When they know what I do for a living, some people seem surprised when I say that the stock market is usually a losing proposition for those getting involved as buyers of stocks and mutual funds. A recent article by book author Michael Lewis supports my contention in ways that may also surprise people, though I donâ€™t know why.
In the article, Lewis tells the story of Blaine Lourd, a former stockbroker formerly employed by some of the largest and most well-known financial firms on Wall Street. Lourd, however, claims to have found â€œreligionâ€ and no longer works as a stockbroker.
His career on Wall Street began in 1987 when he went to work in the broker training program at Shearson Lehman. If you have never been through a training program like this, you can try to imagine what new brokers learn in these sessions.
You might assume that a new broker would learn to evaluate the financial condition and future prospects of publicly traded stocks. And you might think they would undergo an exhaustive regimen on building and managing stock and bond portfolios for clients.
What might surprise you, according to Lourd, is that the training focused mainly on overcoming customersâ€™ objections to purchasing any stocks currently promoted by the brokers. Emphasis also centered, he recalled, on â€˜â€™ a close reading of the bible on how to peddle stocks to people youâ€™ve never met: Successful Telephone Selling in the 80s.â€
The gist of that book is: â€˜â€™ A well-planned presentation creates a sense of urgency. If the prospect fails to act now, he will risk a loss of some sort. Speak with confidence and authority. The most important part of the presentation is to close.â€™â€™
Lourd saw opportunity in this and determined to succeed, so he set a goal to reach 100 people/day by telephone. He found that for every 300 phone calls he made, on average, he would make one sale.
Paid on commission, Lourd was driven by fear of failure. â€˜â€™ â€˜There were a lot better salesmen than meâ€™ he says. â€˜ I just worked harder. I made more calls. And if you make more calls, you will get the sales. And it doesnâ€™t matter what you say.â€™ â€™â€™
â€œMost of the time, he just read from the same script as the other brokers: â€˜Are you familiar with Warren Buffett? We have information from our sources on the Street that his next position is going to be in a company much like Cadbury Schweppes. I know youâ€™re busy, but like to call you once or twice in the next six months when we have a substantial idea that will make you three to 10 times your money.â€™ â€™â€™
â€œWhen Blaine would call back 10 days later, it almost didnâ€™t matter what he said, as long as he demanded an order and then fell completely silent.â€™â€™
Whichever stock Lourd promoted on any given day, he would frequently mention Buffett and how the prospect had the opportunity to take advantage of information that was not widely known among the investing public.
After seven months at Lehman, Lourd became one of the â€œtop rookie producers. But every stock I bought went down,â€™â€™ he noticed. What he did not know at the time was what actually caused his dismal record for picking winning stocks.
According to the article, Lourd later learned that â€˜â€™The traders in New York would accumulate a block of shares, driving the price up, and then get brokers like Blaine to unload the shares quickly at the higher price — whereupon the price would, often as not, fall.â€™â€™
Then comes the best part of the story: â€˜â€™ His ability to be wrong about the direction of an individual stock was uncanny, even to him. At first, he didnâ€™t understand why his customers didnâ€™t fire him, but soon he came to take their inertia for granted. â€™It was amazing, the gullibility of the investor,â€™ he says.â€™â€™
â€˜â€™It wasnâ€™t exactly the career heâ€™d hoped for. Once, he confessed to his boss his misgivings about the performance of his customersâ€™ portfolios. His boss told him point blank, â€˜Blaine, youâ€™re confused about your job.â€™ A fellow broker added, â€™Your job is to turn your clientâ€™s net worth into your own.â€™ â€
One day Lourd met a girl who was a friend of the business manager for the Rolling Stones. Eventually, the business manager gave Lourd $13 million of the groupâ€™s money to invest in the markets. He then realized that, while he knew how to sell stocks to strangers, he was less skilled at actually managing and preserving clientsâ€™ money. For clients, the markets were a place of high risks and low rewards.
