 1961 26.9 1927 33.5

2000 -11.4 1946 -6.2 2007 5.8 1971 16.1 1938 28.2 1991 34.7

2001 -11.1 1990 -6.0 2005 6.2 2012 16.2 1943 28.4 2013 35.2

1969 -10.9 1977 -4.3 1978 7.5 1986 16.2 1967 28.7 1995 36.8 1930 -28.8 1962 -10.2 1981 -3.6 1956 8.3 1972 16.8 2009 28.8 1928 38.4 1935 44.4

2008 -36.7 1974 -27.0 1941 -10.1 2015 -0.5 1926 8.4 2010 17.7 1989 28.9 1945 38.5 1958 45.0 1931 -43.5 1937 -34.7 2002 -21.1 1957 -10.0 1994 -0.1 1992 9.8 1988 18.0 1950 29.6 1975 38.8 1954 50.0 1933 56.7 -50% to -40% -40% to -30% -30% to -20% -20% to -10% -10% to 0% 0% to 10% 10% to 20% 20% to 30% 30% to 40% 40% to 50% 50% to 60%

In US dollars. CRSP data provided by the Center for Research in Security Prices, University of Chicago. The CRSP 1−10 Index measures the per- formance of the total US stock market, which it defines as the aggregate capitalization of all securities listed on the NYSE, AMEX, and NASDAQ exchanges. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the manage- ment of an actual portfolio. Past performance is not a guarantee of future results.

15 In 1933, in the depths of the In 1975, after the OiI Embargo The US was actively involved in Great Depression, what did US and economic stagflation, how World War II from 1941-1945. stock prices do? did the US stock market per- For how many of those years

A. Fell over 40% A. Fell over 40% A. All B. Fell over 20% B. Fell over 20% B. Four C. Fell over 10% C. Fell over 10% C. Three D. Rose over 10% D. Rose over 10% D. Two E. Rose over 20% E. Rose over 20% E. One F. Rose over 40% F. Rose over 40% F. None

Check Answer Check Answer Check Answer

16 In how many years did stock In how many years did stock The largest calendar year US prices fall by 30% or more? prices rise by 30% or more? stock price decline occurred in what year?

A. 1929 A. 1 to 5 A. 1 to 5 B. 1974 B. 6 to 10 B. 6 to 10 C. 1931 C. 11 to 15 C. 11 to 15 D. 1987 D. 16 or more D. 16 or more E. 1932

F. 2008

Check Answer Check Answer Check Answer

17 RULE 4

Everything Eventually Rises: So far, the global economy has always grown larger. Macroeconomic Gravity $59,000 (2017 estimate from the International Monetary Fund). On one particular day, an apple falls from a tree, hits a guy in the head, and from it, we have the Law of Gravity. For thou- That alone is pretty powerful historical evidence that, despite sands of years, countries have risen and fallen while the over- all of the trials and tribulations faced along the way, econo- all value of the global economy has steadily grown. So, why mies (or at least ours) grow at a pretty steady clip. Over the don’t we have a Law of Macroeconomic Gravity? past 242 years, the United States has suffered through multi- ple significant depressions, a debilitating civil war, two It may not be an established natural law, but I think Mac- global wars, and a host of other crippling economic prob- roeconomic Gravity is worthy of being named a pretty com- lems, many of which make today’s financial worries pale in pelling theory of Financial Fysics. It can never be proven cor- comparison. And yet, the American economy has defied rect, but we have some convincing evidence for its exis- every short-term naysayer and continued to grow. tence. “Well,” you say, “the United States is an exception. If you in- Let’s start at home. The United States began as a small, back- clude the rest of the world, has the global economy also water, primarily agrarian society. In 1790, each American pro- grown?” duced approximately $48 of goods and services (in 2010 dol- lars). By 1890, that number had risen to $238 of production I’m glad you asked. Professor Angus Maddison (1926-2010) per person, an almost fivefold increase over one century. spent decades studying the productivity of the ancient world and published his results in 2001. According to his research, Leaping ahead another century to 1990, Americans pro- the global economy has also grown steadily over the past duced over $23,000 per person. That is 100 times more than 2,000 years. the per-person output in 1890. A mere 17 years later and US average productivity per person has soared to more than The chart on the next page depicts the accelerating trend of global economic growth (primarily due to rapid paced tech- 19 nological advances). You’ll notice that global gross domestic If it turns out that there actually was light at the end of those product (GDP) quadrupled between 1900 and 1950, even dark tunnels, it’s pretty safe to assume that, barring some though two world wars raged during that 15-year time frame global catastrophe (covered in our next rule: The Worst Case that all but destroyed the economies of both Europe and Scenario), our global economy is very likely to continue grow- Asia. ing.

“There are no great limits to growth because there are no limits of human intelligence, imagina- tion, and wonder.”

-Ronald Reagan

"Do you want my one-word secret of happiness? It’s growth - mental, financial, you name it."

-Harold S. Geneen

“I think that our fundamental be- lief is that for us growth is a way of life and we have to grow at all times.”

-Mukesh Ambani

20 RULE 5

Worst Case Scenario: The global economy should keep growing until... In Case of Fiery Cataclysm... money. While it’s probably no more than some bits of informa- tion transferred from one computer to another, we both recog- Throughout time, there have always existed groups of people nize what that data represents. Payment could also have been who believe that the end is nigh. We’re often told to make both made with cash or even gold, but with far more effort involved. physical and spiritual preparations for the inevitable “end of the world as we know it.” If everyone went back to using gold as the primary means of ex- change, we might actually damage our economy and that of the Many—including some purveyors of “investments” like gold— rest of the world. Again, why is gold valuable? After all, it’s noth- claim that only hard assets will save your wealth from the inevita- ing more than a durable, conductive, shiny metal. We could just ble economic ruin faced by our nation or world. While there’s as easily choose cocoa beans as a means of storing wealth, as nothing like a good scary story to get our adrenaline pumping, the Aztecs did (gold bored them). the rumors of our impending demise are, as Mark Twain once said, “greatly exaggerated.” Our current system of exchange is very effective, primarily be- cause it’s very fast. What underlies the value of currencies are the Let’s focus on the arguments used by the “gold bugs.” They be- goods and services produced by all of us. Our government can lieve that the only good currency is a hard currency. However, devalue its currency by printing (or merely creating on a com- their case has an underlying flaw. What is it that makes gold valu- puter) more money. However, as ours is a global system, it able? doesn’t take long for other economies and currencies to adjust Gold is valuable because we all agree that it’s valuable. Actually, to the new “real” value of that extra money. it’s only what gold represents that has value. Gold, silver, cur- The system actually seems to work really well. It works so well rency, checks, credit cards, even blockchain merely represent a that it’s hard to imagine a scenario in which every government currently accepted means by which goods and services are ex- and economy on the entire planet would collapse simultane- changed. ously. Even during the darkest part of the German Weimar Re- Rather than me visiting your home to collect something you cre- public hyperinflation of the 1920s, the rest of the world had rela- ated for the value of this book, you paid with something called tively stable currencies.

22 I guess there’s always a chance that the “cataclysm cheerleaders” will be right about something horrible happening, eventually. Even a stopped clock is right twice a day. In that unlikely possibil- ity, it’s hard to imagine that gold will be precious to the few peo- ple who are likely to survive a global disaster. A better invest- ment might be big guns and canned food.

"What the caterpillar calls the end of the world, the master calls a butterfly." -Richard Bach

"Due to lack of experienced trumpeters, the end of the world has been postponed for three weeks." -Unknown

The world dies over and over again, but the skeleton always gets up and walks. -Henry Miller

23 RULE 6

Three “N” Theory: Nobody (K)nows Nuthin’ The Future Remains Unknowable the past. Since past performance is no guarantee of future re- sults, that should help eliminate the expectation of a predict- It amazes me that so many intelligent people believe in finan- able future (at least it couldn’t hurt). cial fortune tellers. Sensible folks who would never consult a psychic for a glimpse of their personal futures are willing to One of the best known and most widely respected analysts of spend hundreds, if not thousands, of dollars on systems or investment predictions is Mark Hulbert, who has been publish- publications that promise to predict the future of investments. ing his “Hulbert Financial Digest” for over 30 years. He follows the performance of almost every investment newsletter ever Billions of dollars would be saved, every year if all of us finally published. Even though his livelihood depends on these in- realized that “nobody knows nothing” about the future. But, vestment newsletters, he has found that very few seem to that won’t stop people from guessing. We’re pretty good at have any clue about the future direction of the securities mar- that. That also won’t stop many from claiming that their kets. guesses represent strong predictive skills. In a past conversation, he told me, “If you own the whole mar- A big part of the problem is the language we use to describe ket you’re going to... do better than about 80% of the (invest- the past performance of securities. Statements like, “the mar- ment) newsletter editors.” Mark calls this his 80/20 rule, which ket is up,” or “prices are falling,” allow us to make the transi- has almost consistently shown that 80% of those who try to tion from the past to the future much more comfortable. beat the market will fail, while only 20% succeed. Bear in mind Although we seem able to make an easy mental transition that many of these prognosticators buy the securities they rec- from the present movement of a market to its future direction, ommend in order to allow them to publish “actual results.” By it’s a bit harder to leap from past performance to future direc- the time the advice reaches you, even if it's e-mailed to you, tion. your results are bound to be worse than those of the "expert" because it’s only the first person making the predicted trade To help break ourselves of the mistaken belief that someone who receives 100% of its benefit. Every subsequent transac- can predict the financial future, we need to stop thinking in tion will be at a price that was influenced by the previous the “now” and start realizing that everything has happened in

25 trade. This effect is particularly prevalent among lightly traded doing. securities. A separate study by the Swiss Finance Institute (chart below) How do those who try to predict the market perform? First, found that less than 1% of active mutual fund managers exhib- let’s consider the effect of random chance. If pure luck were ited any kind of skill after adjusting for luck (and fees). the only factor affecting relative returns above and below the The problem is finding them. Which of those 30% to 40% of average, you would expect that approximately 50% would out- those outperforming, actively managed mutual funds are the perform (in the jargon of the trade “add alpha”) and that the ones that are run by a skilled manager and happen to just be other half would underperform. lucky? To pick even one competent manager out of this huge The reality is that somewhere between 60% and 70% (depend- group, you, too, must be extremely lucky. At best, you only ing on the timeframe measured) underperform their bench- have a one in ten chance of picking the smart one. marks (or produce “negative al- That leaves you with only two pos- pha”). When you factor out the ef- sible choices. You can spend a lot fect of luck (as professors Eugene of time and money trying to find Fama and Kenneth French did in those very few investment advi- their recent paper “Luck Versus sors who seem able to “beat the Skill in the Cross-section of Mu- market” and then hope you’re tual Fund Returns”), a mere 3% of lucky enough to pick one of all active mutual fund managers those that proves to have real managed to beat their market skill in the future. Or, you can benchmarks based on what is stack the odds in your favor and likely to be skill. That means that invest in that which so few active in reality, there may be a tiny managers seem able to beat, the group of professional investors market itself. who seem to know what they’re 26 FAMILY GAME NIGHT “Prediction is very difficult, especially about the future.” Who is the Best Money Manager? -Niels Bohr No special skills required.

“Economists are pessimists: they’ve Next time you have a group of people together try this simple game. Give every- one a coin (what kind depends on your generosity). Then, have everyone flip the predicted 8 of the last 3 depressions.” coin 10 times, counting the number of heads. Those who have 8, 9, or 10 heads -Barry Asmus are the world’s best money managers. Those with 1, 2, or 3 are the worst. The rest are just average. You will see that most of your coin-flipping friends land in the middle, while only a few “beat” the market. Your results will not vary much "An economist is an expert who will from the real world results of several studios. know tomorrow why the things he pre- dicted yesterday didn't happen to- day." -Unknown

STOP FOOLING YOURSELF “Those who have knowledge, don't predict. Those who predict, don't We like to remember our successes and would rather forget our failures, but doing so can create unrealistic future expectations. have knowledge.” So, rather than focusing on your winners, grab a piece of paper and write down every investment or money-making idea that didn’t work out for you.

