Stock Investing Strategy For Idiots
The well-known British economist John Maynard Keynes once said, “In the long run we are all dead.” What he meant by this was that it’s foolish to assume the economy will always balance out.
This is why, for better or for worse, the Federal Reserve is always tinkering with financial policy. The Fed believes they have to intervene to create growth in the economy.
Oddly, the financial-industrial complex does not think this way when it comes to your finances. Instead, they preach the mantra to “invest in a diversified portfolio of stocks, bonds, and mutual funds for the long term.” By this they mean let me manage your money by buying paper assets that you never sell in the hopes that the markets always go up…for a fee, of course.
This diversified investment portfolio myth goes something like this: if you spread your investments over stocks, bonds, and mutual funds and do not touch it but let it grow for years and years, you will have enough money to retire. This comes from the unshakeable belief that over time markets rise like magic.
If there is anything to be learned from the history of the financial markets, both long ago with the Great Depression, the Great Recession, and this entire last year, it’s that nothing is guaranteed (except death and taxes). And that includes all the long-term investments that your financial planner will encourage you to buy, such as mutual funds, stocks, and bonds.
Many people who were counting on the consistent, long-term growth of these markets had a horrible realization that short-term market effects can devastate you financially if you’re not prepared to act. Many people who were ready to retire during the Great Recession were instead financially ruined after years of buying into the advice to build a diversified investment portfolio for the long term.
It’s worth noting that financial planners didn’t exist until about forty years ago when people were forced to take control of their own retirement funds through vehicles like the 401(k).
Someone who invests using a financial planner might say, “My financial planner helped me plan wisely. We invested in lots of different things so that if one company’s stock or one mutual fund takes a hit, there are others that will go up.” But this is one of those scams that only make sense on paper.
The Diversification Myth
When most financial advisors recommend diversification, they are not really diversifying. There are two reasons why the diversification they recommend is not diversification.
The first reason is that financial advisors invest in only one category of asset: paper assets. As the market crash of August 9 and 10, 2007 revealed, diversification did not protect paper asset values.
The second reason is that a mutual fund is already a diversified investment. It is a hodgepodge of good and bad stocks. When a person buys several mutual funds, it is like taking several multivitamins. When a person takes multiple multivitamins, the only thing that goes up in value is the person’s urine.
Professional investors don’t diversify. As Warren Buffett says, “Diversification is a protection against ignorance. Diversification is not required if a person knows what they are doing.”
My rich dad would say, “Whose ignorance are you protecting yourself against, your ignorance, your advisor’s ignorance, or your combined ignorance?”
Instead of diversifying, professional investors do two things…
One is to focus only on great investments. This saves money and increases returns.
The second is to hedge. Hedging is another term for insurance.
For example, my 300-unit apartment house is required by the bank to have all sorts of insurance. If the property burns down, insurance pays my mortgage and rebuilds the building. Best of all, the cost of the insurance is paid out of the rental income itself.
Two of the main reasons I do not like mutual funds is that banks do not lend money on them and insurance companies will not sell me insurance against catastrophic loss if the market crashes—and all markets crash.
Why Do Experts Recommend Diversification?
As Warren Buffett says, “Diversification is a protection against ignorance. [It] makes very little sense for those who know what they are doing.” Buffett also said about money managers, “Full-time professionals in other fields, let’s say dentists, bring a lot to the layman. But in aggregate, people get nothing for their money from professional money managers.”
I believe that when many recommend diversification, it is simply a protection against their ignorance. I suspect Buffett is saying that it’s below-average financial advice from below-average advisors for below-average investors.
Warren Buffett has a different financial strategy. He doesn’t diversify. He focuses.
Focus is the Best Strategy
Warren Buffett looks for a great business at a great price. He doesn’t buy a lot of businesses and prays one of them does well. He doesn’t want average returns, or to play the stock market. He likes to control the company, but not run the company. When Buffett talks about investing, his keywords are intrinsic value, not diversification.
One reason financial advisors recommend diversification is that they cannot find great companies. They do not have control, and most don’t know how to run a business. They are employees, not entrepreneurs like Warren Buffett.
Focus, not diversification, is the key to more sophisticated leverage, higher returns, and lower risk. Focus requires more financial intelligence. Financial intelligence begins with knowing what you are investing for. In the world of money, there are two things investors invest for: capital gains and cash flow.
#1 Capital gains. Another reason so many people think investing is risky is that they invest for capital gains.
In most cases, investing for capital gains is gambling or speculation. When a person says, “I’m buying this stock, mutual fund, or piece of real estate,” he or she is investing for capital gains, an increase in the price of the asset.
For example, if I had purchased the $17 million apartment house hoping I could sell it for $25 million, then I would be investing for capital gains. As many of you know, investing for capital gains means a tax increase in some countries.
#2 Cash flow. Investing for cash flow is a lot less risky. Investing for cash flow is investing for income.
If I put savings in the bank and receive 5 percent in interest, I am investing for cash flow. While interest is low-risk, the problem with savings is the return is low, taxes can be high, and the dollar keeps losing value.
When I purchased the 300-unit apartment house, I was investing for cash flow. The difference is I was investing for cash flow using my banker’s money for a higher return on investment and paying less in taxes. That is a better use of leverage.
Years ago, old-time stock investors invested for both capital gains and cash flow. Old-timers still talk about the price of a stock going up as well as paying the investor a dividend. But that was in the old economy, the old capitalism.
In the new capitalism, most paper investors are looking for the quick buck, to make a killing. Today, the big investment houses are hiring the smartest whiz kids out of college and using the power of supercomputers and computer models to look for the slightest market patterns they can exploit.
For example, if the computer picks up a 1 percent differential, let’s say in tech stocks, the investment house will bet millions of dollars, hoping to gain 1 percent on millions of dollars in a few hours. This is very high leverage, and very risky.
These computer models also cause a lot of volatility in the markets and often cause crashes. When the stock market announces that program trading has been halted, it is talking about these computer programs being halted. The markets crash if the computers say sell. If the computers say buy, the markets boom, and then they crash. In other words, prices can go up or down for no fundamental or business reason at all.
A stock price may have no relationship to the value of the company because the computers created an artificial supply or demand. Just as in the dot-com era, we have companies that fundamentally are not companies, but rather just good ideas, valued at billions of dollars.
As an old-time investor in this new era of capitalism, I must be smart enough to invest for capital gains, cash flow, leverage of debt, and tax advantages, as well as be above the turmoil the whiz kids and supercomputers cause in the marketplace.
Editor, Rich Dad Poor Dad Daily