This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Wednesday, April 14, 2010

Cynicism and a Return to Rationality

The question we are exploring this week is why people get caught up in frauds and fads that run so rampant in the world of finance. Is it because investors are greedy for higher returns? Do they get caught up in the glamour or mystique of some of the more exotic scams (e.g. Bernie Madoff)? Do investors believe lies about the safety of investments they are being sold, or do they simply not take the time to learn about the people with whom they are dealing?

While investors certainly can’t be completely protected from frauds, there are undoubtedly warning signs that should set off alarms in investors’ heads. Investors need to remember that old saying: “If it’s too good to be true, it probably is.” Be very wary of anything with a guarantee, either explicit or implied.

[Considerable time was given to the subject of honest business dealings in this week’s Dollars & Cents article for the Toledo Free Press Star. It can be found on the Free Press website (www.ToledoFreePress.com) under the title “Dishonest Dealings.”]

The question investors need to ask themselves when speaking with an advisor is whether they are being fed a sales pitch/gimmick, or if they are getting truthful responses and honest advice from someone who wants to help them, not sell them. The fact is that markets go up and they go down, there is no denying it. Anyone who tries to tell you otherwise is not being forthcoming.

One common method of selling employed by investment advisors is to make clients feel special. Advisors spend considerable time with prospective clients conducting an analysis of a clients’ risk tolerance, which is used to build a diversified portfolio of stocks, specific to individual client circumstances.

The sad fact, my friends, and one of the best kept secrets among advisors, is that the market simply does not care about you. The world’s financial markets, I’m sorry to say, don’t care how many kids you have, or how great your annual tax liability is, or whether you are nearing retirement.

In the early 2000s, the big brokerage houses were among the most progressive thinkers with regard to diversification and modern portfolio theory. Looking at an updated roll-call, we can see that half of these guru-firms no longer exist, either because of insolvency, or because they were forced to sell themselves to another firm in the wake of financial difficulties that resulted from the crisis in’08.

Investments do not care about investors, but about economic circumstances. That fact seems so basic, yet it is more of an afterthought for many investors (and advisors) rather than the basic principle that it should be in portfolio construction. Consider the following questions:

• Why did people ignore the fact that tech stocks were so obviously over-priced in the late 1990s?
• In the early 2000s, how did investors ever come to believe that real state values consistently rise year-over-year, without fail?
• Generally speaking, why do people insist on holding onto popular fads until they crash, and it’s too late?

Maybe paper profits make investors greedy, or perhaps it’s just too difficult for most investors to avoid the terrible effects of groupthink. In many cases, investors seem not to have even considered as possibilities the facts that ultimately led to their downfall.

In the case of Bernie Madoff, many investors trusted him unequivocally, simply because he was the former head of the NASDAQ. His resume, most thought, spoke for itself, and the implicit trust investors had in him discouraged many from doing their due diligence on his system, much less protecting themselves against the possibility that he was running a Ponzi scheme. Likewise, very few people before 2008 recognized how much excess leverage was in the world’s financial system, so hardly anyone had prepared themselves for the terrible crash it caused.

Unfortunately, this phenomenon is just as applicable outside the financial world. Consider 9/11: Before September of 2001 there hadn’t been a notable hijacking of a commercial flight in this country in over twenty years. The risk of such an event occurring was so far from anyone’s mind, that people simply were not prepared.

Along the same line, how many people died in this country as a result of the following so-called ‘epidemics’: SARS, bird flu, pig flu, mad cow disease. All of these ailments were thought to be, in their times, the biggest threats to American people. Yet, based on some brief research, it’s easy to see car accidents killed more people in this country during 2009 than all of these diseases combined, and by no small margin.

In all of the cases outlined here, there is hardly an example where someone predicted a coming-disaster and was still crippled by it. The lesson to be learned is startlingly simple, and, I must apologize, rather graphic: People rarely get hit by the truck they see coming. In other words, it’s what we don’t know, or never considered, that hurts us much more frequently than those risks that we consider, and cause us so much worry.

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