Archives for November 2008

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Mr. Market: A Lesson from Ben Graham

A few years back, I read Benjamin Graham’s The Intelligent Investor. Ben Graham, if you don’t know, is the man who taught Warren Buffett how to invest. This of course tells us two things about the book:

  • It’s rather old. (Graham himself passed away over 3 decades ago: 1976.)
  • It’s absolutely fantastic.

The book is rather long–my copy is just under 600 pages–so I wouldn’t necessarily expect that many people to go out, pick it up, and read it cover to cover (though it’s worth your time if you’re sufficiently ambitious/patient!). However, after reading Trent’s recent reviews of The Intelligent Investor, I was inspired to share one of my favorite messages from the book: Mr. Market

Who is Mr. Market?

Mr. Market is the name of an allegorical character Graham uses to make a point. The story goes something like this:

Imagine that you own a small share in a private business, which you purchased for $1,000. One of the other owners of the business, named Mr. Market, approaches you to tell you what he thinks your share of the business is worth. And everyday, he offers to either buy your share of the business for that price, or, to sell you an additional share of the business for that price.

Each day, however, he quotes you a different price from the day before. Sometimes the price he quotes sounds about fair. Sometimes it’s high. Sometimes it’s low.

Graham explains:

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him.  You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

Of course, the point Graham is making is that fluctuations in the market value for a given security don’t really affect the fundamental value of that security. If you own a share of a company, the real value of that share is a function of the company’s overall profitability, not a function of whatever price the market happens to be quoting on any given day.

As such, we can happily stay Oblivious to the current market prices of our shares. (The only exception occurs when we need to sell our shares in the near future, in which case the market value becomes of essential importance.)

What if you own mutual funds/index funds?

Naturally, it’s a practical impossibility to stay up to date on the fundamentals of each of the companies in your portfolio of diversified funds. (And even if it were possible, it would ruin the point of owning mutual funds anyway.)

The good news is that the same thing holds true for funds. For example, let’s say that your investment time frame is 30 years, and that you own an index fund that tracks the Wilshire 5000 index (an index designed to track the return of the U.S. economy as a whole).

For you, the real value of your fund is a function of the overall profitability of the U.S. economy over the next 30 years (your investment time frame). At the moment–as a result of all the recent financial/economic turmoil–Mr. Market’s offer for your fund is only 65% of what it was at the beginning of this year. But you tell me: Does that make sense? Do we really have reason to believe that, over the next 30 years, our economy is only going to earn 65% of what we would have estimated at the beginning of the year?

I suspect that Mr. Market is letting his fear get the better of him. Let’s not let Mr. Market get the better of us.

Are You an Oblivious Investor?

I’ve been thinking recently that it would be worthwhile to make our definition of an Oblivious Investor a little more concrete. We’ve already discussed the main elements. So let’s take a step back and see how it all fits together into an investment philosophy as a whole.

Oblivious Investors have a solid understanding of what risk really is (and what it isn’t).

Oblivious Investors don’t listen to other people’s definition of risk. They don’t think of risk as the probability of a decrease in portfolio value. They think of risk as the probability that they won’t have the money they need in order to do the things in life they want to do.

Oblivious Investors know that something can be volatile without being risky.

Oblivious Investors have an unshakable belief in the power of stocks

…and in their long-term superiority over debt investments. They understand that it’s fundamentally better to own than to loan.

Oblivious Investor know that the real threat to investment success isn’t volatility. The real threat is inflation. And debt investments just don’t stand up to the power of inflation.

Oblivious Investors know that they may very well have multiple decades of retirement, so they don’t make the mistake of assuming that they need to move everything into bonds and CDs when they retire.

Oblivious Investors know that investing is actually quite simple.

Oblivious Investors understand that much of the public’s confusion about investing is simply the result of businesses trying to sell us products. When we ignore the ads, it becomes easier to see what’s truly important.

Oblivious Investors are aware that the financial media has a vested interest in:

  • making things out to be more complicated than they really are.
  • making the day-to-day news appear to be of more significance than it really is.