27 RULE 7

No New News Theory: Information spreads fast. Everybody Already Knows certain CEO's wife told him that her husband’s company was about to be acquired by another firm. He goes on to say that Wouldn’t you love to be able to buy a stock before everybody the stock should skyrocket once the news is made public and else realizes that it’s a good deal, or sell a stock before the that he just purchased several thousand shares of the com- market is aware of a problem? There’s only one small issue pany himself. with both of these desires. You need to know something be- fore everyone else does. First, let’s assume that the information has some basis in fact (more often than not, it doesn’t). Is your friend allowed to buy There are two types of information about publicly traded com- the stock and profit from it when it goes up? Are you allowed panies. One is “public” information, which is the story stock to do so, too? Neither one of you are company insiders. After analysts share through company conference calls and re- all, you merely heard it third or fourth hand. Could either of leases. These are the reports that you hear on financial radio you be guilty of a crime? or television or read in print media. In fact, both you and he could be prosecuted for insider trad- The other type of information is “nonpublic.” These are facts ing, if you profit from information that was not yet public, even known only to a select few with insider knowledge of the com- though you had no direct knowledge of the pending transac- pany’s workings. tion. In other words, you could find yourself in jail and facing a Investors are only allowed to trade on public information. It is stiff fine if the Securities and Exchange Commission discov- illegal to buy or sell stocks based on the knowledge of insid- ered your stock purchases (and they actively monitor stock ers. Herein lies the problem with beating other investors to trading for just such activity). the punch when news is about to affect stock price. If it isn’t So, that leaves you stuck with trading only on information that available to everybody, you’re not allowed to use it. has been made public by a company. Even if you’re one of Consider this example. Let’s say you’re having lunch with an the first people to be made aware of this public information, acquaintance and he tells you that at a recent cocktail party, a you’re going to find it extremely difficult to gain an advantage. 29 Knowledge spreads at the speed of light, which means that are long-term investors to enjoy a high degree of liquidity, tens of thousands of people will have the same information as even in our riskier investments. you, within a second or two. Without the occasional quirk in the system, there would be no In fact, many investing computer systems will have the infor- incentive for the major players on Wall Street to keep money mation and will have acted upon it within less than a second. moving at such a rapid pace in their attempt to exploit the There’s little or no chance that you will be able to compete in rare inefficiency. For the most part, the securities markets are, an environment that can buy or sell in nanoseconds (that's indeed, highly efficient. There are few opportunities for indi- one billionth of a second). In other words, you’re out of luck. vidual investors to beat them at their game.

This lack of actionable information is the basis for the “effi- cient markets hypothesis.” This theory, which first came into “Anyone who plays the stock market not as an insider is like being in the late 1950s, states that the securities markets are a man buying cows in the moonlight.” reasonably efficient since most of the information about a se- -Daniel Drew curity is readily available to almost every investor—therefore, securities prices reflect all of the known data. “...all of the news out today is already known.” Critics of this theory use the rare examples of inefficiencies or -Barry Hyman the anecdotal money manager who seems to have a consis- tently “hot hand” as proof that the theory is wrong. The fact “Transmitted at the speed of light, all events on this planet that there are occasional information imbalances, pricing ir- are simultaneous.” regularities, and even apparently predictable patterns over oc- casional periods does not make the entire market inefficient. -Marshall McLuhan It’s these occasional inefficiencies that allow those of us who

30 RULE 8

Risk to Reward Ratio: There is no wealth without risk. No Wealth Without Risk potential for high returns with no risk of loss. A guarantee that, typically, only applies if the owner of the policy dies at a I hate to burst your bubble (and that of much of the “invest- time when the value is down. Otherwise, the value of vari- ment” sales business), but you must take risk to make money able annuities can fluctuate like any other investment (but on your investments. Period. End of story. There is no such with generally higher fees attached). You will find that, typi- thing as a high-yielding, no-risk investment vehicle, no mat- cally, the only people telling you that you can invest in some- ter how much you might wish there were! Sorry. thing with a high return and little or no risk are those who

It is only when we finally accept that risk and reward are inex- are selling products that appear to meet those criteria (as tricably linked to each other, that we can finally get down to long as you don’t read the policy or prospectus too care- the business of really investing. Almost every investment de- fully). bacle in history can be connected to, at the very least, confu- If you would like to know what the real, low-risk return is at sion about the risks involved. any point in time, call or visit your bank (or visit

Customers of Bernie Madoff believed they were among the BankRate.com). Ask them for the current interest rate on a chosen few being offered an opportunity at huge returns savings or money market account. That is the rate to which with little or no downside. Hordes of so-called “professional” all others should be compared. If someone offers you a sub- investors bought the story that you could somehow take a stantially higher return than an FDIC insured banking institu- portfolio of risky investments, bundle them together, cut tion (or the federal government), then, no matter what they them into little pieces, and remove the chance of loss (collat- say, the risk is higher. It may not be blatantly obvious, but a eralized debt obligations, for example). risk of some kind exists.

Every day, in this country, over $100 million pours into vari- There are really only two kinds of risk about which an inves- able annuities with the expectation that the investor has the tor needs to worry. The first, and most obvious, is “default” risk, the risk you take when you buy the stock of a single com- 32 pany (or even several individual companies). Investment re- has, for all intents and purposes (see Rule 5 – The Worst turns will need to be quite high to help compensate for the Case Scenario), no default risk. All that remains is the risk chance that you might lose all of your investment. That’s why that your portfolio will be down in value at the time you need it’s possible, although not likely, for you to earn 10 or 20 the money. times your initial investment in a small, aggressive com- Generally speaking, the higher the degree of volatility, the pany’s stock. higher the risk will be. A portfolio made up of entirely small- It is default risk that we most associate with investing in company stocks will experience wilder swings than will a stocks. Buying one or two stocks could make you rich or portfolio of giant, blue-chip equities. Over time, small- wipe you out. I have never met an individual investor who company stocks have provided a substantially higher return had the stomach for a few individual stocks when presented to investors than have the stocks in large growth companies. with a realistic picture of the possible risk faced, a 100% po- Risk exists for every type of security. Otherwise, there would tential loss. be no need to pay you anything to invest your capital. It is for this reason that I never suggest the creation of portfo- Bond markets provide one of the most explicit examples of lios focused on just a few securities or even sectors to those the link between risk and return. Generally, the longer the investors trying to build wealth for their future. No matter maturity of the bond, the higher the interest rate. The higher how great the reward might be, the risk overshadows it. rate is needed to compensate the investor for possible fu- The other significant investment risk is volatility. Securities ture fluctuation in interest rates. This is because when inter- markets are volatile. That’s what those squiggly lines that you est rates rise, the price of existing bonds must fall (see Rule 2 see on most charts represent. Volatility. - Supply and Demand).

An investor with a diversified portfolio (even diversification The relationship between risk and reward would be far eas- as narrow as that provided by the Standard & Poor’s 500) ier to understand and exploit if it were an absolute relation- 33 ship. It isn’t, because risk remains a somewhat subjective “globally-diversified” portfolio on page 16 with a historically judgment call. Again, the bond market gives us the clearest high return and a reduced level of volatility. example of this imperfect linkage (more specifically, the U.S. One of the first things an investor must do is determine his government bond market). or her tolerance for risk. Don’t even think of looking for in- The chart at right shows the average annual compounded vestments until you understand how much you are willing yields and risk/volatility (standard deviation) of a range of and able to lose, if only for a short time. Then, build a portfo- U.S. Treasury securities from 3-month T-Bills to 20-year T- lio designed with risk in mind. Bonds. The green line is the return, and the red line is the volatility. For most of the maturities, the yield rises with the risk, until the two lines converge at about seven years. Then, the risk continues to increase with no commensurate increase in return.

In this case, our inability to accu- rately assess risk or some investor’s desire to lock in a yield, no matter what the additional risk, account for this anomaly. It is through these in- consistencies that an investor could have built a portfolio like the 34 “To get profit without risk, experience without danger, and reward without work, is as impossible as it is to live with- out being born.” -A.P. Gouthev

"There is no better gambling than to not gamble." -German proverb

"In investing, what is comfortable is rarely profitable" -Robert Arnott

"There is no reward in life without risk." -Barry J. Farber

"Risk is good. Not properly managing your risk is a dangerous leap" -Evel Knievel

35 RULE 9

Confusion to Risk Ratio: Baffling you with BS. Even Pros Don’t Know plexity was needed to improve profitability. Short-term hedg- ing products, like options, were created. Complexity allowed What is the difference between a senior structured collateral- the industry to add a layer of valuable befuddlement to the ized debt obligation (CDO) tranche, and a subordinated “investment” business. Higher fees were the result. tranche? How is a credit default swap linked to CDOs and, from there, to a single mortgage? There was a time when income investors were happy with plain old bonds. They were pretty easy to understand. You Okay, let’s try something a bit more mundane: What position bought them, collected interest, and either sold them to some- would you be taking if you engaged in a naked short strad- one else or held them until they matured, and your principal dle? No, it has nothing to do with that! It involves option con- was repaid. Again, a business way too easy to warrant the pay- tracts. ment of high fees. Confused? Good. That’s what they (the investment sales indus- Yet, Wall Street wasn't satisfied with the meager profits gained try) want you to be. A confused investor is an easily duped in- from plain old bond trading. They wanted more, much more! vestor. The less you think you know, the more you think you need them. The more you need them, the more you are will- Some smart MBAs realized that dull, boring (and cheap) in- ing to pay for their expertise. See a pattern developing here? vestment vehicles could be sliced, diced, and repackaged in ways that made them appear more valuable. Complex deriva- Wall Street is in the business of confusion. There was once a tive securities were born. time when all a broker did was buy and sell stocks. It required no particular skill to do so. Commissions were high because There were all sorts of theories about the potential for these only a select few were allowed to make those transactions. new products, both positive and negative. Even those that cre- ated these monsters were unsure about their potential for When those markets opened to competition, trading stocks good or evil (profit or loss). So, they conveniently ignored or became a simple and very competitive business. More com-

37 downplayed the possible downside and touted the upside po- dollars from Wall Street and the insurance industry had a real tential. problem on its hands.

Sales rose. Profits rose even faster. “Let’s make more!” the The industry’s savior was another variation on the derivative bosses shouted. concept: Variable annuities and all of their offspring.

Each successive generation of a product became more com- Realizing that the vast majority of people wanted investments plicated and confusing. The banks and brokers made money. that offer high returns with little or no risk, the insurance indus- Then, one day, someone realized that there was nothing be- try discovered that through some financial sleight-of-hand, it hind many of these “safe” investments. All hell broke loose. could provide a product that appeared to do just that. Cut to 2007/2008 for the aftermath of this stupidity. This new security/insurance hybrid was designed to offer cus- Complex investments aren’t limited to Wall Street or the big tomers the “performance of the stock market” with a guaran- banks. Insurance companies came to the same realization. tee of principle. Thanks to favorable tax regulations, the insur- ance salespeople were also able to claim that these products There was a time when the only investment type product of- offered the advantage of tax-deferred growth. It all sounds ter- fered by insurance companies was whole, or cash-value, life rific until you start picking the products apart. insurance. You paid a premium of which a portion went to- ward death insurance, and another went into prudent (boring) A variable annuity is a life insurance policy combined with a investments. This "feature" allowed the insurance company to portfolio that looks much like a mutual fund. You place a cer- build up a “cash value” in the policy should you fail to die tain amount of money in the annuity policy, and the company early. invests in the underlying securities portfolio. Attached to that portfolio is an insurance policy that guarantees the return of These policies were not very lucrative, but they weren’t very your initial investment if the securities portfolio value falls be- risky either. They also failed to create massive profits for the low that amount. firm or their agents. Add to that the competition for investable 38 Until this point, it looks good, except for one little problem: to buying them, into thinking they are getting something for collect on the guarantee that you can't lose your initial invest- nothing. But, if you believe the financial product industry was ment, you must first die. Call me crazy, but I’d rather take the satisfied with these relatively simple complex investments, risk of a small principal loss, then not be here to see it. As for think again. the tax advantage, because of the insurance policy that is at- They are continually working to create even more compli- tached, the securities in your variable annuity grow tax- cated and confusing devices to attract your money. There are deferred. now derivatives based on derivatives. If variable annuities What those who sell these products neglect to mention is that weren’t bad enough, now the insurance industry is selling money invested in a growth-oriented mutual fund can also “structured products” (great euphemism) like equity-indexed grow tax-deferred, as there is only tax owed on a fund's divi- annuities. These products claim to give you—even more—some- dends and realized capital gains on an annual basis. Plus, it’s thing for nothing. easier and cheaper to get your hands on your money in a The problem with these products is that those who sell them fund. have no idea what they might do to you in the future. A few Speaking of cost, the other thing they fail to mention in the years ago, brokers sold auction rate notes to a massive num- sales pitch is the fee structure. The average variable annuity ber of investors and institutions with the promise that they has internal expenses of almost 3% per year, and that doesn’t paid higher rates and were 100% safe. It turns out they include the typical surrender charge deducted should you weren't as safe as was claimed. Even those who created them choose to try to access your money in the first 5 to 10 years of say they were taken by surprise when the auction rate note ownership. market collapsed. If those who produce them don’t under- stand them, how can you? Once again, they design these complex products for the bene- fit of those selling them, and to purposefully confuse those

