Posts filed under “Rules”

10 Rules for Dealing with the Sharks on Wall Street

10 inviolable rules for dealing with the sharks on Wall Street
Barry Ritholtz
August 31, 2012



Back in 2001, a very curious deal was struck between the government of Greece and Goldman Sachs. It was an exotic dollar/yen swap for euros. What possessed Greece to do such an unusual — and expensive — financial transaction? It needed help to hide its large and rapidly growing debt in order to maintain its status as a euro-zone member in good standing.

Both parties had something to gain. Greece created the false appearance of being in compliance with the Maastricht Treaty. This mandates that European Union member states with high debt levels must reduce their debt-to-gross-domestic-product ratio. And Goldman Sachs scooped up a ridiculously large 600 million euro fee. According to Bloomberg News, this accounted for “about 12 percent of the $6.35 billion in revenue Goldman Sachs reported for trading and principal investments in 2001.”

Once again, a new group of rubes got rolled by The Street.

I know what you are thinking: Those silly Greeks. Something like that could never happen here. Before you begin tsk-tsking, allow me to point you to the latest group of suckers to get taken in by The Street’s three-card monte: the Poway Unified School District in San Diego. It took a page from the Greek school of bad finance, agreeing to an exotic and costly bit of Wall Street shenanigans. Despite the district’s strong tax base and good credit rating, its officials bought a complex Wall Street-originated exotic loan offering.

Reminiscent of the bubble days of exotic mortgages, this debt deal makes no payments for 20 years. Over the course of the 40-year financing, it pays a very rich tax-exempt interest of 6.8 percent. Had the district done a straight-up school bond offering, it would have paid 4.1 percent. Over the course of 40 years, this interest rate differential is enormous. Poway borrowed $105 million. Instead of paying $300 million for a normal bond offering, the townspeople are going to pony up nearly $1 billion.

I learned of this festering financial debacle courtesy of the investigative reporting of Will Carless at the Voice of San Diego.

It appears there are no good actors here. What motivated this absurdity appears to be an attempt to avoid increasing real estate taxes on the school district residents. Rather than live within their budget, the district is trying its level best to become the next Detroit. The worst part of all is that by the time the bill comes due, everyone associated with this awful deal will be long gone. It’s a classic case of “I’ll be gone, you’ll be gone” financing.

It is astonishing to think that anyone involved in this mess thought that the big investment firms would help them come up with “creative financing” to resolve their budget issues. If only they’d had a helpful guideline, a set of rules for dealing with the sharks on Wall Street.

So I present “The Inviolable Rules for Dealing with Wall Street”:

1. Reward is always relative to risk: If any product or investment sounds as if it has lots of upside, it also has lots of risk. If you can disprove this, there is a Nobel Prize waiting for you.

2. Asymmetrical information: In all negotiated sales, one party has far more information, knowledge and experience about the product being bought and sold. One party knows its undisclosed warts and risks better than the other. Which party are you?

3.Good advice is priceless: I know, easier said than done. The Street buys the best legal talent, mathematicians and strategists that money can buy. Make sure you have expert advisers and lawyers working for you as well.

4. Motivation:Always ask, what is the motivation of the outfit selling me this product? Is it the long-term stability and financial health of my organization — or their own fees and commissions?

5. Legal documents are created to protect the preparer (and its firm), not you or yours: In the history of modern finance, no large legal document has worked against its drafters. Private placement memorandums, sales agreement, arbitration clauses — firms use these to protect themselves, not you.

6. Performance: How significantly do the fees, interest rates commissions, etc., have an impact on the performance of this investment vehicle over time? Determining for yourself what the actual cost of money is will avoid more heartache in the future.

7. Shareholder obligation: All publicly traded firms (including investment banks and bond underwriters) have a fiduciary obligation to their shareholders to maximize profits. This is far greater than any duty owed of care to you, the client. Always ask yourself whether this new product benefits the shareholders or your organization. (This is acutely important for untested products.)

8. Reputational risk: Who suffers if this investment goes down the drain? Who gets fired or voted out of office if this blows up? Who suffers reputational risk?

9. Keep it simple, stupid (KISS): It’s easy to make things complicated, but it’s very challenging to make them simple. The more complexity brought to a problem, the greater the potential for things to go awry — not just astray, but very, very wrong.

10. There is no free lunch: Repeat after me: There is no free money, no riskless trade, no way to turn lead into gold. If you remember no other rule, this is the one that will save your hide time and again.

If you wondered why the biggest financial firms are fighting tooth and nail to avoid having to maintain a “fiduciary standard,” just look at the fees and expenses in deals like this. There is always big money in the ongoing attempts to turn lead into gold.

The never ending parade of stock scandals continues unabated. As history has shown us — from Mexico to Orange County to analyst banking crisis to derivatives — when the Street comes a-knockin’, best you hide your wallets.


Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, The Big Picture. On Twitter: @Ritholtz.

