What You See Is Not What You Get
February 3, 2012
"Reality is merely an illusion, albeit a very persistent one."
Our perceptions are notoriously bad at providing us with accurate information about the world. The atoms we're made of consist mostly of empty space. Although we appear quite solid, we are mostly made of nothing. We see beautiful colors in the objects that surround us. Yet color is not an intrinsic quality of any of these objects. We live on a planet that is spinning rapidly on its axis while orbiting a star that is moving through space at an incredible speed. We are in constant motion, but have no sense of it at all. Our senses fool us every day.
Our senses do not act alone. They have many co-conspirators. In the financial services world, these co-conspirators come in a variety of shapes and sizes. Product sales organizations, service providers, the media and our own government all play a role. Together, these illusionists have David Copperfield and Harry Houdini beat by a mile.
These parties are not involved in an evil plot to deceive us. But financial advisors often seem to overlook the fact that most of the information available to us about investing is provided by sources whose interests are not aligned with ours or our clients'.
Because these sources are highly knowledgeable about their areas of expertise, it is sometimes difficult to assess the validity of the information they provide. I have watched many financial advisors struggle, often unsuccessfully, to sort through the noise.
To help with this problem I am offering ten rules that may help you see behind the illusionist's curtain. These rules are general in nature and many of them will seem obvious. But I have witnessed many investment disasters that could have been avoided if the rules had been followed.
1. Consider the source. Filter the information you receive very carefully. The first step in this process is determining the source of the information. Always ask the question: "Who provided this information and are their interests similar to, or different from, mine?"
Because most of us are honest people, we assume that those we encounter are too. Don't be fooled. Every day, credible individuals render opinions and make recommendations that are driven totally by self-interest. Filter all information through a screen of healthy skepticism.
2. Ask questions. Don't be afraid to ask lots of questions, listen carefully and don't invest in things you don't understand. Because they don't want to appear rude or ignorant, many advisors fail to make sufficient inquiries about potential investments.
Firms that want you to invest in their products owe you an explanation about how they work. If after reasonable inquiry you still don't understand how your money is going to be invested, walk away. There are plenty of other good investment opportunities available to you.
3. Trust your instincts. If something seems too good to be true, it probably is. We read every day about fraudulent schemes that lured investors with promises of high returns coupled with low risk. We laugh at the foolishness of people who thought they could get something for nothing.
Yet our industry is full of firms that promise more than they can deliver-they have simply become expert at doing so within the rules. Behavioral science has demonstrated that we are wired to sense danger. Disregard your internal alarm bells at your peril.
4. Develop a network. No one can sort through all the available information and determine which of it is reliable. Everyone needs help. There are firms in our industry dedicated to providing solid, objective investment information. The difficulty is in identifying them.
Recommendations from a trusted source are the best way to build a reliable information network. But keep your eyes open. Truly objective sources of information stand out because they are so rare. You will probably know it when you find one.
5. Look for red flags. Here are a number of signs that should make you suspicious right away:
Back-tested or hypothetical performance. The use of made-up track records has become commonplace. Anybody can mine historical data and come up with an "investment process" that would have performed well in the past. Recognize back-tested and hypothetical performance information for what it is: pure fantasy.
Market timing. Those who say they can consistently predict short-term market movements are either liars or fools. Jane Bryant Quinn was right: "The hall of fame of market timers is an empty room." Steer clear unless you enjoy playing Russian roulette.
Those who equate a lack of daily pricing with a lack of volatility. Investments that aren't priced daily change in value just like those that are. The changes in value are simply calculated less frequently. It is foolish to believe, and irresponsible to represent, that the value of an investment doesn't change just because it isn't priced daily.
Those who say they can decouple risk and return. Risk and return are like me and my wife-we go everywhere hand in hand. Beware of those who tell you they can decouple them. Markets are pretty efficient. You rarely get overpaid for taking risk.
6. Don't chase past performance. How many times have you seen the warning, "Past performance does not guarantee future returns?" Well, it's true. Although we have become desensitized to this cautionary phrase, good past performance can be the result of either luck or skill and it is the result of luck more than we would like to think.
Dig deep enough to understand how good performance was generated. Is there a process in place that could reasonably be expected to generate good performance in the future? Are there skilled people in place to implement the process? If you don't find both, don't invest.
7. Resist snob appeal. Everyone wants to invest like "the big boys." When someone refers to his or her product as "institutional quality" or invites you to "invest like the ultra-high-net-worth investor," simply ignore that part of the presentation.
Investments should be made based on their merits, not the labels that clever marketers place on them. Sometimes "the big boys" make good investments and sometimes they don't. Don't invest to elevate your status-invest to make money. Then, if status is important to you, use the money to join a country club or buy a Porsche.
8. Why you? We would all like to be in on the ground floor of the next Apple or Google. It is exciting to think about the possibility of the huge gains that a "home run deal" could bring. And many financial advisors, understandably, like the idea of differentiating their practices by bringing their clients investments they can't find on their own or at the local Merrill office.
Tread cautiously when it comes to supposed good deals in the retail or high-net-worth market. Most of the truly interesting private equity investments have been snapped up long before they hit this part of the market. If you find one that looks interesting, ask yourself why this opportunity is being offered to you. You don't want to invest in the leftovers.
9. It's about more than risk and return. When making investments, most advisors give lots of attention to the risk/return equation: "What is the potential return on this investment and how much risk do I have to assume to get it?" Some advisors, however, pay far less attention to the other characteristics of an investment like liquidity and transparency.
There are plenty of good investments that have limited liquidity and transparency, but as an investor you should be paid if your investment is going to be subject to these limitations. These investments also tend to come along with high management fees. Make sure the potential return of the investment justifies the fees and other limitations.
10. Do your homework. Recently, a client asked me about an investment idea he read about in a widely distributed newsletter. I did a little Googling and within about two minutes discovered that the publisher of the newsletter had been brought to justice by the SEC for fraudulent activities a few years ago. The client lost interest in the idea once he learned the truth.
The Internet has given us incredibly powerful tools for doing research quickly and efficiently. Take advantage of its power. Many investment scams are run by repeat offenders. Their past offenses are a matter of public record. Poke around and see what you find. You can save your clients a lot of heartache by doing your homework before you make an investment.
Cutting Through The Smoke
Successful investing is hard enough. Don't let the illusionists make it even more difficult. By observing these ten rules, you can remove a lot of the smoke from the room and make better investment decisions for your clients.
Scott A. MacKillop is president of Frontier Asset Management, a firm that manages portfolios for financial advisors and their clients. He is a 35-year veteran of the financial services industry.