39 Confusing Investments “If you can’t dazzle them with bril- Finra, the Financial Industry Regulatory Authority, regularly publishes “Investor Alerts.” One of those liance, baffle them with bull.” alerts specifically addresses “Alternative and Complex Products.” This is just one example of an al- -W.C. Fields most incomprehensible product that serves little purpose other than to enrich Wall Street: What Is a Reverse Convertible? “An advertising agency is 85 percent A reverse convertible is a structured product that generally consists of a high-yield, short-term note of confusion and 15 percent commission.” the issuer that is linked to the performance of an unrelated reference asset—often a single stock but sometimes a basket of stocks, an index or some other asset. The product works like a package of fi- -Fred Allen nancial instruments that typically has two components: • a debt instrument (usually a note and often called the "wrapper") that pays an above-market cou- "The business schools reward complex pon (on a monthly or quarterly basis); and behavior more than simple behavior, • a derivative, in the form of a put option, that gives the issuer the right to repay principal to the inves- but simple behavior is more effective." tor in the form of a set amount of the underlying asset, rather than cash, if the price of the underlying asset dips below a predetermined price (often referred to as the "knock-in" level). -Warren Buffett When you purchase a reverse convertible, you're getting a yield-enhanced bond. You do not own, and do not get to participate in any upside appreciation of, the underlying asset. Instead, in ex- "Sometimes a concept is baffling not change for higher coupon payments during the life of the note, you effectively give the issuer a put because it is profound, but because it is option on the underlying asset. wrong." You are betting that the value of the underlying asset will remain stable or go up, while the issuer is betting that the price will fall. In the typical best case scenario, if the value of the underlying asset -Edward O. Wilson stays above the knock-in level or even rises, you can receive a high coupon for the life of the invest- ment and the return of your full principal in cash. In the worst case, if the value of the underlying asset drops below the knock-in level, the issuer can pay back your principal in the form of the depreciated "If you can’t convince them, confuse asset—which means you can wind up losing some, or even all, of your principal (offset only partially them." by the monthly or quarterly interest payments you received and the ownership of shares in the de- -Harry S. Truman valuated asset). Not only is this brief description maddeningly complex, but did you notice the most telling word of all with it? It’s in the last paragraph. The word is “betting.” If you are betting, you are not investing. RULE 10

Excitement to Risk Ratio: Selling the Sizzle. Selling the Sizzle being announced. A cold calling stockbroker would be given, at most, a few hundred shares to sell to his or her cli- Back in my “dark period,” over 30 years ago, when I worked ents. for Dean Witter (before I became a “recovered” stockbroker), most of our training was related to sales techniques. Along We were encouraged to sell those IPOs that were likely to with learning how to be “smiling and dialing,” “cold call cow- open trading at a price below that of the initial offering. That boys,” we were also taught the value of being able to tell an required the creation of a pretty amazing story to get inves- exciting story. tors interested in some poor-quality stocks.

Given the fact that most of the investment products offered Brokers have always used incredible stories to sell the invest- by the brokerage community were of dubious value (and ment of the day. All you need to do is visit any investment typically laden with expenses), we were "encouraged" to trade show or listen to many of the financial programs on ra- avoid discussing the actual quality of the product (in most dio and television. cases, a product comparable to a tough cut of “steak”). In- Not so long ago, there were exciting stories about fortunes stead, we were told to create a great story or weave an excit- being made “flipping” real estate. You would hear about the ing tale (the “sizzle”) if we hoped to make the sale. adventure of dabbling in oil and gas exploration. Purveyors Bad investments require building a higher level of excite- of gold spread worrisome tales of economic gloom and des- ment to get them sold. Genuinely great investments sell peration, offering Canadian Maple Leaves or bullion as the themselves. investors' salvation.

Take initial public offerings (IPOs) for example. Back in the Rarely, if ever, are solid investments offered as anything near days when IPOs were hot (the 1990s), the “hot” new offer- exciting or sexy. The best investments are those that rarely ings were oversubscribed (sold out) often within minutes of thrill and almost never frighten. They’re boring.

42 Over the decades that I’ve worked with the investment indus- try, I’ve observed that the more exciting or compelling the story, the riskier the investment. Of course, there are always occasional exceptions. More often than not, you, the inves- tor, will end up paying a considerable price for the opportu- “Be wary of the man who urges an action in which he him- nity to experience a brief moment of exhilaration. self incurs no risk.” -Joaquin Sentanti For some reason, unique investments make us feel “special.” That need for excitement and an added ego boost could be the reason why so many celebrities are taken in by invest- “Take calculated risks. That is quite different from being ment opportunities that feature a thrilling, greed-inducing rash.” tale. At least they, for the most part, can afford the losses. -General George S. Patton Can you?

“Character is the ability. to carry out a good resolution long after the excitement of the moment has passed.”

-Cavett Roberts

43 RULE 11

Fee to Risk/Reward Ratio: Pay less. Make more. Pay Less, Make More 500 or, even worse, the Dow) has historically returned a bit less than 10% per year. The actual inflation-adjusted figure for the Out of all of the compelling investment theories presented so past 40 years (a more realistic period) is 8.1%. Let’s round that far, this is one of the most powerful. In study after study, fees to a simple 8% per year. have been shown to be the best predictor of investment suc- cess. In other words, the more you pay, the less you are likely to According to Morningstar (the mutual fund tracking company), make. Lower-cost investments should make you more money. the average expense ratio for all equity mutual funds in 2017 was approximately 1.1% per year. Since this is an average, half What’s surprising about these “discoveries” is that the conclu- of the funds charge less (these are mainly no-load, low fee sion seems so blatantly obvious. By paying lower management funds from companies like Vanguard and Dimensional Funds) fees and no commissions, more of your money goes to work and half of the funds charge more (typically, broker-sold, for you in your investments. loaded funds). The counterpoint to this argument comes primarily from high- If you invest $100,000 in a mutual fund returning 8% per year priced stockbrokers, highly compensated mutual fund manag- that charges 2% per year (and they do exist), in expenses at the ers, and a host of other investment “experts,” who claim to add end of 30 years (a pretty typical pre-retirement investment time- more value to your investments than they cost. frame) you would have a pretax portfolio value of about It’s this perception of expertise that has kept Wall Street’s earn- $575,000. That same amount invested in the same fund with an ings growing at a breakneck pace for many decades. They have expense ratio of 0.5% would earn you $300,000 more! What a managed to convince you that their unique “expertise and skill” difference 1.5% can make. are worth the exorbitant fees they charge. Are there cases where an expensive active manager can add Before I share the results of some studies on the relationship be- value? The answer may be yes, but good luck finding that spe- tween investment fees and returns, let’s spend a minute look- cial manager. ing at costs from an entirely logical perspective. Over the past Out of every investing component, the one most likely to im- 90 years, the stock market (as mistakenly measured by the S&P prove the return, and the easiest to control, is cost. It may re- 45 quire a tiny bit of additional effort on your part (you may actu- funds.” They went on to state that low fees were the best predic- ally have to read a prospectus) but the potential rewards, as tor of future success, concluding that “investors should make ex- shown above, can be enormous. Pay less, make more. pense ratios a primary test in fund selection. They are still the most dependable predictor of performance.” Below is a summary of a few studies and analyses of the rela- tionship between low fees and higher returns:

• In 1997, Jonathan Burton in Bloomberg Personal magazine stated, “Fund expenses make a huge difference in your bottom- line investment return. In fact, according to a new study by Bloomberg Personal, low-cost funds are much more likely to de- liver above-average performance than high-cost ones...”

• In his paper, “Bond Returns and Expenses...” Professor William Reichenstein found that higher expenses predicted lower future returns in all 42 of the bond fund groups studied.

• In 1999, using Morningstar data, Jonathan Clements of the

Wall Street Journal found that higher fees on bond funds lead “In every single time period and data point tested, low-cost funds to lower returns 100% of the time. beat high-cost funds.” -Russell Kinnell, Morningstar • John Bogle of Vanguard analyzed bond fund fees and found that in 24 of 24 comparisons, higher costs led to lower returns “...the only way an investor can get killed is by high fees or by trying to outsmart the market..” and called high fund expenses a “deadweight loss.” -Warren Buffett • In 2010, Morningstar studied the relationship between high “Remind people that profit is the difference between revenue and ex- fees and performance and reported that “In every single time pense. This makes you look smart.” period and data point tested, low-cost funds beat high-cost -Scott Adams 46 RULE 12

Emotional Factor: Controlling Fear and Greed Fighting Fear and Greed ens of books published on the subject. How we approach in- vesting from an emotional perspective is critical to our finan- Why are we such lousy investors? I know this isn’t universally cial success. true, but it’s certainly a safe generalization to make. As inves- tors, we consistently make less money on our actual invest- Try as we might, we can’t seem to control those primal urges ment portfolios than the returns from the investments them- to panic when things feel scary or to engage in “irrational exu- selves (see Rule 18 – DIY Dilemma). It doesn’t matter how berance” when times are good. Our emotions lead us to buy good the investment vehicle might be, the actual returns we securities after the prices have already risen and sell them af- realize are, on average, well below the stated performance of ter they have already fallen. In other words, we buy high and the investments. sell low. If I remember correctly (and I am a bit past middle- age, so it’s possible I’m wrong), the whole idea behind invest- The reason for this is our lack of “reason.” Instead of approach- ing is to buy low and sell high. To do otherwise isn’t going to ing investing in a disciplined, logical, and dispassionate (rea- make you any money. sonable) way, we get emo- tionally involved. Feelings We go through a roller and money mix about as well coaster of emotions (almost as oil and water. literally) when the securities markets fluctuate. Experts re- An entirely new field of aca- fer to this wild ride as the demic study has sprung up “emotional cycle of invest- around our behavior as inves- ing,” and it follows emotional tors. You can now get a gradu- curves similar to those accom- ate degree in behavioral fi- panying love and grieving. nance. There have been doz- Typically, we only start invest- 48 ing when we're “excited” and sell once we become desperate erage drivers, of more than ordinary intelligence, or better- or panicked. than-average lovers. This overconfidence bias leads us to think that we are all above average investors. We love to brag In addition to the extreme emotions of fear and greed that about our winning investments but hate to discuss (or even drive our investment decisions, there are many “sub- recognize) those that fail. emotions” that lead us to make a host of financial mistakes. Our propensity to create attachments to people and things Those who have studied the financial emotions see little hope causes a psychological effect called “anchoring.” We get at- of overcoming them completely. The only solution is to em- tached to particular investments because they may have done ploy a discipline (or find someone else to do so—a personal well for us in the past or we have strong feelings for a specific financial “trainer” like a fee-only 100% fiduciary advisor) to industry or company. We can even get so wedded to certain keep you focused on your long-term goals. ways of doing things that, even when shown they are wrong, it is difficult to give them up. “The fact that people will be full of greed, fear or folly is predictable. The sequence is not predictable.” Another powerful emotion is called “risk aversion.” Humans -Warren Buffet hate losing anything. When investing, we don’t feel like we ac- tually have a loss until we recognize it (by selling). A paper “Money! It's one of the most emotionally charged issues of loss is not a “real” loss, so as long as we don’t sell, it doesn’t our lives.” exist. This denial is why we often hang onto bad investments -Tony Robbins until they lose most or all of their value.