Category: Apprenticed Investor, Rules

Checklist of Errors

David E. Hultstrom of Financial Architects submitted this list in response to our Checklist of Errors, and its a good one. You can grab a PDF of this here. Enjoy . . . ~~~ I am a long-time reader and thought I could contribute usefully to your checklist, but I don’t want to post –…Read More

Category: Investing, Rules

Words of Wisdom by the late Barton Biggs

I only recall meeting Barton Biggs once (via a Green room somewhere), but his legend preceded him. This list of quotes (Thanks J!) should give you a solid basis as to his thought process and investment philosophy: * “Good information, thoughtful analysis, quick but not impulsive reactions, and knowledge of the historic interaction between companies,…Read More

Category: Apprenticed Investor, Investing, Psychology, Rules

4 Real-World Investing Rules

When investing in the real world, textbooks and theory aren’t much help. So says Michael Comeau, in Four Real-World Investing Rules That Should Be Taught in Schools. His short list of  rules are: 1. What You Know, Everyone Else Probably Knows, Too. 2. Timing Is Everything. 3. You May Be Suffering From Confirmation Bias. 4….Read More

Category: Investing, Rules

Top 10 Investor Errors: Passive vs Active Management

This is post number five in our series, bringing us exactly halfway through our ongoing look at the most common investor errors.

This morning, we are going to briefly look at what may very well be the most common mistake investors make: Being active investors.

Passive vs Active Management

Active fund management – the attempt by an investor or manager to try to outperform their benchmarks through superior stock picking and/or market timing – is exceedingly difficult. It has been shown (repeatedly) that every year, 80% of active managers under-perform their benchmarks.

Those are not particularly attractive odds.

Worse, most active managers typically run higher-fee funds. (all that activity costs money!). That combination — High Fees + Under-performance — are not the ingredients of a winning long-term strategy. This is why for the vast majority of investors, passive index investing is a superior approach.

Why? You:

-Remove the emotional component
-Take advantage of (instead of working against) mean reversion
-Garner the lowest possible fees
-Eliminate all of the friction caused by overtrading
-Keep capital gains taxes as low as possible
-Get good results over the entire long cycle
-Avoids typical cognitive errors
-Stop chasing hot managers and funds


Consider if your portfolio won’t be better served replacing some or all of your active fund managers with passive indices.



Top 10 Investor Errors
1. Excess Fees
2. Reaching for Yield
3. You Are Your Own Worst Enemy
4. Asset Allocation vs Stock Picking

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Category: Apprenticed Investor, Investing, Rules

Top 10 Investor Errors: Asset Allocation vs Stock Picking

Our ongoing series of common investor errors continues. We have looked at Excess Fees, Reaching for Yield. and Behavioral Issues.

This morning we are going to ever so briefly look at mistake number four:

4. Asset Allocation Matters More than Stock Picking: The decisions you make as to your mix of assets has a far greater impact on your investing success than does your stock picking or market timing. This too has proven repeatedly in both academic studies and the real world.

I’ll save you the war story, but when I was on the Sell Side, I was a big Apple fan. When the first iPod came out, the company was trading at $15 (pre-split) with $13 in cash. I recommended Apple, the firm bought a ton at $15, and dumped most of it at $20 for a 33% winner.

Pretty smart, huh?

That was literally the worlds greatest stock — and it hardly mattered at all. The worlds’ greatest stock pickers all got crushed during the 2008 crisis. And a monkey could have thrown a dart at a stock list in 2009 and made a ton of money.

Consider this: If your allocation mix contained too little equities over the past few years, then you probably missed the 100% rally since stocks since March 2009. And a lack of bonds meant that during the 2008-09 crash, you had nothing protecting you as markets fell.

Stock picking is for fun. Asset allocation is for making money over the long haul.


Top 10 Investor Errors
1. Excess Fees
2. Reaching for Yield
3. You Are Your Own Worst Enemy

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Category: Apprenticed Investor, Investing, Rules

Top 10 Investor Errors: You Are Your Own Worst Enemy

Last week, I mentioned some investor errors investors make, and decided to put together a top 10 list of broad and common mistakes.

So far, we have looked at Excess Fees, and Reaching for Yield. Today we are going to ever so briefly look at mistake number three — behavioral issues in investing. (for far more details, see this collection of posts).

3. You Are Your Own Worst Enemy: Your emotional reactions to market events is yet another detriment to your results. Typically described as Fear & Greed, it is more complex than that. But for starters, Fear & Greed does enough damage.

Do you get excited about hot new companies? Do you love chatting about stocks at cocktail parties? On the other hand, do your holdings keep you up at night? Are there periods where you cannot bear to even open your monthly statements?

These all suggest that you, like most humans, are an emotional investor. This manifests itself in two ways: With heavy buying of equities at the regardless of valuation as excitement builds near the top of the cycle (most public ownership of equities occurs this way); secondly, with panicked selling, typically near major inflection points.

You can take steps to protect yourself from, well, yourself. Predetermine your exits and stick with it. Make decisions while objective, before emotional trouble hits.Set up a Mad Money account with a less than 5% of your capital. This will allow you to indulge “your inner Cramer.” If it works out, that’s great — maybe you are thr next Steve Cohen. If it’s a debacle (and the odds are it will be), it’s a terrific lesson that will serve to remind you that trading in and out of stocks like a deranged hedge fund manager is not your forte. Be thankful it wasn’t most of your retirement assets that you lost.

