Don't Take Investment Advice

“What do you think about [insert company name here]? I have been watching it for a couple of weeks and it has gone up 40%.”

“I wouldn’t go near it. But that doesn’t mean that it won’t go up.”

I don’t say that.

“Is the company making any money?”

“Did you notice that the number of shares has been increasing by 6% per year?”

No one thinks to look at the number of shares outstanding. When they do, it doesn’t take long to realize that if it goes up the value of each share goes down by about the same amount.

I highlight the points that I think are important, and let people decide for themselves.

A couple of times though, I have crossed the line and made recommendations to people. It would be bad enough if I only did it when asked, but there have been times when I have been so excited about an investment that I brought the subject up.

It is wrong for me to make recommendations because it is always wrong to take recommendations. I mean that. It is always wrong to make investment decisions based on recommendations.

Let’s assume that the guy giving the advice knows what he is talking about. Things change all the time. New information can cause the advisor to change his mind. Is he going to track down everyone he talked to and let them know?

One thing I have seen happen is for a person to buy, see the stock go down and sell, figuring the advice was bad. Then the stock goes back up, and the person buys back in, figuring the advice was right after all. The advisor looks smart, and the advisee can’t figure out why he is “right” and yet his account balance shrinks.

There are lots of reasons to buy a stock. It is a lot harder to know when to sell. When buying the thinking is “The company is going to….” The thought process on selling is more like “What if the share price…”

The short answer to knowing when to sell is that you sell when the reason for owning the stock is no longer valid.

That is hard enough to determine when you know the reason for buying; it is not possible when you don’t have a reason.

Investing is the opposite of Lake Wobegon. Over the long term, most people are below average. It is a peculiarity of Wall Street vocabulary that makes average returns less than the average’s return.

The average’s return, as it is defined on Wall Street is the return earned by a particular basket of stocks without transaction costs or tax bills.

People who hold the average portfolio do slightly worse than the average because they either have to pay the expenses of the person managing it, or pay transaction costs to keep up with the periodic changes to the “average” portfolio if they manage it themselves.

People who do not have one of the model portfolios are attempting to beat the averages. As a group, the return for each investor, on average, is ___________. After filling in the blank, deduct transaction costs.

Some people do outperform the averages. Some even do it over the long term. There are two kinds of people who do. The first are people who succeed from dumb luck. Those choosing to implement the dumb luck strategy should play the lottery; the payouts are higher.

The second group of people who outperform the market over the long term are those who have a winning investment strategy and adhere to it.

If you have a strategy that you expect will substantially outperform the market, have at it. If you don’t, admit it. Until you develop a market beating strategy, the best strategy is to come as close as you can to the market average.

Index funds are a type of investment where the managers try to copy an average, realizing that trying to outperform the market is more likely to increase expenses than returns. For someone who wants to invest, but does not have a strategy for choosing individual investments, index funds are usually going to provide the best returns over time.

That still leaves the investor with important questions to answer, such as “Do I want to invest in stocks at all? How much of my life savings do I want in stocks? Do I want to invest in big companies, small companies or both? Do I want to invest in foreign or domestic markets?” Just about every answer will have an index that tracks it, and a fund that implements it.

One final note of caution: Stock brokers are dangerous. There are those that give sound advice and can provide guidance in making investment decisions, but I don’t know how to identify them based on a soliciting phone call. They are salesmen, not investment advisors.

Stock brokers get paid a commission when their customers make stock transactions. Investment returns go down as the number of transactions goes up. I am not about to say that every broker is trying make money by giving bad advice. I am saying that every broker working on commission has a compensation package that gives him the wrong incentives.