Psychologists have found that women are better investors “This market right now is moving on nothing more than emotions. Guess what? It almost always moves on emo- than men, in large part because of “overconfidence.” Most of tions.” us suffer from this to one degree or another, and it is the rea- -David Bach son why in survey after survey, we rate ourselves as above av- 49 RULE 13

Lemming Corollary: Following the crowd. Follow the Leader the crowd, because we don’t know better or don’t want to bother finding out. There is something potent taking place First, let me set the record straight about the great “lemming” within our brains that pushes us to follow the crowd. myth. Lemmings, unlike humans, don’t actually follow their peers over the cliff to their demise (although, in the case of hu- Several years ago, I watched a fascinating episode of the ABC mans, the cliff is a metaphor). News program, “Primetime.” The program wanted to test the power of group peer pressure. A professor of psychology While they do sometimes perish during mass migrations, it from Emory University was brought in to create some experi- seems that they don’t actually fling themselves off of some ments. Norwegian precipice to help control their surplus population. This belief was, in large part, perpetuated by the 1958 Acad- In one experiment, participants were told to give whatever an- emy award-winning documentary, White Wilderness by Walt swer one particular individual gave to an oral test. Only one Disney, which featured dramatic shots of lemmings flying person was allowed a free choice in answering the questions. through the air (a special effect staged by flinging the rodents This same individual had also taken the same test in written off a spinning turntable). form earlier. No matter what answers he gave in the oral ex- amination, the man with free choice followed the crowd earn- So, if even lemmings don’t blindly follow other lemmings over ing him a correct score of only 10%. However, on the written the edge, why do investors follow other investors? We prefer test previously taken alone, he answered the questions cor- investing when securities markets have already risen, and we rectly 90% of the time. In every case, the individual partici- sell after they have already fallen. In other words, we are only pants followed the crowd of people giving obviously wrong comfortable following the behavior of others. answers, lowering their scores in these group situations. As social animals, we have been hard-wired to try to conform During some of these studies, the professor, Dr. Gregory and “get along.” In some cases, we don’t want to “rock the Burns, used a diagnostic device called an fMRI to watch their boat.” Other times, we blindly accept the belief or opinions of 51 brain activity. He paid particular attention to those who stood and physical health. Because we are hardwired to follow the up to peer pressure. He found that while standing their opinions of the majority, watching CNBC or reading the “Wall ground, the section of the brain related to fear was extremely Street Journal: every day is likely to push us into making in- active. In other words, it seems that we are afraid to go against vestment decisions that are not in our best interests. the will of the masses. Of course, that’s not to say that everything in the Wall Street In a variety of experiments done by researchers around the Journal is short-term oriented or will turn you into a market world, we seem to be predisposed to following the behavior timer (we’ll leave that to publications like “Investors Business of the crowd, even when we know it to be wrong. How else Daily”). There is useful information within most financial publi- can you explain the horrific behavior of entire “civilized” socie- cations. The trick lies in knowing what to ignore and focusing ties like Nazi Germany in the 1930s and 1940s? on the solid advice and information that occasionally pops up. For some investors, though, ignorance may be bliss. If human beings have a hard time finding the strength to op- pose abject brutality, how will we avoid following the invest- “One hundred thousand lemmings can’t be wrong.” ing crowd? It’s not easy to go against our essential nature. -graffito I’ve found that it helps to tune out the noise. Unless it’s for the sole purpose of commenting on something particular (like “To follow by faith alone is to follow blindly.” Jim Cramer’s investing buffoonery), I avoid watching CNBC -Benjamin Franklin. and Fox Business Channel entirely. What possible good does that constant barrage of information do for long-term inves- Without reflection, we go blindly on our way, creating more unin- tors? tended consequences, and failing to achieve anything useful. -Margaret J. Wheatley I believe that it does precisely the opposite. Always watching, listening to, and reading financial news is bad for your fiscal 52 RULE 14

Buggy Whip Theory: What’s hot is eventually not. Change Happens separate area (like a basement) from the food storage “cold-box.” A new refrigerator could cost you over In the early decades of the 20th century, one of the “hot- $1,000, so the demand was small. test” businesses involved keeping things cool. Most homes had an “ice box,” and every few days, an ice com- In 1927, General Electric brought out the first “mass mar- pany delivered a big block of ice to keep food fresh. Al- ket” refrigerator, referred to as the “Monitor Top” (be- most everyone needed ice, so the stock of those in the cause its round top was shaped like the turret of the Civil ice business was considered a pretty safe investment. The War battleship, USS Monitor). These were still relatively regular demand made for steady, predictable reve- expensive, with prices starting between $300 and nues. $500 (or about the cost of a new car at the time). However, from 1927 until production ended in Few were aware of, and even fewer took an in- 1936, GE sold over one million of these ma- terest in, a new refrigeration technology in- chines. Yet, throughout the 1930s, ice delivery vented in the 19th century. This “cooling com- wagons (and trucks) continued to be a com- pression” system allowed for large-scale refrig- mon sight in the streets of America and ice eration and even mechanical ice making. But, companies kept making money. much like early computers, the first refrigera- tors were large, complicated, and extremely ex- The only highflying giant ice company that pensive. Their use was limited to major indus- managed to survive the “melting” of their busi- tries like meatpacking. ness was a company called Southland Ice. After enduring a 1931 bankruptcy and reorganiza- In the 1920s, the first home refrigeration units tion, the company eventually thrived by enter- hit the market. They required the installation of ing a different market entirely, operating conven- the mechanical and electrical components in a ience stores. The company is now known as 7- 54 Eleven Incorporated with 30,000 stores worldwide, all of “There is no reason anyone would want a computer in which still sell ice. their home.” -Ken Olson, Founder, Digital Equipment Corporation, 1977 As technology advances even more rapidly, individual businesses and even entire industries can quickly fall by “Obsolescence never meant the end of anything, it's just the wayside. Phonograph records endured for over a cen- the beginning.” tury; CDs were popular for just over 25 years and have -Marshall McLuhan quickly been usurped by streaming audio. Which of these will start becoming obsolete soon? We are on the brink of seeing a whole raft of products and services become obsolete. Wired phones. Printed books. Cable television. Even the somewhat new technol- ogy of personal computers is being threatened with obso- lescence by tablets and smartphones.

NOTE: Technology has progressed so quickly that I had to re- write the previous two paragraphs, written just 8 years ago.

These days, smart investors should know better than to place bets on any single stock or any particular industry. Driving your own car? The danger of rapid and unpredictable obsolescence is just too high. What will be the next hot stock or sector? There’s no way of knowing. You are better off investing in all of them. In 2010, I guessed cable tv, desktop computers, and internal- combustion engines. All are starting to slowly fade away.

55 RULE 15

Source Consideration Rule: Follow the Money. Follow the Money a security or financial product. This group includes almost every stockbroker in America, from your neighbor who owns With all of the conflicting messages being sent by thousands the Edward Jones “franchise” in your town, to the well- of competing money management firms, how can you deter- dressed person with the “senior vice president” title at your lo- mine the best way to invest? First, I would suggest that you cal Merrill Lynch office. Other members of this club are the give greater credence to peer-reviewed academic research folks at your place of worship offering “faith-based” or church- than to the hyperbole and anecdotes spread by the invest- affiliated variable annuities or the sweet woman who handles ment industry and far too many individual investors. your car insurance, but also offers investments. Another way to understand the motivation of those offering They do not get paid for giving advice. They must convince financial advice is to know the source of their compensation. you to buy something to get compensated; a bond, mutual For example, those who work on commission are not compen- fund, annuity, or some other investment product from them. sated for providing high-quality advice or great ongoing serv- Don’t count on most of the folks in this trade to disclose their ice; they are paid for making a sale. compensation arrangement with you by choice. Verbal fee or You understand this, almost instinctually, when dealing with a commission disclosure is rare. The industry is aware that most car salesman, someone pushing appliances on the depart- consumers perceive the payment of a commission as an incen- ment store sales floor, and even real estate agents. For some tive to merely make a sale. Their primary compensation and reason, we seem to hold many of those financial “profession- revenue structure run contrary to the industry’s desire to por- als” who occupy mahogany paneled offices in elegant build- tray themselves as providers of a more altruistic form of ad- ings in higher esteem than we do the rest of the sales indus- vice and planning. try. Yes, some of those in the commissioned investment industry We either don’t, or choose not to, realize that most of those in go out of their way to provide a high level of care and service. the financial advice business only get paid when they sell you The problem is that they are dramatically outnumbered by

57 those who claim to be “financial advisors,” but who in reality, upfront commission. They create the up-front commission pay- will do anything for a commission. In fact, the decent people ment through some fiscal “sleight-of-hand” buried deep in- in the industry will tell you, privately, that most of their peers side the prospectus. are not working in your best interests. Instead of charging you a percentage of your assets upfront, How do you protect yourself from those who are only looking the fund collects higher annual fees to replenish the pool for a quick buck, courtesy of you? Since a majority of the from which they pay the broker’s commission. What if you sell commission-based financial sales industry is not likely to be the fund before they have had time to recover the commis- made up of unbiased investment advisors and counselors, sion paid through those higher fees? Don't get too excited. you would be wise to avoid them altogether, which is, of The deferred sales charge funds often impose sizable surren- course, easier said than done. der fees that decline over time.

The industry knows that most people are on to them. We have There are a variety of products, like these, with neatly hidden become more savvy consumers of investment products and commissions. These "liar-load" makes it hard to know whether advice. The voices of fee-only planners and no-load mutual or not you’re dealing with a commissioned salesperson and funds have finally reached almost everyone in the country, are why you’re told to read the sales material and prospectus and the investment sales industry has reacted. before investing. You should also ask anyone who might man- age your money how he or she is compensated and make Thanks to no-load funds from Vanguard, the commission- sure you get it in writing. based (loaded) mutual fund industry was one of the first to try to hide their commissions (loads). They invented what Christo- Remember that these people’s livelihood depends on your pher Cox, former head of the Securities & Exchange Commis- money, so don’t expect them to go down without a fight. Look sion, called load funds “in drag.” These mutual funds are re- for more on this crucial topic in our next rule: The Big Lie. ferred to as “B” or “C” shares. Brokers pitch them as “no-load” funds, and yet the person selling them still collects a sizable 58 Typical Commissions Charged on Broker/Agent Sold Products

“The salesman knows nothing of what PRODUCT UP-FRONT COMMISSION ANNUAL TRAILER he is selling save that he is charging a Mutual Funds (A shares) 5% to 5.75% (up to 8.5%) 0.25% great deal too much for it.” -Oscar Wilde Indexed Annuity 6% to 8% (up to 10%) Up to 1% Non-Publicly Traded REIT 3% to 7% Up to 1%

“Con artists love an environment of Universal Life Products 40% to 90% of Year One Premium 2% to 5% of Premiums trust, ...and insurance agents already Individual Municipal Bonds Up to 10% (fees and spreads) 0% have the trust of older people.” -Jane King Commissions/Charges/Conditions from a Actual Indexed Annuity

“A financier is a pawn-broker with MINIMUM ISSUE STATES INTEREST RATES GUARANTEE WITHDRAWAL RULES WITHDRAWAL CHARGES AGES AVAILABLE COMMISSION imagination.” -Arthur Wing Panero

“It’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to under- stand it.” -John Bogle

From an actual sales matrix used by a major indexed annuity sales organization dated “Summer 2018”

59 RULE 16

The Big Lie: Not always what they seem. Big Bucks, No Risk Then, they can tack on fees for various portions of the product like mortality expenses for the insurance component, manage- For some strange reason, we like to believe that we can get ment fees for the mutual funds, and surrender charges to en- something for nothing. Whether we’re talking about health- sure that they don’t lose the money paid out to the salesper- care or investment advice, the perception of a service being son initially. Plus, a host of other, almost inexplicable expenses free is appealing. about which you will never be informed (often, even if you Both the insurance and financial services industry are well ask). aware of this exploitable human foible. That’s why they make Good luck trying to find the information on your own, particu- it so difficult to know just how much you are paying for their larly with insurance products. Most regulation of insurance in- services and advice. vestment vehicles occurs at the state level, so you don’t get I have talked with literally thousands of investors who were the same type of universal disclosure requirements as those told by their financial salespeople that the products they sold regulated by the Securities and Exchange Commission. The were commission free. In those cases when the question was fees and expenses charged are buried in complicated and explicitly asked, “How much am I paying for this investment?” confusing documents (which are many hundreds of pages The typical response is something like, “Don’t worry, you don’t long) that very few people read, and even fewer understand. pay anything, the company pays me.” While the insurance industry is by far the best at hiding fees, This “big lie” is particularly prevalent in the insurance industry. almost every branch of the investment sales industry works Here, most of the investment products are complex combina- diligently to keep you in the dark about commissions, fees, tions of insurance and securities. They are often combined in and other expenses. As mentioned in the previous rule, a way that makes it hard to know where one ends and the “Source Consideration Rule,” the loaded mutual fund industry other begins. was an innovator in the art of concealing commissions.

