PREFACE

We wrote this book for all sorts of investors, from novice to experienced professional, because all of us knew—independently and at different times—that something was very wrong with the financial services industry (or simply financial industry, in this book), especially its fastest-growing sector: the securities sector and its huge investment management and advisory services arm. We wanted to explain this problem and then offer an easy-to-use solution.

Michael made an important discovery almost immediately after receiving a degree from MIT and a PhD in mathematics from Northwestern, when he joined a brokerage firm known for its use of sophisticated mathematics. He found that although the firm’s representatives spoke to clients in a language laden with mathematical terms (e.g., “This fund has a low beta but its alpha is high”; “The portfolio has the highest expected return for its standard deviation”), they actually knew nothing about the mathematics and the mysterious formulas and algorithms behind their statements.

Kwok, a professor and renowned statistician whose career spanned roles at Bell Labs and several universities, knew that almost all claims of “beating the market” arose from practices that statisticians recognize as unprofessional and downright wrong. For example, investment firms often boast about strong returns on their investment products—mutual funds and such—in their marketing materials. If you were to read the fine print in these documents, you might uncover the data “supporting” these claims. What Kwok recognized, however, is that many firms do what statisticians call cherry-picking: selecting from a vast body of data only those data points that back up the desired claims, and ignoring the mountain of research that disproves those claims. In other words, investment firms typically reveal only what they want investors to see.

Carol became a financial advisor following an MBA from MIT’s Sloan School of Management and a successful career in management consulting. While working for a large brokerage firm, Carol grew dissatisfied with the direct and indirect fees that the firm charged her clients, and with the lack of a formal responsibility to act in the client’s best interest. Today she continues to see complicated descriptions, fancy terminology, and opaque fee structures mislead hardworking investors, who are tirelessly saving to achieve their dreams.

George was a liberal arts major at Georgetown University who became a financial advisor. He naturally assumed that the methodologies that the industry and his employers promoted were correct. But gradually, over a 20-year period working for several of the best-respected financial firms, he began to realize that most of the foundational assumptions and “best practices” didn’t make sense. For example, increasingly over time, every firm he worked for made a key sales point out of the fact that they would “optimize” a client’s portfolio by running a scientific asset allocation; but actually the process was nothing but GIGO: garbage in and garbage out.

Collectively, we authors have concluded that by honing marketing pitches, the financial industry has created a false framework of concepts that it conveys to clients and sells to prospects. With only a few notable exceptions, the confusing proliferation of investment services and products is of no value to any investor. A minuscule subset of the investment products and advice available—the simplest and least costly ones—are all that an investor really needs. To opt for the more complex or confusing investment vehicles and advice is merely to pay a lot for nothing.

WHO SHOULD READ THIS BOOK—AND WHY?

This book is for every individual or family who invests their savings, has a 401(k) or other tax-deferred vehicle or pension fund that is managed on their behalf, or has merely heard about investing and might do it sometime. It is also for everyone who advises or consults on investing, who manages, oversees, or administers investments, including big wheeler-dealers. To all of these readers, we’ll be telling them that everything they thought they knew about investing is wrong. This declaration should not be that surprising. As many of us remember, a very big investment firm, Long-Term Capital Management, went straight down the tubes in 1998, even though it was run by Nobel laureates in economics and finance. Giant banks, with the money to hire top investment talent, also discovered in 2008 that everything they thought they knew about investing was wrong. As news stories about banking disasters around the world continue to reveal, “experts” keep reaching this sad conclusion with depressing regularity.

The everything that you thought you knew about investing, as noted in our book title, is different depending on which sort of investor you are. Let’s see how the “why” varies with each “who.”

Novice or uninformed investors might think that frequent trading of securities will make a lot of money. Millions of investors trading furiously at their computers this very moment suffer from this delusion, believing that they’re making money—or wondering why they’re not.