Oblivious Investors know that their long-term investing habits will have a greater impact on their results than which mutual fund(s) they happen to invest in. Some Oblivious Investors use index funds. Some use managed funds. Some use financial advisors. Some don’t. But all Oblivious Investors follow the same two-step strategy:

  1. Dollar-cost-averaging into stock-based mutual funds.
  2. Ignoring everything else.

Are you an Oblivious Investor?

I’m very interested to hear from all of you.

  • What parts of this are second nature to you?
  • What parts do you think are completely crazy?
  • What parts do you agree with in principle, but find difficult to put into action?

10 Things to Ignore When It Comes to Investing

Things to ignore when investing include (but are not limited to) the following:

  1. Market ups.
  2. Market downs.
  3. Stock tips from your investment-guru-wannabe neighbor.
  4. Stock tips from real experts on TV.
  5. Investment fads.
  6. Formulas involving Greek letters.
  7. Investment firms attempting to show you why their funds are likely to outperform the market.
  8. People telling you that either a) You need a financial advisor, or b) Financial advisors are a waste of money, regardless of your situation.
  9. The idea that owning gold (which at its most fundamental level earns no money, and in fact costs money to store) is the best long-term road to wealth.
  10. Anyone suggesting that you invest in something that you don’t understand.

Which Mutual Fund Should I Invest In? (It Doesn’t Matter as Much as You Think.)

During my time as a Financial Advisor, I slowly came to realize that which funds people invested in wasn’t really the biggest factor in determining their investment results. What mattered far more was how they invested.

During that time, I met several people who had been successful in building their fortunes via investing. Most of them had done it using mutual funds. Sometimes the funds they had used were run by the big companies that you’ve heard of. Many times they were not. Some of the funds had outperformed the market. Most had not. It often seemed like it didn’t even matter.

These people had all used different mutual funds, but they had all succeeded in building wealth.

At the same time, I met countless people who had invested in very high quality funds but had failed to accumulate any substantial wealth. Some of these people had in fact invested in the very same funds that the successful investors had used.

What was the difference?

The difference was in the way they invested. The story was the same with almost every successful investor I met: They had built their wealth slowly but steadily by dollar-cost-averaging into stock-based mutual funds.

The unsuccessful investors, however, had a multitude of different stories:

  • Some had attempted to time the market, but failed in doing so.
  • Some had decided (apparently incorrectly) that they could beat the market by picking stocks on their own.
  • Some simply hadn’t invested enough money. They either waited too long to start investing, or they stopped investing too early, underestimating the savings they’d need for retirement.
  • Some had jumped around from fund to fund every year, always buying the ones that had done well last year.
  • Some had panicked after a market dip, cashing out their portfolios at a market low point, and not getting back into the market until they had already missed the market’s recovery.

What I took away from all this was that unsuccessful investors aren’t unsuccessful because they choose bad mutual funds. They’re unsuccessful because they do something wrong after choosing which funds to invest in.

In other words, success isn’t determined by the fund. It’s determined by the investor. This is a good thing, by the way. It means that all you have to do is choose a handful of good mutual funds. (Yes, “good” will do just fine. Looking for “perfect” is a waste of time.) Then spend the next several decades regularly putting money into them and refraining from doing something stupid. 🙂

The Financial Media is Lying to You

A few examples from this week:

  • “Dow sheds 486 points” <– lie
  • “Blackstone posts loss, shares slide” <— lie
  • “S&P 500 Estimates slashed after third-quarter misses” <— lie

Are the facts wrong? No, of course not. CNN, The Guardian, and Bloomberg wouldn’t have published the articles unless the facts had been checked.

Then why are those statements lies?

Yesterday I wrote about the hidden (and often misleading) messages that we’re bombarded with via advertisements in the financial industry. The same thing goes on in the financial media itself. It’s not exclusive to the ads.

In each of those cases above, the lie is the unspoken statement that accompanies the headline: “…And this is relevant to you as an investor.”