61 To protect yourself and help ensure that you’re working with sion comes from the extra fees charged within the product. an honest, reputable provider of investment advice, you must Then, you should expect a full explanation of those fees and ask how the person you are about to employ is compensated. their purposes. Expect to be “stonewalled,” as this is a sensitive issue with If your financial person provides a full and truthful response, most financial salespeople. They are aware that any percep- congratulations! You have been lucky enough to find one of tion of their advice being driven by a possible commission the truly honest members of the investment sales business. can be a deal-breaker. However, it’s far more likely that you will instead hear “The Big They might start with a little “misdirection.” Expect a response Lie.” A typical financial salesperson will respond by saying, “A like, “There’s no need to worry about that right now; first we commission? Oh no, you don’t pay a commission. The com- must spend a little time discussing your needs.” When pany pays me.” Those words are your cue to rise from the pressed, they may try to defer sharing the information, “Don’t chair, bid them farewell, and make your exit. worry, you don’t pay me anything, and all of the annual fees are in the prospectus.” “The most dangerous untruths are truths moderately dis- torted” Don’t let them off that easy. You must ask The Big Question: -Georg Christoph Lichtenberg “Do you receive a commission from the investment products you suggest?” A half truth is a whole lie. If you’re dealing with an honest salesperson, they should tell -Yiddish Proverb you, “Yes, I receive a commission from the sale of this product. You can either pay it to me in advance, or it can be taken out Like all valuable commodities, truth is often counterfeited. of the funds' assets on an annual basis through an extra fee.” -James Cardinal Gibbons An insurance salesperson should tell you that their commis-

62 RULE 17

Eggs in a Basket Conundrum Too little diversification can be dangerous. Diversification Saves out from the rest. Not only did Wall Street love it, but Aviation Week named it 1999s “Best Managed Major Airline,” and in Some experts claim that owning twenty, ten, or even five differ- 1998, Air Transport World crowned it “Global Airline of the ent stocks is better than holding a broadly diversified portfo- Year.” lio. An article from Morningstar, over a decade ago touted “Owning a Few Good Stocks” and went on to argue that qual- To further diversify your portfolio, you looked for an industry ity mattered more than quantity. that would profit from the “new economy” but that was in a “defensive” business, should the economy stumble. One of Back in the roaring ‘90s, focused funds like Janus 20 were all the best hedges has traditionally been the energy business. the rage. They concentrated their capital on a few stocks with Doing your research, you discovered a diversified energy firm great potential. Suppose that, back in 1999, you decided to that was growing rapidly and was rated a “buy” or “strong create a focused, yet diversified, portfolio. You didn’t have buy” by Merrill Lynch and many others. enough money for ten or twenty stocks, so you decided to buy three of the best blue-chip stocks available. So, you put your money in these three stocks in three diverse industries and waited patiently for your fortune to grow. You You, wisely, chose to avoid the risky Internet stocks but can see the stocks you bought and the results of your invest- wanted to own a piece of the increasingly valuable telecom- ment in Interactive 17.1. munications infrastructure. You checked the analysts' reports and found a great blue-chip telecom firm that was aggres- Of course, this "portfolio" is an extreme example of the need sively adding bandwidth and capacity and was rated a “buy” for diversification, but it drives home the point. If you aren’t by most of the big Wall Street firms. comfortable with the possibility (even probability) of losing a substantial portion of your nest egg, you must build a diversi- You knew that, with business booming and the economy grow- fied portfolio. ing, people needed to get around. To do that, they needed to fly. So, you checked the trade publications. One airline stood

64 For a host of different reasons, far too many investors have placed their money in far too few investment vehicles. In retire- ment plans at work, a huge percentage of employees own too “Asset allocation is not that different from what mom told much of their own company’s stock. In our personal accounts, us growing up: don't put all your eggs in one basket. we might have a few mutual funds invested in some purport- -David I. Lampe edly “hot” segments of the market, but by and large, the bulk of our equity assets are in the equivalent of the S&P 500. Only a fool takes on the additional risk... by failing to diver- This lack of diversification is one of the biggest reasons why sify properly with his or her nest egg.” so many investors lost money between 2000 and 2009—the in- -William Bernstein famous “lost decade.” Perceived diversification has allowed those who profit from your misery, by selling investment tim- “Low fees, broad diversification, hold hold hold.” ing schemes, to claim that “buy-and-hold” investing is foolish. -Jim Wiandt Even worse than the small loss suffered by the S&P 500 over the lost decade are the potential future destroying losses lurk- “First, get diversified. Come up with a portfolio that covers ing in so many company 401(k) plans. According to Financial a lot of asset classes.” Engines, 20% of the money invested in 401(k)’s is in the stock of the employees’ firm. Should their company go out of busi- -Jack R. Mayer ness, they could lose that portion of their portfolio forever. “Diversify your investments.” Take a look at Interactive 17.2. Even well-diversified portfolios -Jack Templeton will lose money at times and without warning.

65 In 1999, these were three of the hottest stocks on the market, just 10 years later they were all worth- less. Obviously, this is an extreme example designed to make a point.

NOTE: Delta success- fully reorganized, wip- ing out the value of their old stock. The current stock is a new issue.

RULE 18

DIY Dilemma: Some times it pays to hire a professional. Go it Alone? lar listeners who, for years, I had been telling that no one can possibly know when to get out or when to get back in. That For much of the past 30 years, I fervently believed that the was my “aha” moment. vast majority of individual investors were capable of manag- ing their own portfolios, without advice from an investment Certainly, some of my listeners did remain invested and con- advisor. I imagine that this belief was a combination of sin- tinued to add money to their portfolio as the market de- cere faith in the ability of most people to control their des- clined. Anecdotally, I believe most did not. It was naïve of tiny and hope that my listeners could avoid the self-serving me to assume that they could. After all, we are fighting sales pitches masquerading as investment advice. against powerful emotions (see Rule 11 – Fee to Risk/Reward Ratio) that have controlled humans for generations. Of all of As it turned out, ironically, luck played a big part in the fact our emotions, fear is likely the most powerful. It’s hard to that I continued to believe this for as long as I did, as stocks blame someone for irrational behavior when they are fright- rose consistently for the first 13 years of my financial talk ened for their future. show. When the market is rising, we have no problem pa- tiently remaining invested for the “long-term.” It’s only when At that point, I began to research and explore the effect emo- the market declines precipitously and consistently that our tions have on investing, something I had little of before (see commitment to patience wears thin. Rule 12 – Emotional Factor). In the process, I discovered that most of us are terrible investors when left to our own de- By early 2001, I noticed a more panicked tone in the calls I vices. However, those to whom we typically turn for financial received on my radio show. Callers asked questions like, advice very rarely improve the situation. In far too many “Should I sell, and wait for the market to go back up?” Some cases, those who we believe to be investing experts (invest- just called to let me know that they had already moved most ment salespeople) are doing more harm than good. of their money to cash and wanted me to let them know when they should get back into the market. These were regu-

69 Not only do most financial salespeople fail to help you build rive at an annual return number (known as a “dollar- a properly diversified portfolio, but they also take advantage weighted return”) based on real investor behavior. Year after of your emotions to convince you to sell one product and year, their results show that investors make substantially less buy another, generating more income for them. There’s little in their equity portfolios than they would have made by just or no money to be made from ongoing investment counsel- buying and holding an index like the S&P 500. ing and regular rebalancing. Plus, their primary incentive is Dalbar’s research also found that the average equity mutual to make sure that you have money in investment products fund investor was only invested for 4 years out of the past that generate the highest level of continuing income for 20, and only during the best years of bull markets. However, them in extra fees—which, consequently, also detract from for the two decades ending in 2017, the average equity fund your returns. investor behaved far better than they typically have. How Bad Are We? According to Dalbar, for the 20 years Just how bad are we as investors? between 1998 and 2017, equity mutual Pretty bad. Although, we are getting fund investors made an average of better. Every year, the folks at the in- 5.29% per year. Those who owned and vestment research firm, Dalbar, in- remained invested in the S&P 500 vestigate the difference between would have earned almost 7.20% per what actual investors make on their year (less fees of course). No wonder money versus the returns of the mar- so many people feel like they aren’t ket, in their Quantitative Analysis of making much money from their invest- Investor Behavior. Using data on all ments. They aren’t! The average equity purchases and sales of equity mu- fund investor made over 25% less than tual funds over 20 years, they can ar- that which most consider to be “the 70 market” (bear in mind, the S&P 500 is only 500 out of thou- insurance agents have time to create), they have a powerful sands). reason to help you succumb to your desire to do something—anything. In the past, the numbers looked even worse. When “Finan- cial Fysics” was originally written—for the 20 years between If, after years of working with brokers or insurance agents, 1989 and 2008—equity mutual fund investors made an aver- and then trying to build your portfolio and not succeeding, age of 1.87% per year (that’s worse than the average return you may have decided that it’s time to let someone else for a money market fund over the same period) versus guide you. That decision is never arrived at easily. Once 8.35% for the S&P 500 or 78% less. made, it can be even more challenging to put into practice. Finding that good investment advisor is hard to do. These results illustrate the biggest issue faced by investors, emotions (as discussed in Rule 12 – Emotional Factor). What I would suggest that you only deal with an advisor who is re- Dalbar and others have seen is the detrimental effect of our quired to act in your best interests. Be sure that the person propensity to buy and sell when we feel something, rather with whom you deal serves as a fiduciary. Most stockbrokers than investing based on our tolerance of and need for risk and insurance agents do not have a fiduciary responsibility based on a solid plan. to their clients (at least not yet). They do, however, have a fi- duciary duty to their employer. Sources of Advice The other thing that you should look for in an adviser is their While this is obviously an issue faced by do-it-yourself inves- form of payment. As mentioned in Rule 15 – Source Consid- tors, much of the financial industry has a vested interest in en- eration Rule, it’s best to avoid those who are only compen- couraging trading behavior. They are not compensated sated when they sell something or advisors who both re- based on your success, rather only when your money is in ceive a fee from you and a commission from the products motion. This often means that instead of encouraging their they provide (a fee-based advisor). Your best choice is a fee- clients to patiently stick to a plan (something few brokers or 71 only adviser. You’ll find some resources to help you do just (DFA) actually made more money than the returns of the that in the next chapter, Last Words. DFA funds themselves. I know that sounds hard to believe, but take a look at Interactive 18.1. Over ten years, DFA fund The fees charged should not exceed 1% per year plus what- investors made 9% more than did the actual mutual funds ever the internal expenses of any mutual funds or securities. within their portfolios. While there are fee-only advisors who charge up to 3% per year, it’s difficult to imagine any added value worthy of one How can this be true? I asked myself the same question, and third to over one half of your expected annual return. Also, the only possible explanation is the addition of the advisor. be sure that they use securities or funds with low internal op- In the same report, Morningstar stated that it’s likely due to erating expenses. Fees do matter. many factors: “Consider the success Dimensional Fund Advi- sors (DFA) has had in selling its funds through advisors who If the fees are reasonable and the advisor offers personal- undergo training on the merits of passive investing and in ized, diversified, regularly rebalanced portfolio services and portfolio construction theory. Consider that over the past ongoing individual support (a form of individualized finan- decade the dollar-weighted return of all index funds was just cial counseling to help keep you on track toward your goals), 82% of the time-weighted return investors could have gotten an advisor can improve your investment returns. Many years with those funds. Yet, the figures for DFA are much better. In ago, I read a powerful piece that both shocked me and ce- fact, the dollar-weighted returns of DFA funds over the past mented by belief in the potential power of the right invest- ten years are actually higher than their time-weighted re- ment advisor. turns.” Make More With an Advisor? So, from 1999-2009, the average equity mutual fund investor In 2005, a Morningstar study showed that clients of fee-only made just over 3% per year, according to Dalbar. The aver- advisers who use a long-term diversified approach to invest- age no-load index fund investor (a savvier investor) earned ing using funds provided by Dimensional Fund Advisors 7% annually over ten years. Index funds beat them. DFA 72 funds beat the index funds. DFA investors beat DFA funds. It “He who represents himself has a fool for a client.” seems that with the right kind of help, there’s an even better -Abraham Lincoln way to invest than disciplined, do-it-yourself investing. “The do-it-yourself version of pensions is a flop, as many Ameri- Several years later, the premise that a fiduciary, fee-only pro- cans have painfully learned.” fessional advisor can improve returns was strengthened by a -William Greider study done by the premier fund group for do-it-yourself in- vestors, Vanguard. In their paper, “Advisor’s Alpha,” the “When a writer becomes a reader of his or her own work, a lot can go wrong. It's like do-it-yourself dentistry.” authors discovered that through ongoing personalized plan- -William Collins ning and behavioral coaching, an advisor can add up 3% to a client’s returns per year. “Whether it be a matter of personal relations within a marriage or political initiatives within a peace process, there is no sure- This demonstrates that there are indeed some investors who fire do-it-yourself kit.” are capable of understanding themselves and their invest- -Seamus Heaney ment needs. A few even have the time and patience to cre- “An expert is a person who has made all the mistakes that can ate and manage a well-diversified, low-cost portfolio. A small be made in a very narrow field.” number might even have the control over their emotions -Niels Bohr needed to ignore the onslaught of negativity that accompa- nies a market downturn. However, most of us need ongoing “In the beginner's mind there are many possibilities. In the ex- financial help from someone whom we can trust will always pert's mind there are few.” -Shunryu Suzuki look out for our best interests.

