Risk Management Strategies for Individual Investors
Location: Honolulu
Author:
Donald R. van Deventer
Date: Monday, May 11, 2009
One of the ironies of the current credit crisis is the bruhaha about
conflicts of interest of the rating agencies--ignoring the fact that nearly
every single financial advisor to individual investors on investment
strategy has a serious conflict of interest. Something's wrong when the only
source of advice for an individual investor is someone on commission for the
sale of financial products. Whether it's Japanese securities firms selling
Australian dollar bonds to Japanese housewives or a Dutch bank selling CDO
tranches to individual investors, commission-based advisors have wreaked a
lot of havoc.
This post is the first of many on investment strategies for individual
investors.
First, three disclosure items should be mentioned. Number one--my firm,
Kamakura Corporation, does not own or trade securities in conflict of
interest with our clients. Kamakura's only investment is a money market fund
with Vanguard. Second, my good friend Nick Wallwork at John Wiley & Co., the
publishing firm, in Singapore told me that no one wants to listen to advice
for individual investors unless CNBC commentator Suze Orman is a co-author.
Nick--I hope you are wrong and that readers who compare my bio on
www.kamakuraco.com with Suze's bio will give me at least 10% of the time
they give to Suze. Finally, as an entrepreneur, it's often hard to follow
some of the rules we suggest below. As John Lennon famously said in a song
from his 1980 album Double Fantasy, "Life is what happens to you while
you're busy making other plans."
Rule 1: If you are not an entrepreneur, never buy the common stock of your
employer or other firms in the same industry as your employer
As employees of Lehman Brothers, Bear Stearns, and Countrywide Financial
learned the hard way, owning the stock of your employer is going "double or
nothing" with the return on your career. Even before you buy the stock of
your employer, your future salary and pension cash flows are highly
dependent on how your employer and your employer's industry perform. If your
employer gets in trouble, your odds of being fired and your odds of not
getting your pension skyrocket. One should never increase the size of the
bet you already have on your employer's well-being. For entrepreneurs, the
same advice applies in theory but it's impossible to follow. An
entrepreneur, by definition, is someone who is willing to bet 199% of his or
her net worth on one stock--that of the firm that they start up. Even in
this case, however, diversifying away from your own company as soon as it is
practical is very important.
Rule 2: Don't believe the assertion that "In the long run stocks outperform
fixed income securities"
This is a common mantra of people who get paid a commission selling common
stock. At a convention in Geneva in December 2004, Nobel Laureate Robert C.
Merton told a joke that goes something like this: "An equity salesmen for a
major Wall Street firm called on a very conservative pension fund manager,
who had invested 100% of the pension fund's assets in fixed income
securities. The equity salesman told him, 'Why don't you shift your
portfolio into common stock? In the long run, you'll have a 99% probability
of having more money because your time horizon is so long.' The pension fund
manager replied, 'Well, if you are right, your firm would find it very
inexpensive to provide me with a portfolio insurance policy that will pay me
the difference if ever an all equity portfolio was worth less than my fixed
income portfolio is worth today. Why don't you price that insurance policy
with your colleagues and call me back? If it's as cheap as your argument
indicates it should be, I am sure your firm will offer me that insurance
policy very cheaply.' " As Merton's audience laughed, he added (of course)
that the salesman never called back, because the risk of equity portfolio
price declines is huge and such an insurance policy would also be very
expensive. Some people just don't believe this, so here's just one example
of how big the risk is. The Nikkei 225 stock index traded at almost 39,000
at the end of 1989. Today, nearly 20 years later, the index is at 9342.
Rule 3: Don't trade securities when it's not necessary. Follow a buy and
hold strategy.
One of my best friends during my years in Los Angeles as a banker was a very
funny guy named Robert T. Sussman. He was also a brilliant and practical
financial guy. He used to tell me, "My family doesn't buy retail." When you
trade securities, you are buying retail. You might be the smartest person in
the world, but you're betting against the house. The head of derivatives for
Bankers Trust once told me "I don't have to have a model for that fancy
derivative--all I have to do is balance the buys and sells, and I keep the
spread." You should not be giving Wall Street both the commission and the
bid-offered spread if you don't have to do it. If you do a million
securities trades, your net worth will be zero when you're done.
Rule 4: Taxes matter. Plan your finances in such a way that you take maximum
advantage of tax subsidies.
One of the richest men in America told me the only ways to make money these
days are "regulatory arbitrage, ratings arbitrage, and tax arbitrage." He's
right. If income on an educational savings account is tax free, find a way
to take advantage of that. If you are an entrepreneur and the tax rate on a
dividend from your firm is less than the tax rate on another dollar of
salary, pay yourself a dividend, not a salary. If an IRA contribution moves
salary to a non-taxable basis, find a way to do it. A tax attorney may well
be the best friend you can have. In the short run, they may appear to be
more expensive than a stock broker, but that won't be true in the long run.
Rule 5: Don't borrow on a charge card. Your first investment should be
paying that balance down.
When I was considering starting Kamakura Corporation, one of my best clients
was Mr. T. at Nippon Shinpan, the big credit card company in Japan.
"Don-san," he said, "if you are going to start a new company, here's what
you should do. While you're still at that securities firm with a good
salary, go out and get a 3 million yen charge card from 30 banks. That way
you'll have 90 million yen (almost $1 million at the time) to finance the
company, and none of the 30 banks will know you have 29 other cards." The
trouble with this advice is that you have to pay the money back. At 29%
interest, there is no investment in the world that will return this much
with the same degree of certainty that your bank expects you to have with
respect to your own payments on the card.
Rule 6: If your employer is in a highly cyclical business, you should own a
lot less common stock than an identical person who has a safe government
job.
The smartest thing I've ever done from a financial point of view was to quit
Lehman Brothers in 1990. The second smartest thing I've done financially
was, during the 3 years I worked for Lehman, to have 100% of my savings in
money market funds. Less than six months after I started at Lehman, the 500
point drop in the Dow Jones average in the crash of October 1987 devastated
Wall Street. My colleagues in New York would call me in Tokyo and cry that
they'd lost a ton on their stock portfolio, they were much more likely to be
fired, and their year end bonus was going to be much smaller than expected
if they survived at the firm that long. For the same kinds of reasons, you
shouldn't have a lot in common stocks if you're in the auto business. You
shouldn't have a lot of common stocks if you're in commercial real estate.
Your employer and the returns on your intellectual property ARE your
investment in the market. You don't need to go double or nothing.
That's all for today--to be continued next week.
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