I can do this….can’t I?
Perhaps you have seen those cute little commercials by E-Trade® that feature the baby suggesting “do some research, diversify our portfolio, and take control.” Surely a one-year-old baby wouldn’t lie, and if a baby can do it…then certainly anyone can. Financial expert R. Lane Farmer weighs the pros and cons of relying on professional investment advisors vs. self-administered investment accounts
By R. Lane Farmer
We baby boomers, always supremely confident in our own ability, imagine managing our own investments just might be the answer to all the losses we sustained in 2008; and what’s more important to a baby boomer than retirement? Why not perform a fundamental analysis of that company on the radar—get information about earnings per share (EPS), factor in leverage ratios, apply your knowledge of their respective accounting procedures, coupled with their strategic investment plans and tax strategies. And “poof.” You know where to put your money, supplanting all those money management wizards who did so poorly during the last financial crisis.
Inside the head of an investor.
If the do-it-yourself-method worked so well for installing my hardwood floors, surely investing can be no more difficult. I can read and operate a calculator, so let me at those financial statements. Here I sit with reams of financial data in front of me studying forecasting charts that seem to dictate the stock’s trend, trying desperately to understand why all those Harvard-trained investment gurus with their fancy PhD’s couldn’t figure out what is seemingly so simple. Then I read the analysts’ concerns about corporate returns on capital, the return on equity, weighted cost of capital, unlisted liabilities or off balance sheet transactions, and the impact of mark to market accounting on accounts that are not held to maturity (HTM). What the heck does all that mean? Well, I am not about to be deterred by some nonsensical rhetoric clearly designed to make me feel inferior.
I will just Google “mark to market accounting” to see if it is something I should be concerned with. Oh dear god. If you have to be an accountant to understand that crap then it must not be very important. Now I understand why Bernie Madoff just made things up; he couldn’t understand it either. Now that earnings-per-share-thing should tell me exactly how much I can expect to make. Wow, this is so easy, all the charts just point out exactly what I need to do. At $93 per share, I will need to buy 5,000 shares and hold them for four months and then I can retire. After I become rich I may just sell this idea to someone else. A few simple calculations, cross reference my charts, put the latest revision of the stock investors guide under my desk leg to stop that wobble, and buy 5,000 shares of some company called Enron and in about four months I can retire in style. Now what’s a stock symbol…….?
How many of you are sitting back thinking, this guy is just too stupid to be real?
Perhaps he forgot a few things: whether or not to trade in options, and if he chooses to, does the Black Sholes option trading model work for him? Should he plan on using the Capital Asset Pricing Model (CAPM) in determining the company’s cost of stock offerings or is that even important? Will he use the standard deviation method to determine his risk, and does he understand the covariance principle and the difference between diversification and allocation? Perhaps someone should tell him that the real secret is in the interpretation of all that data and the associated risk models. Moreover, is it dangerous to assume that the plethora of computer generated reports and graphs are without error?
Do the math
Dallas Federal Reserve President Richard Fisher stated in a 2009 Wall Street Journal article that he was very concerned about the practice of “mathematization of risk” whereby institutions build risk models and rely heavily on quant jocks when in the end there can be no substitute for good judgment. This suggests that relying on even the best financial quantitative analysts in the country would prove deleterious to our entire economy. Interestingly enough, the same person said only one year earlier that our current ability to assess risk by using sophisticated financial models allows us to manage risk with previously unknown accuracy. It seems that at least one person in our government learned something from the meltdown.
This begs the question: If the best and brightest stars in American financial institutions could not accurately predict the market’s direction or the future value of the investments they recommended, what chance does the, untrained, investor have?
One thing is for certain, pure analytics is not the answer. The esteemed Federal Reserve Bank Chairman was correct in that the key is good judgment, not good math skills. As someone who has taken statistics courses all the way to the PhD level, I can tell you that even the most sophisticated math skills will not make you successful in picking stocks. These skills are valuable to be sure, however, emotion defies modeling and it is emotion that drives the market. Fear, greed, panic, and irrational exuberance are what make some investors rich and leave others poor.
A few years ago while dining at one of the most exclusive country clubs in America, I listened to a young business major from the local university tell his aging grandmother that she should sell her annuities and invest all that money in Goldman Sachs. He stated quite confidently, “that stock has no place to go but up.” A few months later Goldman Sachs was on the verge of bankruptcy and required a government bailout. Obviously every stock, regardless of how fundamentally sound, has two directions it can go. The young man’s fundamentals were correct but his judgment was lacking.
Does all this mean that there is no way in which investors can be confident in their investments?
It means that stock picking is more of an art form than a skill. If it was merely a skill, we could program computers that would provide us unerring lists of profit opportunities. Hundreds of mathematical models exist that attempt to predict the market’s direction. In 2008, every model that I am familiar with failed. They failed because these models only work when the markets are operating efficiently. My doctoral research suggests that, at best, the markets are only 30% efficient and, at worst barely 5% efficient. Thus it would seem that buying someone’s analytical information will no more make you a successful investor than buying the Art Institutes’ correspondence course on painting will make you the next Picasso.
If after all this you still feel the need to pick your own stocks, seek the advice of an competent investment professional to help you understand the value of the information you have collected and build a risk model that fits your profile and financial situation. Don’t be misled by the creativity of an advertising firm. Investing is not so easy that a baby can do it. In fact, I don’t believe a caveman can do it either.
R. Lane Farmer is the President and founder of Bromley Business Consulting, an MBA graduate of Regis University and currently completing his PhD in Finance.