Your emotions are often the enemy of your financial well-being. Learn how to keep them in check, or to protect yourself from them, to become a better investor.



Top 10 Investor Errors
1. Excess Fees
2. Reaching for Yield


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Category: Apprenticed Investor, Investing, Psychology, Rules

Top 10 Investor Errors: Reaching for Yield

To start July, we are introducing a series looking at common investor errors. This is the part two of ten. Yesterday, we looked at the impact of excess fees on performance.

In the current low rate environment, many investors make the mistake of reaching for yield. That is our #2 investor error after excess fees.

The first law of economics is there is no free lunch. You would think the mathematics of that would itself be a warning as to the perils of chasing the higher yielding paper, and that it should be self-explanatory. But its not

History shows us there are few investment mistakes more costly then “chasing yield.” Fixed income is supposed to be your safe money, what you have to have back, what will cushion the ups and downs of the equity markets. Hence, you should be first concerned with return of your money, and second, the return on your money.

In other words, safety first for your bonds and preferred.

Don’t take my work for it, just ask the folks who loaded up on sub-prime mortgage-backed securities for the extra yield how that worked out for them.  Some people have suggested I cut the RMBS investors some slack, as the paper was rated AAA. I don’t because they willingly violated the Free Lunch edict.

Quick war story: In 2004, I worked at a firm that was occasionally pitched products from other shops. One day, I walked into the conference room to hear Lehman Brothers offer a higher yielding fixed income product. “AAA rated, Safe as Treasuries, yielding 100-300 basis points more. I was subsequently called into my bosses office for saying:

You guys are either going to win the Nobel prize in economics or go to jail. There is nothing in between.” (Does a firm ending faceplant count as the equivalent of the latter?)

Regardless, we know the outcome of THAT free lunch.

There are three common ways to chase yield: 1) Go out on the duration curve, i.e., buy longer dated bonds; 2) Go down the credit scale, i.e., buy junkier, riskier paper;  or 3) use leverage, which amplifies your gains but also amplifies your losses as well.

With the 10 Year Treasury at 1.6%, I see lots of folks trying to capture more income using some combination of the above. Anyone who engages in this sort of ill-advised risky behavior should best understand the risks you are taking, and what that might mean if and when things go awry.

Simple rule of thumb: Never reach for yield.


What are you chasing for Yield?



Top 10 Investor Errors
1.  Excess Fees


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Category: Apprenticed Investor, Investing, Rules

Top 10 Investor Errors: Excess Fees

Earlier this week, I mentioned a short list of common errors many investors make, and cobbled together a top 10. Readers had a number of very astute and specific suggestions.

For my list, I wanted to keep it as broad as possible

During each of the next 10 days, I want to flesh out these ideas in some more detail. While I am traveling, I will post one per day in no particular order, starting with today.

The first error we are going to look at are high fees.

You can define fees in a variety of ways, but to me, its any non-investment spending relative to your portfolio that detracts from long term performance.

These can include:

-Mutual Fund Loads
-Advisor fees
-Management fees
-12b-1 fees
-Performance fees

The bottom line is simply this: High fees cut into your returns. Every academic and industry study that has ever looked at this issue has determined that fees are an enormous drag on long-term performance. Typical mutual fund or advisor fees of 2-3% may not sound like a lot, but compound it over 30 or 40 years and it adds up to an enormous sum of money.

One Morningstar study found that while 10% of mutual fund managers regularly outperformed their benchmark, net after fees that number dropped to 1%.

The hedge fund fee structure of 2% plus 20% of the profits is even more of a drag on returns. Other than a handful of superstar managers (that you likely don’t have access to), the vast majority of hedge funds simple cannot justify their costs. Speaking anecdotally, my experience has found that to be true for most of the retail stock brokers and for many of the investment advisors that work on Wall Street.

Its as true for investment advice as it is anywhere else, the wealthy get a better deal. Fees typically drop significantly on accounts over $1m, then even more over $5m and $10m dollars.

Sub $500k accounts pay the highest fees as a percentage of dollar invested. I have a few ideas I want to put into place in the coming quarters to lower these fees appreciably, especially for the accounts under $500k and $100k. I don’t believe these accounts typically get especially good service or performance, and I have a few strong ideas about how to change that structure.

Across all of my managed asset clients, my goal is to keep fees down at an average of ~1% or less. (it is not an easy target). Investors should expect to pay a little more for smaller portfolios, and somewhat less for much bigger portfolios.

What fees are you paying?


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Category: Apprenticed Investor, Investing, Rules

Errors and Checklist for Investors

I am working on a checklist of the most common errors investors make. I have my own top 10, but I would love to hear other people think are important. Here is my short list: 1. High Fees Are A Drag on Returns 2. Mutual Fund Are Inferior to ETFs 3. Reaching for Yield is…Read More

Category: Apprenticed Investor, Investing, Rules