“Making good decisions is a crucial skill at every level.” -Peter Drucker

73 The fact that “the dollar-weighted returns of DFA funds over the past 10 years are actually higher than their time-weighted returns” suggests that “advisors who use DFA encourage very smart behavior among their clients, even buying more out-of-favor segments of the market and riding them up, rather than buying at the peak and riding the trend down, which is usually the case with fund investors." -Morningstar - 2006 Last Words

Next Steps: What should you do now? Not So Famous Last Words You will find that, once you do that, there are very few decent options remaining. As you’ve seen, the basics of investing are just that, pretty ba- sic. It’s the bulk of the financial services and information indus- The first thing to go is anything designed to make money try that works diligently to make it seem more complicated quickly. These are not investments; they are nothing more than it is because they need you to need them. Otherwise, than fancy bets. Speculation is a zero-sum game (for every win- their whole over-leveraged, overpriced, and overpaid nirvana ner there are losers). Investing is not. vanishes. Next, you can rule out anything that lacks diversification. You Your money is not their money. Your broker or agent didn't certainly don’t need to worry about individual stocks or mar- earn it and, based on the services provided, rarely do. That’s ket sector mutual funds. because the bulk of their day is devoted to seeking new cli- Avoid high fees at all costs (pun intended). Don’t pay commis- ents rather than servicing existing ones. sions. There’s no equity mutual fund worth much more than There’s no reason why you, as a real investor (not a specula- about 0.60% per year. Bond funds are even easier to manage, tor), needs to worry about the day-to-day fluctuations in the so there’s no justification for a fee higher than 30 basis points securities markets or the daily financial news and commen- (0.30%). The lower the costs, the more you should make. tary. There’s nothing of value to be gained and precious time Speaking of fees, active mutual fund managers cost a lot. Not to lose. in just the actual management fee charged, but there are also Rather than trying to pick the right investment out of an over- transaction costs associated with every purchase and sale whelming universe, with tens of thousands of choices, attack made within a portfolio. The more often a manager buys and the problem from the opposite direction. Eliminate all of sells, the higher the fund's internal expenses will be (and those investments and pseudo-investments that are wrong. these costs are not spelled out in a prospectus). More trading

76 also leads to realized capital gains and a more significant an- From there, all you need to do is determine whether you plan nual tax bill for you. to manage your own portfolio or look to someone else for help. Do you believe that you can accurately assess your future Finally, avoid any investment vehicle you don’t completely un- needs? Do you have a relatively good idea about how much derstand. If someone can't make an understandable explana- risk you can tolerate? Are you able to create a well-diversified tion for an investment in one or two paragraphs, there are portfolio of no-load, low-fee mutual funds? Can you remain dis- probably some negative issues (that even those who created ciplined enough to stay invested in difficult times, and to avoid the product don’t fully understand). Inexplicable complexity rushing into the latest hot product or market? Will you have the has hidden the weakness of products like collateralized debt strength to rebalance in a disciplined fashion? Remember, this obligations, viatical settlements, and even mundane auction means you have to be able to sell a portion of your portfolio rate notes, until they eventually imploded. Could cryptocurren- that’s doing well and place that money into those areas of the cies be the next incomprehensible "investment" product to market that are doing poorly. Can you control your emotions fail miserably? It bears considering. enough to sell high and buy low? Once you’ve gone through this relatively simple process of If you can honestly answer “yes” to all of those questions, then elimination, you will find that there are very few products left. you do have what it takes to manage your own investment A wide array of mutual funds from Vanguard will still be in the portfolio. Those who answered a number of those questions running. A smattering of funds from other groups like Fidelity with “no” would be wise to seek out the services of a profes- or Schwab might be worthy of consideration. You will proba- sional, objective, fee-only investment advisor. bly find that many exchange-traded funds (ETF’s) make it through your screens (although there are still some questions Not too long ago, a qualified, genuinely fee-only advisor was about the stability of their underlying structure) as do all of hard to find. As one who wants to see investors succeed and the mutual funds from my favorite fund group, DFA (Dimen- realize their financial goals, I see the growth in this area as a sional Fund Advisors). 77 source of hope for the investment industry, and more impor- tantly, for you.

Because I believe so firmly in the academic research that un- “When you stop learning you stop earning.” derlies the investing concepts behind the products offered by -Arthur Tugman Dimensional Fund Advisors (DFA), I suggest that you take the process of elimination I indicated earlier one step further and “Most of the time common stocks are subject to irrational choose a fee-only adviser that offers DFA funds. and excessive price fluctuations in both directions as the con- Because of my affiliation with a registered investment advisory sequence of the ingrained tendency of most people to firm that offers DFA funds, you may, understandably, question speculate or gamble... to give way to hope, fear and greed.” my impartiality. Of course, I would be honored if you decided -Benjamin Graham to hire Vestory as your investment advisor. However, I can hon- estly say that I have yet to meet a DFA advisor that I would “The sculptor produces the beautiful statue by chipping hesitate to recommend to you. I have and continue to work away such parts of the marble block as are not needed--it is very closely with many firms that offer DFA funds, and I firmly a process of elimination.” believe that every one of them (so far) can provide you with -Elbert Hubbard high-quality services and an excellent portfolio.

On the next couple of pages, I’ve included some links to addi- “I figure lots of predictions is best. People will forget the tional information and useful tools that can help you become ones I get wrong and marvel over the rest.” a better investor. -Alan Cox

Thanks for reading and be sure to take your final exam in Chapter 20. 78 Your Next Steps to Becoming a Real Investor

There are a ton of great financial education materials available, Now, onto those resources for which there are costs: some a free, some not. Let’s start with my magazine, real investing journal. This is an ac- Among the free resources are some that I have created like or tual printed magazine on investing, period. It’s published four “Better Retirement Guidebook” (you can see the cover on the times a year and a two-year subscription is only $25, but order next page. Id’ like to offer you a free downloadable PDF copy at a subscription using the code FiFy and you’ll get $10 off. retirebetterbook.com. Next, my favorite money and investing book list. These are all My partner Tom and I host a weekly radio show that is available available in the iBooks Store®. as a podcast via Apple Podcasts. I also create a shorter weekly The Smartest Investment Book You’ll Ever Read by Dan Solin podcast called Talking Real Money Quick in which I answer questions called in to 855-935-TALK (8255) 24 hours a day. The Only Guide to a Winning Investment Strategy by Larry Swedroe

A ton of great investing exclusive articles can also be read at Financial Fitness Forever by Paul Merriman realinvestingjournal.com. The Little Book of Common Sense Investing by John C. Bogle

If you have a retirement plan at work, we have a bunch we have Your Money and Your Brain by Jason Zweig analyzed for you at 401411.com. If yours isn’t listed you can sub- Finally, I encourage you to develop a healthy skepticism toward mit it for analysis. everyone in the financial services industry (including me). Ques- We also have a couple of video classes available on YouTube. tion their motives. Question their ideas. Question them. Before you embark on a financial relationship, know what you’re get- Another great, free resource for those who want to delve more ting into by asking them to put everything in writing. I’ve cre- deeply into the science of investing is the Fama/French Forum. ated a handy form for you to download on the next page. 79 Use My Advisor Interview Form Create a Real Plan for Retirement

Before hiring someone as important to my future as a fnancial/investment advisor, I need to know Financial more about you and your business practices. Please understand that, even if we have some kind of Download your free, no-obligation (no sales pitch) PDF copy of Advisor relationship (friend, family member, etc.), hiring an advisor is a decision that can efect the rest of my Preliminary life and cannot be entered into lightly. I would appreciate it if you would carefully and honestly our 60-page, full-color Better Retirement Guidebook at Interview answer these simple questions below, so that I will be better able to understand the extent of our page 1 of 2 business relationship to avoid future misunderstandings or problems. Tank you. retirebetterbook.com

Your name Firm name How long?

Previous frm(s)

Have you been disciplined by a regulatory agency? YES NO (if “YES” explain) Registered with:

Licenses and designations held: Registered as an investment advisor? YES NO ABOUT YOU & YOUR FIRM YOU & ABOUT What do all those letters mean?

Do you provide a written analysis of my current How are you and your frm compensated (check one and elaborate)? situation and future plan? Fee-only Percentage of assets under management YES NO % on the frst $ under management Do you help implement my plan? % from $ to $ YES NO

Do you ofer ongoing fnancial and investment advice, % from $ to $ even for those assets you don’t manage?

YES NO Hourly rate? $ Minimum fee? $ Do you or your frm take custody of my assets? Other fees (explain) YES NO If NO, who will have custody of my assets? Fee-based (fees plus commissions - please provide details)

Do you have discretionary trading authority? ABOUT YOUR PRACTICE ABOUT YES NO Fee-based (commissions ofset fees - please provide details) Other fnancial or investment services ofered:

Commission only (please show commission percentages received) COSTS, FEES, & COMPENSATION STRUCTURE & COMPENSATION FEES, COSTS, Do you pay or receive referral fees from other professionals (explain)? additional notes/comments YES NO Do you receive ongoing fees or “trailers” from products sold or recommended (explain)? YES NO Do you receive any other fees or compensation not mentioned (explain)? YES NO

Download at talkingrealmoney.com, print, and make them sign it. 80 Final Exam

Test Your Learning: If you don’t do well, no one will know. Securities volatility is measured by?

Preface Rule One Rule Two

We learn best by: Inheriting wealth falls under The value of your home is pri- which rule of wealth acquisition? marily determined by?

A. Reading A. Initial building cost A. Luck B. Seeing B. Number of houses on B. Dishonesty the market C. Reading and seeing C. Talent C. An appraisal D. Reading, seeing and D. Work interacting D. Your real estate agent

Check Answer Check Answer Check Answer

82 Rule Three Rule Four Rule Five

Securities volatility is measured Between 1900 and 1950 global Should the entire global econ- by? productivity (GDP) increased by? omy collapse, your best invest- ment is?

A. Alpha waves A. 2 times (doubled) A. Gold B. Standard deviation B. 3 times (tripled B. Government bonds C. Regression C. 4 times (quadrupled) C. Food and guns D. Standard variation D. 5 times (quintupled) D. Diamonds

Check Answer Check Answer Check Answer

83 Rule Six Rule Seven Rule Eight

Adjusted for luck, the majority of If a a friend of a friend who is the The amount you can make on an mutual fund managers? cousin of a company’s CEO investment is proportional to its? gives you a hot inside tip?

A. Beat their benchmarks A. Consider yourself A. Price lucky, buy the stock B. Add alpha B. Earnings B. Buy as the tip came C. Add value from a third party C. Chart D. Underperform bench- C. Tell your friends D. Risk marks D. It’s illegal to trade

Check Answer Check Answer Check Answer

84 Rule Nine Rule Ten Rule Eleven

Which is a complex insurance Most initial public offerings? The best indicator of future re- product? turns is?

A. Make money A. Term Life A. High risk B. Sell out B. Indexed annuity B. High fees C. Fall in price C. Auto insurance C. Popularity D. Are safe D. Homeowners policy D. Low fees

Check Answer Check Answer Check Answer

85 Rule Twelve Rule Thirteen Rule Fourteen

One of the 2 worst investing Which animal blindly follows oth- What was the name of the first emotions is? ers in mass suicide? GE mass market refrigerator?

A. Faith A. Sheep A. Cold Top

B. Fear B. Elephants B. Rocky Top

C. Confidence C. Lemmings C. Round Top

D. Love D. None of these D. Monitor Top

Check Answer Check Answer Check Answer

86 Rule Fifteen Rule Sixteen Rule Seventeen

Mutual fund fees are? How are most brokers and With a portfolio of 5 stocks you agents paid? are?