So Lourd decided to invest the money safely in Treasury bills. â€˜â€™Right away, Iâ€™m in conflict with the firm. My colleagues gathered around this money and asked me, â€˜How are you going to gross this thing up?â€™ Meaning how would they be able to maximize their commissions.â€
He was told flat-out that leaving the money safely invested would generate little in the way of commissions for his firm. At that point, he decided to leave Lehman and join another broker, Bear Stearns.
To his dismay, he found little difference at the new firm. â€˜â€™ â€˜It was the same everywhere,â€™ he says. â€˜It was all about getting people to transact.â€™ â€™â€™
After Bear Stearns, he went on to Dean Witter, which later became Morgan Stanley. While his income grew and he lived very well, â€˜â€™he was quickly becoming the worldâ€™s unhappiest man.â€™â€™
Then Lourd read a book on investing recommended by an older broker: Charles Ellisâ€™ Winning the Loserâ€™s Game. On the first page, Ellis says, â€˜â€™ Investment management, as traditionally practiced, is based on a single basic belief: Professional investment managers can beat the market. That premise appears to be false.â€™â€™
Lourd was also becoming aware of the â€œEfficient Market Theory,â€ which argues that beating the market is futile for all but a very few like Warren Buffett. And, as Buffett himself warns, once you factor in the costs involved with using a financial professional, or â€œhelper,â€ an investorâ€™s chances of beating the market are reduced to almost zero over the long term.
Lourd now exclusively invests his clientsâ€™ money with the mutual fund firm Dimensional Fund Advisors (DFA). This company invests strictly in a basket of index funds, using asset allocation and Modern Portfolio Theory.
Buffett also believes that index funds truly are a better way to go for the vast majority of investors. Their low costs and relative inactivity are features to be admired.
The DFA management team includes some of the most accomplished academics associated with the field of investing. But when they say that beating the market is virtually impossible, they completely ignore the career accomplishments of people like Warren Buffett, Peter Lynch, Ken Heebner and others who have done just that.
DFA also dooms investors to long periods of losses by allocating large amounts of their portfolios to the domestic stock market. Given that the S&P 500 is lower today than it was at the beginning of the decade means that core holdings in a DFA portfolio have lost money in absolute terms and even more in real terms after factoring in inflation.
Regular readers of this column know that I am no fan of either Modern Portfolio Theory or asset allocation, and neither is Buffett. He has said several times that if the markets were truly efficient, he would be selling pencils on the street corner, since the profits he has generated over his long career would never have been possible.
Think of the investor in Japan, who, if using asset allocation methods, has kept the bulk of his portfolio invested in the Nikkei over the past 20 years. That investor has become steadily and significantly poorer over the past two decades.
One day, Lourd will realize that what he now believes to be DFAâ€™s superior portfolio management is nothing more than just another way to sell stocks and mutual funds. One look at the performance of its 25 largest funds shows losses so far this year, just as we are seeing with the major market averages. That major market averages have been down throughout the current decade should mean that their portfolios have done nothing special for returns.
For most investors, indexing is often a better way to go. But keeping large allocations invested in a market enduring a secular bear market means that Lourd will be living with disappointing returns for quite some time. He will no doubt perform better with DFA than he was doing with the large brokers. And at least now, he has an impressive list of academics to back him.
During secular bear markets, investors need to think creatively. They should be willing to do what the academics say investors should not do: find the best looking secular bull market, load up, and ride it out for the duration.
As I have repeated in this column consistently over the past few years, international and emerging markets stocks and bonds, energy and gold should be your largest allocations. And since there now is no question that we are in a domestic secular bear market, smaller allocations into bear funds that work inversely to market indexes should round out your portfolio nicely.
My advice will strike the academics and investment specialists at DFA as ridiculous. To them, there is no place in an investorâ€™s portfolio for bear funds, and loading up on the sectors I like the best smacks of market timing, a foolâ€™s errand at best.
Let them have it their way, but I find my way working far better. And, after all, if they are right, then Warren Buffett has been wrong for the past 50 years!
Have a great week. Bob
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., firstname.lastname@example.org.