Ordinary individual investors also fall victim to misconceptions fed to them and reinforced by a vast array of “helpers.” These helpers comprise a pantheon of advice givers, some of whom may not realize that they’re lending support to misconceptions: financial advisors, financial journalists, radio and television personalities, and financial academics. Even the most conscientious helpers often don’t know that many of the things they think are true about investing are, in fact, wrong. They are themselves victims of misinformation—such as the cherry-picked data and “sophisticated” math lingo we described earlier that promise low risk and high returns—and they unwittingly victimize their clients and audiences in turn.

Other types of ordinary individual investors, informed in the investment field through helpers’ counsel, their own research, or both, may believe they’re doing all the “right” things prudent and smart investors do: making sure to contribute to a 401(k) plan, rebalancing or diversifying their portfolios regularly, putting money in target-date funds, and dollar-cost averaging. Many of these practices, however, are of no use, with some even losing investor dollars.

Less ordinary, so-called sophisticated investors—such as very wealthy people, retirement plan administrators, endowment fund managers, and investment consultants—suffer from different misconceptions. Consider the individual-investor victims of Bernie Madoff—members of the socioeconomic elite. Many of them clamored for Madoff’s investment advice based on the recommendation of friends and family, fellow members of the much-touted “1%.”

Investment professionals—retirement plan and endowment fund managers, investment consultants, and so forth—often have joined a financial firm believing in its stated mission. Accepting organizational values like offering focused attention on unique client needs or helping create security for future generations, these service professionals believe—as George did at first—that they’re helping their clients. But the strategies their firms offer to make good on those values are usually riddled with misconceptions, many of which serve only to enhance the revenues of the firms. And if employed at one of those five or so investment banks that are still often described as “too big to fail,” they’re victims of another misconception: that the mathematical risk models their firm uses protect against disaster. Actually, these models are nearly worthless.

Administrators of large public pension or university endowment funds—and wealthy individuals, too—typically engage a consulting firm that may recommend investing in alternatives like hedge funds or funds-of-hedge-funds. These types of investors probably don’t realize that bloated payments for these all too often inferior alternatives heedlessly squander their money—money that was to protect heirs, finance charities, support needy university students, or secure the pensions of city employees like firefighters and teachers.

And for readers who are financial academics or investors with a technological bent and a fondness for cutting-edge ideas, the misconception dogging them is that employing a quantitative strategy, using an 18-factor mathematical model, or replicating hedge funds will make them millionaires. What they don’t realize is that, again, such models aren’t as effective as they sound and that the fees hidden inside these investment strategies will obliterate the return—if any—they might get.

If you recognize yourself among these types of investors, then we encourage you to read on.

PLAN OF THE BOOK

We begin our main discussion in the introduction, where we describe our recommended “Simplify Wall Street” portfolio, as well as explain why Wall Street and the mainstream financial industry don’t want you to hear our advice. We’ll explain how these entities make their money, and we’ll clarify the terminology and numerical assumptions that we use in Part I.

Part I describes the 3 Simple Rules of Investing, with a chapter dedicated to each one. The first rule is to ignore 99.9% of all the investment alternatives offered to you by the financial industry. That’s not a misprint: a huge number of investment products are available, but 99.9% of them are of no use to any investor. We’ll tell you which two or three should be your mainstays, and a few more that will do no harm and could be helpful.

The second rule is to invest by looking forward. That recommendation may seem rather obvious, but it’s not what most people do. Most people—and their advisors—comb through historical investment performance figures to decide how to invest. Because that information is about as relevant to your investing future as the price of wool in Uzbekistan, you should learn to ignore the past and look only forward.

The third rule is to screen out almost everything that Wall Street and the mainstream financial and investment advice industry tell you, because almost everything they tell you is simply wrong. Tuning out the noise will free you up to pursue simpler yet more rewarding investing strategies.

Following these three rules means taking control of your own financial future. Therefore, it also involves your coming to grips with risk and uncertainty. Let this modified version of Reinhold Niebuhr’s famous “Serenity Prayer” guide you: “Grant me the grace to accept with serenity what I can’t foresee, the courage to plan for what I can, and the wisdom to know the difference.”