A. In sales brochure A. Hourly A. Well diversified B. In prospectus B. Salary B. Very safe C. Provided orally C. Commission C. At risk for total loss D. Not allowed to be dis- closed to the public D. Annual fee D. Conservative

Check Answer Check Answer Check Answer

87 How did you do? Rule Eighteen Last Word

16 or more correct - I am impressed. Over the past 20 years the aver- Speculation is also called? You have the basics of investing down age equity mutual fund investors pat and you also paid attention. has? 11 to 15 correct - Close, but this was a really easy test. I even gave you a cou- A. Investing A. Outperformed S&P ple of freebies. You should probably 500 B. Safe hire a good fee-only advisor.

B. Underperformed S&P C. Planning 10 or less correct - Did you really read 500 the book? If you didn’t, try again after D. Gambling you have. It won’t take you very long. C. Matched S&P 500 Otherwise, you definitely should not be managing your own investments.

Check Answer Check Answer

88 Legal Stuff

Disclaimers & Disclosures Here’s all that fun legal stuff. The information presented in this class reflects the views and opinions of the 1994-2017: 40% International Market Equity, 30% International Small Cap author and his firm, Vestory, LLC. It is provided for general education pur- Value, 20% Emerging Markets Value, 10% REIT poses, and should not be construed as an offer to buy or sell investment prod- ucts or securities. Information and data provided are for illustrative purposes Bond Allocations: only. The various hypothetical portfolios shown are not meant to be actual 1970-1996: 30% Short-Term Treasury, 70% Intermediate -Term Treasury portfolio recommendations. 1997-2017: 30% Short-Term Treasury, 50% Intermediate-Term Treasury, 20% TIPS The performance figures in this presentation often use hypothetical results. While we believe that this information provides value, hypothetical data can Stocks: be misleading as it does not represent actual performance and should not be Emerging Markets: Dimensional Emerging Markets Value Index from 1994 interpreted as an indication of actual performance. International Market Equity: MSCI World ex-USA Index 1970-1993; Dimen- sional World ex-US Adjusted Market Index from 1994 All data is based on simulated transactions that were never actually made. As International Small Cap: Dimensional International Small Cap Index 1970- always, past returns do not imply future results. 1980 International Small Cap Value: Dimensional International Small Cap Value In- The portfolio performance data used in this book is from academic simula- dex from 1981 tions created by Dimensional Fund Advisors (DFA) using their Returns 2.0 US Market Equity: Dimensional US Adjusted Market 2 Index from 1970 software. Figures shown (unless noted otherwise) are total returns including US Small Cap Value: Dimensional US Small Cap Value Index from 1970 interest and dividends. Fund expenses were subtracted from the returns, ex- Real Estate Investment Trusts: Dow Jones Select REIT Index 1981-1993, S&P cept in the case of Standard & Poors 500 (S&P 500) data. Global REIT Index from 1994

Portfolios Shown Reflect Annual Rebalancing Bonds: BofA Merrill Lynch 1-Year US Treasury Note Index 1970-1980 US Stock Allocations: Barclays Treasury Bond Index 1-5 Years from 1981 1970-1980: 70% US Market Equity, 30% US Small Cap Value Five-Year US Treasury Notes 1970-1980 1981-2017: 60% US Market Equity, 30% US Small Cap Value, 10% REIT Barclays US Treasury Bond Index Intermediate from 1981 Barclays US TIPS Index from 1997 International Stock Allocations: 1970-1980: 50% International Market Equity, 50% International Small Cap Vestory, LLC is a SEC Registered Investment Advisor. 1981-1993: 60% International Market Equity, 30% International Small Cap Registration does not imply any level of skill or training. Value, 10% REIT You can read Vestory’s Form ADV and Part 2 brochure here.

90 10-year T-Note

An interest bearing bond issued by the US Treasury Department with a maturity of 10- years from the issue date.

Related Glossary Terms Bonds, Interest, Maturity, T-Bill, T-Bond, U.S. Treasury security

Index Find Term Chapter 2 - RULE 2 401(k) plans

An employee retirement plan based on contributions from the employee. Also called a defined contribution plan.

Related Glossary Terms Drag related terms here

Index Find Term Chapter 17 - RULE 17 Active management

A portfolio management approach that aims to outperform a market rate or return, or a specific benchmark, by choosing investments that deviate from the market portfolio or benchmark.

Related Glossary Terms Exchange-traded funds, Expense ratio, Financial advisor, Investments, Mutual fund

Index Find Term Chapter 6 - RULE 6 Advisor

In the financial industry, a generic term for anyone who provides financial advice or sells financial products or securities.

Related Glossary Terms Financial advisor, Investment advisor

Index Find Term Preface - Preface Agrarian

Related to agriculture, farming.

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Index Find Term Chapter 4 - RULE 4 Alpha

The rate of return on an investment in excess of a benchmark or return predicted by a financial model. A higher alpha value implies greater outperformance.

EXAMPLE: XYZ Growth & Income Fund returned 8.1% for the year while the S&P 500 (its benchmark) returned 9.5% during the same period. The alpha of the XYZ product would be -1.4 (or 1.4% less than the benchmark).

Related Glossary Terms Drag related terms here

Index Find Term Chapter 6 - RULE 6 Annuity

Originally a contract between a purchaser and insurance company in which the buyer invests either a lump-sum or regular payments in exchange to a promised income over a period of time (usually a lifetime). Also called a fixed or immediate annuity.

Over time annuities have morphed into investment vehicles using mutual funds (vari- able annuities) or complex alternative investments (indexed annuities) to provide market-like returns.

Related Glossary Terms Surrender charge, Variable annuity

Index Find Term Chapter 15 - RULE 15 Auction rate note

A debt instrument for which the interest rate is regularly reset through a dutch auction. Since 2008, most of these auctions have failed, which effectively killed the market for these securities.

Related Glossary Terms Drag related terms here

Index Find Term Chapter 9 - RULE 9 Chapter 19 - Last Words B Share

A mutual fund class generally offered without an upfront sales commission (load) or with a very small load. Instead, a “B” share imposes an extra annual fee (12b-1 fee) that is used to recover the commission paid to the salesperson. In addition, “B” shares usually charge a declining “contingent deferred sales charge” if shares are sold before several years Have passed. A typical “B” share 12b-1 fee typically ends at some date in the fu- ture.

Related Glossary Terms Drag related terms here

Index Find Term Chapter 15 - RULE 15 Bid/ask spread

The difference between the price that buyers are willing to pay for a security and the price being asked by sellers. This difference is also referred to as either a markup (to the buyer) or a markdown (to the seller).

Related Glossary Terms Drag related terms here

Index Find Term Chapter 1 - RULE 1 Blockchain

A list of records, called blocks, which are linked using cryptographic code and currently are primarily used as the basis for cyber currencies like BitCoin.

Related Glossary Terms Drag related terms here

Index Find Term Chapter 5 - RULE 5 Blue-chip Stock

A Wall Street name for a large company that is considered to be a leader in its field with a stellar reputation and a strong financial footing.

Related Glossary Terms Drag related terms here

Index Find Term Chapter 8 - RULE 8 Bonds

A bond is a debt security, under which the issuer owes the holders a debt and (depend- ing on the terms of the bond) is obliged to pay them interest (the coupon) and to repay the principal at a later date, termed the maturity date. The interest can also be paid through a discount from the face value of the bond at maturity.

Related Glossary Terms 10-year T-Note, Default risk, Subordinated security

Index Find Term Chapter 8 - RULE 8 Chapter 15 - RULE 15 C shares

A mutual fund class generally offered without an upfront sales commission (load) or with a very small load. Instead, a “C” share imposes an extra annual fee (12b-1 fee) that is used to recover the commission paid to the salesperson. Unlike “B” shares, with a declin- ing deferred sales fee and vanishing 12b-1 fee, the added 12b-1 fee on “”C” shares is usually charged for as long as the shares are held

Related Glossary Terms Drag related terms here

Index Find Term Chapter 15 - RULE 15 Canadian Maple Leaf

A gold bullion coin that is issued annually by the Government of Canada in various weights and denominations.

Not to be confused with the flat appendage at the end of maple tree branches or the To- ronto hockey team.

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Index Find Term Chapter 10 - RULE 10 Capital gain

The profit from a sale of a capital asset, such as stock, bond or real estate, where the sale price exceeds the purchase price. The difference between a higher selling price and a lower purchase price.

Related Glossary Terms Investments

Index Find Term Chapter 19 - Last Words Cataclysm

A large scale violent, destructive natural, social or political event.

Related Glossary Terms Drag related terms here

Index Find Term Chapter 5 - RULE 5 Collateralized debt obligation

A structured asset based security that uses debt products, like bonds, as collateral for a variety of of products (called “tranches”) or various maturities and risk profiles.

Related Glossary Terms Subordinated security

Index Find Term Chapter 8 - RULE 8 Chapter 9 - RULE 9 Chapter 9 - RULE 9 Commission

A payment to a salesperson typically based on a percentage of the value of the transac- tion.

Related Glossary Terms No-load fund, Surrender charge

Index Find Term Chapter 15 - RULE 15 Commodity

Typically a product that has a recognizable value to where or by whom it is produced. Commodity examples include: gold, oil, corn, cattle and orange juice.

Related Glossary Terms Hard asset

Index Find Term Chapter 1 - RULE 1 Chapter 2 - RULE 2 Credit default swap

A complex contract that is a lot like an insurance policy against debt default. The buyer of a credit default swap pays the seller a fee in exchange for the seller agreeing to make a certain payment to the buyer should a particular debt security default on its obliga- tions.

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Index Find Term Chapter 9 - RULE 9 Cryptocurrency

A totally digital currency used as a medium of exchange. Cryptocurrencies (like BitCoin) employ strong cryptography to create additional units (“mining”) secure transactions, and verify transfers.

Related Glossary Terms Drag related terms here

Index Find Term Chapter 19 - Last Words Currency

Anything recognized as a medium of exchange between two parties. Examples of cur- rencies are bank notes, coins, stones, shells, and even cocoa beans (Aztecs).

Related Glossary Terms Drag related terms here

Index Find Term Chapter 5 - RULE 5 Day trading

Speculation on the price of various securities by buying and selling financial instruments within the same trading day.

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Index Find Term Chapter 1 - RULE 1 Default risk

The chance that the issuer of a security might no longer be able to meet its obligations to those who hold those securities. Usually involves an inability to make required pay- ments on debt obligations, like bonds.

Related Glossary Terms Bonds, Maturity, T-Bill, T-Bond, U.S. Treasury security

Index Find Term Chapter 8 - RULE 8 Defensive strategy

An attempt to structure investment assets in such a way as to reduce volatility or the chance of loss.

Related Glossary Terms Drag related terms here

Index Find Term Chapter 17 - RULE 17 Deferred sales charge

A fee that mutual fund investors pay when selling “B” shares within a specific period af- ter the purchase of shares. It’s also called a "back-end load."

Related Glossary Terms Drag related terms here

Index Find Term Chapter 15 - RULE 15 Derivative security

A financial product whose value is derived from or determined by the value of some other security. Examples are options and futures contracts.

Related Glossary Terms Drag related terms here

Index Find Term Chapter 9 - RULE 9 Dollar-weighted return

A measure of a mutual funds returns reflecting investor cash inflows and outflows to the product combined with the actual performance of the funds. Also called “investor re- turn.”

Related Glossary Terms Drag related terms here

Index Find Term Chapter 18 - RULE 18 Dow

The “Dow” is the accepted moniker for the Dow Jones Industrial Average, a more than century old measure of the value of a small number (currently 30) large, blue-chip stocks that were chosen by a committee. It is often referred to as “the market,” but is many thou- sands of stocks short of even accurately reflecting the US stock market.

Related Glossary Terms Drag related terms here

Index Find Term Chapter 11 - RULE 11 Efficient markets hypothesis

The efficient markets hypothesis (EMH), developed by Eugene Fama in the 1960s, sim- ply states that security prices reflect all available information and are therefore extremely difficult to beat on a regular basis.

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Index Find Term Chapter 7 - RULE 7 Equity

A ownership interest in an asset. In investing the term refers to the buying and holding of shares of stock on a stock market by individuals and firms in anticipation of income from dividends and capital gains.

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Index Find Term Chapter 8 - RULE 8 Equity-indexed annuities

EIAs (or just indexed annuities) are type of tax-deferred annuity product whose credited interest is loosely linked to an stock index, like the S&P 500. EIAs guarantee a minimum interest rate (between 1% and 3%) if held to the end of the surrender term and promise no loss of principal. It is a contract with an insurance company that features very high (and undisclosed) commissions to those selling them with a high surrender charge if sold early. The returns on EIAs do not come close to the returns of stocks in good mar- kets, but do protect against losses when stock prices fall.