They can’t actually put it in writing. If they did, it would be easy to question it. After all, how many people own (or were thinking about buying) shares of Blackstone? And how many of us long-term investors really care what the Dow did on any one given day? Instead, they publish articles with the knowledge that we’ll see them and assume that they’re important. They wouldn’t be in the newspaper if they weren’t important, right? 😉

And you can’t really blame them. If the media published only the truly important information, it would get rather repetitive. For example, imagine what the financial portion of the evening news would look like if it was always framed in terms of how relevant it really is to the average investor. I’m guessing it would go something like this:

“Market is up [or down] today. But that probably doesn’t matter to anybody’s long-term plans. Most of us are, after all, looking at a multiple-decade time frame. Let’s all just remember to spend less than we earn, diversify our investments, refrain from panicking when the market is down, and take advantage of our employers’ 401k match programs.”

That would sum up just about everything that’s truly important about investing, wouldn’t it? But after a few nights of the same thing over and over, everybody would stop watching.

Instead, we get sensationalized headlines and a nation full (nationful?) of people convinced of the importance of today’s financial news. Personally, I do my best to stay Oblivious to stock market news. I’d suggest you try and do the same. 🙂

It’s a bit disheartening to know that we can’t really rely on the media to teach us the truth about investing. Some of us (myself included) are lucky enough to have parents who taught us about money when we were young. Sadly, not everybody is so fortunate. If only our education system actually taught kids about personal finance…

Simplifying Investing: Ignore the Ads

We’ve all seen ads with promotions such as these ones:

  • $4 stock trades
  • 7 mutual funds that have beaten the market for the last 5 years in a row
  • A free consultation with a financial advisor

It’s obvious that in each case somebody is trying to sell you something. After all, they’re advertisements. What’s not so obvious though is that they’re not just selling you their products/services. They’re also selling you on the philosophy behind those products.

The Hidden Messages

For example, any company that’s trying to sell you on $4 (or $7, or $20) stock trades needs to first sell you on the idea that the price per transaction is a relevant piece of information when choosing an investment firm. Hidden message: Smart investors do their own investing. And they make lots of trades. So saving $5/trade will really add up.

Alternatively, when a company tries to get you make a phone call to schedule an appointment with a financial advisor, the goal is clearly to sell you some investment or investment services. Hidden message: This is too complicated to do on your own. You need help choosing investments and creating an investment strategy.

Why it’s so sneaky:

When we read an advertisement, it’s always with a healthy dose of skepticism. We know that when the local supermarket offers “unbeatable values,” their prices aren’t literally unbeatable. That’s just how ads work. We’re used to it.

The problem with financial industry ads is that their hidden messages sometimes sneak in under our “advertising radar.” When a company advertises $7 stock trades, it doesn’t trigger our natural advertising skepticism. After all, they couldn’t get away with advertising $7 trades if they really charged more, could they?

As a result, the hidden messages sneak in unnoticed and unquestioned. Without even realizing it, we’ve internalized two ideas of questionable validity:

  • Smart investors don’t use mutual funds. They pick their own stocks. And…
  • Smart investors make frequent trades, buying and selling stocks very regularly.

Alternatively, when we see commercials from investment firms offering free consultations with their financial advisors, it’s easy to unthinkingly accept their hidden message: Investing is complicated, and you can’t (or at least shouldn’t) try it on your own.

Sorting out the mess…

It’s no surprise that the general public is confused. They’re attempting to reconcile conflicting ideas (perhaps without even realizing that they are conflicting). If person has watched enough TV, they “know” two things as fact:

  • It’s possible to make a fortune by investing on your own, buying and selling stocks all day, and
  • Investing is too complicated to be done without a professional advisor…

So what does this person really know? They know that investing and personal finance are confusing and convoluted.

So what should we do about it? What can a person do to try and sort out this mess of conflicting messages?

First option: We can realize that ads sell more than products. They sell philosophies as well. And we can make a better effort to think critically about what an advertisement is really telling/selling us before accepting it as truth.

Second option: (See title of this post.) <— This one is my preferred solution. 🙂

What about you? What do investment industry ads make you think? Which ones are your “favorites” ?

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