Because our 3 Simple Rules don’t include most of the standard recommendations from the investing community, financial media, and academia, we’re going to have to explain why they don’t, or you won’t believe us. This is the objective of Part II, with a chapter dedicated to each of the investing world’s 7 Deadly Temptations. Seductively appealing, these seven claims and recommendations have been molded over many years to sound “right,” through a trial-and-error process of testing client reactions. We’ll tell you why they are all wrong, meaningless, or inapplicable in the real world.

We’ll begin with the temptation to beat the market. Aside from whether it makes sense as a primary goal, both theory and evidence compiled over decades of research show that beating the market is about 99.9% luck and no more than 0.1% skill.

A second and very seductive temptation is to seek wise counsel. Of course this is fine advice—wise counsel can be very valuable. Our real concern is, is the counsel truly wise? So-called wise counsel—no matter how well intentioned it seems or how smart it sounds—may simply lead you into further temptations, temptations that are, at best, of no value and, at worst, will destroy your finances—due partly to the cost of the counsel itself.

A third temptation is to decrease risk and increase returns by submitting to a mathematically calculated asset allocation. Providers of “wise counsel” often use this temptation to entice prospects to become their clients. As we’ll show, however, asset allocation is usually a meaningless exercise (whether the professional advisor realizes it or not) that has to be laboriously rigged to produce acceptable outputs. It does nothing to improve your investment results.

A fourth temptation is to control risk by applying discipline to your investing approach. Of course you want discipline and risk control—who wouldn’t? But many falsehoods and enticements to pay extra fees can lurk in the folds of this temptation. Furthermore, the mainstream financial industry construct of “risk” is different from how average investors define the term. We’ll tell you how understanding this difference can save—and make—you money.

A fifth temptation is to do the things that always work—except that they don’t. These include activities almost always regarded as best practice, so no one doubts that they are correct, such as “Always fund your 401(k) to the max,” “Regularly rebalance your portfolio,” and “Dollar-cost averaging increases return and reduces risk.” The problem is that all of these conventional wisdoms are wrong.

A sixth temptation is to do what the most wealthy and supposedly sophisticated investors do, in hopes that financial reward follows. This temptation often motivates people to hire (at high cost) a major brand-name investment manager or advisor. If you had the chance to have Goldman Sachs as your investment advisor, wouldn’t you do it? You may not believe this, but as we’ll see in Deadly Temptation #6, if you had invested with Goldman Sachs in recent years, your investments would have performed far worse than most of the alternatives.¹

And the final temptation: use modern scientific financial theory. Nothing is both more seductive and more mind-muddling than the idea that finance uses “science” and “technology.” We’ll show you that, if the finance industry even uses science and technology at all (which is rare), not only does it not get better results, but the science and technology themselves aren’t even that sophisticated and actually are often inaccurate or wrong.

George and Michael follow the 7 Deadly Temptations with an epilogue that will show how our Simplify Wall Street investment strategy might achieve far more than greatly enhancing your own investment prospects. It could also inspire a collective movement to help reduce systemic financial risk and economic and political inequality, and help eliminate the overconcentration of power in the hands of a rich few. The global financial crisis (GFC) of 2007-2009 triggered a lot of discussion about how to regulate banking and finance to prevent more crises. But another way to change the industry is through mass action, by boycotting those investment services that are of no value to clients—namely, the vast majority of them. The more investors adopt some or all of our book’s recommendations, the more they can help reduce the financial complexity that creates systemic risk and global crises.

Following our simple strategy not only benefits your own financial health, but represents a step toward healing the entire financial system—our iteration of “think globally, act locally.”

THE 3 RULES OF INVESTING WEBSITE

References to this book’s website, 3rulesofinvesting.com, appear throughout our discussion. The website goes into more detail about some topics and also shares useful tools, timely news, articles, book updates, and corrections to the book (if there are any). Also included is a page of clickable links to all the reference materials and websites that are mentioned in the book, a forum for discussion, and ways to contact us directly.