Related Glossary Terms Surrender charge

Index Find Term Chapter 9 - RULE 9 Exchange-traded funds

ETFs are portfolios of various securities much like regular (open-end) mutual funds ex- cept that they trade throughout the day. An open-end fund is only priced for purchase of sale once per day after the markets close.

Related Glossary Terms Active management, Institutional trading

Index Find Term Chapter 19 - Last Words Chapter 19 - Last Words Expense ratio

The cost of operating a security portfolio like a mutual fund or ETF based on a percent- age of the portfolios assets.

Related Glossary Terms Active management

Index Find Term Chapter 11 - RULE 11 FDIC

Federal Deposit Insurance Corporation is a US government agency created in 1933 to protect the depositors to member banking institutions from loss of their assets. Current insurance limits are $250,000 per depositor.

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Index Find Term Chapter 8 - RULE 8 Fee-based Advisor

Someone who provides financial advice for a fee of some sort (usually a percentage of assets under management) who can also receive commission from the sale of financial products.

Related Glossary Terms Fee-only Advisor

Index Find Term Chapter 18 - RULE 18 Fee-only Advisor

Someone who provides financial advice for a fee of some sort (usually a percentage of assets under management) who does not collect any commission or other form of sales compensation.

Related Glossary Terms Fee-based Advisor

Index Find Term Preface - Preface Chapter 12 - RULE 12 Fiduciary

A fiduciary is a person who holds a legal or ethical relationship of trust with one or more other parties. In the financial industry it is a person who is required, by law, to act in your best interests. Currently, only a small percentage of those in the financial services indus- try are ALWAYS required to act as their clients’ fiduciary.

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Index Find Term Chapter 12 - RULE 12 Chapter 18 - RULE 18 Financial advisor

Essentially a totally meaningless term except in the most generic sense of being some- one who provide some kind of financial guidance, even if it’s only selling insurance. Un- like the designation “investment advisor (or adviser) there is no legal definition of “finan- cial advisor.”

Related Glossary Terms Active management, Advisor

Index Find Term Chapter 15 - RULE 15 Gross domestic product

A measure of the market value of all goods and services produced by a geographic en- tity, like a country, in a single year.

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Index Find Term Chapter 4 - RULE 4 Hard asset

A physical item that has value. Examples are gold and other metals, oil, real estate, corn, and many other commodities.

Related Glossary Terms Commodity

Index Find Term Chapter 5 - RULE 5 Hedge

A row of bushes or, in our world, a strategy intended to protect an investment or portfo- lio against loss.

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Index Find Term Chapter 17 - RULE 17 Hypothetical

A demonstration or premise based on possible ideas or situations rather than actual ones.

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Index Find Term Chapter 3 - RULE 3 Chapter 21 - Legal Stuff Initial public offering

The first sale of stock issued by a company to the public

Related Glossary Terms Stock

Index Find Term Chapter 10 - RULE 10 Chapter 10 - RULE 10 Institutional trading

Those who buy and sell securities for accounts they manage for a group or institution like pension funds, mutual funds, insurance companies and exchange-traded funds (ETFs).

Related Glossary Terms Exchange-traded funds, Mutual fund

Index Find Term Chapter 9 - RULE 9 Interest

A payment from a borrower or institution to a lender or depositor of an amount above repayment of the borrowed amount or principal sum at a stated rate.

Related Glossary Terms 10-year T-Note, Subordinated security

Index Find Term Chapter 8 - RULE 8 International Monetary Fund

The International Monetary Fund (IMF) is an organization of 189 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce pov- erty around the world.

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Index Find Term Chapter 4 - RULE 4 Investing

Committing money or capital to an endeavor or security with the expectation of gaining income or profit.

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Index Find Term Preface - Preface Investment advisor

An individual or a firm that is in the business of giving advice about securities to clients.

Related Glossary Terms Advisor, Registered investment advisor

Index Find Term Chapter 19 - Last Words Investments

Something into which money is allocated (or sometimes another resource, such as time) in the expectation of some benefit (such as income or capital gain) in the future.

Related Glossary Terms Active management, Capital gain

Index Find Term Chapter 5 - RULE 5 Chapter 8 - RULE 8 Large cap stock

A publicly traded share of a company with a total market value of over $10 billion.

Related Glossary Terms Small Cap stock

Index Find Term Chapter 8 - RULE 8 Load fund

A mutual fund that pays a commission (or load) to those who sell them.

Related Glossary Terms Mutual fund, No-load fund

Index Find Term Preface - Preface Macroeconomics

A branch of economics dealing with the performance, structure, behavior, and decision- making of the broader economy including regional, national, and global economies.

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Index Find Term Chapter 4 - RULE 4 Management fee

A periodic payment charged to shareholders by an investment fund to cover investment advisory and administrative services.

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Index Find Term Chapter 16 - RULE 16 Market timing

Making buy or sell decisions of financial assets (typically stocks) by attempting to predict future market price movements using various forms of market analysis.

Related Glossary Terms Securities trading, Trader

Index Find Term Preface - Preface Maturity

The time period during which financial instrument pays interest, the end of which typi- cally requires the repayment of the principal or face value..

Related Glossary Terms 10-year T-Note, Default risk

Index Find Term Chapter 8 - RULE 8 MBA

Master’s degree in business administration.

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Index Find Term Chapter 9 - RULE 9 Mortality and Expense

A fee included in certain annuity or insurance products that compensates the insurance company for mortality (death) risks and other risks and expenses.

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Index Find Term Chapter 16 - RULE 16 Mutual fund

A pool of money from multiple investors that is invested in a shared portfolio of securi- ties such as stocks, bonds, and other assets.

Related Glossary Terms Active management, Institutional trading, Load fund, No-load fund, Prospectus

Index Find Term Chapter 11 - RULE 11 Chapter 15 - RULE 15 Naked short straddle

Does not involve actual nudity. Instead, it’s a complex writing uncovered (naked) call op- tions and writing uncovered put options at the same strike price and expiration. Some- thing that no real investor will ever need to consider.

Related Glossary Terms Option contract

Index Find Term Chapter 9 - RULE 9 No-load fund

A mutual fund sold directly to clients without a sales commission (load).

Related Glossary Terms Commission, Load fund, Mutual fund

Index Find Term Chapter 11 - RULE 11 Option contract

An agreement that gives the purchaser of the option the right to buy or sell a particular asset at a later date at an agreed upon price.

Related Glossary Terms Naked short straddle

Index Find Term Chapter 9 - RULE 9 Ponzi scheme

A type of fraud in which someone lures investors with promised high returns by paying earlier investors with funds from newer investors.

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Index Find Term Chapter 1 - RULE 1 Prospectus

A legal disclosure document issued by companies that are offering securities for sale which includes information on strategies, background, fee structure and financials.

Related Glossary Terms Mutual fund

Index Find Term Chapter 16 - RULE 16 Psychic

Someone who claims to have a supernatural ability to foretell the future.

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Index Find Term Chapter 6 - RULE 6 Rebalance

The process of realigning the weightings assets in a portfolio by periodically buying or selling assets to maintain an original desired level of asset allocation.

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Index Find Term Chapter 19 - Last Words Registered investment advisor

A firm that provides investing advice and is registered as such with the Securities and Ex- change Commission or a state's securities agency.

Related Glossary Terms Investment advisor

Index Find Term Preface - Preface Securities

A tradable financial asset.

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Index Find Term Chapter 1 - RULE 1 Chapter 1 - RULE 1 Chapter 3 - RULE 3 Securities and Exchange Commission

The SEC is a U.S. government agency created by Congress to regulate the securities markets and protect investors.

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Index Find Term Chapter 7 - RULE 7 Securities market

A physical or virtual place where securities are traded (bought and sold).

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Index Find Term Chapter 3 - RULE 3 Securities trading

Active short-term buying and selling of securities such as stocks or bonds to try and make money quickly.

Related Glossary Terms Market timing, Trader

Index Find Term Preface - Preface Small Cap stock

A publicly traded share of a company with a total market value of under $10 billion.

Related Glossary Terms Large cap stock

Index Find Term Chapter 8 - RULE 8 Speculation

Gambling.

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Index Find Term Chapter 19 - Last Words Standard & Poors 500

A stock market index that consists of the 500 largest publicly traded US companies by market capitalization.

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Index Find Term Chapter 8 - RULE 8 Standard deviation

A measure used to quantify the variation or dispersion of a set of data points. A low stan- dard deviation indicates that the data points tend to be close to the mean (also called the expected value) of the set, while a high standard deviation indicates that the data points are spread out over a wider range of values. In securities markets a standard de- viation of zero would imply no fluctuation in value. While a high standard deviation num- ber indicates extreme volatility.

Related Glossary Terms Volatility

Index Find Term Chapter 3 - RULE 3 Stock

A security that provides the owner with a portion of ownership in a corporation.

Related Glossary Terms Initial public offering

Index Find Term Chapter 1 - RULE 1 Stockbroker

A regulated person who buys and sells stocks and other securities in return for a fee or commission.

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Index Find Term Chapter 10 - RULE 10 Structured product

A packaged investment vehicle that can consist of a single security, a basket of securi- ties, options, indices, commodities, debt issuance or foreign currencies, and derivatives.

Related Glossary Terms Tranche

Index Find Term Chapter 9 - RULE 9 Subordinated security

A security that ranks below others as to claims on a firm’s assets or earnings. Also known as a junior security.

Related Glossary Terms Bonds, Collateralized debt obligation, Interest

Index Find Term Chapter 9 - RULE 9 Surrender charge

A fee you incur when you sell, cash in, or cancel, certain types of investments, insurance policies, or annuity policies. Typically charged to allow the firm to recover initial costs like commissions paid to sales agents.

Related Glossary Terms Annuity, Commission, Equity-indexed annuities, Variable annuity

Index Find Term Chapter 9 - RULE 9 Chapter 15 - RULE 15 T-Bill

A short-term US Government debt obligation maturing in one year or less.

Related Glossary Terms 10-year T-Note, Default risk, U.S. Treasury security

Index Find Term Chapter 8 - RULE 8 T-Bond

A longer-term US Government debt obligation maturing in 20 years or more.

Related Glossary Terms 10-year T-Note, Default risk, Tranche, U.S. Treasury security

Index Find Term Chapter 8 - RULE 8 Trader

One who is actively buying and selling of securities such as stocks or bonds to try and make money quickly.

Related Glossary Terms Market timing, Securities trading

Index Find Term Chapter 1 - RULE 1 Tranche

A “slice’ or part of a number of related securities offered as part of the same transaction generally used to refer to portions of securities created through structured finance.

Related Glossary Terms Structured product, T-Bond

Index Find Term Chapter 9 - RULE 9 Transaction cost

The cost involved in making any trade when participating in financial markets.

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Index Find Term Chapter 1 - RULE 1 U.S. Treasury security

Debt obligations issued by the United States federal government and considered to be among the safest investments you can make, because all Treasury securities are backed by the "full faith and credit" of the U.S. government.

Related Glossary Terms 10-year T-Note, Default risk, T-Bill, T-Bond

Index Find Term Chapter 8 - RULE 8 Underlining

The placement of a line underneath a word.

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Index Find Term Variable annuity

A contract between you and an insurance company, under which the insurer agrees to make periodic payments to you, beginning either immediately or at some future date. You purchase a variable annuity contract by making either a single purchase payment or a series of purchase payments.

A variable annuity offers a range of investment options. The value of your investment as a variable annuity owner will vary depending on the performance of the investment op- tions you choose. The investment options for a variable annuity are typically mutual funds that invest in stocks, bonds, money market instruments, or some combination of the three.

Related Glossary Terms Annuity, Surrender charge

Index Find Term Chapter 8 - RULE 8 Chapter 9 - RULE 9 Chapter 15 - RULE 15 Viatical settlement

The sale of a policy owner's life insurance policy to a third party for more than its cash surrender value, but less than its net death benefit.

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Index Find Term Chapter 19 - Last Words Volatility

The degree of variation of a trading price series over time as measured by the standard deviation of returns. Historic volatility measures a time series of past market prices.

Related Glossary Terms Standard deviation

Index Find Term Chapter 2 - RULE 2 Chapter 3 - RULE 3 Chapter 3 - RULE 3 Chapter 8 - RULE 8 Wall Street

The name of a street in lower Manhattan used as a collective name for the financial and investment community including stock exchanges and large banks, brokerages, securi- ties and underwriting firms, and even big businesses.

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Index Find Term Chapter 9 - RULE 9